Happy tax year

Today is the start of the new tax year in the UK and to celebrate the Institute for Fiscal Studies recently published a nice little piece outlining the impact of the inflation indexation of tax thresholds (here). As the IFS points out, the UK routinely uprates the cash value of tax thresholds in line with inflation, unlike many other countries. This process dates back to 1977 when two backbench MPs introduced a process forcing the government to automatically uprate thresholds in what became known as the Rooker-Wise Amendment. This makes a lot of sense: Without such indexation as wages rise in line with inflation, so ever more people at the lower end of the income scale would be dragged into higher tax brackets.

But the IFS notes that across many tax categories this automatic uprating has not taken place for a number of years. Two of the most interesting examples are fuel duties which have not increased in cash terms since April 2010 whilst working-age benefits have been frozen since 2015-16. At a time when governments around the world are trying to curb vehicle emissions it does seem rather odd that the UK is not taking the opportunity to take the moral high ground by raising emissions taxes. Consumer prices have risen by 16% since the start of 2011 which would add around 10p to a litre of diesel (7.5%). Obviously, drivers will not complain that the real value of fuel taxes has declined over the last 9 years but it does seem at odds with the government’s self-professed green credentials. We can view this move in one of two ways: It is an overtly political move to curry favour with motorists or it is an attempt to reduce the regressive effect of such taxes.

Being charitable, we should perhaps assume the latter option in an effort to redress the effect of a freeze in the cash value of working age benefits, which obviously means a decline in real terms. But as the IFS put it, “the government might believe that benefits should be more or less generous, but the extent of any change in generosity should be thought through and justified, not the arbitrary and accidental result of what the rate of inflation turns out to be.”

The IFS has also identified a growing trend of instances where thresholds are maintained in cash terms and only uprated when the government believes it to be necessary. Most of these instances really only affect those at the upper end of the income scale and whilst the vast majority of taxpayers will not shed any tears for the better paid members of society, they do illustrate how arbitrary manipulation of tax thresholds can result in some strange outcomes which may impact on work incentives.

One such is the £100k threshold at which the personal tax allowance is progressively withdrawn. Anyone earning below this amount is entitled to a £12.5k tax-free allowance but for every £2 of income above £100k the tax free amount is reduced by £1. One result of this is that those earning between £100k and £123.7k are taxed at a marginal rate of 60% (i.e. they keep just 40p out of every £1 they earn thanks to the allowance taper). Yet more bizarre is that those earning between £123.7k and £150k are once again subject to a lower marginal tax rate of 40% (above £150k the marginal income tax rate rises to 45%). “Oh dear, how sad, never mind” you may say. But there are now 968,000 taxpayers’ earning more than £100k – an increase of more than half since 2007-08, who have been dragged into the net due to the failure to index the threshold.

That said, higher taxes on the better off in society have been used to fund an extension of the zero-tax threshold for the less well paid. In fiscal year 2007-08 (the last year before the financial crisis) those earning £10,000 paid an average tax rate of 13.1% (income tax plus National Insurance Contributions). The government’s stated policy of taking the lower paid out of the tax system altogether means that someone earning this amount today pays an average tax rate of only 1.6%. As the chart suggests, the average tax schedule has clearly shifted to the right compared to 2007-08, illustrating the reduction in tax liability of the less well paid. The curve is also lower than it was in 2007-08 for incomes below £100k, so most people pay less tax, but it rises sharply thereafter, and those earning £120k are paying more.

But the true marginal tax rate is not merely made up of the amount levied on income – we have to account for the withdrawal of social welfare entitlements, and those lower down the income scale are in the line of fire. For example, those earning more than £50k per year have to pay back some of their Child Benefit in the form of extra income tax. If they earn between £50k and £60k and have one child, they face a marginal income tax rate of 51% but if they have three children their marginal income tax rate is 65%. Again, this threshold has remained unchanged for some years which means an increasing number of people are likely to run into this problem.

However, one of the more bizarre quirks is the reduction in the pension annual allowance for high-income individuals. The first £40k of pension contributions is free from income tax but those whose income (excluding pension contributions) exceeds £110k face a tapering in their tax free pension allowance. Without going through the details (they are outlined in the IFS paper), the upshot is that someone earning £150k (including pension contributions) can put £40k into their pension without incurring extra taxation but someone whose total income (including pension contributions) is £210k finds that their tax free allowance is reduced to only £10k. More bizarre still is that the likes of senior doctors, whose generous defined benefit pension schemes result in contributions exceeding £40k, can end up facing marginal tax rates of more than 100%. I was recently made aware of instances where such doctors are not prepared to work beyond a certain point because they pay more tax than they earn (obviously, they could offer their time for free but they could equally well enjoy an evening at home if they are not getting paid for it).

