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The evidence is in from across the Atlantic, and tax cuts benefit everyone

The evidence is in from across the Atlantic, and tax cuts benefit everyone

From discussions on how the UK should reform its tax and regulatory landscape to make the most of post-Brexit opportunities, to the rallies midterm election candidates have been holding across the US championing or lambasting the President’s tax cuts, the debate is still raging about how changes to taxes impact economies.

But if you need convincing, or even if you’re just curious, events across the Atlantic provide a natural experiment in which we can observe in real time the effects of big tax cuts on an economy.

Nearly a year ago, on 22 December 2017, President Donald Trump signed the Tax Cuts and Jobs Act (TCJA), the most sweeping revision of US tax law since the Tax Reform Act of 1986.

Since then, economic growth has gone up. Between the fourth quarter of 2016 and the fourth quarter of 2017, GDP grew by 2.5 per cent in the US. In each quarter since, the annual growth rate has accelerated. The provision estimates for the third quarter of 2018 – the latest we have – suggest growth is now three per cent.

The jobs market is also booming. In the year to October, employment rose by over 2.5m. In that month alone, there was a rise of 250,000 jobs on the previous month.

Of course, all sorts of things can contribute to a strong economy. The headline figures simply support rather than confirm the narrative that tax cuts work.

A paper published this week in the leading Journal of Economic Perspectives focuses specifically on the corporate tax changes in Trump’s TCJA.

Beginning in 2018, the federal corporate tax rate fell from 35 per cent to 21 per cent, some investment qualified for immediate deduction as an expense, and multinational corporations faced a substantially modified treatment of their activities.

Alan J Auerbach of Berkeley sets out a detailed theoretical and empirical analysis of the Trump legislation. He is careful to qualify his findings with the usual kind of academic hedges. But they are unequivocal: tax cuts work.

The loss of revenue to the government of the various corporate tax changes in 2020 is estimated to be some $130bn. What will companies do with this money?

Auerbach concludes that at least a half of this will go on increases in wages. There are some 125m families in America, and on average they will be at least $500 a year better off.

Much of the rest will be spent on additional investment, which will further stimulate the economy.

And Auerbach cites a paper by the Harvard economist Robert Barro, due to be published in the Brookings Papers series, which suggests that the impact of the tax cuts will be even higher.

Leading American economists writing in leading academic journals are examining the Trump corporate tax cuts. They are concluding that everyone – both the companies and their workers – benefits from them.

Perhaps Philip Hammond should take a break from his spreadsheets and catch up with his reading.

As published in City AM Wednesday 7th November 2018

Image: Statue of Liberty by National Park Science
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John McDonnell’s ideology won’t lead Britain to a bright new future, but to the dismal 1970s

John McDonnell’s ideology won’t lead Britain to a bright new future, but to the dismal 1970s

The focus this week has been on Philip Hammond’s Budget.

The opinions of the shadow chancellor have been rather in the background by comparison.

But John McDonnell is doing us all a favour at the moment. He is busily promoting a collection of essays which he edited, under the title “Economics for the Many”.

These cover a wide range of policy areas, and are written by a mixture of politicians, think-tankers, and academics sympathetic to the shadow chancellor. The book contains a substantial introduction by McDonnell himself, and so is a useful guide to his thinking.

McDonnell appears to believe that spending vast amounts of money on nationalising industries will cost the taxpayer nothing.

From a balance sheet perspective, this is technically correct. The government could issue debt to take over the rail companies, say, but this would be balanced by the value of assets acquired.

This misses the point. If someone were mad enough to lend you £10m to buy a house valued at that amount, your household balance sheet would not have changed. But how would you service the debt, and what rate of interest would you be required to pay?

The rate of interest on UK government bonds is currently low, at around 1.5 per cent. But this is determined by the markets, not by government diktat. If the markets lose confidence, the rate can change rapidly. In recent years, Italy, Spain and Portugal have all seen rates in the six to eight per cent range. And in Greece, they were as high as 23 per cent.

