Corporation tax vs. sales tax

I was on the Today programme this morning, at the ungodly hour of 6.15am, making the case for scrapping corporation tax and replacing it with a sales tax. This has come onto the agenda because Lord Lawson, chancellor under Margaret Thatcher, and great shifter of tax from incomes to consumption, suggested the idea. I also made a similar argument in City A.M. last week.

Why might we want to scrap corporation tax? Corporations are legal fictions; the burden of the taxes they pay must come out of the pockets of their stakeholders. In fact, it comes out of their employees' wages and their shareholders' returns. In itself this is not a huge problem, but we have a huge weight of economics research telling us that we must not tax capital.

Why might we want to switch to a sales tax instead? Well, unsurprisingly given where I work, I'd probably prefer no tax hikes at all. But, presuming we have to raise revenue somewhere, then the goal is to minimise the distortions in the system. Taxing corporate profits discourages profits—the most reliable guide a firm is doing its joband discourages corporatesthe backbone of modern capitalism.

Sales taxes shift the burden away from successful, desirable economic activity and towards less successful or unsuccessful firms. And note that if firms have a future, investors will plough more and more money into them despite making tiny profits or even losses. This does not change that: start-ups can still spend years making losses before they make it big.

They also go some way to resolving public discord over the corporate tax burden. Since it seems impossible to get over the point that it's pension funds and Google staff who lose out if Google is squeezed (Google might be a bad example because it seems that in this case it's paying the amount required by both the letter and the spirit of the law), maybe this more transparent levy would satisfy popular demands.

Certainly taxing firms on their profit but based on their sales in a territory (rather than where they create value, as in the current system) would create horrendous disincentives—driving many firm subsidiaries out of the UK.

The main objection is the same objection as people give to VAT: sometimes it's unclear whether a sale is made in the UK or not; smaller firms find it costly to keep up with. These are legitimate but dwarfed by the costs of distorting investment under the current system.

The real problem is if a 'sales tax' becomes a revenue tax, and falls on intermediate transactions as well as final sales—this would discourage any subcontracting and push firms to become giant vertically-integrated behemoths. But I am optimistic: with a bit of pushing, sometimes reforming civil servants and politicians will do the right thing.

Why taxes and snooker rules are not that different


Pretty much anyone with even the sketchiest understanding of economics knows that a competitive market is the mother of all driving forces for efficiency. In fact, Kenneth Arrow and Gérard Debreu have a mathematical proof called the Arrow–Debreu model which shows that if the conditions are propitious in terms of a competitive free market there will be a general equilibrium between total supplies and total demands reflected in a set of prices. Obviously there are all sorts of reasons why the reality isn't the case, and that's largely due to all the ways in which politicians interfere with the natural mechanisms of prices (taxes and price controls are two prime examples). Like others at the ASI, I am not unfriendly to some form of government - but one of the primary rules of thumb is that in most cases an interference in the market that upsets the natural price mechanisms created by supply and demand is an inefficient interference.

For a more generalised indicator about when it is likely to be bad to interfere in the market in terms of negatively affecting people's behaviour, consider the game of snooker as an analogy. I used to play in two types of snooker league: the open league and the handicap league. In the open league both players would start the game on zero, and the best players had the best chance of winning. However, in the handicap league, based on a points system conditioned by past results, better players would give inferior players a head start in an attempt to narrow the gulf in ability and make the frames more evenly contested.

The handicap league works because even though the points are differentiated at the start of play, both players are still incentivised to try their hardest and play to the best of their ability. A handicap snooker league in which poorer players were given more of a chance by the better players being compelled to deliberately play below par would be no fun for either player.

The snooker handicap league can provide a pretty good illustration for when governmental interference in the market is good and when it is not. Policies that cause the participants in the market (snooker players) to waste opportunities (play below par) are likely to be bad policies, whereas any policies that cause as few wasted opportunities as possible (in a way that's similar to handicap scoring) are less likely to be bad policies (note: pretty much all taxes and price controls cause some loss of efficiency, so that's why I said 'cause as few wasted opportunities as possible' rather than 'cause no wasted opportunities').

To translate that in market terms, taxes or price controls that change behaviour in a way that diminish efficiency are undesirable. A price control on renting apartments is going to negatively affect property development and create a shortage (which ironically makes renting apartments more expensive). This is the snooker equivalent of making players play below their best ability. On the other hand, taxes like inheritance tax or savings tax or consumption taxes on goods to which consumers are relatively price insensitive, while not without some behaviour-changing costs, are more like the snooker equivalent of handicapping - they don't greatly diminishing anybody's drive to perform well. And let’s not forget, some taxes, such as taxes on negative externalities like pollution and congestion are taxes that can change our behaviour for the better.

