The case for hard Brexit

For all the talk of Brexit meaning Brexit what has become abundantly clear over the past few months is that most politicians and political commentators haven't got a clue what Brexit means or should mean, and nowhere is this confusion more apparent than in the Labour Party. At the heart of this confusion is the single market. Time and again we hear politicians from both the Leave and Remain camps declaring that while we might leave the EU, we will still need to be part of some aspects of the single market. On this they are all completely wrong to the point of delusion.

The problem is not that they want to cherry-pick which parts of the single market they want to keep, and thereby appear to trying to have their cake and eat it. The problem is that (a) they clearly do not fully understand what "access to the single market" (as they term it) means or entails, and (b) they have still failed to realise that all aspects of the single market, not just the freedom of movement of people, represent an existential threat to the very concepts of nationhood, sovereignty and democracy in the UK and in the rest of Europe. As a result it is not just small parts of the single market architecture that we need to reject, like the free movement of people, it is ALL of it.

Today Theresa May finally seemed to get some of this. Speaking from the same venue, Lancaster House,  where Margaret Thatcher once extolled the virtues of the single market, the current prime minister finally admitted that Brexit is incompatible with single market membership. Of course the big irony in this whole debate is that the single market in its current incarnation is primarily a child of unbridled Thatcherism. It is economic neo-liberalism in its purest form. In which case one would think that the Labour Party should be the party above all others that opposites it tooth and claw while the Tories should be the most vociferous advocates. It's a strange old world. No wonder the public are confused.

As we are forever being told, the single market is constructed around four fundamental freedoms: the freedom of movement of goods, the freedom of movement of labour, the freedom of movement of capital, and the freedom of movement of services. This is my reasoning on why we need to reject all four of them.

The freedom of movement of goods

On the face of it this is the one aspect that everyone agrees that we should keep. After all we are all in favour of free trade aren't we? Well yes, maybe, up to a point (although in a future post I may proffer a more contentious view). But we can protect most free trade using World Trade Organisation (WTO) agreements, and as most global tariff barriers now average less than 2%, any further reductions will have diminishingly small economic gains. Unfortunately this aspect of the single market goes much further than just free trade. It also seeks to create a "level playing field" within the EU by prohibiting any form of state aid and outlawing any government action or policy that could be construed as having distorted the market. Now while this may appeal to the neoliberal free marketeers, it should fill anyone with a social conscience with profound horror.

This freedom, in concert with EU competition law, effective curtails many socially progressive state interventions, ranging from taxation policy (such as minimum pricing of alcohol) to industrial strategy such as support for key industries like steel or nuclear power. If we accept the freedom of movement of goods, then we will be compelled to accept the rest of EU competition law and thereby be prevented from running our own economy in a way that allows us to protect it against external shocks and predatory pricing from outside the EU. If we can't set minimum prices for socially damaging substances like alcohol, then we can't set minimum prices for anything else such as labour. So you can kiss goodbye to the national minimum wage. If we can't support key industries in a recession then you can kiss goodbye to Keynesian economics. In short you can kiss goodbye to any form of economic choice at the ballot box. That is one reason why support for social democratic parties has fallen across Europe. It has fallen because those parties can no longer offer the policies that they once could. Instead they are forced to offer a sanitised version of centre-left neo-liberal economic orthodoxy and so democracy effectively dies.

The freedom of movement of labour

The negative effects of this part of the single market have become obvious. More than any other it has led to mass migration across the continent and widening inequality in all member states. The result has been catastrophic depopulation in the east and high structural unemployment in the west. Yet it didn't need to be this way.

Before most of the eastern former communist states joined the EU they were granted interim status where they were able to trade freely with the EU but had no freedom of movement of people, much as many Brexiteers want for the UK now. The result was that firms inside the EU, including a number of major German car manufacturers, moved some of their production out of the EU and into these states attracted by the lower wages and supply of labour. The jobs moved to where the labour was. Then, when these states gained full membership of the EU it all changed. The jobs stopped moving east and the people were forced to move west instead. Why? Because it was cheaper and more profitable for the corporate sector for people to move to where the jobs were rather than the opposite happening. The result has been one of the greatest economic migrations Europe has seen since the Irish potato famine of the 1840s, and both have been driven by the same laissez-faire liberal economic free-trade ideology.

This highlights one of the key objections to the freedom of movement of labour: it transfers the economic cost of matching jobs to people from the firm to the worker. In effect the costs are socialised and the gains are privatised. There is nothing remotely socially progressive about that. In fact it smacks of moral hazard as was illustrated in extremis by the financial sector pre and post 2007 where the benefits of an unequal system are privatised and the costs socialised. The result for member governments is also potentially calamitous. Their potential liabilities in terms of future welfare and education payments will become unlimited due to immigration while their income could become squeezed by tax avoidance from an increasingly mobile upper-middle class. The result would be either economic insolvency at a national level or a collapse in public services, and before either of these happens we would see a rise in income inequality and unemployment as migrant workers drive down wage rates ever further.

Then there is the effect on tax revenues. Those that support freedom of movement claim it benefits the UK economy, that it leads to increased taxes and that immigrants make fewer demands on public services than the average UK citizen. What they fail to note is that many migrants are temporary and so are exempt from UK tax, and those that stay often send money back to their country of origin. According to the World Bank (pdf) this could be over $11.5bn. This has the double whammy effect of both reducing jobs and GDP per capita in the UK and worsening our current account deficit.

