Tag Archives: John Kay

Rethinking Liberalism 4: taxing the wealthy

There is a growing view that”inequality is one of the main problems confronting the modern world. This is quite a change. Distribution of income or wealth (or indeed the difference between the two) was not a major concern in the previously dominant neoclassical economic world view. But now that the benefits of growth in the developed world go almost exclusively to a tiny elite, while median incomes stagnate, this view has become complacent. And the work of the French economist Thomas Piketty has drawn attention to the potential power of the very wealthy. This presents a major challenge for liberals.

The problem is that liberals should have no particular problem with inequality of income and wealth in their own right. We believe in individual responsibility and free choices. We have unequal economic outcomes because people want and choose different things. So what? In fact inequality is cover for a series of issues which liberals should care about. Today I am writing about one of them: the wealthy elite.

The problem is known colloquially as the “1%”, because a disproportionate share of developed world income is going to the top 1% (or 10%; or 0.1% depending on how you want to present the figures). Rather than providing evidence for this assertion, and how it specifically might apply to Britain (perhaps less than in some countries), I will take it as a given, and look at some of the issues of principle that it uncovers.

Why does it matter? To some it is a simple matter of social justice. Inequality is one thing, but the justification for these extremes is another. There is more than a suspicion that the lucky few are winning because of unfair advantages, rather than just ordinary luck and talent. But regardless of this is a further problem. This wealthy elite has the chance to consolidate its advantages with political influence, so as to rig the economy in its favour. The growing influence of big money in politics, and the enormous lobby industry in places like Washington DC, points in this direction. There is an economic problem too: excess wealth is deadweight. The wealthy do not consume as high a proportion of their income as poorer people. And only a small proportion of their savings get channelled into constructive investment  (paying people to build things) rather than various forms of speculation in pre-existing assets.

Why is the problem growing? It seems to be a case of a weakening middle. In other words it is not a question of rising poverty, but a hollowing out of the middle class. It is easy to see the culprits: technologies that automate medium-skilled jobs, and globalisation that weakens local bargaining power. Thus we have the problem: the economy becomes more productive, but the benefits do not go to most workers. Can this trend be reversed? That is a central challenge for progressive policymakers, and it is a question I will return to.

But if we take the trend as a given, which I fear we must, then what can be done about it? The answer is clear: redistribution via taxation, public services and transfers. This issue divides politics like no other. On the right, we have “economic liberals”, who think that lower taxes and smaller government will unleash economic growth that will benefit all of society. On the right we have what I will call progressives (not all liberal), who appreciate that with today’s skewed power structures such growth will only benefit an elite, and will in any case be undermined by the deadweight effect of excessive wealth. Like most Liberals, I am in the progressive camp here.

Apart from the deep flaws in the economic liberal logic, progressive thinkers can see something else. The state has no choice but to grow. We have signed up to a society which seeks to (more or less) guarantee minimum levels of access to health care and old-age pensions.  The aging of developed world populations will increase the burden of these. And much of the investment needed to keep a modern economy growing, from education to roads and bridges, requires some level of state support. Meanwhile the ability of the middle classes to fund their own needs through savings is under pressure – both because their own incomes are not keeping pace with inflation, and because returns on saving are diminishing, a little appreciated aspect of the “hollowing out” process – with the exception of those able to own property in prosperous parts of the country.

So this comes back a stark truth. Taxes on the rich must rise. This serves to recycle wealth that would otherwise drop out of productive economic flows, and it helps fund the basics the state has to provide. So how to do this? There are broadly three directions: income, assets and capital gains.

Until now, most of the argument has been over income taxes, and in particular the best top rate of tax. When I started my first accountancy job in 1976, the top rate of tax was 83%, which rose to 98% for investment income. Conventional wisdom turned against the wisdom of such high rates. They dropped to 60% and then to 40% in the UK, before rising to 50% in 2010, and then being clipped to 45%. Economists are less sure about the wisdom of cutting such high rates. They did think that cutting tax rates would mean that rates of pay (for the elite) would fall, as it was cheaper to provide the same net salary. In fact the opposite has happened. This seems to point to senior salaries being more about power politics than market forces. Companies paid their executives more because they could; they did not do so when tax rates were high, because they did not like to see so much of the extra money disappearing in tax.

I can see no harm in reinstituting the 50% top rate of tax, though experience suggests that this won’t bring in a huge amount of extra revenue. Such high rates create a tax avoidance industry. There is a problem with very high rates of income tax though: they tend to entrench a wealthy elite, because they make it more difficult for outsiders to join them. The way to become wealthy becomes to to inherit rather than earn. This was the rather interesting conclusion of a quite wonderful contemporary study of the British tax system of the 1970s by Mervyn King and John Kay – which was recommended as a model piece of economic writing 30 years later by the UCL Economics department.

