Monday, 16 January 2012

Scotland's currency conundrum

This post considers some of the issues that would arise if Scotland were to vote in favour of independence. The timing of the referendum is not yet clear, and there are ongoing debates as to the actual questions to be asked of the Scottish people. This post only considers full independence, i.e. Scotland leaving the United Kingdom and becoming a separate sovereign country. Other proposals that stop short of full independence are also likely to be on the table, and I will return to these in a subsequent post.

One of the major arguments has been whether Scotland leaving the Union would in effect mean that the United Kingdom (UK) ceases to exist. The Scottish National Party (SNP) seems to think that it would have this effect, and appears almost gleeful at the prospect. But I concur with the writer of this paper from the Centre For European Reform (1999), who concluded that the principle of parliamentary sovereignty, which is fundamental to the UK's constitution (and historically one of the major areas of disagreement between England and Scotland), means that the Westminster parliament can simply change the rules. It would probably repeal the Treaty of Union and create a new Treaty redefining the UK as England, Wales and Northern Ireland: this is similar to what was done when Ireland was brought into the Union, and again when Ireland left it. It is completely wrong to assume that dissolving the existing Treaty of Union would destroy the UK parliament (which I think is what the SNP believe). Nor would it mean that the Westminster parliament would become the "English" parliament. Wales and Northern Ireland would still be represented there, although there would probably need to be fundamental changes to prevent them being swamped by the dominance of England.

As I am of the opinion that the Westminster parliament will have both the desire and the ability to ensure the continuation of the UK as an entity in the event of Scotland leaving the Union, I will assume in the remainder of this post that the UK would continue to exist as a union of England, Wales and Northern Ireland.

Much of the discussion around the economic case for Scottish independence has centred on its GDP and its claim to North Sea Oil. And much of the discussion around the political case for Scottish independence has centred on the Scottish people's historic and current grievances against the English. I don't propose to address those in this post, although they are serious matters. I want to look at the financial implications for Scotland, and in particular, the question of its currency. I appreciate that for many Scots this is a sideshow compared to their sense of injustice and their desire to run their own affairs, but I believe understanding the currency issue is essential if the Scottish people are to make an informed and rational decision on their future. If they make the wrong decision, Scotland could end up like Greece.

As I see it, the currency options for an independent Scotland are as follows:

- retaining sterling
- joining the Euro
- issuing a new Scottish currency

Each has significant economic and political implications.

1) Retaining sterling

There are in my view serious issues with Scotland retaining sterling. The relationship between the UK and Scotland would be fundamentally different from today. Alec Salmond's remarks the other day suggest that the SNP does not fully appreciate the extent of this difference, and this has been borne out in conversations I have had with members of the SNP. To them, sterling has historically been Scotland's currency and they don't see why they should have to change it - and indeed, as sterling is freely traded the UK cannot prevent them using it. The reality, though, is that if Scotland left the union it would also lose any right to issue sterling or control it in any way. It would in effect be using a foreign currency.

Adopting a foreign currency means giving up control of monetary policy to a foreign state. The value of sterling is controlled by the Bank of England through interest rate policy, base money creation and open market operations. At present, as a member of the UK, Scotland can reasonably expect to have its needs taken into account in the conduct of monetary policy - and indeed the SNP's 2011 manifesto contains a commitment to press for Scottish representation on the Monetary Policy Committee (MPC). But after independence Scotland would have no right to have its needs considered or to be represented on the MPC. It would simply have to suffer the consequences of the MPC setting monetary policy to suit the needs of the UK only.

The SNP argues that this is not significantly different from the present situation. But I'm afraid they are wrong.
Yes, the MPC sets monetary policy for the UK as a whole, not to suit particular parts of it. But the UK is a fiscal union. Monetary strains are offset by fiscal transfers, which in the UK are of the "shared taxation" variety: Scotland does not levy its own income and corporation taxes, but shares in the total "pot" of UK taxation. The formula by which Scotland receives back tax revenue in the form of a block grant is known as the Barnett formula. It is widely seen by English people as benefiting Scotland at the expense of England, and is one of the main reasons why Scottish independence is more popular in England than it is in Scotland.

An independent Scotland would levy its own taxes and would receive no money at all from the UK. It would still be in monetary union with the UK, but no longer in fiscal or political union.  As we have seen in the Eurozone, when there is monetary union without fiscal union smaller countries suffer because monetary policy is inevitably set to suit the dominant economy. In the case of the Eurozone, peripheral countries have suffered catastrophic loss of competitiveness because monetary policy for over a decade has suited Germany but been completely wrong for them. In the case of the UK and Scotland, this imbalance would be aggravated by the fact that monetary policy would actually be set by the dominant economy, which isn't the case in the Eurozone. If Scotland chose to run a looser fiscal regime than the UK - which from the electoral dynamics seems very likely - it would suffer the same loss of competitiveness as peripheral countries in the Eurozone. Because it would not be in any sort of political union with the UK, Scotland would not suffer externally-imposed fiscal discipline as peripheral Eurozone countries are experiencing. But it wouldn't get any help either. It would no longer have the protection of the fiscal transfers it currently receives. And its banking system would no longer automatically have access to "lender of last resort" support from the Bank of England - and I suspect that if the Bank of England were seen to be supporting Scottish banks after independence, there would be a political storm from English people already angry about the extent of the support that Scottish banks received from the UK government in the 2008 financial crisis.