So freedom of movement of labour represents a complete volte-face in terms of economic rationale. It treats workers as little more than a commodity that exists to serve the economic machine rather than treating the economy as a system designed to optimise the happiness of the individual. When coupled with other measures that effectively remove any form of democratic choice for the individual, then it really is the stuff of a some nightmare dystopian future that has so far only really existed in the pages of a few sci-fi novels.

Even more worryingly given that most in the Labour Party appear to support it, it is not even remotely socialist. For a start you cannot have full employment if you have open borders because the faster you create jobs the more migrants will flood in. It is like trying to bail out a rowing boat with a hole in the bottom. And if social democracy is about anything it is about aiming for full employment. On top of that freedom of movement of labour increases inequality. It allows rich countries to strip poor countries of their best talent to the disadvantage of the least well of in both countries. So much for international solidarity.

The freedom of movement of capital

The ability to move capital freely between member states may at first glance seem relatively harmless, but actually it has had a major detrimental impact on the ability of states to balance their budgets. The recent controversy over Apple's tax dealings with Ireland illustrate how multinationals can exploit the freedom of movement of capital to avoid tax. And it is not just Apple. Google's Dutch double-Irish sandwich tax avoidance scheme also plays heavily on this freedom, not to mention that of GSK and many others.

It is of course not just corporate tax avoidance that benefits from the freedom of movement of capital. Tax avoidance by individuals does as well. In my last post I argued for the taxation of UK ex-pats, partly as a way of tackling tax avoidance by the rich. Yet as long as we are in the EU, and more importantly, obliged to respect the freedom of movement of capital such measures will be impossible. In short freedom of movement of capital is at the heart of most tax avoidance, and so as long as we cling to it we will be unable to tackle the scourge of tax avoidance and governments will find it ever harder to raise the taxes they need to fund the services we all want.

And then there is the issue of financial speculation. For years there have been calls for something akin to a Tobin tax to be levied on financial transactions in order to suppress both the size and the volatility of the financial markets in order to improve market stability. Yet such a tax, particularly if imposed on currency trades, would again violate the principle of the freedom of movement of capital.

The freedom of movement of services

Of all the four freedoms this is perhaps the most rarely used, overvalued and misunderstood. The principal argument in favour of it is that because the UK has a large service sector that accounts for up to 80% of its economy, and also because a large part of that is the financial sector that accounts for a large part of our invisible exports, then we desperately need to retain access to the single market in order to protect jobs in London and to generate wealth and taxes. At the heart of this freedom is the concept of the financial passport. This allows any financial institution to operate in any other EU member state once it has been given regulatory approval in another EU state. The problem is that this just doesn't work.

This financial passporting is the system that allowed unregulated Icelandic and Irish banks (among others) to operate within the UK before 2007 and then collapse. It also allowed UK banks to import much of the financial crisis in 2007 from the US and the Eurozone. Do we really want a repeat of that?

The fact is the freedom of movement of financial services is a red herring. After 2007 the City was complaining about excessive future EU regulation. Now it says it needs to be part of the EU. These two positions are contradictory. The reality is it is easy for a UK financial company to open an office inside to EU for regulatory reasons and the cost is negligible. Moreover the financial benefits of exported financial services are puny. Financial services may account for about 13% of the economy, but exported financial services are a mere fraction of that. It really isn't worth the hassle.

Summary

What I have shown is that none of the four freedoms of the single market brings any real benefit. The freedom of movement of services exposes our economy to high risk lending and other dubious financial practices. The freedom of movement of capital prevents governments taxing the rich and large corporations, and will ultimately lead to a collapse in national tax receipts. The freedom of movement of people leads to social disintegration and alienation, inequality and unemployment, and will ultimately lead to a collapse of national finances. The freedom of movement of goods leads to a loss of democratic choice and sovereignty.

What I think all this illustrates is how the EU has lost its direction and its soul. The EU could have been a force for social good. It could have protected workers rights while promoting equality across the continent through the redistribution of income and resources such as through a common industrial policy. Instead of exporting jobs to China and importing labour from Poland we should have been exporting jobs to Eastern Europe thereby re-industrialising the continent and not de-industrialising it.  The result would have been an EU that was richer and more equal. Instead it has become consumed by a neoliberal monster that ultimately has had the opposite effect. That monster is the single market.

The EU, and particularly the single market, has become little more than a protection racket. As we are now seeing as we try to leave, the EU not only bullies those countries that have chosen to join, like Greece, it also bullies those outside. The message it is sending out, even to non-members, is play by our rules or we will trash your economy. This is another reason why it must be stopped.

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.

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.

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...)

Does migration reduce inequality?

In his defence of the EU the Oxford economist Simon Wren-Lewis recently made a number of interesting claims that directly relate to the general debate on the benefits, or otherwise, of immigration, globalisation and free trade. One that stands out is this in response to Kate Hoey's claim that migration has been used to suppress the wages of the low paid:

"She seems to be arguing that free movement in the EU is a means of keeping down the wages of the low paid. The first point to make is if labour mobility keeps wages down in the destination country, it should increase wages and/or reduce unemployment in the country the migrant came from. As migrants move from lower to higher wage countries, then migration tends to equalise incomes. This should normally count as a plus from a left wing perspective."

