It has been another funny old week in Brexit Britain as parliament reconvened after the summer. We
were treated this week to the views of former BoE Governor Mervyn King who
criticised the government’s “incompetent” preparations for Brexit. In an
interview to be broadcast next week, he argued that that the government had
weakened its negotiating position by “a whole lack of preparation” for a
no-deal Brexit and said it “beggared
belief” that the world’s sixth-biggest economy should be talking of stockpiling
food and medicines.
It is hard to argue with that view. Yet at the end of 2016
King suggested that whilst leaving the EU would not be “a bed of roses – no one should pretend that – but equally it is not the
end of the world and there are some real opportunities that arise from the fact
of Brexit we might take … There are many opportunities and I think we should
look at it in a much more self-confident way than either side is approaching it
at present. Being out of what is a pretty unsuccessful European Union –
particularly in the economic sense – gives us opportunities as well as
obviously great political difficulties.” Maybe King retains his belief that
leaving the EU is a good idea and his differences with the government are more
about tactics than strategy, but he is the latest in a long line of Brexit
supporters whose expectations are not being met.
But I have always struggled to see what the economic
opportunities are. In an environment where trade flows are negatively related
to distance – as is the case in standard trade gravity models – the UK will
require a more-than-proportional increase in non-EU trade to make up for any
losses with EU countries in the event of leaving the single market, as King has
advocated. It is not as if King has a great track record over the years of
being on the right side of the economic argument. In 1981 he was one of the
signatories to a letter to The Times
arguing that “present politics will deepen the depression” – just before the
economy started to recover. More damningly, he was Governor of the BoE when the
UK suffered its first bank run since 1866 having failed to deal with the
circumstances that led to the failure of Northern Rock and was slow to
appreciate its significance. So forgive me for not being a knocked out fan of
Mervyn King’s forecasts.
But there is no denying that he is right about the sheer
incompetence of the government’s planning so far. Yesterday we were treated to
the Treasury’s secret no-deal Brexit contingency plans unwittingly being made
public after a photographer snapped an official holding a letter detailing an
outline of Project Yellowhammer. The briefing documents state: “The Civil Contingencies Secretariat held a
two-day workshop last week to review departments’ plans, assumptions,
interdependencies and next steps.” The paper reveals it is an aim of the
Treasury to build a “communications
architecture” that can “help maintain confidence in the event of contingency
plans being triggered.” It added this is “particularly important for financial services” and seems to include
a reference to “aviation and rail access
to the EU.” Whilst the government is quite right to be considering the
possibility of no-deal before March, this all seems a little alarmist.
Indeed, the more we think about it, the less likely is a
no-deal. It is not in the EU’s interests to allow the Brexit process to collapse,
particularly if Michel Barnier has ambitions to be European Commission
president, as has been speculated in the press. Moreover, as recent IMF research has indicated their calculations show “EU output losses
of 0.2 to 0.5 percent in the “FTA” and “hard Brexit” scenario, respectively”
(see chart). Perhaps this explains why Barnier’s opposition to elements of the
Chequers Plan has reportedly softened in recent days, and why Germany is rumoured
to be asking for less detail from the UK at this stage, in order to get beyond
the March deadline and set up a transition period during which the hard negotiations
will take place.
But the UK government has even more to fear. Whether or not
people are changing their views on Brexit, the electorate appears to be showing
rising distrust regarding the government’s negotiating approach. Boris Johnson’s
newspaper article earlier this week suggesting that “The scandal of Brexit is not that we’ve failed but that we have not tried” was met with widespread derision (if only he had had a position of influence
in government for the last two years!). The
British government cannot be seen to be delivering a no-deal Brexit for it
would damage its credibility beyond repair. So despite all the horse trading
which is likely over the next few months, and the associated adverse headlines,
it is likely that the EU will bend a little in order to make way for the UK to
bend a lot. And in my next post, I will look at ways in which this could be
done.
To paraphrase the nineteenth century British Prime Minister
Lord Palmerston, only two people have ever understood the tax system: One went
mad and the other died. Indeed, one of the few people to have properly understood
the tax system was the Nobel Prize winning economist Sir James Mirrlees, who
died earlier this week. Mirrlees was best known in academic circles for his
work on decision making under uncertainty for which he won the Nobel Prize in
1996, and his most insightful work was his 1971 paper on optimal tax systems
in which he showed how and why there was a trade-off between equity and
efficiency.
