The global economics of corporate tax cuts

Jim Flaherty, Canada’s minister of finance, may well be exasperated.  Speaking of the federal government’s plan for a national corporate tax of 25 per cent, the Minister affirmed that ‘we believe lower taxes create investment and jobs.  I continue to encourage our provincial partners to follow our lead.’  Unfortunately, his counterparts remain to be convinced, with British Columbia and Ontario signalling their intentions to halt the downward trend.

How times have changed!  ‘On New Year’s Day,’ reported Neil Reynolds, ‘Canada’s corporate tax rate — federal and provincial rates combined — fell to 25 per cent, giving Canada the lowest rate in the Group of Seven countries, and a more competitive economy on a global basis.’  (According to the 2012 Index of Economic Freedom, Canada’s federal rate of 15 per cent compares favourably with the United Kingdom’s 26 per cent.)

Flaherty could remind officials in the provincial treasuries of the global consequences of their actions, citing an economic truism published in The Wealth of Nations two-centuries-and-a-half ago:

The proprietor of stock is properly a citizen of the world, and is not necessarily attached to any particular country.  He would be apt to abandon the country in which he was exposed to a vexatious inquisition, in order to be assessed to a burdensome tax, and would remove his stock to some other country where he could, either carry on his business, or enjoy his fortune more at his ease.  By removing his stock he would put an end to all the industry which it had maintained in the country which he left (V.ii.f.6).

Proponents of raising corporate taxes make two fundamental mistakes.  First, since the fundamental reason for taxes is to fund public expenditures which benefit the common good, a logical corollary follows:  You can’t tax what you don’t have.  ‘Every tax ought to be so contrived as both to take out and to keep out of the pockets of the people as little as possible,’ Adam Smith cautioned, ‘over and above what it brings into the publick treasury of the state.’  But a rise in corporate taxes will punish native industry, as Henry Hazlitt noted in Economics in One Lesson:

It does not expand its operations, or it expands only those attended with a minimum of risk.  People who recognize this situation are deterred from starting new enterprises.  Thus old employers do not give more employment, or not as much more as they might have; and others decide not to become employers at all.  Improved machinery and better-equipped factories come into existence much more slowly than they otherwise would.  The result in the long run is that consumers are prevented from getting better and cheaper products, and that real wages are held down.

Moreover, in to-day’s globalised economy, high corporate tax rates serve as incentives for businesses to move to countries with more favourable tax structures.  Thus it was even in Smith’s day:  ‘A tax which tended to drive away stock from any particular country, would so far tend to dry up every source of revenue, both to the sovereign and to the society.  Not only the profits of stock, but the rent of land and the wages of labour, would necessarily be more or less diminished by its removal (f.6).’

Second, a rise in corporate taxes will not necessarily raise more revenue.  Businesses will simply transfer the burden of the tax to the ordinary consumer, whether through price increases (thereby shifting over-all demand) or through lost employment.  Smith alluded to this ‘expence’ when he wrote that ‘much unnecessary trouble, vexation, and oppression (b.6)’ is visited upon the tax-payer by the tax-gatherer.  Ultimately all will suffer in the drag on capitalist accumulation, which in turn effects innovation — and a contributing factor why businesses are ‘hoarding’ profits and not investing in either human or capital resources.

Worse, a rise in corporate tax rates may raise less revenue.   As John Ivison noted in his report on Flaherty, ‘Corporate tax reductions increase after-tax profits.  When after-tax profits rise, there is more money available for wages, machinery to improve competitiveness and dividends — which can, in turn, be taxed.’  The data contradict the critics:

In fact, the federal government’s corporate income tax revenues have been on a steady incline since the recession, averaging around 1.9% of GDP.  At the same time, the Bank of Canada’s latest business outlook survey suggests 40% of businesses plan to increase investment this year, with only 19% saying they plan less investment.  More than half said they see increased employment.

These rosy projections are shared by Reynolds.  ‘Remarkably’, he wrote, ‘the gradual lowering of the corporate tax rate appears to have resulted in little loss in corporate tax revenue’, noting that revenues were higher with a lower tax than a higher tax — the Laffer curve hypothesis at work.