Well it is certainly true that migration reduces unemployment in the country of origin. It is also true that migrants tend to repatriate a portion of their earnings to their country of origin and so help to  increase its GDP per capita and thus increase its overall prosperity. In theory this should help to close the gap in inequality between rich countries and poor ones, and thereby "equalise incomes".

 One could also then argue that once the poorer countries have attained a sufficient level of income, they will also be able to trade with richer countries as equals, in effect increasing the size of the market accessible to firms in both countries. This is the essence of current globalisation policy and is one reason for the EU's policy of continued expansion. It is therefore certainly true that it could be claimed to be "a plus from a left wing perspective" in that it raises living standards and reduces inequality in the poorer country. As such it probably does the same globally as well. The problem is that it doesn't do so in the richer country.

In the richer country most of the immigration will be into low paid jobs, and much of the earned income that results will leave the country. This will have two negative effects on aggregate demand in the rich country. Firstly, it will force down wages of the low paid through increased competition; secondly, the additional economic activity that results from the immigrant workers will be exported and so will not be used to stimulate extra demand (a multiplier effect) to replace that lost through job losses and earnings reductions of the existing low paid workers. On top of that the population will have increased so GDP per capita will be reduced.

Now it is probably true that once the economies of the two countries have equalised both countries will benefit fully and equally from the larger market available to them.  The question, though, is how long will this take? As Keynes famously put it, "In the long run we are all dead." The point he was making when he said it was that time is not infinite and people are not immortal. After a recession or depression the economy will inevitably recover eventually. The argument of classical economists is that, if the economy is going to recover anyway, then it doesn't need any government intervention to help it along. The argument Keynes was making was that ordinary people can't wait that long and therefore the recovery needs to be brought about as soon as possible through active interventionism, rather than arriving at some unspecified later date because of passive liberalism. That same statement can also be applied to the effect of immigration on the poor in developed countries. How long must they wait for the benefits of migration to bear fruit? Until after they are all dead?

The reality is migration is just another manifestation of globalisation policy and both have been exploited and abused to suppress wages in developed countries because that is how western governments have managed to deliver economies that simultaneously have low inflation and low interest rates. That is why living standards in most developed countries have stagnated for the bottom 50% over the last 30 years. In which case I would argue that Kate Hoey is correct in her viewpoint and Professor Wren-Lewis is wrong. Moreover, I would argue that an economic policy is only beneficial and equitable if those that sacrifice the most in the short term also benefit the most in the long term. That after all is one reason why most on the left reject austerity. But if migration hurts the poor in the UK and benefits the rich, how is this "a plus from a left wing perspective"? And of course the adverse side effect of all this of course is massive wage inequality in the rich countries, excess savings by the rich, low investment and asset price booms. Ultimately that is why we are in the mess we are in now.

But the above is not the only point of contention I find with the views of Professor Wren-Lewis. In the same blog post he then went on to say:

"Migrants tend to be young, healthy and working. They provide more in terms of resources than they take out by using public services. I remember having a conversation about this with someone who lived in Spain. He said if anyone should be angry about free movement it is Spain, in having to take lots [of] non-productive British pensioners who will be a burden on Spain’s health service."

This argument also contains a number of major flaws in its reasoning. Firstly, it neglects to take into account the fact that most of the UK pensioners that have moved to Spain have done so on large pensions. These pensions are paid out in the UK by insurance companies and the government but spent in Spain. Therefore not only does this constitute a massive export of capital from this country, it also leads to an equally massive loss of both consumption and taxation in the UK. This loss of government revenue far exceeds any burden those pensioners would place on the NHS if they were to return to the UK. The UK therefore loses from this arrangement and Spain gains.

Secondly, the argument fails to take account of my previous point, that migrants tend to repatriate a large portion of their earnings to their country of origin. As a result any increase in economic activity that results from the immigrant workers will be exported and so will not be used to generate extra demand in the UK. In short there will be no multiplier effect that would create additional jobs to compensate for the immediate effects of immigration.

What this shows is that it is not just inward migration that can hurt the UK economy, but also outward migration. Both have negative effects on our budget deficit and our trade deficit. And as I have argued previously, both therefore represent an existential threat to the solvency of the national government and therefore ultimately to the democracy of the UK, because if a Labour government cannot fund its programmes, then there can be no Labour government. In short we end up like Greece.

But if you still think unlimited immigration is a good thing then consider this from Social Democracy for the 21st Century:

"Corbyn is also delusional if he thinks effective Keynesian fiscal policy will be possible in Britain with an open border policy, for the more prosperous a country becomes, the more it will simply become a magnet for mass immigration from Europe, which in the process will defeat the whole purpose of fiscal policies to create full employment."

In other words full employment is impossible if you have an open borders policy. And what is the point of a Labour Party that doesn't believe in full employment?

Lies, damned lies, and EU statistics

According to virtually every major economics organisation (IMF, OECD, IFS, BoE, The Treasury) the EU is such an enormous benefit to the UK economy that leaving would amount to economic suicide. Yet despite 95% of mainstream economists supporting the Remain campaign the public is unimpressed. Why? Well perhaps the reason is this: there is no definitive data to support their claim.