The upshot is, whenever you consider a tax, a price control, a subsidy, or any other kind of government involvement in the market, it is good to consider whether it is a solution akin to adjusting the starting scores in a handicap snooker match, or whether it is akin to asking some snooker players to perform below the best of their ability. The closer that government involvement is to the latter, and the farther away it is to the former, the less good for society it probably is.

People are still very confused about the Google tax story


As a masterpiece of tripping over your own argument we think that this from The Observer takes some beating:

Recent wrangles between the European Union and the US on tax show how difficult achieving international consensus can be when competing interests are at stake. But it is possible: the EU is the most successful example ever of international co-operation.

Opinions obviously differ on how good the EU is at international consensus. But to use this argument when we are discussing Google's tax affairs does take some sort of chutzpah, possibly even ignorance:

Last week, the government chose to play both David and Goliath. George Osborne declared the deal UK tax authorities struck with Google to cover a decade of tax liabilities “a major success”, despite the fact that some estimates suggest this may represent an effective tax rate of just 3%.

The 3% number is nonsense of course. It is calculated by looking at the revenues that Google gains from sales in the UK and then applying their global profit margin. But if that's the sort of nonsense that people wish to use then why not humour them. And then ask, well, what rules are they that allow such a tax rate?

The rules that allow this are of course the European Union's own Single Market rules. Which give an absolute right for a company in any one EU country to sell in all EU countries and pay tax where the company is resident, not where the sales take place.

Some success in international co-operation and international consensus then. The organisation which is being praised is the one producing the initial problem being complained about.

Our own view is as we've said before. Corporations used to be a useful proxy as a place to tax the returns to investors, even with the unfortunate side effect of some of the economic burden falling upon workers. They are clearly no longer such a useful proxy so we should give up the pretense. Just abolish corporation tax altogether and simply tax people in their incomes and or consumption. At which point tens of thousands of tax experts have to go do something useful with their lives.

Such a pity, eh?

There's a declining marginal utility to government just like there is to everything else


We are perfectly happy to agree with the idea that government is a good thing to have. We are not, after all, anarcho-capitalists around here. However, we are at least economically informed, and are aware that there's diminishing marginal utility to pretty much everything. And thus, inevitably, there's also diminishing marginal utility to more government. Thus we have no objection to this basic statement from Noah Smith:

There’s a good argument that quality of government in North America, Europe and Japan improved dramatically in the 19th and early 20th centuries. Government became steadily more participatory and less predatory. Bureaucracies became more professional. Spending on infrastructure dramatically increased, funded by taxes. Public services such as urban sanitation -- which Gordon counts among the Great Inventions, but which is dependent on government efficiency -- curbed disease and improved health dramatically. Health and safety regulations helped as well. Public education greatly increased the skills of the workforce.

Libertarians often portray the state as a parasite, but there is a good argument that big government -- and, more importantly, good government -- was responsible for a significant amount of the growth in developed nations between 1870 and 1970.

That kind of improvement was probably a one-off.

We wouldn't, perhaps, emphasise it in quite that manner but the underlying idea is to us clearly true. Some part of the improvement in life over the past century or two was indeed because government became less predatory, more efficient and so on. However, we would also insist upon thinking about Maslow's Hierarchy (as Smith does in part) a little more with reference to government. Maslow's point being that some needs or desires become satiated and then our ever increasing wealth gets turned to sating other and different needs and desires. And we are really pretty certain that our need and or desire for more government has been sated.

Note the important point at the heart of Maslow's thinking: it is that at any point of income or wealth we have superior, normal and inferior goods. A superior one is where if our income (or wealth) increases then we will spend a greater portion of that new income on that good than we have previously being paying of our total incomes. Normal goods claim the same proportion of that extra income, inferior ones less than that average rate. And given that, the real point is that all goods are, at some income level, superior, normal or inferior. Yes, even including government and or governance.

We're entirely happy with the idea that at some level of income more government is a superior good. Medieval government was lucky to get hold of 5 perhaps 10% of the economy in any one year and yes, we do think that rather more than that devoted to a basic welfare safety net is entirely reasonable. But note again that at varied income levels absolutely everything becomes a superior, normal and inferior good over time.

All our contention is is that at this level of income government is an inferior good again. As our incomes rise we should be spending a smaller portion of our incomes on it. We've beaten the big problems that more government can beat: so, let's have less of it into the future as a portion of our incomes.

