Monday, 29 August 2016

Time to tax ex-pats

Apparently, John McDonnell, the shadow chancellor, wants Sir Richard Branson to be stripped of his knighthood. Why? Because, he claims, Branson is a tax exile living (for most of the time) on his private island in the Caribbean (well the British Virgin Islands to be exact).

According to McDonnell:
"The whole purpose of the honours system is undermined when the rich and the powerful can collect their gongs without giving anything back. It's even worse when tax exiles are given honours."

Now John McDonnell may have a point, but is his solution the right one? Is the right solution to strip Branson of his "gong"? Or is the better solution to make him pay more tax in the UK?

According to McDonnell the problem is the honours system but I would argue that the real culprit is the tax system. What we are dealing with here is tax avoidance, even if Sir Richard Branson claims his choice of residence is driven by the scenic location and not the potential tax advantage.

Sir Richard Branson is, however, not the only alleged tax-avoiding knight to be domiciled outside the UK. Sir Philip Green has attracted controversy recently, and it is probably only a matter of time before a neighbour of his in Monaco, Lewis Hamilton, receives his own gong as well. So why does this matter? Well, because this issue highlights one of the key issues in tackling tax avoidance: residence.

In previous posts I have discussed how different types of corporate tax avoidance schemes work such as transfer pricing and the abuse of debt interest relief. Other possible techniques involve the abuse of royalty payments, but more on that some other time. Unfortunately it is not just corporations that are guilty. The super-rich, celebrities, sports stars and entertainers are all complicit. And so too are millions of middle income professionals living and working in places like Dubai, or retiring to sunnier climes with lower tax rates. In 2010 it was estimated that 3.97 million Brits were living abroad. Today the figure is probably even higher. Most are earning much more than the average wage in this country and many are earning that money virtually tax free. As I pointed out when discussing Brexit, tax avoidance within the EU is a major factor in undermining the finances of sovereign member states, but so too in tax avoidance from outside the EU.

At the heart of the problem is the tax system itself and its rules. Most countries only tax people who are resident in that country. Additionally they may tax their citizens living abroad, but only on income earned in their native country. The exception is the USA. Only it of all the industrialised countries taxes its citizens wherever they live.

What is now becoming abundantly clear is that taxing individuals on the basis of either their country of residence or the place/location/country of their income does not work. In a globalised world with freedom of movement of labour and capital it is impossible to definitively allocate a person's earnings to a single territory. The result is that it is relatively easy for the rich (and not so rich) to avoid tax to the detriment of their fellow citizens whose employment is less mobile. The only way to solve this problem is to tax people based on the thing that they cannot change or disguise easily: their nationality. So why don't we?

Well part of the reason is historical, but another reason is the EU, and in particular the single market. Single market rules currently prevent us from taxing our citizens living in the rest of the EU, but as we are about to leave the EU there is now no legal reason why we couldn't follow the example of the USA. If we did we could also apply the same rule to UK citizens living in overseas crown dependencies like the British Virgin Islands, the Isle of Man and the Channel Islands. 

So how would this work? Well tax should be payable in two stages. The first obligation should be based on residence (as now) with all individuals being obliged to pay tax first on income derived in their country of residence to the government of their country of residence. However, the second stage would be based on nationality with the payee paying additional tax to their country of origin (i.e. the UK) equal to the difference between what they would be expected to pay if they resided in the UK and all their income was generated in the UK, and the tax on their total global income that they do pay. 

So, for those who are already living in countries that do tax their income on the basis of residence, standard double taxation rules should apply with the UK citizen paying the difference to the UK Treasury between what they pay abroad and what they would pay on their entire global income if they had remained in the UK and all their earning had been generated in the UK. For completeness we should of course continue to tax overseas nationals on their earnings in the UK based on residence. 

In short, the only changes would be that British citizens living abroad would be obliged to pay tax as if they lived in the UK while British citizens living in the UK would be taxed in the UK on their worldwide earnings. 

Taxing UK citizens in this way would have a number of positive advantages. Firstly, it would be easier to enforce. Secondly, there would be no tax advantage for UK nationals to move their country of residence away from the UK. That would make it easier for governments to adjust the tax rates without losing tax through avoidance schemes. Thirdly, it would reduce emigration of highly skilled professionals such as doctors. Fourthly, it would reduce demand for tax havens, and finally it would increase tax revenues. In fact it could raise over £100bn in extra revenues; enough to fund the entire NHS. And then if UK citizens did still decide to go and live on their own private Caribbean island, we could at least be more certain that the decision was more likely to be motivated by a love of the scenery and not by a love of their bank balance.