2) Joining the euro

Until recently, this was the SNP's preferred option, and it still remains their long-term policy - although in the conversation I had with Dundee SNP, they suggested that this might actually be indefinite.

The first, and most obvious question here is - as only EU members can join the Euro, would an independent Scotland retain its European Union (EU) membership, or would it have to apply for membership in its own right as an independent entity? There are differing opinions on this. The SNP assumes that Scotland would remain a member of the EU, but this stems from its belief that the UK would no longer exist and therefore the EU would have no basis on which to determine which of the four countries should inherit EU membership.  I've explained above why I think this belief is mistaken and the UK will continue to exist.  In my view the EU is likely to acknowledge the re-formed UK as simply a smaller version of the old UK - sort of Germany in reverse. But it is by no means certain that it would automatically recognise Scotland as an EU member separately from the UK. As the Centre for European Reform paper explains (op. cit.), accepting Scotland's membership independently from the UK would involve treaty amendment because the number of EU members is written into the treaties. Treaty amendment to increase the number of members requires unanimous agreement from all existing member states. I suspect that Scotland would formally have to apply for membership, but the ever-pragmatic EU would fast-track its application and attempt to waive the normal convergence requirements to get it approved quickly. There may be objections to this from existing EU members.

If Scotland retains EU membership, it would probably also retain the UK's opt-out regarding Euro membership, although it could apply for membership if it chose. However, if Scotland has to apply for EU membership, the EU leadership would be likely to make joining the Euro in due course a condition of membership.

Membership of the EU creates a problem if Scotland is still using sterling. The central banking model in Europe places the European Central Bank (ECB) as the "hub" of a system of national central banks. Scotland would have no central bank of its own but would not be represented or supported by the Bank of England.  It could not meet the ECB's requirement for submission of gold and foreign currency (FX) reserves unless it established its own central bank and persuaded the UK to relinquish a share of its gold and FX reserves at the ECB. But that central bank would have no currency-issuing powers. Even Eurozone central banks can issue Euros!

Joining the Euro is fraught with problems. Convergence criteria are strict, requiring public debt/GDP under 60% and cyclical deficit no larger than 3% (structural 0.5% or less). If Scotland were to take on its share of the UK national debt, its debt/GDP would be about the same as the UK's and its deficit between 5% and 11% depending on how much of North Sea Oil revenues it was able to claim. It would have to experience significant GDP growth to reduce these to the level required for euro membership.  If Scotland were able to negotiate taking a significantly reduced share of the UK national debt (perhaps as quid pro quo for relinquishing any claim to past North Sea Oil receipts) it might run close to the debt requirements. But even 100% of North Sea Oil receipts would not bring its deficit down to the 3% target.

Furthermore, Euro membership would not confer the fiscal benefits that membership of the UK does. It is not a fiscal union in any meaningful sense, and there are at present no plans to make it one, despite all the rhetoric from EU leaders. Scotland would receive no fiscal transfers as at present, but would be forced through sanctions and budgetary supervision to impose fiscal austerity even against the wishes of its electorate.  And it is clear from recent events that the EU leadership expects non-Euro members to meet convergence criteria too. This is much tougher than anything Scotland has experienced in the UK.

Scotland should think very hard before abandoning the UK's full fiscal union for the half-baked and increasingly authoritarian Eurozone.

3) A new Scottish currency

The three largest Scottish banks already issue Scottish pound notes that are widely accepted both north and south of the border, although not legal tender. An independent Scotland could therefore simply declare the "Scottish pound" as its legal currency. What value this would have internationally would be difficult to determine since Scotland would have no "credit history", and if Scotland was carrying a fairly high level of inherited debt in relation to GDP and a largish deficit the currency markets might not be too keen on the new currency. They would be even less keen on it if Scotland increased its deficit to support the SNP's social and investment spending commitments. To prevent the Scottish pound collapsing, therefore, Scotland might have to peg it to one with a more solid history, such as sterling, the US dollar or the Euro (although I would suggest pegging a new currency to one on the verge of collapse wouldn't be too clever).  The history of exchange rate pegs is not a happy one: economies have to be broadly equivalent economically for the peg to hold, as the UK's experience with the ERM shows, and if the peg is at an inappropriate exchange rate a serious trade imbalance can result. Holding a currency peg would require the same sort of fiscal convergence that retaining sterling or joining the Euro would need.

Having its own currency would at least give Scotland control of its monetary policy, although if the currency were pegged monetary policy would be largely defined by the need to hold the peg. In theory it wouldn't have to have a central bank (although this would probably be a requirement for EU membership). But its three currency-issuing banks would all be foreign-owned. Royal Bank of Scotland (RBS) is 84% owned by the UK government: Halifax Bank of Scotland (HBOS) is wholly owned by the English bank Lloyds TSB, itself 43% owned by the UK government: and Clydesdale is owned by the National Bank of Australia. Having all its currency issuance capability in foreign ownership may not be acceptable to Scotland's electorate, in which case setting up a central bank would seem to be essential.