While we have our sympathies with Guy Fawkes, apologies, this just won't work


There's a great deal to like about this idea. Given that the Palace of Westminster needs billions in repair work, why not simply abandon it and stick the politicians in a series of rabbit hutches in Barnsley. Or, perhaps, Bradford. Rather joyous to contemplate in fact. However, sadly for our fantasies, we don't think it will work:

No matter how much those who have worked there love the rodent-infested, mock-Gothic fun palace, perhaps the time has come to let it go. And if we’re getting radical – and this will please the Chancellor – why not go whole hog and avoid the punishing costs of building in the dead centre of the Capital by relocating elsewhere?

The reason is this:

The Palace of Westminster has been a Grade I listed building since 1970 and part of a UNESCO World Heritage Site since 1987.

We most certainly can't knock down a Grade I listed building and there's very serious limits on what can be done to change it internally, too. Given the laws that have, err, been passed in that Palace there's not really anything we can do with that Palace except leave it pretty much as it is. Maybe with a spruce up, yes, but even trying to change the internal layout of rooms would almost certainly be verboeten.

That is, the choice is not between saving money by abandoning Westminster and locating elsewhere, it's between repairing Westminster (no, you cannot simply leave a Grade I listed building to collapse) and sticking the politicians back into it or repairing Westminster and paying a further fortune to stick them elsewhere (recall, the Scottish Parliament did not exactly come in on budget).

So, nice idea but not one that really passes the public expenditure test. We've got to repair that building anyway and we can't really use it for anything else. Joyous as it would be to have the Commons in, say, Radstock, and the Lords in, possibly, Scunthorpe.

People just still aren't getting it about Google's taxes


There are any number of people saying things akin to this about Google's tax affairs. And sadly all of them are exactly and precisely wrong:

But Jeremy Corbyn said experts thought it amounted to an effective rate of about 3%, in contrast to rates of corporation tax of above 20% over the last decade.

The Labour leader pointed out that most people did not have the luxury of personal meetings to discuss their tax affairs. “Millions of people are this week filling in their tax returns to get them in by 31 January,” he said. “They have to send the form back. They do not get the option of 25 meetings with 17 ministers to decide what their rate of tax is.

“Many people going to their HMRC offices or returning the [form] online this week will say this: ‘Why is there one rule for big multinational companies and another for ordinary small businesses and self-employed workers?’”

About lobbying: well, what does anyone expect will happen? The more arbitrary and political the treatment of a company is the more lobbying will be done to influence the politics. But the thing which is exactly wrong is this idea that Google is exploiting some set of rules available only to large and or multinational companies. That is precisely wrong: completely the opposite of reality.

What it is actually doing is saying that it sells its advertising into the UK from Ireland. The tax treatment of those advertising sales is thus up to the Irish taxman, not the UK. Maybe it shouldn't be this way, maybe it should, but that is the way that it is. And under the usual treaties (OECD standard ones, and also current EU law) that really is the way it is.

So, why is it this way?

Because international tax law accepts that we would like to have small companies taking part in international trade and also that it's possible for the demands of the tax authorities to be too high to allow them to do so. A UK company which makes the occasional sale in Germany say: or India. Do we think that they should then file a German, or Indian, tax return? Try to pull out the profit that was made on perhaps 0.5% of their turnover just for that one tax authority? Prepare accounts according to the standards of every country they ever ship a package to?

No, obviously, we do not insist upon that. It's as plain as the idiocy on a tax campaigners' face that we're not going to insist upon that: not if we're to allow small companies to take part in international trade.

So, how do we organise it? We have a definition of when a company is "really" in a particular taxing jurisdiction. Essentially, when there is a "permanent establishment". No, don't worry how that is defined: just accept that there's going to be some cut off point. You're a big company with a big presence, cough up locally. You're a flea bite on the economy? This economy is trivial to you as a company? Well, why not just account for profits and pay taxes at home then?

Note again: we do not insist that the current rules are right. Only that there is always going to be some approximation to this system in any international taxation system. We simply are not going to insist upon a German tax return for the two man UK company that ships a model train steam boiler to one customer in Germany. And thus we must have a distinction.

What is it that Google is doing? They are claiming that their Irish Google, the one that sells all the advertising, is in fact an Irish company with no such permanent establishment in the UK. Is this thus special rules for multinationals, for large companies?

No, obviously it isn't. This is a tax simplification set up for small companies. And Google is claiming it by claiming to be a small company. This is a tax simplification available to absolutely every Irish company that sells into the UK. It's one that applies to every French one selling into the UK, to German ones selling into Romania and to all UK companies selling everywhere. As long as you don't have a permanent establishment where you are selling then you pay your tax at home.