One of the arguments against Brexit from economists such as Simon Wren-Lewis is that it would make it more difficult for us to trade with countries next to us and that would hurt our economy. It is the classic neoliberal free-trade argument even though Wren-Lewis claims to be a New Keynesian. But no-one who supports Brexit is arguing that leaving the EU is for the purpose of reducing trade with Europe. Nor can any rational and informed thinker possibly believe that a reduction trade with the EU would be the end result. The lobbying power of the multinationals would ensure that. This then is a spurious argument. The fact that it relies on a contentious, unproven and ideological belief in the universal benefit of free trade makes it even worse.

Another argument put forward is that because 40% of our overseas trade is with the EU then our future economic growth will be greater inside the EU than outside. This is the argument put forward by George Osborne. In addition he and David Cameron have claimed that leaving the EU would result in a massive recession and a third world war (or both), while our membership of the EU has delivered greater economic growth than would otherwise have happened. The problem is that claim is untestable because the alternative scenario is counterfactual. That said, we can attempt to test it simply by going back in time.

If we assume that leaving the EU represents the converse process to joining, then leaving should deliver the converse results of joining. So the question then becomes: what was the economic consequence of joining the EU? Well the graph below shows the growth rate in real GDP in the UK over the last sixty years.

source: tradingeconomics.com

If joining the EEC was the economic boon that the Pro-Europeans claim then there should have been a significant increase in the growth rate after 1973, yet according to the graph above there was none. Moreover, after the signing of the Maastricht Treaty in 1992 there should have been a second boost. Again none is detectable. What there is instead is a clear decrease in the amplitude of the fluctuations in growth rate, possibly in part due to a decrease in the inflation rate over the period in question. To analyse the above data more clearly it is perhaps better to present it as a plot of real GDP per capita versus time (rather than growth rate versus time) and calculate the compound growth rate. This is shown below for the period 1960-1973 covering the period immediately prior to the UK joining the EEC.

source: tradingeconomics.com

The above data shows that real GDP per capita rose by a factor of 53% over this period. This equates to an average growth rate of 3.3% per annum. Now if we look at the period immediately after joining the EEC we see a different behaviour.

source: tradingeconomics.com

Over the period 1973 to 1992 real GDP per capita rose by 38%. This equates to only 1.7% per annum.

source: tradingeconomics.com

Finally, if we look at the period after the Maastricht Treaty was signed real GDP per capita grew by 42% equating to an annual growth rate of only 1.6% per annum.

What all this clearly demonstrates is that there was no spurt in economic growth after joining the EEC, or after signing the Maastricht Treaty. In fact in both cases the growth rate went down. So this appears to torpedo the principal claim of the Remain camp that EU membership boosts growth. The reasons of course are easy to understand.

Firstly, over much of the last thirty years the EU has been obsessed with enlargement, and most of the new member states have been economically underdeveloped. It therefore follows that any process of economic convergence must have involved a transfer of economic growth from the old member states to the new ones. This will inevitably have had a negative impact on growth rates in the developed countries. In effect at each level of increasing EU integration the developed countries have effectively exported an increased amount of their economic growth to other countries in the EU.

Secondly, migration has had negative impacts on wages, tax receipts and investment. According to Simon Wren-Lewis:

"Migrants tend to be young, healthy and working. They provide more in terms of resources than they take out by using public services."

Well the first part of this may be true but the second is most definitely not. What Professor Wren-Lewis has conveniently omitted from his thesis is that most migrants pay little or no tax because most of them are seasonal workers, and under EU rules, if you work in a country for less than 6 months you are exempt from income taxes. In addition, most migrants are net savers and they spend those savings in their country of origin, not here, so there is no multiplier effect. The result is that they do not create as many new jobs as they take away. The best migration is permanent migration because it is more likely to involve people with tradable skills, in high income professions who invest all their earnings in this country thereby creating as many, if not more, jobs than they take away. On top of this, migration also has a negative impact on investment because employers don't need to train or retrain their existing workers if they can source the necessary skills from elsewhere at zero cost. 

The analysis above all seems to have passed by the economics establishment. The big question is why?

The Labour case for Brexit

You would be hard pressed to deduce this from the current political mood music but, like the Conservatives, the Labour Party has always had a pretty ambivalent attitude to the EU. That much is at least self evident if one looks back at the history of the party and how it split over the 1975 EEC referendum. The main difference though between the two parties is that the things Labour likes about the EU (the Social Chapter, protection of human rights etc.) tend to be the things the Tories hate, and vice versa. What is therefore surprising is that there is not the same debate about the EU in the Labour Party this time around as there was in 1975. My view is that there should be because the potential threats posed to our democracy and to the viability and effectiveness of any future Labour government by the EU (at least in its current form and with its current direction of travel) are now much greater than they have ever been.

These threats I believe are two-fold. The first is economic, the second democratic. The economic threat comes from the increasingly unviable state of national finances and taxation frameworks and the negative impact on both of these posed by the single market. For a government to function effectively it needs to be able to borrow what it needs when it needs, and it needs to be able to tax who and what it needs in a similar vein. This is because taxation is not just a means of raising revenue to fund services: it is also a macroeconomic tool that should be used in conjunction with borrowing to correct imbalances within the economy and thereby promote economic stability. Yet even outside the euro this will become increasingly hard as the EU becomes more integrated and the single market becomes all-powerful and all-consuming.