There are also serious questions about the future in Scotland of its two biggest banks, RBS and HBOS. The SNP currently claims that Scotland should not have to accept any of the costs (paywall) of the bailout of those two banks: their arguments for this are that the banks were regulated in London, large parts of their retail operations are in England, and many of the activities that failed were south of the border or overseas. The counter argument is that although regulators bear some responsibility for failing to supervise banks properly, the failure of those banks was due to their appalling management. The view of many English people - and, it seems, some Scots -  is that they can't see why England should bear all the costs of the mismanagement of Scottish banks, especially when it seems that some of their disastrous decisions were supported and endorsed by the Scottish government. The destruction of a major English bank (NatWest) by a Scottish megalomaniac still rankles with many English people, and the fact that they are being expected to pay for this adds insult to injury.

Personally, I don't think the fight is worthwhile. The solution is easy. If Scotland refuses to accept any responsibility for the cost of bailing out Scottish banks, then it should not have any share in their ownership. The UK government should retain its current stake in both banks, and return them to the private sector in due course. Scotland would have no claim on any profits from their privatisation. I would also personally like to see the UK government repatriate the headquarters of RBS to London and rename it NatWest, in recognition that it would be a UK-owned bank with 90% of its operations in the UK.

General conclusions

There are no simple solutions to Scotland's currency conundrum. Economic convergence and some surrender of monetary and fiscal sovereignty seems inevitable under each scenario, although issuing a new currency would at least give the possibility of genuine financial independence once the credibility of the new currency was established. But whichever currency alternative is adopted, deficit spending by an independent Scotland immediately after independence would carry terrible economic risks because of the inflexibility of any form of currency peg and the negative view of sovereign deficits that bond and currency markets tend to have. In my view, therefore, current SNP spending plans would not be sustainable post-independence - which begs the question why they are apparently sustainable now. Maybe there is some truth in the prevalent English belief that Scotland is subsidised by England?

And finally, I question what, in a world where countries and corporations are increasingly interconnected and interdependent, "independence" really means. Can any country truly be said to "run its own affairs" any more? Or are nation states in reality subservient to the demands of supra-national organisations, international markets and multinational corporations? Across the world, the drive is for nation states to band together and form economic unions as a response to increasing globalisation. Scotland's demand for independence seems to run counter to this. But as the SNP wants a future in a different kind of union, namely the EU, I wonder whether "independence" is really what they are asking for, or simply decoupling from England and the political system that they hate? And would this give them real economic benefits? For me, the economic case for Scottish independence is not made, and the currency issue appears fatal.

If the call for Scottish independence is simply based upon ancient grievances, current injustices and dislike of the union as currently consituted, surely it would be better to address these issues and have a sensible debate as to how the union could be reformed to suit all its members better? For although Scotland can leave the United Kingdom, it cannot leave the British Isles. England and Scotland still have to coexist  peacefully.

Friday, 6 January 2012

The trouble with Hungary.....

.... is the European Union.

Let me explain.

Hungary has a silly government which is doing some objectionable things and playing fast and loose with the country's finances. On that we can all agree. But it has a two-thirds majority in its parliament and the disarray of the opposition parties means that there really isn't a credible electable alternative. Yes, there have been street protests against its policies. So what, frankly. There have been street protests against government policies in many European countries now, including the UK. That is no indication that the government is either undemocratic or about to fall.

Hungary, unlike the Eurozone members, is a sovereign country that issues its own currency, the forint. It is therefore technically unable to go bankrupt since it can if necessary print the money it needs. It also has control of its monetary policy as well as fiscal policy, which means it can raise interest rates to counter inflationary pressures and protect the value of its currency. There has been a lot of hype recently about the yields on Hungarian government debt, after it refused to pay over 10% on newly issued debt. But this isn't quite what it seems. The base rate in Hungary is a whopping 7.5% at the moment. Which means it is paying a spread of 2.5% over its own base on its debt. That doesn't sound nearly so bad, does it? It's actually about the same as the UK is paying on gilts.

However, Hungary has very large amounts of government and private debt denominated in Euros and Swiss francs. This is its real debt problem - not its forint-denominated debt. There is some evidence that Hungary wouldn't  be in such dire straits if the rest of Europe wasn't a mess as well - and in particular, if Eurozone banks were in better shape. In this post, Robert Peston notes that Eurozone banks have been shedding cross-border assets at a rate of knots to improve their capital positions. The Eurozone leadership prohibited them from unloading Eurozone assets or scaling back lending to the Eurozone. So they have been selling off non-Eurozone assets - which includes Hungarian private and government Euro-denominated debt. What a surprise, the yields on that debt have been rising as a result, and the Hungarian government is therefore having to find more Euros just to pay the interest. It can't print Euros, so it has to buy them on the open market.  Furthermore, because of those rising yields on both foreign and forint-denominated debt, coupled with investor nervousness about the behaviour of the Hungarian government, the forint is dropping like a stone versus just about everything else, so Euros are becoming more and more expensive. Rising yields on forint-denominated debt really aren't the issue. The major problems for Hungary are firstly capital flight causing rising yields on foreign currency debt, and secondly the collapse of the forint.

