Pensions tax relief is no stealth subsidy

The UK Labour Party’s plan to reduce the tax relief that higher-rate taxpayers can take when making private pension contributions (in order to fund job-creation programmes) is an intriguing one.

Labour finance spokesman Ed Balls argues that “When times are tough it cannot be right that we subsidise the pension contributions of the top two per cent of earners at more than double the rate of people on average earnings paying the basic rate of tax.” Under his plan, those earning £150,000 would be able to claim only 20% tax relief on their pension contributions – the same rate as a person on average earnings – rather than the 50% that top earners can claim now (which will fall to 45% in April as the top rate of tax is reduced).

What Mr Balls forgets, however, is that the tax relief available on contributions to private pension plans is not, in fact, a straight subsidy. It is, rather, deferred taxation. And that makes a big difference, since if taxation is being deferred, it should be deferred at the rate it is paid.

Confused? You should be. Pensions are absurdly complicated. But here is how the tax relief actually works. Decades ago, governments wanted to encourage people to make private pension contributions. This, they reasoned, would help keep them off the welfare rolls when they retired and no longer had a wage coming in. And it would encourage thrift and self-help. So they decided to defer the tax on pension contributions. In other words, if you took all your salary now, you would pay tax on it. If, however, you chose to defer taking part of your salary and instead invested it in a pension, then part of your tax would be deferred too. That is, people would be taxed only when they actually consumed their pay: postpone the consumption, and the tax is also postponed. They would not pay tax on income that they were not actually enjoying right now.

Thus a 20% income tax payer would not pay the 20% tax on contributions to a pension, until they actually started drawing that income. Likewise a 45% income tax payer would not pay the 45% tax until they did the same. It is not a differential subsidy for high earners, just a postponement of their tax on income that they have decided to put off enjoying.

Under this logic, reducing the tax relief on higher-rate earners amounts to confiscation. They defer consumption, but still get landed with 25% tax on income they have not yet drawn.

However much governments might like to tax people on income they do not draw, it doesn’t make it right.

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Mr Cameron's fuzzy electioneering

UK Prime Minister David Cameron MP says that he fully intends to to fight the next election (in 2015) and serve another full term as Prime Minister – meaning that he will be Prime Minister until 2020. But you can't take what any politician says quite literally.

For a start, Mr Cameron's vision of staying in power until 2020 depends on the Conservatives winning the 2015 election. This is by no means certain. But evenif the Conservatives did win in 2015, what would the future hold? A narrow victory would still leave Mr Cameron in a weak position. There would be plenty of people jostling for his job, and a series of knife-edge parliamentary debate would do nothing to strengthen his hand. A strong victory should, you might think, make his leadership unassailable. But would it?

There would still be doubt. What does he say a year or two before the 2020 election? That he will step down at the end of his term and let someone else fight the election? Changing leaders just before an election is no way for a party to win – particularly if the leadership contest has been divisive. The public need time to get used to party leaders and know what they are voting for.

Nor could he say he would fight the election and then let someone take over. The public won't take kindly to voting for one person then getting another. Could he perhaps say that he will fight the election, serve a couple of years, then let someone else take over then? Once more, the public might well ask why they should elect someone who quits halfway through the job.

Mr Cameron's problem is faced by all Prime Ministers. For the party, the ideal is to go halfway through your term of office, so that your successor can get experience and public familiarity before fighting the subsequent election. But you can't say this. And if your colleagues take you at your word that you intend to carry on too long, they are quite likely to give you the push anyway, as Margaret Thatcher, despite winning three elections, found out.

The only option for any Prime Minister loyal to his or her party is duplicity. You have to tell the public that you will fight for a second term and see it out, but you have to make way for your successor before your time is up. In any case, seven and a half years is plenty for a Prime Minister. Any longer and, no matter how great you are, your accumulated baggage starts to weigh you down.

Another silly idea crashes and burns

It wasn't long after the financial crisis that we had every lefty worth their name crawling out of the woodwork insisting that this just proved how wrongly banking was structured. We must move back to local banks. Banks which had local politicians on the boards so as to make sure that the wider interests of the community were considered. Other stakeholders, like the unions must be included. And we most certainly had to divorce any investment banking from retail banking

There were a number of problems with this set of ideas: for example, none of the banks that went down in the UK did so because of investment banking. It was the wholesale bank run (Northern Rock), corporate hubris (RBS) or plain and simple bad lending (HBOS, various building societies).