McDonnell is silent on how he would ensure that the same thing would not happen here.

Some of the essays in his edited volume share this silence. One of them, somewhat ironically, points out the dangers of debt levels being too high. Admittedly this refers to household debt and not public sector debt, but no recommendation is made on how the problem can be solved.

In the same way, several contributors attack the discipline of economics. We read, for example, that it needs to be “more diverse and representative of the society it serves”. Yet no argument is put forward which offers a scientifically superior explanation of events to that of standard economic theory.

To be fair, most of the essays do put forward proposals. But the striking feature is not their radicalism – it is how dull and unimaginative they are.

So, for example, when new firms are launched based on new technologies, they should be set up as cooperatives. Cooperation as a form of business model has been around since the Rochdale Pioneers in 1844. It has not exactly set the world alight.

There is much talk in the media about how Jeremy Corbyn’s Labour party has captured the zeitgeist. This is not reflected in the opinion polls, where the Tories remain obstinately in the lead.

But if it has, these essays suggest that we are not in for an exciting and innovative future. Rather, we will be condemned to a repeat of the dismal and depressing 1970s.

As published in City AM Wednesday 31st October 2018

Image: John McDonnell by Rwendland via Wikimedia is licensed under CC BY-SA 4.0
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At long last, economists appreciate that private debt was the catalyst for the crisis

At long last, economists appreciate that private debt was the catalyst for the crisis

This month saw the tenth anniversary of the collapse of Lehman Brothers, a collapse which precipitated one of the only two global financial crises of the past 150 years.

The late 2000s and early 1930s were the only periods in time when capitalism itself has trembled on the edge of the precipice.

It was in November 2008 that the Queen put her famous question about the crisis to the academics of the London School of Economics: “Why did nobody notice it?”

The answer is simple. In the models of the economy at the time, finance did not matter.

Mainstream economists did not notice the massive financial imbalances in the economy, because in their models, any problems that might link to these imbalances were assumed away.

To be of any use, all scientific models have to make simplifications of reality. But orthodox macroeconomics took a step too far. It assumed that the workings of the whole economy could be explained by analysing the theoretical behaviour of just a single decision maker. In the jargon, this is the “representative agent”.

The agent is a device which economists used to model the economy. It was extremely clever, and could solve hard mathematical problems – calculating how the decisions of average consumers and companies would affect the macroeconomy.

These kinds of models go by the splendid name of “dynamic stochastic general equilibrium models”, or just plain “DSGE” to their friends. But at its most basic, the problem with such economic models was that there was only one decision maker in them.

Having just two, a “creditor” and a “debtor” for example, would have helped a lot.

Over the past decade, economists have been scrambling to incorporate other financial factors into their models, such as household debt. Key contributions to this research are discussed in the latest issue of the Journal of Economic Perspectives.

Bizarre though they may seem, DSGE models now finally recognise the potential importance of household finance in causing crashes.

A particularly interesting paper in the journal is by Atif Mian of Princeton and Amir Sufi of Chicago. Their focus is considerably wider than the crisis of the late 2000s in the United States. They quote empirical studies across some 50 countries with data going back to the 1960s. They found that a rise in household debt relative to the size of the economy is a good predictor of whether GDP growth will slow down.

Rickard Nyman, a computer scientist at UCL, and I applied machine learning algorithms to data on both public and private (households and commercial companies) sector debt in both the UK and America. We find that the recession of 2008 could have been predicted in the middle of 2007.

Perhaps the most striking result is that public sector debt played little role in causing the crisis. The driving force was the very high levels of private sector debt.

A critic might say that this is simply a case of generals fighting the last war.

True, we don’t know whether a completely different nasty event lies around the corner. But at long last, economists appreciate the fundamental importance of debt and finance in Western economies.