Although some of the examples highlighted here are extreme cases, they illustrate how an ill-designed tax system can result in high marginal tax rates that act as a disincentive to work. And the more people are dragged into the tax net due to the absence of indexation, the greater is this effect. A good tax system should meet five basic conditions: fairness, adequacy, simplicity, transparency, and administrative ease. A lack of inflation indexation undermines all of them.

What do we want? Brexit. When do we want it? Err...

The last few days in British politics have been as tumultuous as at any time in recent history with Brexit opening up unprecedented fissures within the two main political parties. Attempts by MPs on Monday to find alternative solutions to the Brexit crisis failed to yield a majority solution as all four motions on the agenda were rejected – the customs union option falling short by a margin of just 3 votes, which curiously matches the number of Labour MPs who abstained. Such is the parliamentary impasse that the prime minister yesterday requested the support of the opposition Labour Party to secure her withdrawal agreement whilst intending to ask for a short delay to the Article 50 process. Meanwhile there is mounting evidence that uncertainty is beginning to weigh on the economy.

The politics

Turning first to the politics there were four options on the parliamentary agenda on Monday: A customs union; “Common market 2.0”; a “confirmatory” referendum and one designed to assert parliamentary supremacy to prevent a no-deal Brexit, with the ultimate sanction being the revocation of Article 50. All were rejected, but it is notable that across the four votes the Conservatives averaged just 24 votes per motion in favour whereas Labour’s average was 185. When it came to opposing the motions, the Conservative average was 244 versus 19 for Labour. For all the criticism levied at Labour’s opposition to Brexit, it was the Conservative rebels who have on three occasions prevented the Withdrawal Agreement from being ratified by parliament and it was they who blocked MPs efforts to find alternatives to a no-deal Brexit.

Having spent nearly three years appealing to the right-wing of her party, only to be rewarded by constant undermining of her position and a challenge to her party leadership, it should be no surprise that the prime minister finally decided to reach out beyond the Conservative Party to try and find a resolution to what can only be described as a political crisis. The bluster and fury of Conservative MPs suggesting that the destiny of Brexit now rests with Jeremy Corbyn rings hollow in view of the fact that it was their own intransigence that led us to our current position. Typically, the debate tends only to be seen through the prism of Westminster. What MPs have failed to recognise is that their rejection of the Withdrawal Agreement means the destiny of Brexit was long ago handed over to the EU.

The prime minister’s suggestion that “we will need a further extension of Article 50 – one that is as short as possible and which ends when we pass a deal” will not go down well in Brussels. There are two separate issues in this one sentence. One is the idea of a further extension, having already been given one, and the other is the issue of finding some sort of “deal” (I did like the optimistic conditional “when” rather than the more likely “if”). By far the bigger problem is likely to be the reaction in Brussels to the first point.

Speaking today, European Commission President Juncker set an “ultimate deadline” of 12 April for the UK parliament to pass the Withdrawal Agreement: “If it has not done so by then, no further short extension will be possible. After 12 April, we risk jeopardising the European parliament elections, and so threaten the functioning of the European Union.” This makes perfect sense. UK hopes for an extension to 22 May merely risk pushing the cliff edge further out into the future without any guarantee that a domestic political rapprochement will be found. Indeed, the reaction of Conservative MPs following the PM’s plan to reach out to Labour suggests that the political climate could become more, rather than less, dysfunctional.

Thus, unless May is able to go the summit in Brussels next week with a cast-iron guarantee that the UK has ratified the withdrawal agreement, the EU is likely to insist on the UK taking part in the EU elections (if indeed it offers an extension at all). Minister for the Cabinet Office David Lidington (widely known as the de facto deputy PM) has already given local councils the green light to start preparations for the elections. In advice delivered in a letter to local government officers, he wrote “the opportunity to guarantee that the UK would not participate in EP elections has been removed.” The calculation that MPs will have to make is whether they are prepared to back the Withdrawal Agreement in order to quickly remove the UK out of the EU or whether they are prepared to accept participation in the elections in the hope that they will be able to secure a better compromise in the longer-term.