So should we not look at taxing wealth? This is the recommendation of Mr Piketty, who worries that the rate of return on the elite’s assets is too high, and entrenches their dominance. Such a tax would probably be about 1 or 2% per annum – which may not sound much, but is enough to dent annual returns significantly. Such a tax exists in the Netherlands, hardly as basket-case economy. A variation on this general idea is just to tax land – an idea (Land Value Tax) that has an ancient history in the Liberal movement. I personally have a difficulty with taxing a theoretical value of an asset, rather than a realised one – given that the reliability of asset valuations is weakening. But I have to admit the idea is growing on me, especially the land-only version.

A further way of taxing assets is at death. This is theoretically very sound, but too easy to avoid in practice. The rates here can be very high. In order to make this more watertight such taxes should no doubt be applied to large gifts as well. This used to be the case in the UK. But taxing legacies and gifts seems to attract a particular political opprobrium, and we have to tread carefully.

Finally we should mention capital gains: where assets and incomes meet. These are the commonest loopholes in tax systems. Aligning such taxes with income tax seems the best way of dealing with this. But this may undermine the case for an asset tax: the Netherlands does not tax capital gains.

But in discussing such details we must not miss two big and interrelated issues. The first is that our elites tend to be globally mobile. Taxing them will require growing levels of transnational cooperation. And indeed the need to tax such mobile elites puts greater importance on such transnational cooperation. The EU’s tax dimension should grow. Such bodies as the G20 need to focus on the matter too. It is not particularly surprising that so many rich businessmen are in favour of the UK leaving the European Union.

Which brings me to the second issue: politics. The rich seem to be of an economically liberal mindset (which is actually a recent development, as this article in the New Yorker observes). They increasing fund political movements with an economically liberal agenda. This is already poisoning the politics of the USA. It will make taxing the wealthy harder. But not impossible. If the public understands that the alternative is to cut basic pension and health systems the economic liberals will lose. But whereas we used to think that politics in the developed world was getting dull, this growing clash of economic interests will inject real conflict into it. Class war is back.


Solving the Euro crisis means a stronger ECB

I do not regret paying my access fee to the FT website.  This morning there are two excellent articles on the Euro crisis from the two regular Wednesday morning columnists: Martin Wolf and John Kay.  It has helped clarify the way ahead for me.

Mr Kay comes in at high level to give an overview of the crisis.  It is not comfortable reading for supporters of the Euro project like me, but, as usual for this author, pretty much spot on.  The main problem is not that the currency area lacks appropriate institutions at the centre, but that local institutions in many member countries are not strong enough to cope with the pressures of being in the single currency.

The eurozone’s difficulties result not from the absence of strong central institutions but the absence of strong local institutions. A miscellany of domestic problems – rampant property speculation in Ireland and Spain, hopeless governance in Italy, lack of economic development in Portugal, Greece’s bloated public sector – have become problems for the EU as a whole. The solutions to these problems in every case can only be found locally.

So the answer will not come from strengthening the EU’s central institutions.  This goes back to the original design of the Euro: the whole idea was to put pressure on governments to reform themselves, by denying them the easy escape route of devaluation. Unfortunately the EU’s politicians forgot this in the first decade of the Euro, so no real pressure was brought to bear, making the crisis infinitely worse once it hit.

This article does not say much about how to go forward from here, beyond suggesting that grandstanding at summits like today’s may be part of the problem rather than the solution.  Mr Wolf’s looks at one aspect of how to manage the crisis itself.  This in turn in is based on a paper by Paul de Grauwe of Leuven university, who literally wrote the textbook on the Euro (I know, since I read it as part of my degree course).

Professor de Grauwe points out an interesting fact: the bond markets are much harder on the Euro zone fringe economies of Italy and Spain than they are on the UK, even though the underlying positions of the countries is not all that different.  The difference is that the UK markets are stabilised by having the Bank of England as a lender of last resort which is able to deal with liquidity crises (i.e. an inability to raise cash for temporary reasons rather than underlying insolvency).  The European Central Bank does not do this, or not enough, for the Eurozone economies.  Mr Wolf, who structures his article as an open letter to the new ECB president Mario Draghi, argues passionately that it should.  This would stop the contagion spreading from the insolvent economies of Greece and maybe Ireland to solvent but challenged economies like Italy, Spain and indeed France.