As published in City AM Wednesday 26th September 2018

Image: Her Majesty The Queen by UK Home Office on Flickr licensed under CC-BY 2.0
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Unemployment down, GDP up – there’s no logic for a public spending boost now

Unemployment down, GDP up – there’s no logic for a public spending boost now

Despite the warmth of the days, there is a distinct autumn feel to the mornings.

And in the autumn, thoughts begin to turn to the Budget.

Speculation has already begun about what the chancellor Philip Hammond might or might not do.

For Labour, recent weeks have been dominated by Jeremy Corbyn’s alleged antisemitism and undoubted incompetence. So the anti-austerity tour of Britain by shadow chancellor John McDonnell, begun in Hastings in July, has scarcely obtained a mention in the media.

McDonnell obviously believes that there is a need to “end austerity”. He is far from being alone.

It is remarkable how this anti-austerity narrative continues to pervade political and economic discourse – it is as if the UK were in the grip of a massive recession.

In reality, the economy continues to do well. GDP is now over 18 per cent higher than it was at the trough of the recession in the first half of 2009. Unemployment has fallen steadily since the Brexit vote, and now stands at its lowest rate since February 1975.

The name of John Maynard Keynes is frequently invoked by those who want to “abandon austerity” and increase public spending. Yet in his major book The General Theory of Employment, Keynes stated very clearly: “when full employment is reached, any attempt to [stimulate the economy] still further will set up a tendency in money-prices to rise without limit”.

In other words, according to Keynes himself, at full employment any further stimulus will simply lead to higher inflation, with no benefit to output or employment.

Unemployment is at a 40-year low, while employment is at a record high, with 32.3m people in work – an increase of 3.4m from the depths of the financial crisis. This sounds like full employment in anybody’s language.

The overall shape of the recovery since 2009 has been balanced. Consumer spending has actually grown less than GDP, by just over 16 per cent since 2009 compared to an 18 per cent rise in GDP. Capital investment by companies has gone up by 35 per cent.

Public spending has also risen, but only by seven per cent (all figures after allowing for inflation).

This has been a recovery generated by the private sector.

The same point applies even more strongly to the US. Compared to the low point of the recession in 2009, public spending has actually fallen by three per cent, though there has been a modest rise in employment in that sector of 100,000. In contrast, the private sector has roared away: 19.5m net new jobs have been created since the winter of 2009, and GDP is up by over 22 per cent.

As in the UK, an important driver of the recovery in America has been investment by firms. This has grown by no less than 54 per cent compared to 2009.

There is no case at all for stimulating the economy by increasing public spending (funded by increased taxes) and abandoning so-called austerity, not when the private sector has done such a good job on its own.

As published in City AM Wednesday 5th September 2018

Image: Money by Max Pixel is licensed under CC0 1.0 Universal

 

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The UK’s capacity to innovate matters far more than panic over consumer spending

The UK’s capacity to innovate matters far more than panic over consumer spending

The debate about Brexit has become mired in a virtually incomprehensible quagmire of detailed and technical negotiations between the UK and the rest of the EU.

Yet the campaign itself in 2016 was dominated by broader questions of political economy.

In addition to the hurly burly of claims about extra NHS spending or Project Fear, both sides took a serious, longer-term view of what was needed to sustain Britain’s prosperity. All this has been lost sight of, but the fundamental issue has not gone away. So does Britain have an economy which is fit for purpose in the twenty-first century?

At one level, the evidence seems to side with the Remain camp. Growth in the UK since the depth of the recession in 2009 has been decidedly unbalanced compared to much of the rest of the EU.

We can break down the growth of the total economy – GDP – into categories defined by who is doing the spending: how much is done by individuals as consumers, how much by firms in terms of capital investment, and how much by the public sector. We also have the net balance between our exports and imports.

Looked at this way, Britain’s growth since 2009 has been concentrated in a seemingly unhealthy fashion on consumer spending. This accounts for no less than 58 per cent of the total growth in the economy 2009-18. Investment by companies takes up another 29 per cent, and there has been a slight deterioration, amounting to just three per cent of GDP, in our net exports.