But let's leave that aside. Let's assume that we did indeed have a local banking system. One that didn't have anything at all to do with investment banking. No CDOs, no CDS, no "trading", just plain vanilla lending in their specific regions. And we'll bring on board the local worthies, the local politicians, the union chiefs. Heck, we'll even make them non-profit shall we? Perhaps they should be owned by charitable institutions?

What do we end up with? Actually, we end up with the Spanish banking system:

Bankia stands as a reminder that Spain's property bubble—and the banking crisis that is its aftermath—had its roots in the intertwining of government and finance. Until the crash, Spain's cajas were community institutions closely tied to regional governments, and bank boards and regulators were peopled by party insiders willing to overlook lenders' real-estate excesses. Spain will see more disasters like Bankia's until these links are fully wrung out.

Note that here in the UK a few banks went bust (and rightly so), a couple were rescued as too big to fail and the rest became illiquid but not insolvent. They needed temporary funding aid but that could be and was repaid. That's what happened with the capitalist shareholding investment and retail bank mixing national system in the UK.

In the Spanish localised, politically directed and not for shareholder profit system absolutely all of that banking system went resoundingly bankrupt. No, not just illiquid: bust. In such large numbers that it's bankrupting Spain itself. So that's another one of those trendy lefty ideas that crashes and burns then, eh?

Oh, by the way, the only three banks in Spain that are still standing are the shareholder owned, for profit, mixing investment and retail banking, national and international ones.

Reduced liquidity really does increase price volatility you know

One part of the drivel we hear (or hear being repeatedly asserted perhaps) about the financial transactions tax is that lots of trading increases price volatility. Thus the tax, by reducing liquidity, will reduce price volatility which would be a good thing. So tax the markets and Hurrah!

There is one slight problem with this idea. It's only a teensie problem to be sure. The teensie weensie problem being that there's absolutely no evidence whatsoever that it's true.

It's entirely possible to construct theories in which it is true: that's certain. Assume that everyone's a momentum investor, just following the herd, and it quite possibly would be true for example. But it is always necessary to benchmark such theories against the real world. As an example, I've always been quite taken with the theory that The Moon is made of green cheese. That has indeed been tested and no, Neil Armstrong was not able to consume regolith on a Jacobs Cream Cracker. So it is with this idea that increasing liquidity in a market increases price volatility: or the inverse, that reducing it would reduce such.

Eric Hunsader at Nanex presents us with a nice start to 2013 markets — a no less than an 8 per cent drop and subsequent clawback in natgas futures during early Thursday trade: That’ll teach you for not waiting for a bit more liquidity later in the day.

Interesting, isn't it? How actual facts often upset the wilder suppositions put forward by those who would tax us all more?

Indeed, there's almost certainly a Ph.D thesis in there for someone who wants to do it. Take 20 or 50 different markets (and cover different things, stocks, bonds, derivatives, commodites), in different countries, with different holiday periods. Compare and contrast price volatility in those markets with those holiday periods and reduced volumes and liquidity.

My bet is that we'll see increased price volatility in circumstances of reduced liquidity. And to supporters of financial transactions taxes (and the idiocy that is the Robin Hood Tax) if you're so sure of your claim, why haven't you done this analysis already to prove your point to us?

EU derision time

The EU Federalists have already written the script for the UK’s new relationship as an “associate member”.  We will be subject to all the regulations and costs of EU membership without any influence or voting rights.  That is roughly the deal Norway currently has.

So is this decision time as we choose between attractive alternatives or derision time as we crawl pathetically back into our hutch?

The Federalists believe the UK has little negotiating room and Cameron will be out of office before the talks get tough.  At the next election, UKIP will not be taking many, if any, Westminster seats but they will be drawing away the key marginal voters.  Any Lib Dems remaining will undermine negotiations. 

So is the EU now a lost cause?  If it was left to the FCO, it certainly would be.  Our diplomats have no blueprint of an EU, nor of an exit, that we would like, nor any plan to achieve either of them.

What can we do?  Cameron needs to agree the seriousness of the issue with Milliband – forget Clegg.  The UK’s national interest needs a negotiating team and a strategy  that will survive the next election whatever the outcome.  The team should work in secret and bring together some of the more thoughtful MPs and MEPs, both Conservative and Labour, as well as the City – our most crucial economic interest.  Unfortunately it will also need diplomats, but retired ambassadors rather than serving civil servants, because it will be essential to know the extent to which we can bring other EU members along with us.