Whether it should be this way is another matter. But we really do think it's important to point out that Google is not exploiting some loophole only available to large companies. It's actually using one that was designed for small companies and applies to all small companies. And it's also one that just about every company that does any international trade at all uses at some point or another. Even the largest global exporter does not have a permanent establishment in every tax jurisdiction. Finally, the tax system just wouldn't work at all, not and allow small companies to conduct international trade, if something like this were not in place.

Exploitation? Loopholes? Abuse? Unfair? Could be any of those things according to your own opinion. But let's get it right about which loophole is being exploited to produce possibly unfair abuse. Unlike, you know, all the tax justice campaigners. This is a small company exemption, not a large company one.

The Housing Market: from Whitehall Clichés to Local Initiatives


At present we have housing policies which revolve around clichés. If something is repeated often enough, it soon begins to be taken for truth. We are told time after time that there is a housing crisis. We are also told that the level of new build is too low and lower than in the past. Finally, there is the policy stereotype that we need national targets to solve the crisis. The crisis is usually defined in terms of affordability, and measured in terms of the ratio between income and house prices. Income is taken as the income of an individual. Yet most mortgages are taken by couples both with earnings so a more realistic figure would be the joint household income. There are no published figures for such joint income: but partners who are both on the minimum wage would be earning £30K between and across the labour market, £40K would be a more reasonable estimate.

Outside London, the South East, and East: prices paid by first time buyers in 2014 were:

  • West Midlands - £146,000
  • East Midlands - £137,000
  • Yorkshire and the Humber - £133,000
  • North West - £136,000
  • North East - £118,000

(Source ONS)

The average price across these five regions is £134,000. The (Help to Buy) scheme with a 5% deposit has been popular in these areas, but even a 10% deposit should be feasible in a population where most young people under 30 have ISAs. For a 10% deposit, in the extreme case in which they had no savings at all, our young or not so young couple would have to save between them £600 a month over two years - from a gross income of £3300 a month. In Scotland, the average first time buyers price was £137K and in Wales £133K.

In other regions there are more serious problems of affordability. In the East the starting price was £204K, in the South East £231K and in the South West £181K. But even in these regions there are lower priced properties in some areas. There is a real affordability problem in London where the starting price was £364K. So in terms of affordability, there is a range with no problems in five regions, some in three, and an acute problem in London.

Excess Demand -The second test of crisis is the existence of strong excess demand. There are 124 post code areas in the UK. Our estimate is that of the 124 there are 30 with intense demand pressure, 70 where turnover is steady, and 24 where there is a housing surplus measured by the existence of housing stock that hardly ever sells. Again the problems are much more limited than the usual description in terms of crisis.

The Holy Grail of Owner Occupation

There is another idee fixe which has a great influence on policy— there is a crisis in terms of reduced access to owner occupation. Between 1961 and 2008 owner occupation rose from 43% to 68% of households and private renting rose from 9% to 14%. This rise in owner occupation was due to some factors, such as, the coming of the right to buy not likely to be repeated on this scale. The private rented sector has made several contributions:

  1. Local initiative through buy to let has led to increased choice and the availability of tenancies in every town and city including London. This was a totally different situation from that at the end of the era of rent control in the 1960s.
  2. Renting gives people with middle to low incomes much more choice of the area in which they live. Every year many thousands of new graduates and new migrants find accommodation in London. The rental market even in London has adjusted to the purchasing power of the customers which is much lower than that for house buyers.
  3. Renting allows people to find accommodation quickly in new areas—the transaction costs are much lower. Owner occupation fitted well to a labour market in which people had jobs for life, but makes little sense for people who may move jobs, become self-employed or even move abroad for a period.
  4. There is a tendency to exaggerate the shorter term capital gains to owner occupation. If house prices rise 5% a year in real terms, they would double in 20 years. The £134K house would be worth £270K—but the owner occupier –allowing for mortgage payment and depreciation of £2k a year for repairs, would have paid £180K even before discounting which would reduce the long term gains. The capital gains to owner occupation accrue mainly to those with very long term occupation who have paid off their mortgages—in fact the generation who were in jobs for life.
  5. Even the problem that young people continuing to live with their parents is not as simple or heart rending as it sounds. This is not just a question of housing shortage. It may be the better option if the parents are under occupying larger houses. There are also gender differences with many more males in their 20s continuing to live at home. Perhaps the next Whitehall programme should be to promote evening classes for young males on how to turn on washing machines and cook simple wholesome fare.