What can the Hungarian government do about this? Well, it could raid its foreign currency reserves. The Hungarian central bank is currently holding over 36 billion euros, which the government would dearly like to get its mitts on to meet its foreign-currency obligations. Alternatively, it could do a Weimar and print more and more forints to meet the ever-rising cost of buying the foreign currency it needs to meet its debt obligations.  So far the central bank has steadfastly refused to give the government the keys to the vaults or allow access to the printing presses. So it's not surprising, is it, that part of the legislation that the Hungarian government has railroaded through parliament is a measure that would allow it effectively to take control of the central. bank.

Both the IMF and the European Union have objected to this legislation. Central bank independence is a  requirement of European Union membership and a basic tenet of IMF fiscal prudence. Hungary was bailed out by the IMF in 2008 and is still paying IMF loans - most of the debt payments due in the next 6 months are to the IMF. Not surprisingly, the IMF still calls the shots.  And because the Hungarian central bank is refusing to allow the government to monetize debts or seize reserves, it is increasingly likely that the government will have to borrow more money to meet its debt obligations. It has already commenced talks with the IMF and EU about further financial assistance. So far the IMF and EU have refused to cooperate unless some of the legislation forced through parliament is repealed - not only the measures compromising central bank independence, but also flat income taxes, which in the IMF's view will not enable the government to raise sufficient in tax to meet its obligations.

What most sovereign governments tend to do when debts skyrocket and currencies collapse is the following:

- impose capital controls to stop people taking their money out of the country
- impose exchange controls so the external value of the currency is fixed
- redenominate foreign currency debt in local currency (or repudiate loans that cannot be redenominated)
- print enough money to monetize fiscal deficits and stimulate the economy
- wait for inflation and/or growth to sort out debts.

Hungary has actually managed to do one of these - it has forced external banks to take losses on their Euro loans, much to their annoyance, which amounts to fixing the exchange value of the forint for payments to private banks. But it can't do that to IMF loans. And all the other measures are prohibited under European law.

You see, although Hungary isn't a member of the Euro, it IS a member of the European Union. And the European Commission has made it clear that Hungary will not be permitted to break the rules, even to save its economy from collapse. Further, in order to qualify for the financial assistance that it will need because it is prohibited from sorting out its own problems, it must conform to the legislative and economic norms of the European Union even against the wishes of its elected government. So Hungary's position is no different from Italy's. It cannot do all that it would like to do. It does not have the right to choose its own path to hell.

So Hungary's problem is the European Union, isn't it?

Tax oddities

I am puzzled. On Thursday 5th January, there was a report on the BBC's Newsnight programme which outlined five ways in which people and organisations might seek to avoid tax:

1. by changing the location of transactions to take advantage of lower tax rates
2. by changing the timing of payments
3. by changing the identity of the person or organisation to which the taxable income is allocated
4. by changing the type of transaction to one that attracts a lower tax rate
5. by obscuring information

Now, all of these can be perfectly legal methods of minimising tax bills, although the last can run dangerously close to unlawful evasion. Most of us use some of these methods of avoiding tax - for example, giving gifts to grandchildren to reduce inheritance tax (point 3), or accepting part of our remuneration in shares instead of money (point 4 and possibly point 2). And indeed, no-one in the report suggested this activity was unlawful, though Richard Murphy of Tax Research UK did say it was unethical.

The report then went on to give, as an example of tax avoidance of borderline legality and dubious ethics, the Vodafone settlement with Her Majesy's Revenue and Customs (HMRC). This is a complex issue involving a German acquisition, so involves both UK and European tax law. The reporter said that the Vodafone dispute was ended last year when Vodafone made a payment of £1.25bn. But this isn't quite right. Yes, Vodafone has settled its dispute with HMRC. But UKUncut protestors, footage of whom outside a Vodafone shop formed the background to this part of the report, argue that Vodafone's settlement with HMRC was itself dubious and claim that HMRC was complicit in reducing Vodafone's bill to a lower amount than that which UKUncut believe they really owed. This is currently being investigated by the National Audit Office (NAO). Until they report, we really can't say for certain whether this was an example of illegal tax evasion (with HMRC's involvement, so government corruption too), lawful tax avoidance, or even simple interpretation of the European tax laws with no tax benefit intended. Allegations fly, but nothing is proven.

Following this, footage was then shown of Bob Diamond, CEO of Barclays Bank, failing adequately to explain to the Treasury Select Committee the breakdown of Barclays' payments to HMRC in 2010. Now, Diamond's behaviour is in my opinion mendacious - I simply don't believe that a CEO as capable as he has shown himself to be wouldn't know how much of his headline corporate tax bill was payroll taxes (income tax and employers' & employees' National Insurance, deducted at source and paid by the employer on behalf of the employee) and how much was corporation tax. But the implication in this report was that Barclays was deliberately avoiding tax. In fact the 2010 corporation tax bill was unusually low due to prior year losses carried forward.  Barclays had suffered severe losses in the financial crisis of 2008-9 which it offset against profits in 2009-2010. Carrying forward losses in effect gives companies a tax rebate when they return to profit after making losses, and can make a difference between marginal profitability and insolvency. It is a completely legal accounting practice and does not constitute tax avoidance unless the loss itself was engineered for the purpose of obtaining the tax rebate, which no-one is seriously suggesting in this case. Despite this there have been continual calls for Barclays to pay more tax, and suggestions that the law should be changed to prevent banks (but not other companies) carrying forward losses. Why banks should be discriminated against in corporate tax law is one of the things that puzzles me.