The team should be given a year, no more, to come up with an A and a B scenario to compare with scenario C, and plans to achieve A and B:
A. What is the best “staying in” deal we can reasonably expect to achieve?
B. What is the best “opting out” deal we can reasonably expect to achieve?
C. If we are blocked from both of those and continue to be dragged, whingeing, along, how will that look?

A referendum should be deferred until we are ready but that is easy.  If a premature referendum comes to the wrong answer, have another a year later.

We can win this campaign but not if we continue to deal with the EU in the manner we have for the last 40 years.  If we lose this campaign it will resemble our last Eurovision Song Contest entry: a tired old gent being derided by a bunch of countries with whom we have lost touch.

Opportunities for students this spring

2013 is shaping up to be a good year for young fans of liberty. Here are some opportunities available to them.

Free Books for Schools
In October we began sending out books for A‐Level students studying politics, economics and philosophy. By December we mailed out over 1,000 books to Sixth Form students. The books available are listed below, and we can provide up to three copies of each to your school.

Freedom 101 (Free PDF)
Freedom 101 gives answers to 101 common errors made by opponents of free markets and open societies.

A Beginner’s Guide to Liberty (Free PDF)
A short, accessible introduction to liberal ideas from free trade to banking to legalized drugs.

The Condensed Wealth of Nations (Free PDF)
An explanation of Adam Smith's The Wealth of Nations that uses Smith's own words and explains them for a modern audience, point-by-point, to allow his great ideas to shine through.

Win £500 in our Young Writer on Liberty Competition
If you’re under 21, there is still time to enter our writing competition before the closing date on February 1st. The first prize includes £500 and an internship at the Adam Smith Institute. You can find more information here.

Independent Seminar on the Open Society (ISOS) March Student Conference
The Independent Seminar on the Open Society (ISOS) is a free one-day seminar for sixth-formers, held in London twice a year. This March the conference will focus on free market economics. Topics covered will include:

Limits of knowledge
The benefits of trade
The fallacy of evidence-based policy
The private supply of public goods
Debate: Should we be able to sell our organs?

Students are welcome to attend independently, or with teachers. Refreshments will be provided.

If you are interested in finding out more about any of these, do contact us at info@old.adamsmith.org.

How not to start negotiations with the EU

David Cameron is expected to make his long awaited EU policy speech shortly.  We are told it will be radical and bold. The consequence, we are told again, will be a major renegotiation of our EU terms or departure with our head held high.  That choice will be for the UK to make on the basis of an in/out referendum.

Cameron is in the weakest negotiating position of any British Prime Minister since Edward Heath.  With her Bruges speech, Thatcher turned us from a respected contributor to a moaning Minnie, complaining at every step of the EU way and thereby alienating our friends.  Major dismantled what could have been a powerful trading partner for the EU leaving a rump EFTA today.  He led our potential allies into the arms of Brussels.  Now they want our money but not us.  Blair, to appease the unions, gave away John Major’s opt-outs and, to curry favour with new EU members, much of the Thatcher rebate. Brown handed City regulation over to Brussels.

So far Brussels has been helpful on Scottish independence because Spain is terrified that Catalonia will go the same way.  But if the Federalists can use Scottish independence as a further way to undermine the UK position, they surely will.

The track record of our City, regulators and civil servants has been weak.  Much of the EU treaty and regulatory wording has been drafted by our people.  They claim, naturally, that the treaties and regulations are better than they otherwise would have been. From the Federalist perspective these civil servants look remarkably like a Fifth Column, advancing the EU cause under British colours.

And finally consider the witlessness of our MPs. Have any have sat down and worked out what we are trying to achieve and how that can be done?  Bill Cash is thoughtful but no one listens to him any more. On fisheries, did we not sell most of our rights to Spanish fleets?  Will the courts allow us to repatriate those rights without compensation and will the compensation not be higher for an independent UK?

Our MPs and our media have further alienated Brussels and other member states by blaming them for UK intervention and undermining our sovereignty  when, for example, far more regulations have arisen from Whitehall and Westminster than ever came from Brussels.  Transparently, it has suited Whitehall to escape the odium that should be theirs.

In short, the UK will begin the negotiations with the worst possible background. 