The Myth of Under Production

Housing policy is deeply affected by the view that we are building far too few houses. Often mentions are made of the 400,000 plus built in the 1960s. However these numbers were a once for all event in conditions which were very different. There were residual problems with slum clearance and bomb damage: but the main feature of the 1960s was the ruthless demolition of large areas of housing, especially in Manchester and other Northern cities, and replacement with large estates often of poor quality. There was much demolition of houses which should have been improved. Many of the properties built in the 1950s and 1960s have had to be demolished because of their poor quality having caused misery to their residents. Many of the famous Macmillan 300,000 houses have had to be demolished. The photos show striking examples in Hackbridge, South London. workers cottages at least 200 years old could be on the market for £500K while a 40 year old development by the River Wandle is being demolished.

Hackbridge 1 Hackbridge 2

In social housing the Peabody properties built 150 year ago are of better standard than many of the modern properties close to them. Whole estates have had to be demolished such as the Quarry Hill flats in Leeds and the Ferrier estate in South London—but not before they had caused misery to successive generations of tenants.

In fact the output of private sector housing has been quite stable up to 2008, at around 150,000 houses a year — one of the few features of the housing market that has shown some stability. (See graph) The lessons of the past are that national targets promote poor quality in housing and that government interventions have been the main cause of a repeated boom and bust cycle in the housing market.

Screen Shot 2016-01-28 at 15.34.55

The New Realities of the Housing Market

There used to be a housing life cycle which involved early periods of renting or living in the family home, followed by movement to a small house or flat, and then for some after a few years moving to a larger house with family space. The stay in that house could be decades. This life cycle pattern led to a stable core of long term owner occupiers—or council tenants.

Now the market is more divided into sub-markets depending on a much greater variation in housing preferences by ‘consumers’. The market is adjusting to changes in household types which are leading to greater variations between local areas. There is not one national housing market but a series of sub-markets between housing of different types and sizes, and with differing economic incentives. We need much more information about the housing demands of specific groups including:

  • Single people—now 44% of households.
  • Regional and sub-regional differences demand for properties of different types and sizes.
  • Housing mobility by younger people and housing aspirations.
  • Likely downsizing by older people—and how equity release has reduced the incentive to downsize. Mobility and post retirement options.
  • How do people see options for changing housing space without moving? There is a much more extensive business in terms of additions to properties than there was in the past. How far will these options affect local demand for housing?

The most obvious regional difference in housing is between London and the rest of the UK. The London market is distinctive in its housing stock with more than half the flats in the UK in London. It is distinctive in the average price and in the top end property values. It is also distinctive in turnover and mobility.

The London market is affected by Hirsch effects named after the economist Fred Hirsch[1]. (Hirsch 1976) There can be intense competition for scarce positional goods. The word “cool” is worth £200K on the London housing market as formerly low income areas such as Balham and Tooting acquire social cachet. The Sloane rangers have now moved to Battersea. Transport and tube availability reinforce the Hirsch effects. Such effects are found much more strongly in London than in any other parts of the UK. These special conditions certainly require feasible measures to increase the availability of housing—but they are a bad guide to policy for the rest of the UK.

Policy Directions: Quality and Choice

Housing needs to use DevoMax. We need not national housing targets but a series of more local and sub-regional policies to build momentum for further improvement. There has been some very significant progress over the last two decades in raising quality and choice. 90% of British properties now have central heating and reach standards which would have seemed out of reach 40 years ago. Social housing agencies have greatly improved management of rented public housing. Buy-to-let investment has increased choice and mobility.

Local Enterprise Partnerships can be leaders in improving the local environment. Some LEP plans and County Councils are already setting targets for housing. They now have the chance to lead in better local environments. For example SEMLEP the LEP for the South Midlands covering Buckingham, Northampton and Milton Keynes with a current population of 1.7 m has set out aspirations for building 100,000 houses in the next ten years.

West Sussex is expecting 56,000 houses over the same period.

Overall LEPs are planning 1.5m houses over the next ten years. These developments create opportunities for some distinctive high quality additions to the local stock. But first LEPs should commission studies of the potential customers in the area. What seem to be the gaps in the existing housing stock? There are opportunities for many different types of scheme, from starter flats for young people through to extra care housing. Targets for ‘housing’ are too simplistic. What kind of housing in a time when there is much less standard life cycle than used to be the case?