So neither of the two cases chosen by the BBC was a reliable example of deliberate tax avoidance. One is still under investigation and the other isn't tax avoidance at all.  I'm sure there are enough examples of genuine tax avoidance and evasion to fill a hundred BBC documentaries, so why did the BBC choose these two? Surely it isn't simply because they have been the subject of noisy protests and newspaper headlines? If it is, that is lazy research and sensationalist reporting. As a publicly-funded organisation, the BBC should do better than that.

Following the report, there was a discussion between Simon Hughes MP (LibDem) and Jesse Norman MP (Conservative), hosted by Emily Maitlis, about Graham Aaronson's proposal for a General Anti-Avoidance Rule (GAAR). At this point I became even more puzzled. There was no discussion of the five "tax avoidance" methods outlined in the report. Instead all three participants were discussing the general principle of preventing "abusive" tax avoidance practice. What did they mean by "abusive"? And how does it relate to the five legal methods of avoiding tax outlined by the BBC reporter?

I was so puzzled by this that I spent about three hours reading the Aaronson report. But this didn't help. I couldn't find anywhere in the report itself any reference to the five tax avoidance methods outlined by the BBC reporter. In the appendix there is a suggested draft GAAR which includes the following:

3. (1) For the purposes of this Part an “abusive tax result” is an advantageous tax result (see section 15) which would be achieved by an arrangement that is neither reasonable tax planning (see 
section 4) nor an arrangement without tax intent (see section 5).

(2) For the purposes of this Part an abnormal arrangement is contrived to achieve an abusive tax result if, and only if, the inclusion of any abnormal feature (see sections 6 and 7) can reasonably be 
considered to have as its sole purpose, or as one of its main purposes, the achievement of an abusive tax result by –
(a) avoiding the application of particular provisions of the Acts, or
(b) exploiting the application of particular provisions of the Acts, or
(c) exploiting inconsistencies in the application of provisions of the Acts, or
(d) exploiting perceived shortcomings in the provisions of the Acts.

So "abusive", it seems, means deliberately benefiting from the fact that tax legislation is incomplete, inconsistent and avoidable. I can't help wondering whether it would be better to simplify, streamline and broaden the legislation so it is less easily abused, rather than spending huge amounts of time and money chasing abusers. And to be fair Aaronson does suggest this, particularly in relation to trust law. But the more significant points that Aaronson raises in the body of the report are firstly, that most tax planning is simply prudent management of finances and not abusive; that the aim of the GAAR would be to end the minority of abusive tax avoidance cases, not make normal tax planning impossible; that changes to reduce the incidence of abusive tax avoidance must not make the UK tax regime unattractive to business; and that there are features of the UK tax system that are INTENDED to reduce tax liability in certain cases and that people and businesses should not be prevented from taking advantage of these when appropriate. It would be HMRC's responsibility to prove abusive tax avoidance, not the taxpayer's to defend; and there would be safeguards to stop HMRC using the threat of GAAR as a weapon to enforce payment of disputed taxes.

None of this told me where these "five methods" came from. Aaronson identifies the following characteristics of tax arrangements (legal structures and transactional processes) that would in his view constitute abusive tax avoidance:

(a) they may understate taxable returns from a transaction
(b) they may overstate the tax-deductible expenses associated with a transaction
(c) they may deliberately misprice a transaction with the intention of reducing the tax payable
(d) they may be inconsistent with the legal obligations of the parties to a transaction
(e) they may include a person, a transaction, a document or significant terms in a document, which would not
be included if the arrangement were not designed to reduce tax liability
(f) they may omit a person, a transaction, a document or significant terms in a document, which would not
be omitted if the arrangement were not designed to reduce tax liability
(g) they may include the location of an asset, a transaction, or the place of residence of a person, which would not have been so located if the arrangement were not designed to reduce tax liability

These sort of relate to some, but not all, of the BBC reporter's five methods of tax avoidance:

- Point g) is changing the location of transactions to take advantage of lower tax rates (method 1)
- Points e) and f)  involve changing the identity of the person or organisation (method 3)
- Points a), b) and c) all involve changing the nature of a transaction

Point d) looks much like money laundering to me, which isn't mentioned by the BBC. And Aaronson doesn't mention timing of payments or obscuring information.  So I was left still wondering where the BBC reporter got his definitions from. Evidently it wasn't from Aaronson.