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If elections have consequences, then so does economics

Speaking on Fox News Sunday following the U.S. presidential election, Bill Kristol, editor of The Weekly Standard, said that Republicans, having lost to the Democrats, could no longer hold out free market principles with respect to taxation.  ‘I think there is a very good chance that [President Obama will] pass major consequential legislation in the second term, and people like me won’t like it that much.  I think Republicans will have to give in much more than they think,’ he said.

Kristol elaborated on the GOP fallout:  ‘The Democrats picked up seats in the House and Senate, and the President is in good shape ... the Republicans in the House will be able to get some concessions and some compromises, but I think there will be a deep budget deal next year, it will be an Obama-type budget deal, much more than a Paul Ryan budget deal, type budget deal.  And elections have consequences.’

Kristol’s musings were the subject of much Democratic smugness and Republican alarm, with his singular sacrifice for the greater good echoing Cato’s 10th Letter:

No man living laments the calamities brought upon his country, more than I do those brought upon mine:  Yet I freely own, that I think the paying off the nation’s debts, and restoring, by that means, the kingdom to its power, its grandeur, and its security again, was an end worth all the evils which we have yet suffered; an end which ought, if possible, to have been purchased with greater than we have yet suffered, if it could not otherwise have been purchased.  I think that it ought to have been done, though attended with many ill circumstances; and might have been done, even upon those hard terms, with justice to private men, and honour to the nation.  We are not a people without it; nor is it worth while to dispute about the best cabin in a ship that is sinking.

But not only elections have consequences; so do economics.  For those who believed that GOP intransigence on ‘tax cuts for the wealth’ — or ‘tax cuts for the economy’, a rhetorical ploy by one knowing Republican wit — was motivated by selfish greed, no doubt this volte face must come as a welcome return to common sense.  To their peril, they ignore the findings of the Laffer curve.

Named for Reagan-era economist Arthur Laffer, the curve charts government revenues against taxation rates, based on the idea that at both zero and one hundred per cent taxation the State will collect no monies, but that somewhere along this curve are rates for optimum private sector growth (nurtured by the provision of public goods by the State) and optimum government revenue. ‘The uniform, constant, and uninterrupted effort of every man to better his condition’, wrote Smith, ‘the principle from which publick and national, as well as private opulence is originally derived, is frequently powerful enough to maintain the natural progress of things toward improvement, in spite both of the extravagance of government, and of the greatest errors of administration (II.iii.31).’

Ultimately, the question must be focussed on what the market will bear.  It is one thing if additional taxes will be no more than an irritant for entrepreneurs and corporations; quite another, though, if these additional burdens occasion distortions and disincentives to economic activities.  Such conditions met one of Smith’s definitions of a bad tax, for ‘it 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 (V.ii.b.6).’

For adherents of Laffer, studies indicate that the threshold lies at government expenditure at about 18-20 per cent of GDP; that is, up to this point most business activity will continue unabated, but once this nominal level has been crossed, then extraneous considerations enter into business calculations.  (Thus, there is a gap between growth-maximisation and revenue-maximisation on the Laffer curve, the difference being that greater government pressure via increasing tax rates will result in slowing private-sector profits.)

What this means is that applying additional taxes past their maximisation point will not result in higher revenues, but lower — bringing neither justice to private men nor honour to the nation.  The nineteenth-century French economist Frédéric Bastiat popularised this economic phenomenon as ‘That Which Is Seen, and That Which Is Not Seen’:

Between a good and a bad economist this constitutes the whole difference—the one takes account of the visible effect; the other takes account both of the effects which are seen and also of those which it is necessary to foresee.  Now this difference is enormous, for it almost always happens that when the immediate consequence is favorable, the ultimate consequences are fatal, and the converse.  Hence it follows that the bad economist pursues a small present good, which will be followed by a great evil to come, while the true economist pursues a great good to come, at the risk of a small present evil.

A step in foresight to improve the nation’s finances proves in hindsight a wounding blow to the public treasury.  A century earlier, Bastiat’s compatriot the Baron de Montesquieu proclaimed pithily in The Spirit of the Laws that when savages ‘are desirous of fruit, the cut the tree to the root, and gather the fruit.  This is an emblem of despotic government.’  Now savagery and despotism are camouflaged as enlightened policy.