This must be right.  The Germans, who are the main sceptics, must be persuaded – and convinced that such interventions would only apply to liquidity crises and not solvency problems, and that the ECB has the integrity and independence to tell the difference, in the way that politicians never do.

Giving the ECB a wider and stronger remit will be a big help.  This should extend to supervision of the European financial system (preferably for the whole EU and not just the Eurozone).  This will help deal with one of the biggest problems for modern central banking – that of coping with spillover effects, as described in this thought-provoking paper from Claudio Bono of the BIS (warning: contains mild economic jargon, such as “partial-equilibrium”).

So a reconfigured ECB will help the Euro through the crisis and prevent self-fulfilling prophesies of doom in financial markets having to be solved in grandstand summits.  That still leaves the longer term problem of how the less competitive Southern European economies can have a long term future in the zone.  But then again, I think they would have just as challenging a future outside the zone – even if it were possible to devise an orderly exit mechanism for them.



Taming the banks: two views from the FT

Oh the shame of the FT’s paywall!  Yesterday  the paper presented a wonderful view of the debate on the UK banking reforms proposed by the Vickers Commission with two opinion pieces under the title Taming the banks, long overdue or utter folly?  For the reforms was regular columnist John Kay.  Mr Kay (though I’m sure he’s not really a mere Mr) is one of my favourite FT columnists.   His articles do come out on his website in due course, but not this one yet, I’m afraid.  It is a very lucid article, pointing out the massive size of UK banks balance sheets: at £6 trillion, four times the size of the country’s income.  Of these but a tiny fraction is lending to industry, and a rather larger fraction is domestic lending such as mortgages.  The bulk of it is to the finance industry pumping up the great game of leverage.  The idea of ringfencing, the critical part of the proposed reforms, is to stop the small fraction of balance sheets that matters to individuals and “real” businesses from being poisoned by financial engineering gone wrong; or to put it another way, to stop the British state from having to underwrite the latter to protect the former.  Mr Kay’s only criticism is that the reforms are being implemented too slowly.

The opposing article is from Sir Martin Jacomb.  Sir Martin is no more a banker than Mr Kay, that is to say he’s done non-executive directorships but not much more; he’s a lawyer and chiefly famous for saying that universities should be independent of government, and that Oxford University should cut its ties with the state.  The bankers are in fact rather quiet on the reforms, after some rather clumsy lobbying to get the implementation delayed, which appears to have been quite successful.  The weakness of their case seems reinforced by Sir Martin’s article, which nearly nonsense.  Is this really the best the FT could find?

Sir Martin reiterates a familiar litany:

  • The reforms advocate breaking up “universal banks”, but this model “can be perfectly safe”.
  • It will hurt the City’s international position. “There must be universal bankers in Frankfurt rubbing their hands.”
  • It will cause the loss of jobs and taxes.
  • the new banks will not able to offer helpful products to industry.
  • It does not address the immediate problems besetting European banking,  “which result not from mistakes by bankers so much as blunders by European Union governments in the management of the euro.”

This lot is readily disposed of:

  • Universal banks did not come out the recent crisis well.  It is true that some of the better managed ones did not need direct government rescue (Barclays and HSBC in the UK, BNP Paribas, JP Morgan), though still benefited from implicit and explicit guarantees.  But far too many did, especially in America (notably Citigroup and Bank of America), here (Natwest and HBOS) and Switzerland (both UBS and SBC).
  • This is yet another cry of “Wolf!” from the City.  I remember how us not joining the Euro was supposed to kill the City in favour of Frankfurt.  The City’s standing is based on network effects of people, skills and time zones.  Most of its activity is from foreign owned institutions already.  If the UK owned activity shrinks, it is because the public liabilities that go with it are too large.  It best that we adapt.
  • This sort of answers the jobs and taxes bit.  As Mr Kay points out, lending to job-creating non-financial businesses should not be affected, and might even benefit if they do not have to compete for attention with gearing up of financial products.  It is much healthier if our economy is less dependent on highly paid bankers’ jobs.
  • Sir Martin uses the example of a currency hedging, which might be useful for an exporter with a long term contract.  But surely his ordinary banker can introduce him to an investment banker at little extra cost?
  • This is true; it’s a separate issue.  But is quite astonishing for him to suggest that the Euro area problems are the fault of politicians rather than bankers.  It was the bankers that bankrolled the Italian, Portuguese and Greek governments at absurdly cheap prices.  It was its banking industry that laid the Irish government low.  It was bankers from across the zone that pumped up the Spanish property bubble.   This kind of “it wasn’t us” defence from bankers simply shows how little they have learned from the disaster.