Monday, 15 August 2016

MMT vs the bond market

Why do governments borrow from the bond market? Is there a better way for governments to finance their deficits than this? If so, what economic factors should determine where governments need to look for finance? These are questions that I have been asking myself over the past few months and years, but I seem to be in a minority. Certainly most mainstream economists don't seem to be that bothered, but I think they should be because it is becoming pretty obvious that the old ways don't work any more.

This week the Bank of England cut interestrates to 0.25% and embarked on a new wad of quantitative easing (QE) in a bid to head off recession. Now I pointed out a few years ago that lowering interest rates to near zero will have practically no effect on stimulating extra demand for credit and so will not create new demand via increased consumer spending in the real economy either. Only a fiscal stimulus will do that but this government has set itself against doing anything that remotely resembles Keynesian interventionism. But as I pointed out last time, even governments that are supposed to believe in Keynesian economics have consistently failed to apply sufficiently large fiscal stimuli during major recessions.

Yes they increase welfare spending, but only because unemployment has increased and that has forced their hand. Meanwhile, they compensate by cutting spending in other areas to try and minimise total borrowing. These cuts often further increase unemployment and lower GDP. This leads to the austerity that we have been familiar with over the last eight years, and while welfare spending has still increased, it has often been undertaken grudgingly and parsimoniously. Consequently, while government spending increases, it does not increase fast enough to reverse the effects of the recession. The result is the recession is longer and deeper than it needed to be and chancellors like George Osborne continuously miss their deficit targets.

So while the government may claim that their actions are Keynesian because they are increasing spending and borrowing in the recession, their actions cannot in any way be considered to be within the spirit of Keynesianism because they make no attempt to restore the economy to full employment or maximum output. But this failure to adhere to Keynesian orthodoxy is not totally ideological. As I pointed out previously, the last Labour government was almost as obsessed with deficit reduction post-2008 as the Tories have been. What drives this fiscal trepidation is fear and loathing about debt. In the aftermath of the 2007 crash the worry was all about debt to GDP ratios and sovereign default. We were bombarded with threats to our credit rating from the very credit agencies that partially created the financial crisis in the first place. We were told that if we borrowed too much we would end up like Greece. But all this was bogus economic scaremongering for two reasons.

Firstly, unlike Greece we had control of our own currency, and secondly all our debt was denominated in our own currency. No developed country has ever defaulted on its sovereign debt when that debt has been denominated in its own currency. But there is another more important point that needs to be appreciated when it comes to sovereign debt. Who you borrow from matters just as much as, if not more than, how much you borrow.

To see this consider these two examples. Greece currently has a debt to gdp ratio of 180%. As a result most economists consider Greece to be essentially bankrupt and incapable of paying back what it owns. Most expect it to default sooner or later. Japan on the other hand has an even higher debt to gdp ratio of 230% but no-one expects Japan to go bust. Why?

The answer is because Greece owes virtually all its debt to foreign creditors (ECB, IMF, German and French banks) in a currency that it cannot print, cannot control, and cannot devalue. Even if Greece left the euro its new currency would devalue and its economy shrink relative to its economic competitors, but its debt would not. So its debt to gdp ratio would skyrocket even further.

Japan's debt on the other hand is owned mainly by its own citizens and domestic banks and corporations and is also denominated in its own currency. The Japanese government can never fail to repay its debts because it can always raise taxes on the people it owes money to in order to pay them the money it owes them. As a result it can never run out of money and the money it pays out in interest and maturity repayments never leaves the Japanese economy. The only risk to the Japanese government is loss of confidence by the public in the government and a rush to liquidate the bonds they hold, but this can be avoided in two ways. Either the government can impose fixed maturity dates on the bonds or savings, or it can borrow from itself in the form of its central bank (like QE). This latter mechanism is the essence of what is known as modern monetary theory or MMT, which I will discuss further in a future post, and what this and previous posts are intended to provide the justification for.

What this shows is that when it comes to national debt, borrowing from within your own currency area is more sustainable than borrowing from outside it. In short, countries that borrow internally instead of externally from the bond market can never go bust. This is one major reason why countries should shun the bond market, but there are other good reasons as well.