The paper is mathematically dense but it had a huge
impact on information economics by introducing models with asymmetric
information into contract theory. Until the late-1990s the results of these
models were not closely connected to empirical tax studies and had little
impact on tax policy recommendations. But a number of authors, including Peter Diamond
and Thomas Piketty have since connected Mirrlees’ model to practical tax
policy.
He was thus the obvious choice to head up a review of the UK tax system commissioned by the Institute for Fiscal Studies almost a decade ago.
It was a follow-up to the Meade Committee report of 1978 which was concerned
with the question of how the tax system impacted on the wider economy by
distorting incentives. Thirty years later, the IFS noted that the tax system had
evolved in a piecemeal fashion “rather than by strategic design” and that it
had not adapted to changes in the general economic environment in which it
applied. Moreover, as the IFS pointed out, “tax
design has not benefited as much as it could from advances in theoretical and empirical
understanding of the way features of the system influence people’s behaviour.”
Mirrlees and his colleagues took an in-depth look at the
state of the UK tax system “to identify reforms
that would make the tax system more efficient, while raising roughly the same amount
of revenue as the current system and while redistributing resources to those with
high needs or low incomes to roughly the same degree.” They noted that the
UK system is “unnecessarily complex and
distorting” with tax policy “driven
more by short-term expedience than by any long-term strategy” in which
policymakers did not seem to grasp the extent to which individual agents change
their behaviour in response to changes in tax incentives. This was a damning
indictment and it is still true today, with a myriad of small changes having
come into effect since the report was published which impact on the way people and
companies behave.
The report noted in particular that income inequality had
widened, particularly during the 1980s, but that merely soaking the rich was
not necessarily the way to go. In any case, corporate and capital gains taxes
are at least as important as income taxes in terms of their wider impact, and
certainly the combination of all three is likely to be more critical than
looking at one in isolation. In this sense the Mirrlees Review took a far more
wide ranging view of tax issues. Indeed, a key recommendation was that the
complex benefits system should be harmonised with income taxation, in order to
increase work incentives for the lower paid (something which the government has
tried – and failed – to achieve with the Universal Credit System).
The report also noted that the corporate tax system favours
debt finance over equity finance which in turn has increased the reliance on
debt, and recommended an allowance for
corporate equity (ACE) be introduced into the corporate tax system. Taxation of savings is another aspect requiring
radical reform. Savings in the UK are subject to double taxation, with income
tax levied on the original income from which the saving is generated and again
on interest income derived as a result. With the government having for many
years exhorted individuals to save more, this is an obvious anomaly. The Mirrlees
Review thus recommended that standard bank and building society accounts should
be entirely free of tax. Neither of these recommendations has been implemented
(though the interest on bank accounts these days is so low that tax is
negligible).
I was heartened by the Mirrlees Review when I first looked
at it almost a decade ago because it was an accessible review of the state of
the tax system, which looked at how the various parts fitted together without
delving into the politics of taxation. It is a shame, therefore, that many of
its recommendations have not been implemented. Perhaps it was the right report
at the wrong time, with governments then too preoccupied with the day-to-day task
of reducing deficits to pay much attention to reforming the tax system itself.
Perhaps the passing of Sir James Mirrlees offers us another opportunity to revisit
what I believe to be an outstanding piece of work, and to think again about
some of its conclusions.
For all the trials and tribulations which the British media
have over the years elevated to the status of great political dramas, none has
had the resonance of Brexit – an episode in which the political establishment
appears to have lost its collective reason. In many ways, it is reminiscent of
the McCarthy era in the US 70 years ago when a political ideologue used the
legal process to conduct a witch hunt against those who did not share his
extreme distaste for communism. As in the McCarthy era, a small coterie of
politicians has hijacked the British parliamentary process and appears intent
on delivering their version of an ideologically pure Brexit whatever the cost
to the British economy.
Wikipedia defines McCarthyism in a wider sense as “the practice of making accusations of
subversion or treason without proper regard for evidence.” Elements of that
definition certainly apply to Brexit: Indeed, some of the more rabid
commentators even accused those seeking to minimise the impact of a hard Brexit
as treasonous – notably this Daily Mail article, lest we forget.
Those advocating Brexit not only pay no regard to the evidence – they make up
their own. It was bad enough to lie during the referendum campaign but now that
we are seven months away from the UK’s EU departure, they are still at it!