Targets lead to a focus on numbers and easy options to reach numbers. This will tend to push action towards building large numbers of houses on the outskirts of exiting towns, often without adequate infrastructure and social amenities. Instead of ribbon development we will get rectangle development. There is a danger that opportunities will be overlooked for infill developments within towns. Change on the High Street and on supermarket sites is creating new opportunities for much more building in towns. LEPs can provide information both in terms of the types of housing required and for local opportunities. There are particular opportunities for social housing agencies to develop these local schemes. Instead of national targets we need different market driven opportunities which will vary between LEPs. Devolution means promoting housing choice and housing quality—for people with lower income as well as the better off.

A local approach is highly relevant to the special problems of London. Here there are pressures but also an active market for any middle income housing either for rent or buy. There are many new opportunities to develop sites. For example one supermarket chain (Tesco) in London has just released ten large sites for development.

The reduction in planning restrictions on adaptation of offices into residential has had highly positive effects but there is far more that could be done, especially in the suburbs, for more intensive use of smaller, often semi derelict industrial and garage sites, as well as for change in High Streets to redevelop unused shops. There is of course scope for developing new kinds of industrial site as is being done in Shoreditch, but many of the smaller sites in the outer suburbs such as Richmond and Hounslow are not suitable.

There are already positive developments in rented housing in London. Under the Build to Rent scheme there are already close to 14,200 units in planning, completed or under construction in London compared to 7,112 in the rest of the country. These schemes are attracting pension fund and institutional investors and can do for the wider range of mainly young people what investment has done for student housing.

The housing problems of London should be addressed by local initiative not by national targets.

[1]Hirsch F. Social Limits to Growth . Routledge 1978

Even if we were Mariana Mazzucato we wouldn't have chosen this example.


Talking about Labour's "rock star" economists and their tour of the UK to tell all how neoliberalism is not longer where it's at, Anne Perkins gives us this:

On Tuesday night, the economist of the Entrepreneurial State, Mariana Mazzucato, wondered, in the course of a brilliant inaugural lecture in a Labour-backed series of talks to fire up a conversation about the state and the economy, what food was necessary to turn timorous business folk from gerbils into lions.

Her answer is mission-oriented public investment, which sounds very much like rocket science until you realise that actually she is pointing at the way entrepreneurs very often ride off the back of state investment.

She argues that we need a way of recognising and talking about this unacknowledged role of the public sector, and points at the way Germany has tackled greening the economy. It’s not just building wind farms, it’s investing massively in research and technological development too


If we're honest about this that just isn't the sort of example we would have chosen. No, not even if we were Ms. Mazzucato herself. Because if we're going to have a government spraying around 40-45% of everything the country produces in a year then we're really certain that we could find a better example than a pro-renewables policy which has led to the reopening of the appallingly filthy lignite mines and power plants.

No, really, we're really quite sure that government can manage one or another thing better than that, even if we're not quite sure what it is.

Again, if we're fair, we would in fact use this example to bolster our own case about public investment. It's wasteful, inefficient and in almost all, but not entirely all, cases there's a better way of doing it. Or, of course, just deciding not to do it at all.

The Bank of England’s Headline Stress Test: An Exercise in Really Weird Accounting

(For the previous blog in this series, see here.) This posting goes through the Bank of England’s headline stress test and explains that the reassuring conclusion that the Bank drew from them – that the UK banking system is in healthy shape – cannot be taken seriously because the Bank set the pass standard way too low. On the other hand, if we repeat the Bank’s stress tests but impose higher minimum capital standards in line with those called for under Basel III we find that the UK banking system is in very poor shape.

In this posting, I will go through the Bank of England’s 2015 headline stress test – the test based on the CET1 ratio – the ratio of CET1 (Common Equity Tier 1) capital to RWAs (Risk-Weighted Assets). The definitions of these terms were explained here.

In this test, the Bank sets its minimum pass standard equal to 4.5%: roughly speaking, a bank passes the test if its capital ratio (as measured by the CET1 ratio) post the stress scenario is at least 4.5% and it fails the stress test otherwise.

The outcomes for the 7 banks involved – Barclays plc, HSBC Holdings plc, Lloyds Banking Group plc, the Nationwide Building Society, the Royal Bank of Scotland Group plc, Santander UK plc and Standard Chartered plc - are given in Chart 1:

Chart 1: Stress Test Outcomes for the CET1 Ratio with a 4.5% Pass Standard

stress test blog 1

Notes to Chart 1 at end

By this test, the UK banking system might look to be in reasonable shape. Every bank passes the test, although one (Standard Chartered) does so by a slim margin of under 100 basis points and another (RBS) does not perform much better. Nonetheless, according to this test, the UK banking system looks broadly healthy overall.