Every time a government borrows from overseas it is adding to the current account deficit. The UK gilts created are in effect exchanged for foreign currency which can then be used to purchase additional goods from overseas. This happens without an equal amount of production having taken place inside the UK and then exported. Alternatively, the foreign currency is first converted to sterling in order to buy the gilts, thereby leading to a strengthening of sterling on the currency markets. Neither of these effects is desirable.

So what is clear is that conventional methods of government borrowing come with a significant sting in the tail, and yet as QE has shown, these stings are often unnecessary and could be avoided. So why does most of the mainstream economic community not appear to get this? Why don't they recognise that there might be better ways for governments to finance their deficits and to run the economy?

Well one reason that they continue to use the bond market is perhaps because that is what they have always done. In the times before fiat currency and free flows of capital governments needed to physically borrow other people's money in order to spend it. Money creation was not possible. But I think there is a deeper problem. Economists don't think like physicists. A physicist will always tackle a problem by simplifying it to its core. This means first considering a closed system problem and then looking at system leakage as a perturbation to that initial system. Economics on the other hand seems obsessed with open systems, globalisation and free trade.

What I think MMT could do is allow a government to more effectively internalise its economy and protect its currency. It could enable it to borrow unlimited funds (from its own central bank) in a recession in order to enact a proper Keynesian response to a financial crisis. This in turn could be used to fund investment, job creation or helicopter money which would be far more effective than cutting interest rates to zero or providing QE for banks. The result could be much greater macroeconomic control and shorter and shallower recessions.

Thursday, 11 August 2016

Who is afraid of the bond market? The paradox of Keynesianism

One of the added benefits of Brexit is that it has finally forced the government to kill off George Osborne's tenure at No. 11 Downing Street and thus abandon his insane attempts to balance the country's finances through austerity. But it would nevertheless be unfair to blame George Osborne entirely for the austerity of the last six years. Why? Because he was only doing what most mainstream economists and the opposition Labour Party were telling him to do, only doing it better.

The problem is this. Cast your mind back to the 2010 general election and remind yourself of the options that were available to the electorate. In essence there were only two: Osborne with his austerity-max, and the Labour Party with its austerity-lite. Neither were very appealing, but more pertinently, neither had any basis in macroeconomic theory, or more specifically in that part we consider as pure Keynesianism.

According to Keynes, the appropriate fiscal response of a government in a recession is to cut taxes and increase spending. The aim is to increase aggregate demand in the economy to compensate for the fall that has induced the recession thereby helping to rebuild confidence and restore output to pre-recession levels. Unfortunately there is a problem with this plan: nobody seems to have the necessary bottle to carry it out. This is because the plan as it is conventionally implemented contains a fundamental flaw. That flaw is debt.

In a recession incomes and employment levels fall and hence so too do tax revenues. In contrast unemployment levels rise and so consequently does social security spending. As a result the government budget deficit grows more negative and the national debt increases. And the bigger the recession, the bigger the deficit and so the bigger the borrowing requirement will be. Now in theory this shouldn't matter because a government that prints its own currency can never run out of money, but in practice it does matter because economists and the financial markets obsess about debt to GDP ratios and sovereign default, and driving this fear are the IMF, the bond market and the credit agencies.

The consequence of this is that in a recession when Keynesian theory demands that governments borrow whatever is necessary to get the economy moving again and operating back near full capacity, the bond market is urging caution and threatening to restrict credit. So in 2010 even though UK gilt yields were at historic lows and government borrowing was dirt cheap, all the talk was about reducing borrowing as quickly as possible to prevent market bond rates rising and our credit rating falling. Yet paradoxically, before the crash when the economy was booming and the government should have been discouraged from borrowing, there was no such alarm in the markets about UK debt and borrowing was positively encouraged.

This is the paradox of current Keynesian economics. When your economy is in a deep recession and Keynes says "borrow borrow borrow", the bond market wants to do the opposite. Yet when the economy is booming and Keynes says governments need to operate a surplus, the bond market is quite happy to lend you anything you want. Just ask Gordon Brown.

So in 2010 instead of both main political parties promising to cut taxes, raise welfare payments and increase investment as Keynesian theory demands, both political parties promised to do the opposite, but by slightly different amounts (obviously) in order to at least maintain a pretence of economic and political pluralism. All of this should therefore make economists think seriously and critically about what they really understand by Keynesian policies and how they can implement them because what this clearly demonstrates is that the current paradigm that they adhere to just isn't working. Not only that, it can NEVER work.

Fortunately there is a solution. That solution is Modern Monetary Theory or MMT. (To be continued...)