All this would be old hat to Smith, who had observed in 1776 that excessive taxation ‘may obstruct the industry of the people, and discourage them from applying to certain branches of business which might give maintenance and employment to great multitudes.  While it obliges the people to pay, it may thus diminish, or perhaps destroy some of the funds, which might enable them more easily to do so (b.6).’

All open-market countries can either accept global economic realities and tailor their tax systems to encourage industry; or bow to calls for ever-higher rates, subjecting  corporations to uncompetitive taxation, and in the process ‘dry up every source of revenue, both to the sovereign and to the society.’  Adam Smith knew the right answer — does Canada?

Reforming the financial sector

Banking is a tricky topic for liberals. The lines between state and private sector are blurred: if a private bank knows it will be bailed out by the government, it won't act with the prudence it should. Banks, trading in state-monopolized money, act as intermediaries between the state and the private sector, and can be the direct beneficiaries of monetary expansions by the Bank of England, like QE. Government interventions in the banking sector create bad incentives. Banks themselves aren't to blame for responding, rationally, to those bad incentives, but those responses can cause serious problems in the rest of the economy, as we saw in 2008.

Today, Steve Baker MP is proposing a ten-minute rule bill,  to try to fix some of these bad incentives. The bill, says Baker, will:

• Enforce strict liability on directors of financial institutions
• Enforce unlimited personal liability on directors of financial institutions
• Require directors of financial institutions to post personal bonds as additional bank capital
• Require personal bonds and bonuses to be treated as additional bank capital
• Make provision for the insolvency of financial institutions
• Establish a financial crimes investigation unit

In a perfect world, I would object to special rules to increase bankers' personal liability — fixing the principal-agent problem should be a private matter between banks' shareholders, directors and managers. But we don't live in a perfect world. It's virtually certain that the government would bail out any major bank that collapsed. That means that second-best provisions may have to be made to reduce the bad incentives facing bankers. Increasing their liability is a tough way to realign bankers' incentives along those of the bank itself.

The real key, though, is the fifth point. Making provision for bank insolvencies is the key to weaning banks off the government's teat. Governments will bail banks out whenever it's politically expedient. So, how do we make provisions for bank collapses without granny losing her savings? Sweden dealt with its financial crisis quite successfully in the early 1990s by taking a "bail-in" approach, where bank creditors are required to foot the bill instead of taxpayers, and debt-to-equity swaps are made, imposing haircuts on bank bondholders. If Baker's bill can start the ball rolling on this sort of reform, we'll all owe him a debt of gratitude.

Read more on Steve Baker's site: Financial Institutions (Reform) Bill – Liability of bankers and treatment of bonuses; Use of personal bonds and bonus pool to make good bank losses; Other measures

Economics is fun, part 11: Competition

It's the force that drives prices down and wages up; that lets us take longer holidays and have better quality products. Outside of economics, it's the force that drove our ancestors out of the sea and turned us into human beings. Yep: it's competition time. This week Madsen explains why we can afford things we want without anybody having to intervene to force suppliers to sell things cheaply.

If you want to catch up with the series, the whole set of videos is here.

Pensions redux

Remember pension tax simplification in 2006? At the time, it seemed like a reasonably good idea - reduce the patchwork of legislation built-up by successive governments to encourage retirement provision by simplifying the previous eight tax regimes into one single regime. But as with all national schemes, politicians can’t leave well enough alone and the tinkering with simplification began from day 1. And it just won’t stop – we can expect the Chancellor to fiddle some more come the March budget statement.

Throw in a history of scandals like Robert Maxwell, pension mis-selling and exorbitant fees and it’s little wonder normal folk are confused and suspicious, not to mention hugely reluctant to save.

But, lo on the horizon, rides Merryn Somerset Webb, editor-in-chief of Money Week and columnist for the Financial Times money supplement, with a battle cry to do away with the whole bloody mess.

In short, here’s her plan: “Abolish the pension system. Increase the annual ISA limit to somewhere around £30,000, with some kind of lifetime contribution limit included too. Make a big deal about how the money comes out entirely tax-free. Not having to pay tax on my income when I am old is an attractive option to me and I bet I am not alone.”