This is because at the heart of the new EU is the single market. The single market is everything. The single market is sacrosanct. Nothing will be allowed to interfere with the single market. That means all government policies will be tested against this question: do they distort the single market? If so then they will be deemed to be illegal. We have already seen the start of this trend with the decision of the European Court of Justice (ECJ) to vote against minimum pricing of alcohol in Scotland. Next it will be differences in excise duty that come under the spotlight, then VAT. After that it will be corporation tax on companies, and possibly even income tax. But you don't need the single market or the ECJ to bring about harmonisation of tax rates: that will happen automatically if we continue to allow the freedom of movement of people.

The freedom of movement of people or workers is one of the four pillars of the single market, the other three being the freedom of movement of capital, goods and services. Implicit in these is a fifth freedom, the freedom of movement of jobs. Most criticism of the first of these, the freedom of movement of people, has concentrated on its effect of immigration. However, there is a secondary impact. If you allow people to move country then you effectively allow them to choose which taxation regime they wish to work under. In other words they are able to exercise consumer choice to choose their tax rate by selecting a country of residence with as low a tax rate as possible.

We have already seen the effect of this when President Hollande raised the top rate of income tax in France to 75%. Many of the wealthy moved to London or across the border into Belgium, Luxembourg, Germany or Switzerland, and then commuted back to France for their work if they needed to. Of course if your income tax was dictated by your nationality and not your country of residence (as is the case for US citizens) such movements would not be financially beneficial, but of course EU rules and the single market prevent this.

The impact of all this will be two-fold. Firstly it will undermine democracy because it will effectively allow some voters to circumvent the democratic outcome of national elections. If you don't like the result then you can just move somewhere else. If your fellow countrymen vote for a socialist government with better public services and higher taxes on the wealthy, then the wealthy can just move to a country with lower taxes. The rich get to have their cake and eat it.

The second impact is a direct consequence of the first. If the voters can move from country to country in search of the best tax deal, then countries will be forced to compete for income. This competition will force them to outbid each other in terms of tax cuts. The net result will be an inevitable race to the bottom in terms of tax rates. As a consequence the tax gap that governments currently suffer from will widen, revenues will fall, spending will decline, and services will worsen, whether these are in social security, healthcare or education.

The one great virtue of the EU in the eyes of Labour voters and trades unionists has always been the Social Chapter of the Maastricht Treaty. This encapsulated the core ideal that the EU should be for the benefit of workers, and not the owners of capital, by setting common standards for working rights and conditions that multinational corporations in particular operating in the EU would have to abide by. The rationale was that individual member states were too small and powerless to implement these standards unilaterally because multinationals could effectively force nations to compete against each other for the jobs those multinationals could provide. The irony now is that it is competition within the single market that is the great threat, not to wages but to government finances. Once you allow freedom of movement of labour then you undermine the fiscal sovereignty of individual states. Eventually they become financially non-viable with only the EU itself being able to levy income tax across the EU and across national borders. The result will be a push towards introducing a federal income tax and a federal budget with more loss of sovereignty and democracy at national level.

The result of all this is that it will become virtually impossible to elect a left wing government because a left wing government by definition is one that will always want to intervene in the market, either to prevent economic crisis or to stabilise an economy that is already in crisis, or to reduce the impact of inequality. All these interventions will necessarily result in a distortion of the market, and even though the market is imperfect and may be in crisis, this will be deemed to be against the rules of the single market. So while you may still be able to vote for a left wing government, that government will not be allowed to implement anything that resembles a socialist platform. It will be like voting for a Labour local council but finding that they still have to implement the same austerity-driven cuts as would have happened under a Tory administration. And of course the Greeks have already discovered this. They elected Syriza (twice) and still ended up with their economy being run by Dr. Strangelove in Berlin.

To put this into perspective imagine some of the policies that a future Labour government might wish to implement to raise extra taxes and tackle wealth inequality: the mansion tax; a citizen's income, support of key industries (e.g. steel) in times of external shocks; taxes and controls on intellectual property. All of these could be at risk from EU rules and regulation. The citizen's income (or basic universal income) in particular is one idea that is gaining support across the continent. The Swiss are currently voting in a referendum on this issue, but one concern is that the freedom of movement of people would make it unworkable whereas if eligibility were based on nationality then immigration would have little or no negative impact. But under EU rules countries are not allowed to "discriminate" on grounds of nationality.

The worrying thing is that the current Labour hierarchy seem oblivious to most of these potential pitfalls of EU membership. Moreover, by hitching his wagon (and by association most of the Labour Party) to the Remain campaign, Jeremy Corbyn has made a massive tactical miscalculation. If the electorate votes to leave them he will have made Labour unelectable for a generation as no-one will trust the party in government to keep the UK out of the EU. After all who is going to vote for a pro-EU party and prime minister if the country is negotiating to leave the EU? At least if a significant number of senior Labour figures (other than the commendable Frank Field and Gisela Stewart) had signed up to the Leave campaign then there would be sufficient alternative leadership candidates, or cabinet members who could be entrusted to lead future negotiations. And even if the public votes to stay in the EU the Labour party will likely lose significant votes to UKIP in future elections as a result. It is an outcome Frank Field has warned about but no-one seems to be listening.