Though unaware of Laffer curve economics, Cato was not unmindful of its effects.  ‘If, in taxing labour and manufactures, we exceed a certain proportion, we discourage industry, and destroy that labour and those manufactures,’ he astutely noted.  ‘The like may be said of trade and navigation; they will bear but limited burdens:  And we find by experience, that when higher duties are laid, the product is not increased; but the trade is lost, or the goods are run.’

Key to policy formation is whether America has reached or exceeded the optimum marginal tax rates for optimum government revenue; and whether increases in the one will lead to increases in the other.  Indicators are that the threshold has been met:  record amounts in bank reserves and corporation coffers suggest that current levels are curtailing business growth, as does anecdotal evidence from CEOs and small business owners who fear that further taxes and regulations will eat into viable profit margins.  Yet, were the highest marginal tax rates decreased toward growth maximisation levels, innovators and entrepreneurs would doubtless invigorate the market, boosting tax revenues further — another facet of Bastiat’s counterfactual analysis.

‘You know what?’ Kristol concluded, ‘It won’t kill the country if we raise taxes a little bit on millionaires.  It really won’t, I don’t think.’   But the financial argument is not about the supposed merits of any nominal marginal tax rate on the highest incomes (moral issues are another matter), but on its effects on the total American economy.  Kristol sees only short-term political compromise and is blind to long-term revenue shortfalls; his apparent graciousness in electoral defeat is economic illiteracy in disguise.

Political equivocations cannot trump economic realities.  By masquerading as a commendable compromise to save the nation’s sinking finances, will the ship of state surely be lost.

On the false precision of mathematical economics

Halfway through an MSc Economics at a well-respected department, I have found myself learning no new economics, but only struggling unpleasantly with a level of maths that seems relevant only for pure scientists.

The students, for their part, wish only to master the equations in order to pass the qualification and get good jobs. Broader economic ideas are seen as an optional module, rather than the core that they are. Microeconomics seems exclusively to rely on comparative statics (holding one variable constant whilst you assess another, in a state of equilibrium, using differential calculus).

But since we are not rational beings, the irrationality of this seems profound. The recent trend in "Behavioural Economics" is a step in the right direction (intertwining psychology into statistical assessments of activities), but again, one isn't certain if the exercise is just a ruse to further complicate the statistics.

I remain a fan of Schumpeter, and though for a time, he was head of the Econometric Society, he was also concerned to integrate more sociological understanding into his economic theories. The profession would not do too badly by trying to revitalise this (more integrationist) approach, utilising more of the core social scientific developments, and perhaps fewer of the natural science attempts at mapping certainty.

In order to be useful, the computationalists argue, we have to quantify our actions and be able to replicate them - anything else is simply hokum, and lacks both scientific rigour and logic. These, the theorists demand, is the key to everything. Maybe. But with increasing numbers of economists stemming from maths and engineering, what they are bringing with them is not economic understanding. Well-equipped critical thinkers are being discouraged from entering a discipline that is obsessed with the false certainty of mathematical analysis.

In a lifetime of work, study, family interactions and educational exposure, I have known very few people who are logical and rigorous, consistent and replicable. And the financial markets? Again, comes the argument, if we had cracked the phenomena of financial dynamics, software programmes that have automated actions following trends' analysis, we would not have brought august institutions to the ground in hours and there would probably be no business cycle.

And yet after decades of mathematical economics, we haven’t cracked these things. Institutions still fail, cycles persist and the human nature underlying it all remains just as unquantifiable. Perhaps by embracing the lack of clarity, the human “fuzziness” we can promote the contemplative again and start teaching and learning some real economics.

Damian Merciar is a Business Economist and Strategist, with 20 yrs experience of public and private sectors. He is also currently studying part time for an MSc Economics.

Article: If elections have consequences, then so does economics

Speaking on Fox News Sunday following the U.S. presidential election, Bill Kristol, editor of The Weekly Standard, said that Republicans, having lost to the Democrats, could no longer hold out free market principles with respect to taxation.  ‘I think there is a very good chance that [President Obama will] pass major consequential legislation in the second term, and people like me won’t like it that much.  I think Republicans will have to give in much more than they think,’ he said.

Kristol elaborated on the GOP fallout:  ‘The Democrats picked up seats in the House and Senate, and the President is in good shape ... the Republicans in the House will be able to get some concessions and some compromises, but I think there will be a deep budget deal next year, it will be an Obama-type budget deal, much more than a Paul Ryan budget deal, type budget deal.  And elections have consequences.’

Read this article.

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