Now oddly enough, Richard Murphy issued a blog earlier on 5th January. In it he outlines the following methods of tax avoidance (I have summarised them here, follow the link to read the full version).
  1. Reallocate their income to a person or entity that has a lower tax rate than the individual whose activity really generates the income
  2. Change the location of a transaction
  3. Change the nature of a transaction so that it appears to be something different from what it actually is
  4. Delay recognition of income e.g. delaying a bonus so that it is taxed later
  5. Obscure the information available on a transaction
How odd. Apart from the order in which they appear, these match the BBC reporter's definitions exactly. I can't believe this is coincidence. It would seem that Murphy not only appeared on the programme, but was a consultant to it. I do think the reporter should have acknowledged his sources. He gave the impression that these definitions were from Aaronson's report, since that was the subject of the subsequent discussion. It seems they weren't - they were Richard Murphy's definitions. Now, Murphy gave evidence to the Aaronson committee in his capacity as tax advisor to the TUC, but he was not a member of that committee. The Aaronson committee was made up of academic professors, legal experts and industry practitioners who are acknowledged experts in the area of tax. Why did the BBC reporter ignore what these people said and instead use definitions from someone who represents a particular special interest group, namely trade unions?

And here's something that puzzles me even more. In that blogpost, Murphy is severely critical of the Aaronson recommendations. He claims that they are simply ineffective in relation to his five definitions of abusive tax avoidance:

....none of them will be touched in any significant way by Graham Aaronson’s General Anti-Avoidance Principle which Cameron claims will beat tax avoidance. 


But back in November, when the Aaronson report was published, Murphy was very supportive of it:


Graham Aaronson QC’s report for HM Treasury on the desirability of a General Anti-Avoidance Rule (GAAR) for the UK is published this morning, and I warmly welcome it.


He went on to write two more blogposts (here and here) supporting Aaronson's recommendations and promoting their adoption into law. But now he is claiming that they are pointless. Now as far as I can tell Aaronson's report has not been changed since November and its proposals have not been watered down - in fact the Government seems to be planning to implement them in full. So why on earth has Murphy's opinion of this report undergone such a sea-change? He must have missed something in his initial reading of it. I am puzzled.

In fact I end this very long blogpost more puzzled than when I started. I don't understand why the BBC prefers the opinions of special interest groups over the findings of acknowledged experts, and I don't understand why two groups who are both seeking to curtail abusive tax avoidance are failing to present a united front. The Newsnight programme explained nothing and raised more questions than it answered. It was no credit to anyone.

Wednesday, 4 January 2012

It doesn't work like that - government finances edition

This is intended to be a short "idiot's guide" to how government finances REALLY work. I'm writing it partly as background for my posts on economic policy in the UK and Eurozone (and maybe the US), and partly to debunk various urban myths about government spending.

Firstly, let's define some terms.

"Deficit" is the excess of government spending over its income
"Surplus" is the excess of taxes over government spending.
Please note that for the purposes of this post, these terms relate only to government finances, not to trade finances. We also use the terms "deficit" and "surplus" to mean the excess of imports over exports and vice versa, but that is not how they will be used in this post.

"Taxes" are the contribution of the population to government spending - this is by far the largest part of government income, but there can be other components to government income such as asset sales. "Taxation" is the process of obtaining taxes from the population.

"Fiat currency" is currency whose value depends on the economic worth of the issuing country rather than an underlying asset such as gold. In practice the value of a fiat currency depends on the perceived trustworthiness of the issuing government.

Now to the urban myths that I mentioned in my introduction. This is how most people think government finances work:

1. Governments receive taxes from their population
2. Governments determine their spending plans on the basis of those taxes
3. Governments spend the taxes they have received
4. If governments spend more than the taxes they have received, they have to borrow the difference

These beliefs lead to the following value judgements:

- Governments should only spend what they receive in taxation. A government that runs a deficit to fund public spending is irresponsible.
- Government borrowing is a bad thing because it has to be paid off from future taxation, which means higher taxes in the future. We should get rid of government debt and "live within our means".
- Government surpluses are a good thing because it means we are being prudent and can pay off debt.

The problem is the beliefs are wrong, and therefore the value judgements are wrong as well. Government finances don't work like that.

The first thing to get your head around is that government spending PRECEDES taxation. Yes, that's right - governments spend first, tax later. This is roughly similar to the precedence of bank lending over saving that I explained in a previous post. Just as banks lend, then look for reserves to settle that lending, so governments spend, then extract taxes from their populations to extinguish the debt obligations created by that spending. It's always been like that throughout history: kings go to war, borrow to pay for their campaigns, then extract punitive taxes from their subjects to pay off their debts. The fact that present-day governments are spending money on many other things than war doesn't change the way it works. They spend, then extract the taxes.

The fact that spending precedes taxation means that government must establish its spending priorities on the basis of ANTICIPATED income, not actual income. And as anyone who has tried to forecast a business budget knows, what you anticipate you will get and what you actually get can be very different. So the idea that government should only spend what it receives in taxation is actually impossible. Tax forecasting is about as reliable as weather forecasting. Even spending plans are by no means certain.

Deficits and surpluses

There is a prevalent belief that deficit=bad, surplus=good. This belief is even being forced into law in the European Union.  But value judgements such as "good" and "bad" have no place in finance and economics. Government spends according to the priorities agreed with its electorate, and it taxes that electorate to extinguish the debt obligations arising from that spending. In a perfect world the taxation would exactly balance the spending, so there would be neither a surplus nor a deficit. However, the world isn't perfect and taxation rarely if ever exactly balances spending. There will therefore in practice always be either a deficit or a surplus. And budget plans have nothing to do with this either. Government plans to run a surplus may be completely undermined by a sudden economic downturn that causes tax receipts to crash. A surplus can turn into a deficit in one budgetary cycle.