However, the choice of a 4.5% pass standard is odd, because the Bank itself requires that UK banks meet not only the 4.5% minimum but also meet an additional requirement – usually known as a Capital Conservation Buffer (CCB) – of a further 2.5%, making for a minimum of 7%.

If we apply the Bank’s stress test to a 7% pass standard, we then get the outcomes shown in Chart 2:

Chart 2: Stress Test Outcomes for the CET1 Ratio with a 7% Pass Standard


stress test blog 2

Notes to Chart 2 at end

We now get a rather different picture: two banks (Standard Chartered and RBS) fail the test and two more (Barclays and HSBC) barely pass with surpluses of less than 100 basis points. Only three (Lloyds, Santander and Nationwide) are above the pass standard with room to spare.

As I evaluate the results in Chart 2 using the Bank’s own criteria, I can see two banks that did not remain above international agreed minimum standards and two others that nearly didn’t – that’s 4 banks out of 7.

Furthermore, even the 7% pass standard is less than the minimum required CET1 ratio that will be implemented under Basel III by the end of the stress period, as it ignores two additional components of the total minimum capital requirement that will be in place by then – the Counter-Cyclical Capital Buffer and the Global Systemically Important Banks (G-SIBs) Buffer. The first of these is an additional buffer meant to counter cyclical factors and is set at the discretion of the Financial Policy Committee (FPC); it is current set at 0% but can be set as high as 2.5% under the Basel III rules. The second is an additional buffer applied to institutions that the FPC deems to be globally systemically important: the values of these buffers were announced in February 2015: 2% for Barclays, 2.5% for HSBC, 1.5% for RBS and 1% for Standard Chartered. These additional buffers will all be implemented as additional capital requirements by the start of 2019.

It would therefore be prudent to include these components in the pass standard as well, and in so doing, to set the Counter-Cyclical Capital Buffer to its maximum possible value of 2.5%.

Chart 3 shows the outcomes if we apply these more stringent capital requirements as the pass standard in the stress test:

Chart 3: Stress Test Outcomes for the CET1 Ratio with the Potential Maximum Basel III Pass Standard

stress test blog 3

Notes to Chart 3 at end

In this case, no less than four banks (Standard Chartered, RBS, Barclays and HSBC) are clear failures with outcomes well below the pass standard aka the maximum possible required CET1 ratio under fully-implemented Basel III. Lloyds is exactly equal on the pass standard, Santander is only a tiny bit over it and only Nationwide is comfortably above. Overall, the banking system clearly fails the stress test exam – and this despite the fact that the stress scenario was a mild one!

Pulling all these results together. The UK banking system passes the stress test exam if we take the Bank’s preferred (low) pass standard of 4.5%, which just happens to conveniently support its preferred narrative that the system is sound. However, the banking system performs far less well if we take a pass standard to be 7% (which was the minimum required CET1 ratio by end-2015), and it unmistakably fails the test if we take the pass standard to be the maximum requirements that could be in place under Basel III by the end of the stress period.

Put another way, even if we blindly accept all the major features of the Bank’s stress tests but the pass standard – if we accept the Bank’s chosen scenario, its use of the CET1 ratio as its capital-adequacy metric, the Bank’s own calculations etc. – and merely alter the pass standard to come into line with what the minimum capital requirement might plausibly be under Basel III by the end of the stress period, itself hardly a demanding standard – then we get a very different outcome to the one portrayed by the Bank: the UK banking system would then revealed to be massively capital-inadequate.

At the risk of belabouring the obvious, there are two further points about the Bank’s credibility that cry out from these results:

First, if the outcome of the stress test happens to depend critically on the choice of pass standard, then the outcome of the Bank’s stress test is not robust and therefore neither reliable nor credible – and this is especially so if the Bank’s preferred pass standard happens to coincide with its own self-interest which is to reassure us that the banking system is sound.

Second, the plausibility of the Bank’s view that the UK banking system is in good shape should not be contingent on such finer issues as whether the pass standard should be 4.5% (i.e., the pass standard implemented by the Bank) or higher (e.g., the pass standard promised by the Bank): if the UK banking system really were in good shape, this resilience should come through in all the tests, not just the least demanding test that happens to be the one that the Bank prefers. Moreover, for the test to be credible, the pass standard should be as high as is reasonably plausible. Conversely, for the Bank even to be suspected of applying the minimum pass standard they think they can get away with – when higher pass standards would give more negative outcomes – is to undermine the credibility of the whole exercise. The Bank’s stress tests need to be above suspicion if they are to be convincing.