Ms Somerset Webb already anticipates some objections. Some will worry about liberated pensioners blowing it all in Las Vegas but she suggests a requirement to keep an age dependent minimum in the ISA. Others will cluck-cluck about the impact on public finances but Ms Somerset Webb suggests the Treasury “could amuse itself” with a one-off levy on all pension holdings to convert them into ISAs and believes the savings on pensions tax relief should compensate for the lack of income tax from ISA investments.

The proposal’s beautiful simplicity, of course, makes this a tough sell – there’s just too many vested interests keen on making things complicated: politicians who need fiddly toys, treasury officials aghast at losing buttons to push, financial advisors needing someone to advise, bankers flogging incomprehensible products.

And then there’s the problem with all proposals to simplify any tax regime – overwhelming inertia to undertake such efforts and an irresistible urge to keep changing the rules. How could  savers be confident Mr Somerset Webb’s new regime would outlast their days on this planet? It was just a blink of the eye before tax simplification became a standing joke.

Still, Ms Somerset Webb has floated a brilliant idea and could be taken a step further - if we’re going to think big - by ending company sponsored and managed pension schemes. Employers would simply make contributions directly into an individual’s ISA account at some basic minimum rate, say 8%, or more if they want to attract and retain good staff. Companies would be freed from a tiresome cost and employees would benefit from a seamless and portable savings plan independent of their employer.

Could the nation cope with so much simplicity?

The good intentions paving company

By now we should be well on our way to the "Big Society, Small Government" that David Cameron promised us. Now the Coalition is weakening on GDP growth, the idea is to promise us happiness, or at least well-being. Apparently, the government will nudge us towards more wholesome life styles rather than enforcing it through tax and regulation. In December 2010, the Nudge Team in the Cabinet Office published how their insights could be applied to health. The topics covered were: smoking, organ donation, teenage pregnancy, alcohol, diet and weight, diabetes, food hygiene, physical activity, and social care.

So far, so good.  Who could argue with improved well-being for us all and it being achieved through our own preferences and behaviour rather than government fiat?

Unfortunately, the programme has both a flaw and a problem. The flaw is the idea that GDP and happiness (i.e. satisfaction with life) are not as independent as the government would have us believe but closely correlated. Look no further than Greece to see the impact of a sharp deterioration on incomes on life satisfaction.  In January the IEA published an admirable analysis (“...and the Pursuit of Happiness: Wellbeing and the Role of Government”) showed clearly that GDP led life satisfaction.

It concluded “Happiness economics, which tries to extend a deficient hedonic morality to the arrangements of an open society, must be pronounced an unworkable project.”  Well that’s a bit high-flown but it boils down to the need for government to stick to its knitting, and that includes improving GDP, and desist from trying to manipulate our behaviour to match its preferences.

The problem is measurement.  A whole new science of indexing happiness is developing.  The OECD has a big hand in this as it wishes to measure well-being across countries.  Five years ago, an introductory paper on measuring subjective well-being noted four methods for starters: multi-item scales such as the Positive and Negative Affect Schedule and Satisfaction With Life. More recent important measurement approaches include the Experience Sampling Method, Ecological Momentary Assessment and the Day Reconstruction Method. There have been no shortage of proposals since then but the problem has less to do with confusion than dealing with time effects.

For example, an excessive imbiber of alcohol may report high satisfaction with life until his doctor diagnoses cirrhosis. The observer may know that no good will come of his drinking but if subjective well-being is what is measured, then drinking will increase his score on party nights even if the mornings after tell a different story.  It is not just a matter of short-term fluctuations but of factoring in the bad consequences from many years later.  To account for those, the government statisticians have to, in effect, present value the dire future and subtract it from today’s satisfaction.

In other words, we are no longer measuring subjective well-being as promised but what that subjective well-being would be if we were rational people with perfect knowledge of the government’s forecasts for us and if those forecasts were correct.  That is a lot of “ifs” to correct our illusions of our own well-being.

It does not take much manipulation of the figures to provide justification for whatever it is that the Department of Health, for example, wishes to do. It opens the door to more government interference in our lives and choices.  They know how to maximise our well-being even if, and especially when, we do not.