In fact, because there is a time delay between government spending and taxation, there must always be a gap - a temporary deficit - within a budgetary cycle. This has to be funded, either with surplus taxation from the previous cycle, or if there is no surplus, by borrowing or by creating new money.  If the currency in which government spends and receives taxes is tied to an asset such as gold, government has to borrow against the value of its holding of that asset in order to finance its spending.  Conversely, if the currency is not tied to any asset but exists simply because the government says it does - what we call "fiat" currency - the government can print unlimited amounts of that currency, or it can borrow against the security of the productive assets of the country. For various reasons that I won't go into here, most governments don't choose to print money even if they have fiat currencies - they opt for borrowing. Short-term funding is used to cover the spending-to-taxation delay. Longer-term borrowing is used to cover deficits that aren't paid off within one budgetary cycle. Governments that run persistent large deficits over several years can end up deeply in debt.

Keynsian economics argues that governments should run surpluses in boom times and deficits in recession. This looks like a good idea - saving up reserves in the good times to cover the shortfall in recession, when tax receipts fall and benefits payments increase. The problem of course is how do you know when you are in good times so should be running a surplus? There are always calls on public money, problems to be fixed, pockets of poverty to be alleviated. And of course, when times are good governments believe they will last for ever, so there will always be more money and there's no need to save. The Blair/Brown government famously said they had "fixed Tory boom and bust". They had to eat their words.

The reality is that governments DON'T generally run surpluses in good times - they increase spending. But boy do they run deficits in bad times. So generally, governments tend to get deeper and deeper into debt.

There are exceptions, of course - for example, Germany and the Netherlands both run large surpluses. If a government runs a surplus, it has the option of cutting taxes and/or reducing debt. Government debt does not automatically reduce when there is a surplus. The government decides whether to pay off debt, and on this they should be guided by the electorate: if the electorate wishes the government to return that surplus in the form of tax cuts instead of paying off debt, that is what the government should do.

The idea that a government persistently running a surplus is more "prudent" than one running a deficit is another value judgement, and fundamentally wrong. A government that persistently runs a surplus is every bit as irresponsible as one that persistently runs a deficit, because it is overcharging its population for public services and reducing their capacity to provide for themselves.

Automatic stabilisers and other uncertainties 


Automatic stabilisers are changes in government spending and income that help to smooth out economic highs and lows - rather as the stabilisers on a ship help to stop it rolling excessively in a storm. They are set up to happen automatically as a consequence of economic performance, and once established the government has  little or no control over them. In general, in an economic downturn tax receipts fall and benefits bills rise, while in an economic boom tax receipts rise and benefits bills fall.

Examples of automatic stabilisers are as follows.


- When unemployment rises, tax receipts fall because fewer people are paying taxes. At the same time, the government's benefits bill rises because it is paying more in unemployment benefits.

- If there is a system of top-up benefits for low wages (as there is in the UK), wage cuts and short-time working when the economy is performing poorly also increases the government's benefits bill and reduces its tax take.

- If corporate profits decline due to poor aggregate demand, collapse of exports or other such economic problems, tax receipts also decline. Companies that make losses can carry those forward and offset them against future profits, too, so corporation tax receipts may take some time to recover.

- If corporate profits rise due to high demand in a booming economy, tax receipts rise

- If unemployment falls, tax receipts rise and benefits fall

- If wages rise and/or working hours increase, tax receipts rise and benefits fall

None of this is under government control. But these changes can be sufficiently large within one budgetary cycle to move the public finances from surplus to deficit, or vice versa.

There may be other areas of spending that occur as a consequence of things beyond the government's control, such as hardship payments to elderly people in cold weather and compensation payments to farmers for crop failure in drought. These are spending commitments which are not known in advance and the amount of which cannot be realistically estimated.

Automatic stabilisers and other uncertain spending commitments make it difficult if not impossible to maintain a balanced budget over the business cycle - as our European friends would like.

Government debt

People who have grown up with the Anglo-Saxon virtuous model "savings good, debt bad" tend to feel very uncomfortable if their country has much in the way of debt. It offends their values. But as I said above, value judgements have no place in economics and finance.

Government debt can be regarded in a number of ways.

1) It is deferred taxation. Debt obligations created by government spending are extinguished through taxation, so if the taxes aren't raised from current taxpayers, they fall upon future ones. Additionally, there is an interest cost to debt which has to be paid from future taxation even if the debt itself is not paid off.  When people talk about government debt being a burden on their children and grandchildren, this is what they mean.

2) It is spending brought forward. Government debt is a way of enabling present citizens to share in a country's future wealth. If a country is growing fast and living standards are rising - as is the case in emerging markets, for example - future generations will have a better standard of living than their parents and grandparents who have worked hard to create that economic growth. Bringing forward some of that wealth from the future enables the older generations to experience some of the material benefits from their hard work. Note that this only applies in a young, growing economy. It should be obvious that in an older, richer economy that is stagnating, bringing forward spending from the future in this way benefits no-one and could leave future generations with a debt burden that they cannot service.