Earlier this month, former cabinet minister Peter Lilley argued that the UK had nothing to fear from a no-deal Brexit because “WTO terms are designed to provide a ‘safety
net’ ensuring all members can trade without discrimination.” Lilley claims to know what he is talking about because “as Trade and Industry Secretary, I spent 10 days incarcerated in the
Heysel Stadium negotiating the Uruguay Round which set up the WTO.” That’s
a bit like saying if you incarcerate someone in Ornenburg’s Black Dolphin Prison for 10 days, they will emerge with an intimate knowledge of Russia.
In fact, the WTO fallback option is not much of an option at
all. Brexiteers seem to believe it confers some special status which will allow
trade to continue much as it does today. But if it is such a great deal, why do
countries seek free trade agreements which confer considerably greater
benefits? As Alan Winters pointed out in a blog post,
“since the WTO came into being, 243 new
Free Trade Agreements have come into operation … None of this suggests that
'WTO terms' are viewed generally as a satisfactory option.” Even the head of the WTO has suggested it is “unlikely” the government will have agreed
tariffs and quotas with all other member countries by next March.
And most Brexit supporters clearly do not understand the
most favoured nation clause. This merely defines the lowest possible set of
barriers that a country will be prepared to offer all other WTO members. It does
not mean that the EU will offer the UK any concessions that it is not prepared
to offer the likes of Russia, China or the US. In fact, Lilley’s article is
full of economic nonsense, as Winters points out. Amongst the highlights was
the claim that “we will be free to join
the Trans-Pacific Partnership.” Wonderful: Except the TPP does not even
exist as it was nixed by Donald Trump soon after he came to office. Moreover, “without a trade deal, Parliament will reject
any Withdrawal Agreement offering the EU £40bn … That leaves Britain £40bn
better off, and ends our annual £10bn net contribution immediately[1] – boosting our GDP, balance of
payments and public finances.” It is hard to know whether this is a
deliberate parody or just plain stupidity. My own calculations suggest a
no-deal Brexit imposes costs which are roughly three times the monetary savings
– a view which is broadly in line with the literature estimates.
Then of course, there is Brexiteer-in-chief, Jacob Rees-Mogg
who suggests that the UK could maintain an open Irish border but still impose checks “as we had during the Troubles”
– a suggestion that is as laughable as it is offensive.
In a functioning democracy, the near half of the electorate which voted against
Brexit could expect some parliamentary representation. But the opposition
Labour Party has refused to oppose the Conservatives which have taken back
control of Brexit policy despite being a minority government. Labour leader
Jeremy Corbyn is widely seen as a Brexit supporter and in a TV interview last week he refused six times to answer the question whether he believes the UK
would be better off outside the EU.
To compound the sense of the absurd the government last week
issued a series of reports on how various sectors should prepare in the event of a no-deal Brexit. Although DExEU claims that leaving without a deal “remains unlikely given the mutual interests of the UK and the EU,”
the fact that it has seen fit to issue such a series of papers suggests it is
taking the prospect seriously in the wake of EU pushback against the Chequers
plan. There is no reassuring news in the policy papers which effectively
highlight all the things that the experts said would happen in the event of no
deal (more red tape, higher compliance costs and a need to stockpile in key
areas such as medicines). Whatever happened to “they need us more than we need
them”?
In short, Brexit is a looming disaster of the government’s
own making compounded by the failure of the opposition to set out a credible
alternative. It is hard to shake off the suspicion that it represents a coup by
right-wing Conservatives desperate to grasp this one chance offered by a
non-binding referendum. But heed the lessons of history: Like Brexit, public
support for McCarthyism only ever peaked at around 50% in January 1954. Within
six months public support had dwindled to only 34%. Joe McCarthy himself was
censured by the Senate at the end of 1954 and he was dead within three years.
As William Bennett, noted in his 2007 book America: The Last Best Hope, “The
cause of anti-communism, which united millions of Americans and which gained
the support of Democrats, Republicans and independents, was undermined by Sen.
Joe McCarthy ... his approach to this real problem was to cause untold grief to
the country he claimed to love ... Worst of all, McCarthy besmirched the
honorable cause of anti-communism. He discredited legitimate efforts to counter
Soviet subversion of American institutions.”
A similar epitaph may yet be written for Brexit: genuine
concerns about the EU undermined by the efforts of Brexit supporters. But a
no-deal Brexit is like McCarthy unleashing the nukes to solve the Soviet
problem. And even he was not that stupid.
According to former US President Ronald Reagan, the nine
most terrifying words in the English language are “I’m from the government and
I’m here to help.” Indeed over much of the past 40 years, Anglo Saxon economies
have tried to shrink the size of the state in the belief that the markets are
more efficient at allocating resources. In a narrow sense this may be true since
the private sector has an incentive to generate the lowest cost solution in
order to maximise profit.