So what started out as a benign philosophy, Big Society, Small Government, perversely turns out, and not unusually, to have unintended consequences.  The issue is not the means, i.e. whether changing our behaviour is achieved by nudging (behavioural economics) or traditional tax and regulation.  The issue is freedom.  No one will quarrel with the need for government to tell us what the consequences of our behaviour are likely to be – assuming the science is valid – but we should be allowed to make our own choices. 

National happiness cannot be divorced from GDP; if our government wants us to be happy (and vote for them), they should concentrate on GDP..  Manipulating subjective well-being statistics to justify further government interference in our lives will not deceive the electorate.

Selling the Rule of Law for £500m

On Radio 4’s Today Programme this morning, Exchequer Secretary to the Treasury David Gauke defended the introduction of retrospective tax law to make Barclays pay tax which it had avoided legally. “When we see something like this, behaviour which is unacceptable, we are willing to step in”, he said. There are always reasons to ditch rules which aren’t very convenient.  But such reasons are rarely good enough.  And certainly not when it is to scrape away the glue which keeps the law together: the Rule of Law.

Retrospective legislation – or Ex Post Facto law, as it is called in jargon – is unacceptable because it make coercive rules random at the behest of the rule maker.  In The Constitution of Liberty, Hayek describes how some coercive action by government is acceptable, provided it satisfies three conditions: generality, certainty, and equality.  Retrospective legislation fails on the certainty ground, and is therefore objectionable. Earlier, in The Road to Serfdom, he said:

“[The Rule of Law] means that the government in all its actions is bound by rules fixed and announced beforehand – rules which make it possible to foresee with fair certainty how the authority will use its coercive powers in given circumstances, and to plan one’s affairs on the basis of this knowledge.”

How is a company to assess costs and gains before it makes an investment if greedy government can turn around at any given moment and ask for more?  It is fundamentally unfair to hold a person to be in contravention of the law when the law did not exist when the alleged contravention occurred.

This is not the first time a greedy government has decided to outlaw behaviour after the facts. But there is even worse: leaving tax laws vague to give the taxman discretion to tax no matter what has been common practice in the UK for years.

Some have tried to legitimise the Treasury’s actions by pointing out that Barclays has signed a voluntary code of practice in which it promised not to use tax avoidance schemes. It was certainly silly of Barclays to do so, as tax avoidance is not illegal (tax evasion is); and by signing this code of practice it effectively harmed its shareholders. Its action may have been inspired by a fashionable public spirited sense of “corporate responsibility”.  Barclays wouldn’t be the first corporate player to decide that it’s quite a good little idea to collaborate with coercive greedy government. Never mind the consequences for the entrepreneurs who arrive later.

You cannot opt out of the Rule of Law. Barclays' silly signature changes nothing to that simple fact.  For the Treasury, £500 million of additional tax revenue is a sufficient reason to walk over legal certainty. Never mind the billions of pounds investment which will now walk out of the UK.

Engineering works

When explaining what think tanks do, their members often quote the words of F A Hayek about "dealers in second-hand ideas."  It's a good phrase, because popularizing and explaining the key insights of thinkers such as Hayek, Popper and von Mises is very important. 

The Adam Smith Institute does some of this, but chooses a different role as its main activity.  We liken ourselves to engineers rather than pure scientists, and the engineering is of policy initiatives.  Thinkers such as Newton, Boyle and Kelvin make insights about falling and moving bodies, or about the behaviour of gases under pressure and temperature.  But if you sit waiting for a steam engine to appear, you might wait a very long time.  It takes a second kind of creativity to craft those breakthroughs of pure science into machines that function on their principles.

Understanding and propagating the principles of economics or public choice is one thing.  It is quite another to construct policies that apply those principles.  It is a creative process that uses insights into those principles in order to devise policies that will succeed in making the world a better place.  Introducing choice, enterprise and opportunity is not achieved by simply putting across the merits of those desirable goals, but by creating policy initiatives that can bring them about.

At the Adam Smith Institute we have always seen ourselves as engineers, creative in a different way to the pure scientists, and quite ready to roll up our sleeves and get the oil of machinery onto our hands.

Madsen's history of the ASI, Think Tank, is available to order now.