This is in sharp contrast to Germany. The increase in investment is similar, making up 27 per cent of the total increase in GDP. But consumption is just 32 per cent, and net exports have boomed, accounting for 22 per cent of the increase in German GDP. No wonder President Trump has concerns about German trade surpluses.

This pattern is similar in countries closely connected to Germany. Compared to the UK, increases in consumer spending are only a relatively small part of the total expansion of the economy since 2009 in Austria, Belgium, Denmark, France, the Netherlands, and Sweden.

Surely an economy which relies less on spending by individuals is better placed than one in which they splurge every last penny?

Well, up to a point. For one thing, public spending accounts for a larger proportion of total growth in the Greater Germany group than it does in the UK. The rise in public spending in Britain makes up just eight per cent of total growth. In France, it is 25 per cent.

But the key evidence comes from the US. Here, spending by individuals makes up no less than 75 per cent of the total expansion of the economy since 2009. Yet America remains the most dynamic and innovative economy in the world.

Economic theory has long identified the capacity to innovate as being the key determinant of long-term growth, not who spends what. The debate over post-Brexit Britain should be about how to boost innovation, and whether the European Commission is a help or a hindrance to this.

As published in City AM Wednesday 25th July 2018

Image: Regent Street & Oxford Street by Tony Webster is licensed under CC-BY-2.0
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Investors should intervene to stop high executive pay, before the regulator does

Investors should intervene to stop high executive pay, before the regulator does

Shareholder discontent over executive pay continues to rise. Last week, the outgoing boss of BT, Gavin Patterson, was in the firing line.

At the company’s annual general meeting, 34 per cent of investors voted against the remuneration report, which included a £1.3m bonus payment to Patterson.

Concern about top pay has spread even to the regulatory bodies in the United States. Traditionally, they adopt a rather hands-off approach, and yet, when they do decide to act, they act decisively.

About 40 years ago, the typical compensation of a chief executive in America was around 30 times more than that of the average employee. By the mid-1990s, this has risen to a ratio of 100 to one, and now it is some 300 times as much.

True, share prices have boomed over this period, but the rate at which the economy has grown has fallen.

Between 1957 and 1987, real GDP in the US grew by 3.5 per cent a year, but by only 2.5 per cent from 1987 to 2017.

Chief executives have not got better at expanding the rate at which goods and services are produced, but they have got better at free-riding on the rise in equity markets.

Against this background, in September last year, the US Securities and Exchange Commission mandated that companies must disclose the ratio of the chief executive’s compensation to median employee pay.

Some may see this as bureaucratic meddling. But the behaviour of board members both here and in America has given rise to what economists describe as an externality.

The decisions to reward the relative failure on the part of executives have consequences outside of the decisions themselves. So while capitalism is by far the most successful economic system ever devised, the perception that executives are receiving unfair levels of compensation is undermining belief in capitalism itself. This is the externality.

In economic theory, the existence of externalities provides a sound justification for intervening in the workings of the free market.

A fascinating paper published a year ago by Ethan Rouen of Harvard Business School provides strong evidence that unwarranted executive pay levels adversely affect firm performance.

He obtained very detailed data, some of it not publicly available, from the US Bureau of Labor Statistics for 931 firms in the Standard and Poor’s 1,500 between 2006 and 2013, including total employee compensation and the composition of the workforce.

Overall, Rouen found no statistically significant relation between the ratio of executive-to-mean employee compensation and performance. This is telling in itself.

His results went on to show “robust evidence of a negative (positive) relation between unexplained (explained) pay disparity and future firm performance”. In other words, people do not mind high pay – when it can be justified. It is when the snouts are in the trough that resentment rises and performance suffers.

Shareholder opposition to excessive executive packages is certainly rising, but has rarely been decisive. Investors need to act if they are to avoid the regulators really clamping down.

As published in City AM Wednesday 18th July 2018

Image: Fat Cat by Linnaea Mallette is licensed under CC-BY-1.0
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