Football economics part 1: transfer fees

This weekend is the start of the Premier League football season. Hooray! Or maybe not? As a football fan even I am becoming disenchanted by the role money plays in the game today, the effect it has on motivating or de-motivating players, and the contribution it makes to the financial instability of clubs of all sizes. So perhaps it is time we started asking if the economics of football can be redesigned, and we could start with that most topical of issues: transfer fees. 

The last few weeks have seen the sports pages of our national newspapers monopolized by speculation over the future of players like Luis Suarez, Cesc Fabregas, Gareth Bale and Wayne Rooney. Of particular interest has been the £40m clause in the contract of Luis Suarez which bares a certain similarity to the buy-out clauses that often feature in the contracts of players at European clubs. These clauses are supposed to represent the amount any other club would need to pay to acquire that player, except that the buy-out clause is hardly ever enforced, and when the player does move clubs it is usually for a much smaller fee. 

Of course the Suarez clause isn't technically a buyout clause, so at the time of writing Suarez is still a Liverpool player, and in theory there is nothing that any bidding club or Luis Suarez can do to change that situation. But as we have seen in the past, if the bid is large enough then the club will sell irrespective of the wishes of the player, and if the player demands a move strongly enough then he usually gets his wish irrespective of the wishes of his current club. The result is a system that suits no-one, that is opaque and arbitrary, and which appears vulnerable to external manipulation and corporate bullying. 

The current system is therefore clearly dis-functional. The contracts often appear to be meaningless, particularly to supporters who expect total loyalty of the player to the club and the contract. However those same supporters are less exercised when it comes to selling players that the club no longer wants. And when it comes to the players themselves there is an equal degree of hypocrisy. Players have temporary fixed-term employment contracts that they expect to be honoured in full if they suffer an injury, but which many try to break if they see a better opportunity elsewhere. 

So is there a better way for players to be exchanged between clubs? I think there is. As money is the facilitator of such actions then the answer must lie in the economics of the transfer process. At the centre of any transfer policy must be the market value of the player, or his marginal utility. It is fairly easy to calculate what this should be. It will be determined by the player's salary and his length of contract. At any given time an employee's wage is supposedly (in neoclassical theory) determined by the company's gain in net revenue that results from his employment. Therefore his annual value to the company is determined by his salary. His total value over time will be set by the expected duration of his working life at that club and his average annual salary over that time period. For a footballer his expected working life at his current salary is set by the length of his contract. Risk of injury, age and loss of form are all factored into the contract length. Therefore the total marginal utility of the player is set by his current salary multiplied by the time left on his contract. 

The advantage of this formula is that everyone would know where they stand. The player and his current club would know that if a rival club were to bid more than the product of the player's current salary and the remainder of his contract then the player can move. His current club would know that if they wish to ward off such rival bids then they must offer the player either a longer contract, or a higher salary. And everyone would know that the closer that a player gets to the end of his contract the less his transfer fee will be. In that sense this idea merely formalizes the situation that already operates in practice where players with only one or two years left on their contract start to see their transfer value decline. 

The net result of such a change would be that transfer fees would probably fall and players' wages probably rise, with the wages of the very top players being most affected. Whether that is good or bad depends on your perspective (I will deal with the question of clubs' income and player salaries in another post), but it would mean that transfers of players would be smoother with the player's current club being unable to block such moves with outrageous demands over transfer fees. (Is Gareth Bale really worth £100m, or Suarez worth more than £40m?) In return though, the selling club would be guaranteed a fair fee. It would also mean that the most valuable players would move to the teams where they would have the greatest marginal utility. But more importantly it would rid football of the current tug-of-love fiascos that are played out in the media between players and competing clubs, as well as the tapping up of players, and all the other mechanisms by which clubs, journalists and agents seek to unsettle players in order to force a move, often at below the market rate.

Loony policy proposal No. 1 - 200 GBP visas to deter use of NHS

Have we reached the silly season already? It seems like it with this proposal. 

Political parties are rarely any good at coming up with workable policies when they are in office, but then again they don't seem to be much better at it when they are out of office either. And when it comes to the design of inept policies they don't get much wackier than this one. It therefore seems entirely apposite to start a new series of articles highlighting such political ineptitude and fuzzy logic with this real corker of an idea. 

The ConDem coalition's latest big idea is to charge all overseas non-EU visitors an extra £200 for their visas in exchange for the right to use the NHS when they are here in the UK. The alleged reason for this policy is to counter so-called health tourism where overseas migrants come to the UK to use our NHS but then avoid paying for the treatment they get. The first question, therefore, is will this policy work? Will it deter people from coming to the UK just to use our health service for free? 

The answer to this is clearly no. Charging foreigners £200 pounds is going to be no deterrent when the potential benefits are health costs that could be a hundred or a thousand times greater. In fact £200 is even barely significant when compared to many international air fares. So where is the actual deterrent? In fact you could argue (and Richard Murphy does) that the new policy could actually increase the scale of the problem by legitimizing it. That, however, is not the only massive flaw in this policy. 