3) It is a savings scheme. In most countries, government debt is generally bought by their own citizens as an investment for their future, often - though not always - as part of pension schemes. In countries that have developed capital markets, the debt may additionally be bought directly or indirectly by the citizens of OTHER countries. Government debt is regarded as the safest form of investment, because it is guaranteed by a sovereign government and is backed by the worth of the entire country. Owning, directly or indirectly, the debt of the country in which they live makes people stakeholders in their country's future.

4) It is another form of money. Yes, I mean that. Or, if you prefer, it is a liquid asset which is backed by the productive assets of the issuing country - which is the same thing as money (see my definition of "fiat currency" above).  The debt of rich fiat-currency-issuing nations such as the USA and UK is essential to the functioning of the capital markets - so much so that when that debt is in short supply, market representatives have been known to lobby for more to be issued.

Now, you ask - if government debt is simply another form of money, why not just issue currency? Provided that a fiat currency is allowed to float freely against other fiat currencies, there is in my view no reason to prefer debt issuance over currency issuance, or vice versa. I have heard it argued that fiat-currency-issuing governments should prefer to issue currency rather than debt, because currency would be interest free. Yes, there would be no interest to pay. But the interest cost on government debt issues is directly related to the value of the currency through its exchange rate. Issuing more currency reduces the value of each currency unit, which causes the exchange rate to fall, raising the cost of imports and creating inflationary pressures in the economy. Correcting those pressures involves increasing interest rates to private sector borrowers. The overall cost to citizens of the country I think would be equivalent.

I admit I have not done the maths to prove this and haven't seen anyone else do it either, not even Bill Mitchell who is a staunch advocate of governments funding deficits with currency issuance rather than debt. I'm aware that the relationship of currency issuance to inflation is disputed, and I should emphasise that the above paragraph is my personal opinion.

If I am right, though, then Quantitative Easing as conducted by the UK government cannot possibly be inflationary, since all it is doing is issuing one form of money to buy an equivalent quantity of another form of money. Yes, the government debt purchased is held, rather than being redeemed - but it is removed from circulation, which is what matters. And yes, the government still pays interest on that purchased debt, but only to itself (because it owns the Bank of England).

How governments get rid of debt

Note that I did not say "pay off" debt. Generally governments don't pay off debt. They refinance it - by which I mean that when one lot of debt falls due and has to be repaid, they issue some more debt so they can repay the debt that is maturing.

Nevertheless, government debts historically have reduced. The UK's public debt after World War II was considerably higher than it is now. At least that is what we are told by those who think that the way out of our economic difficulties is to issue loads more public debt.

The trouble is, it isn't true. The nominal amount of public debt only reduces if it is REPAID, which it hasn't been. What has actually happened is that UK public debt has reduced AS A PROPORTION OF NATIONAL INCOME. Government debt is nearly always quoted in relation to Gross Domestic Product (GDP). There are two ways in which the proportion of public debt to GDP can be reduced:

- GDP can ACTUALLY increase through economic growth (this is what happened in the 1950s and 1960s, when the UK was a young economy growing fast after the Depression and the War)

- GDP can APPEAR to increase through inflation (this is what happened in the 1970s after the OPEC oil crisis)

Either way, because the nominal amount of debt is fixed, it declines as a proportion of GDP. Obviously we like to reduce our debt/GDP ratio through growth and are much less happy about inflating it down, because inflation erodes people's savings and reduces their real incomes. But both methods are equally effective at reducing the debt/GDP ratio, so if growth is hard to come by and debt is a real problem (perhaps because investors are getting nervous about the amount of debt and demanding higher interest rates), it is very, very tempting to go for inflation.....

The relationship between government and private spending and saving

I mentioned above that a government that runs a surplus is depriving its population of the opportunity to provide for themselves, because it is overcharging them for public services. That government surplus represents LOST private sector savings and/or spending. Running a surplus in an economic downturn is counterproductive, because it reduces people's spending power. And it can be argued that running a surplus in a boom is unnecessary if public debt is under control, because people are perfectly capable of saving for themselves and don't need the government to do it for them.

Conversely, a government that runs a deficit is undercharging for public services. That means its population is paying less in tax than it should and therefore has the capacity both to spend more and to save more. In good times, undercharging for essential public services is in my view irresponsible. But in an economic downturn it can be helpful, if the problem is a failure of aggregate demand. For example, cutting taxes to low- and middle-income earners can be an effective way of stimulating demand. If the propensity of the population is to save, though, cutting taxes can simply allow people to save more, which doesn't help demand - this is the "paradox of thrift". A government that deficit spends excessively in a downturn when people prefer to save can end up with a stagnant economy and very high debt.

If the private sector (households and corporates) is highly indebted and paying off debt, government must run a deficit. This is because economically, paying off debt is the same as saving, and as I pointed out above, government surplus represents LOST private sector savings. The excess taxes that people pay when government overcharges for public services reduce their capacity to pay off debt. I hope this is clear to my readers, because it is a fundamental principle and one I shall return to in future posts.