But it is increasingly evident that rolling back the state
does not always generate outcomes that are in the interests of wider society. The
Private Finance Initiative (PFI)
in the UK has incurred billions of pounds in extra costs to deliver
infrastructure projects for no clear benefit. Indeed, recent PFI contracts –
for schools, hospitals and other facilities – are between 2 and 4 per cent more
expensive than other government borrowing, and involve significant additional
fees. There is also widespread criticism that the chief executives of formerly publicly-owned utilities receive huge
salary packages whilst not delivering any improvement in services.
In other words, the ideological basis of Anglo Saxon
economic policy over the past four decades is not all it is cracked up to be.
The model took a massive hit following the financial crisis of 2008 and
governments around the world are still struggling to cope with the changed
economic and political realities. Efforts to resume business as usual have
struggled to gain traction and governments are increasingly struggling to
retain the trust of their electorates. We see it in the populist surge across
Europe and in the conduct of US politics, and it is evident in the rise of
strongman administrations in places such as Turkey and the Philippines. In some
ways the perception of government failure is unfair – in other ways not. But
the widening gap between the perceptions of politicians and the electorate is
both unfortunate and dangerous.
It is unfortunate because in western democracies politicians
are representatives of the people. They are us and we are them – something that
is too often forgotten by the body politic. It lies within the power of the
people to change the status quo. In France, this led to the formation of a new
political party which in the space of a year had propelled Emmanuel Macron to
the presidency, although it has proven more difficult to replicate this
strategy elsewhere. But the widening gap between people and politicians is also
dangerous because it creates space for populists who advocate simplistic
solutions to complex problems. The inability of the established political
powers to counter these problems runs the risk that nominally sensible
politicians will be forced to ape populist measures in order to stay relevant,
thus taking politics in an unfortunate direction. Moreover, when the populist
solutions are shown to have failed how will electorates respond?
Despite the strains which have been placed on western
economies in recent years, they have just about managed – and so far, at least,
rather better than in the 1930s. But continued fiscal austerity threatens the
social fabric in ways that will only become evident in the longer-term. Greece
and Ireland have emerged from a period of EMU-imposed belt-tightening, which
has left the Greeks in particular significantly worse off. And I have long
pointed out that the fiscal austerity imposed in the UK is outright regressive
as it takes the axe to welfare spending. But for an example of how fiscal austerity can be taken to unacceptable limits,
recall the experience of the city of Flint in Michigan.
To summarise, Flint had suffered huge employment losses over
a period of many years as GM, the city’s main employer, cut back on local jobs.
This adversely affected tax revenues and by 2011 things were so bad that the
governor of Michigan declared a state of financial emergency, appointing an
emergency manager to cut costs to the bone. Alongside such measures as reducing
the size of the police and fire departments, the authorities decided in 2014 to
cut costs by switching the city’s water source from Lake Huron to the heavily
polluted Flint River. In order to save yet more cash, the authorities opted not
to add anti-corrosion agents to the water which would have prevented the
pollutants from causing lead to leach into the town’s water supply.
Despite mounting evidence to the contrary, officials
continued to deny that the drinking water in Flint was unsafe. When Dr Mona Hanna-Attisha published her work in September 2015 highlighting the health
risks associated with high lead concentrations in the drinking water, her research
was initially ridiculed. A Michigan Department of Environmental Quality
spokesperson accused her of being an "unfortunate
researcher … splicing and dicing
numbers" and causing "near
hysteria.” But she was right and they were wrong. As a result, huge amounts
of extra spending were required to replace pipes and ensure a supply of clean
drinking water until the operation was complete, and criminal proceedings were
launched against a number of officials involved in the scandal. Ironically, the
cost of adding anti-corrosion agents to the water in the first place would have
cost only around $36,500 per year versus an estimated $97 million over three
years to replace the plumbing.
This is a classic example of short-sighted policies that are
consistent with the Bluffocracy.
By focusing only on one policy objective – saving money – the authorities
ignored the non-pecuniary costs associated with their strategy. Worse still,
the authorities failed to address residents’ concerns – the very people who
they are supposed to represent. When this happens on a national scale you get
politicians like Trump filling the gap. A decade ago, we were concerned with
market failure as the global financial system tottered on the brink of
disaster. Today, we are more concerned with government failure and nowhere is
this more evident than in the case of Brexit – the subject of my next post.