The second question is does it result in any adverse or negative consequences? The answer here is clearly yes. In effect the proposal is to levy a tariff on all foreign visitors in order to pay for a minority that might abuse the NHS system. But that means that the majority will be punished for the actions of a minority, and as the majority are free to avoid the tariff by simply travelling to another country, the result is likely to be a substantial fall in students and tourist numbers entering or visiting the UK. So not only does the policy not deter the people it is supposed to, it instead actively deters the people we want and need to come here to boost our economy. 

The third test of any policy should be, do the benefits outweigh the costs? The answer here is also clearly negative, as the results of the first two tests do not even begin to compensate for each other. They are clearly both additive and negative. So the sum of the two effects in massively negative. 

The fourth question any new policy needs to address is, do we need it? Well in the case of health tourism no-one really knows how big this problem is. It may cost the country £12m a year or it may be £200m, but either way it is still insignificant in comparison to the size of an NHS budget of £109bn. So this policy clearly fails the fourth test of any workable policy - necessity. 

So what we have is a policy that we don't need (yet), that will fail to deter the people it is designed to deter, that will instead deter the overseas visitors we want and need, and may in fact even encourage the problem of health tourism to grow further by legitimizing it. It really does take a phenomenal degree of incompetence to invent a policy that is quite that useless and counterproductive. 

Tax avoidance #3: transfer pricing

When will they ever learn? Just when it looked like a politician had finally begun to get real over tax avoidance Ed Miliband goes and shoots himself in the foot again.

First he pledges that if elected PM he will tackle corporate tax avoidance without international agreement if necessary. So far, so good. But then he falls for the same misguided arguments as the rest of the political class by seeking to blame the existence of avoidance techniques on the companies that use them. Principal amongst these is the technique known as transfer pricing.

This is a technique used by multinationals where the prices for goods or services traded internally within the company but across international frontiers are set either artificially high or artificially low in order to move profits from one (high tax) country to another (low tax) country. As a problem it is not new. Economics texts have been highlighting the issue for over forty years (for proof see Chapter 19 of Economics of the Real World, by Peter Donaldson, published in 1973). The received wisdom is that all that is needed in order to counter this activity is some form of international agreement, greater corporate transparency, more resources for HMRC staff and a modicum of moral pressure. Robert Philpot of Progress tried to make some of these arguments again last week on the Huffington Post. Yet none of this is true.

As I have pointed out before, under capitalism companies are driven by the imperative to maximize profit, not some moral obligation to maximize government tax revenues. The moral choice is to do what is best for the shareholders, not what is best for the wider community. And anyway, why should Google or any other company be obliged to pay more than it needs to in tax when to do so could put it at a competitive disadvantage with respect to its rivals?

The arguments in favour of international agreements are equally flawed. Such agreements would require all countries to sign up to the same set of rules as those that didn't would gain a competitive advantage over those that did. Yet as long as countries compete against each other to attract multinational corporations to their territories, either in order to generate greater tax revenues at the expense of other nations, or to attract inward investment at the expense of other nations, then there will never be any hope of a binding international agreement. There will always be one country that refuses to be bound by the wishes of the majority in order to gain advantage. And given the size of multinational profits in comparison to national incomes, the power to undercut on tax will always favour the small nation (e.g. Luxembourg, Switzerland, Austria, Ireland) over the large nation. Countries like the USA and UK can therefore never hope to compete with these smaller countries by lowering their corporate tax rates. They need to look for a different approach. That means implementing tax laws that are not reliant on the actions or agreement of governments in competitor countries, but are instead based on objective measures of business activity within each country's own borders. One possible solution is the Common Consolidated Corporate Tax Base (CCCTB) proposed by the EU.

At the heart of the transfer pricing problem is the thorny issue of corporate profits and how they are calculated. Even at the best of times the quantification of a company's true annual profit is something of a black art, one that is complicated by one-off asset write-downs, debt interest, rolled over losses from previous financial years, and the deferral or front-loading of capital investment. Yet over time most of these factors cancel themselves out. However, on top of all that there is the problem of how those profits are spread across the different divisions of the company. Again, if all the divisions of the company are located within the same country it matters not a jot. The total profit of the company in that tax jurisdiction is the same however it is divided between subsidiaries, and so the tax paid is the same. Yet, as soon as the profit is spread across subsidiaries in different countries with different tax rates, problems abound.

This is where transfer pricing comes into its own. There are a number of variants of this type of scheme that essentially only differ in the form of the goods used as the vehicle for the price transfer mechanism. In its most classical manifestation the goods are typically manufactured components of a larger or more complex final product. However, increasingly transfer pricing schemes have begun using brand licences or other intellectual property as the good that is traded internally within the company (as used for example by Starbucks). As an illustration of how transfer pricing works it may help to consider the following hypothetical example.

Suppose a car maker has two production facilities. The main assembly plant is in the UK and is owned and run by subsidiary A. However, the engines are manufactured in country Z by the company's subsidiary B. Now suppose it costs £4000 to build the engine and another £4000 to construct the rest of the car, but the car sells for £10,000. The profit is therefore £2000 per car. If the car company builds 1,000,000 cars each year then its annual profit will be £2bn, but which in country should this profit be declared and taxed; the UK or country Z?