Wicked web

Oh what a tangled web we weave,
When first we practise to deceive

The tangled web that has become university funding in the UK is already throwing up early evidence of what a fraud the whole thing will prove to be.

In last week’s Times Higher Education, an article purports that students would be foolish to repay their loans early, even after the government’s scrapping of early-repayment penalties. It quotes Tim Leunig of CentreForum and a lecturer at the London School of Economics as saying graduates should think twice about paying off their debts early because most will never repay the full amount within 30 years, after which time arrears are written off.

He’s quoted as saying “Every penny of their early repayment is a gift to the government.” A gift to the government!!! That heavenly body showering us all with free goodies? What he really means is that failing to repay is a good kick in the ass to every hardworking taxpayer now stumping up the cash.

Putting yet another boot into the taxpayer is Liam Burns, president of the National Union of Students who’s quoted as saying “Ministers must come clean on student finance that those on low and middle income are not duped into chipping away at their outstanding debt.” Duped!!! Doesn’t he mean reneging on a promise?

So the government whips up a scheme for which it has no plans to fully collect unpaid debt, a teacher of our young advises against doing so and a student leader fans the flame of irresponsibility.

How morally bankrupt our body politic has become. 

Economics is fun, part 10: Taxation

We've reached the halfway mark and, inevitably, the conversation turns to taxation. There will always be someone with a big stick breathing down your neck, creaming off as much of your stuff as he can. The only surprise is how many people want him to take more!

If you're enjoying these videos, you can buy the book they're based on here. The Kindle edition is remarkably affordable, and even if you don't have a Kindle, it's readable on Kindle apps for iPhones, iPads, Android phones and lots more. Now there's a smart way to while away the morning commute.

The Gender Pay Gap is Shrinking, Hurrah!

In fact, the gender pay gap has more than halved in just the past couple of years which is really pretty fast work for a societal change of that sort of type, isn't it? This wondrous information is contained in the latest release on the subject from ONS.

For full-time employees, hourly earnings excluding overtime were £11.91 for women (up 1.9 per cent) and £13.11 for men (up 0.8 per cent). This has resulted in the gender pay gap narrowing in 2011 to 9.1 per cent, down from 10.1 per cent in 2010 (see Figure 5).

My word, that is impressive, isn't it? For only a couple of years ago we were being told that the pay gap was 20% or more. No, really, Polly, The Guardian, the Fawcett Society, all were shouting this aloud and Something Must Be Done! In fact, it was worse than that. We were being told by the Equal Opportunities Commission that the female part time pay gap was as high as 37%!

Median hourly earnings for women working part-time are higher than those of part-time men. Men’s hourly earnings were £7.67, up 0.1 per cent since 2009, compared with women’s hourly earnings of £8.10, an increase of 1.3 per cent. The negative gender pay difference for part-time employees has therefore widened to minus 5.6 per cent from minus 4.3 per cent in 2010.

Goodness Gracious Me. Something needed to be done and Something Was Done! So, what was it that was actually done?

In 2009 ONS reviewed the way it presents gender pay statistics. The review concluded that there was no single measure which adequately dealt with the complex issue of the differences in men’s and women’s pay. ONS now highlights the following measures: • female full-time employees’ median pay compared with male full-time employees’ median pay • female part-time employees’ median pay compared with male part-time employees’ median pay • all female employees’ median pay compared with all male employees’ median pay ONS prefers to use hourly earnings, excluding overtime, and focuses on estimates of the median.

I was one of those people, here on this very blog, that revealed what was happening. Fawcett, Polly, the EOC and all, were using mean wages (means will always overstate gaps because of the rightwards skew of the earnings distribution), were comparing all female employees to all male (and not accounting for the greater number of female part time workers, part timers getting less per hour than full timers) and incredibly, were comparing part time female hourly wages to full time male to give their female part time pay gap.

So what actually happened in 2009 was, well, ONS call it a review. Actually what it was was a snarl at those so willfully misusing statistics and an admonition telling them not to be so stupid and not to do it again.

Which is why you haven't been reading turgid editorials about how appalling the gender pay gap is recently.

No, I do not claim any credit at all for this happening. I do take immense satisfaction in it having happened though.