Apart this whingeing, Sir Martin makes a more subtle point.  We should be promoting more competent management amongst banks, and excessive regulation does the opposite.  Well, we must ask what caused the rampant incompetence in the most of the world’s banks before the crisis.  Surely it was the thought that if things went bad governments would come to the rescue, and it would all then be somebody else’s problem?  This is exactly what the reform seeks to address.  By separating the investment banking side out, it means that failure from that side will be easier to tolerate, and should not require the UK tax payer to stump up.  The retail side would be bailed out in the event of a failure, true, but it will be more difficult for these banks to pump themselves up to create a massive hole.  

There is an irony behind all this.  The point about banking reform is to make banking more, not less risky, for bankers anyway.  We need to see more bank failures, not less.  The by-line to Sir Martin’s article is perhaps its most cogent bit:  “Beware the paradox that a system to limit risk invariably increases it”.  But risk to whom?


Vickers Commission: so far, so good

I have deliberately paused before commenting on the interim report of the Vickers Commission on UK banking reform.  I wanted to read more about it; it didn’t help that the post office delivered my Economist several days late.  Unfortunately I still have not had time to read the report itself; let me come clean on that.  Most of the commentary seems to be that the banks have largely got away with it, and are heaving a sign of relief.  My answer is “not necessarily”.  It may be clever politics not to go for the more totemic ideas, like a full split between retail and investment banking, since that clears the path for the reforms that really matter.

The report primarily concerns itself with two things: preventing a future UK government being forced into bailing out or underwriting banks, and increasing competition between the banks.  The latter was behind one of the more controversial recommendations: the breakup of Lloyds Bank.  But I don’t think that’s the main battle.  I despair about the lack of competition in UK retail banking, but I don’t see that the costs to the economy are that large.  The main game is preventing the next bailout.

The suggested strategy makes plenty of sense.  Ring-fence retail banks, force them to hold more capital, and leave investment banks to their own devices.  The significance of the second part of that proposition needs to sink in (as this article from John Gapper in the FT (£) makes plain).  An investment bank may be “too big to fail” in global terms, but the UK government will say is that this is somebody else’s problem, so long as our retail banks are protected.  This is an entirely realistic admission that the UK government is now just a bit part part player in the world of global banking.  If one our big investment banks fails, then we don’t mind if it is bought up by foreigners.  This is a striking contrast to the approach taken by the Swiss government.

But it leads to an obvious issue.  How do you prevent a meltdown in investment banking infecting the supposedly ring-fenced retail banks?  The collapse of Lehman’s in 2008 caused such chaos not because it was so big and important in its own right, but that it was too entangled with banks that had big retail deposit bases.  A retail bank will gather in lots of retail deposits; the question is where does all this money go?  If the bank is to make money it needs to get lent out.  If this lending gets into fancy investment banking products, then the ring-fencing has failed.  There must be some pretty heavy restrictions; the assets don’t need to be absolutely safe, but we want to insulate these banks from the complexities of the investment banking melee.  This will not be easy, as John Kay points out (in another FT paywall article, I’m afraid); all that is needed is an oversized treasury department, which is supposedly there just to oil the wheels of the machine.  Mr Kay knows this from bitter experience; he saw (as a non-exec director in the earlier days) how a runaway treasury department at the former building society The Halifax took that institution down a route that led first to demutualisation and eventually its own destruction; each step presented as innovative and sensible.  The detail must be subject to intense scrutiny.

But what of those excessive bankers’ bonuses and all the outrage that goes with them?  To the extent that this is a retail banking problem, the Vickers reform surely deals with it adequately.  The only way of tacking with it properly is to turn these banks into less profitable, lower risk utility organisations which can’t afford to pay big bonuses.  That is what ring-fencing and higher capital requirements should achieve.

But the bigger problem is investment banking.  This is an international issue, and Vickers is really about damage limitation.  As I have said before, the answer is not directly regulating remuneration, but cutting the profits.  This industry must be made much smaller and less profitable.  The two most important ways are through increased capital requirements and choking off its finance (or “leverage” as they like to call it).  The Basel committee is already making headway on the first.  Retail ring-fencing, if it is done properly, will help a lot with the latter.

Banking reform is a long hard road.  There is a danger that we have “wasted a good crisis”, and the passing of the crisis’s worst peak means that the pressure on politicians to deliver has eased.  But the crisis has not passed, though many financial types waving graphs seem to disagree.  A lot of banks are still in a shaky condition – and so are many governments’ finances, including those of the USA and UK.  There may well be a steady stream of aftershocks to remind our leaders that the journey is not over.  So far the Vickers Commission is playing its part.