The answer is that it depends on the price that subsidiary B charges subsidiary A for its engines. For most goods bought by ordinary consumers or firms the price is set by the market and it is therefore beyond the capabilities of any single agent to dictate this price unilaterally. In transfer pricing schemes, however, the commodity or good at the centre of the scheme is only ever traded within the multinational company. There are no external customers and so there is no objective market price for the good. Whatever the multinational charges for the good it ends up paying to itself, so it can set its own price for its own reasons. That reason is usually tax.

In the above example the cost of producing the engine and the car body is the same (£4000 each), so one might naturally assume that the fair way for the profits to be divided between the two subsidiaries would be in the same 50:50 split. In which case subsidiary B would charge £5000 for each engine, thus allowing it to make a profit of £1000 per engine. Subsidiary A in the UK would then buy the engines for £5000 each, build the rest of the car at an additional cost of £4000, and then sell the cars to the public for £10,000 each. Thus the cost of manufacture for subsidiary A is £9000 per car and its profit is £1000 per car, the same as for subsidiary B. If the tax rates in the UK and country Z are the same, let's say 30%, then the multinational will pay £300m of tax in each country, or £600m in total.

But if the tax rate in country Z is lower than in the UK (say 25% instead of 30%), then the car maker will pay less tax in country Z (£250m) than the £300m it continues to pay in the UK. Its total tax bill at £550m is now less than the £600m it was originally. But it can reduce its tax bill even further by raising the price of its engines.

If subsidiary B charges £6000 for each engine, then subsidiary B will make £2000 profit per car. Yet the cost of production for subsidiary A then rises to £10,000 per car, £6000 for the engine and £4000 for the body, and so it makes zero profit. Now all the profits are taxed in country Z at 25%, and so the total tax bill falls to £500m.

Similarly, if the UK were to retaliate by lowering its tax rate to 20% (as advocated by Osborne and Cameron) then the car company would respond by changing the cost of its engines once more. Now subsidiary B might charge £4000 for each engine so that it makes no profit while subsidiary A earns £10000 for each car sold but now spends only £8000 on their manufacture (£4000 on assembly costs and another £4000 buying the engine from subsidiary B). As all the profits are now located in the UK they will be taxed at the UK rate and the total tax bill for the company is now £400m.

Thus by raising or lowering the cost of its engines (or any other internally manufactured component) the car maker can in effect choose which country it wishes to be taxed in. And in so doing it can also force countries to compete against each other by competitively reducing their tax rates in a self-defeating race to the bottom where the only winner is the multinational.

One reason why the scheme is so difficult for governments to challenge is that there is usually no other external customer for the good or service used in the transfer pricing, so the price is difficult for the tax authorities to challenge. In addition, multinationals can always find one country to base their headquarters in that will offer a lower tax rate than any other. Worse still, with complex lines of procurement it is doubtful whether even the company itself can accurately determine the true cost of many of its internally sourced components. Nevertheless, despite these difficulties it is clear that many multinationals actively operate aggressive policies of tax avoidance based on transfer pricing that are designed to minimize their corporate income tax bill. It is therefore time governments adopted an alternative approach to tackling the problem.

The Solution:
There is only one realistic solution to the problem of transfer pricing, and that is to tax companies on the basis of data that they cannot challenge or manipulate. As already noted, profits can have a distinctly ethereal quality at times, particularly when looked at on a country-by-country basis. However, a company's global profit (P) is much more tightly defined. So too for that matter are other global aggregate measures of a company's performance such as its global sales (S), its global wage bill (W), and the total value of its global capital assets (K).

It is also true that, while a multinational operating in the UK can disguise its UK profit via transfer pricing, it cannot disguise the level of its UK sales, wage bill or capital investment. Its UK sales are already recorded for VAT purposes, and its wage bill for calculating its national insurance liability. As for its UK capital, that is mainly in the form of property, which is also rather difficult to conceal.

It therefore follows that governments should take the initiative when it comes to determining the profit levels of subsidiaries operating in their territories. As neither the government nor the multinational really knows the true profit level of these subsidiaries, the government should in effect use the objective data outlined above to tell the multinational what its UK profits are, rather than relying on the multinational to tell the government what it thinks it is. And it turns out that a formula for just such a calculation already exists.

In an attempt to tackle the issue of transfer pricing the European Commission has proposed the Common Consolidated Corporate Tax Base (CCCTB). This utilizes data for the company's global sales (S), wages (W), capital (K) and profits (P), together with the equivalent terms S_i, W_i and K_i pertaining to any individual country i only. This allows the company's profits in country i to be estimated by taking a weighted average of the fraction of its global capital, sales and wages that are deployed in that country, and using that average to set an estimate for its profits in country i. In the absence of any more authoritative data, this estimate will de facto be assumed to be the true profit level P_i for the subsidiary operating in that country.

The coefficients are defined to be the same for all companies operating in country i, and are then set such that each is less than unity, and their sum is always equal to unity as follows.

In practice these coefficients are all likely to be set to be equal to each other as there is unlikely to be much overall variation in the proportion of wages, sales and investment capital for all multinationals within a given country i. In which case the profit in country i becomes

We have then a profit calculating mechanism that is impervious to transfer pricing. Companies cannot manipulate their profit in country i because they cannot manipulate the quantities used in Eq. (3) to calculate that profit. It is this type of approach that politicians and government tax advisers should be adopting, not the empty rhetoric of cynical political posturing.