If you don’t find this argument convincing, consider the medical analogy. A doctor is performing a medical check-up on a patient. He has a choice of tests to conduct: Test 1 has weak power to detect a particular problem, Test 2 has more power and Test 3 is more powerful still. By Test 1 there is no sign of any problem, by Test 2 there are hints that there could be a problem and hence a need to follow up, and by Test 3 the patient is clearly poorly. However, Test 1 is so weak that the doctor is not allowed to use it; instead, the weakest test he is allowed to use is Test 2, and the best practice advice among medical practitioners is to use Test 3 or something even stronger.

So what does the doctor do?

He tells the patient the results of test 1 and the patient thinks she is fine.

In the next blog, I will examine stress tests based on the more reliable leverage ratio as a capital adequacy metric.

Notes to Charts

Notes to Chart 1

(a) The pass standard is the bare minimum requirement (4.5%), expressed in terms of the CET1 ratio - the ratio of Common Equity Tier 1 capital to Risk-Weighted Assets.

(b) The outcome is expressed in terms of the CET1 ratio post the stress scenario and post any resulting management actions. The data are obtained from Annex 1 of the Bank's stress test report (Bank of England, December 2015).

Notes to Chart 2

(a) The pass standard is the sum of the bare minimum requirement (4.5%) and the Capital Conservation Buffer (2.5%), both expressed in terms of the CET1 ratio - the ratio of Common Equity Tier 1 capital to Risk-Weighted Assets.

(b) The outcome is expressed in terms of the CET1 ratio post the stress scenario and post any resulting management actions. The data are obtained from Annex 1 of the Bank's stress test report (Bank of England, December 2015).

Notes to Chart 3

(a) The pass standard is the sum of the bare minimum requirement (4.5%), the Capital Conservation Buffer (2.5%), the maximum Counter-Cyclical Capital Buffer (2.5%) and the Global Systemically Important Banks Buffer, which varies across the banks. These percentages are expressed in terms of the CET1 ratio - the ratio of Common Equity Tier 1 capital to Risk-Weighted Assets.

(b) The outcome is expressed in terms of the CET1 ratio post the stress scenario and post any resulting management actions. The data are obtained from Annex 1 of the Bank's stress test report (Bank of England, December 2015).

We can't help but think that numbers are important


We find ourselves somewhat ticked off. Not because people are trying to persuade us of something, that's just normal. But that they're willing to, umm, brush over perhaps, the numbers in order to convince us of their desired course of action. And that's not the way it should be: numbers are important, the proper appreciation and quotation of them allows us to actuallly work out what is the truth of any matter. Yes that isn't how they are being used. On the NHS and the exploding livers brought about by booze:

The recent report into life on the liver ward makes sobering reading. John has alcohol-induced dementia (Korsakoff’s syndrome) and doesn’t know where he is. Rita has cirrhosis of the liver and is homeless. Her life has spiralled downwards as a wine habit segued into damaging dependence. It’s easy to feel sorry for the Johns and Ritas, though most of us think it’ll never happen to us.

But will it? Are we becoming a nation of drinkers and drunks? The UK death rate from liver disease has increased fourfold in the past 30 years as cheap alcohol has flooded our shores and our gullets.

In the rest of the piece it actually says nothing at all about possible other causes of such cirrhosis or liver disease. Which is odd:

Common causes of cirrhosis are long-term alcohol abuse, hepatitis B and C infection, and fatty liver disease. Of those, hepatitis B and C together are said to be the leading cause of cirrhosis (WHO).

Agreed, that second number is not coming from the UK but there's obviously some amount of those other causes going on. That someone wants to persuade us to drink less, well, go ahead. But can't you do it using the actual and real numbers? And then of course there's Bill McKibben:

I’ve spent much of my life chronicling the ongoing tragedies stemming from global warming: the floods and droughts and storms, the failed harvests and forced migrations. But no single item on the list seems any more horrible than the emerging news from South America about the newly prominent Zika disease.

Spread by mosquitoes whose range inexorably expands as the climate warms,

Or as implied, Zika is caused by climate change. Well, no. This is the spread of a virus into the extant mosquito populations of the areas affected.

And yes, we do think this is important. Because numbers are the secret to science and science is how we make sense of the world. Rather than rejecting the Demon Rum or worshipping Gaia. as the sign says, "Down With This Sort Of Thing". If we want to discuss what we should do about the world let us do it on the basis of facts: as represented by actual numbers, not incantations pulled out from who knows where.