The economics

There are increasing indications that Brexit-related uncertainty is beginning to weigh on the economy. The purchasing managers index in the services sector last month dipped below the critical 50 threshold, below which activity is contracting, for the first time since July 2016 in the wake of the EU referendum: Aside from this one-off, we have to go back to December 2012 for a sub-50 reading on this index. The new business sub-component of the services PMI declined for a third consecutive month. Against that, the manufacturing index spiked up to 55.1 – the highest since March 2018. But this was driven entirely by companies’ inventory building ahead of a potential no-deal Brexit. Needless to say, once the stockpiling process is complete, there will be a sharp decline in the manufacturing PMI. Although we will have to wait another five weeks before the ONS publishes March GDP figures, it certainly looks as though Q1 ended on a weak note.

One of the regular conversations I have been having with clients in recent weeks is whether it would not be better for the economy to face a hard Brexit so that the uncertainty factor is eliminated. My answer is an unequivocal no. It would be far less damaging for a 10% decline in investment to be spread out over (say) 18 months than to occur in the space of three. Continuing to kick the can down the road also avoids the potential for disruption to trade flows. Moreover, uncertainty does not dissipate once a hard Brexit takes place as companies will struggle to figure out how to operate in a post-Brexit environment.

The bottom line

The UK remains in limbo so far as Brexit is concerned, whose main proponents have proven unable to deliver on their promises and they have no one but themselves to blame for the fact that the UK is (still) a member of the EU despite being supposed to leave last Friday. They had Brexit within their grasp and blew it by continuing to vote down the Withdrawal Agreement. Part of me wonders whether this was their intention all along. Brexiteers never had a plan and were concerned they would be blamed if Brexit turned out not to be the promised land. This way at least they can continue to do what they do best: Sniping from the sidelines.

Not out

I assumed two years ago that I would be waking up on 30 March 2019 with the UK as an ex-member of the EU. After all, parliament voted by 498 to 114 in favour of triggering Article 50 in a vote on 1 February 2017, in the full knowledge that this was what the legislation entailed. But no. A litany of errors and political miscalculations over the last two years means that Brexit has, at the very least, been postponed for two weeks. 

Why is Brexit so difficult to deliver? 

The intellectual dishonesty at the heart of Brexit becomes more apparent by the day. It was always clear that triggering Article 50 meant accepting whatever compromise was agreed at the end of the negotiation period, otherwise the UK would have to leave the EU and rely on relationships governed by general international public law (e.g. trade would be subject to WTO rules). Of course, that would not be a problem because, according to Liam Fox, we would now be in a position to have rolled over the 40 trade deals with third counties that are currently covered by EU trade arrangements. He has managed just 8, the largest of which is with Switzerland. He also said that doing a trade deal with the EU would be "one of the easiest in human history." Nobody seems to have told his parliamentary colleagues.

Two years on and we are now in a position where the UK parliament has rejected the deal negotiated with the EU three times and is scrambling to find an alternative before it crashes out of the EU without any form of backstop on 12 April. The political system is simply not capable of dealing with the complexities of the Brexit problem. Over recent weeks, the executive (government) and legislative (parliament) arms of government have blamed each other for the current impasse but in reality they are both to blame. Starting with the government, there has been an appalling lack of leadership from Downing Street. Article 50 was triggered without giving any thought as to what the UK wanted from the negotiations and what it could realistically achieve. Theresa May then made a serious error of judgement in calling an election AFTER triggering Article 50 which not only wasted valuable negotiating time but resulted in the Conservatives losing their parliamentary majority. May’s inability to instil discipline on her own party has allowed backbench MPs to act with impunity, thus undermining the government at every turn.

However MPs as a whole have failed to cover themselves in glory either, and are held in low regard by most of the country. Jacob Rees-Mogg’s band of Brexit ultras has failed to heed the warnings that a no-deal Brexit threatens major economic disruption and are so obsessed with delivering an ideologically pure Brexit that the concerns of the electorate have been totally ignored. Rees-Mogg, lest we forget, has long derided the withdrawal agreement and claimed that the UK will become a “vassal state” if it signed up to it. This week, he indicated he would then back the deal if the DUP would do so. They didn’t but he supported it anyway. Meanwhile the Labour Party continues to suggest that an election is the only way forward because it will somehow be able to deliver a Brexit that has eluded the Conservatives, and has focused its energies on this issue rather than the task at hand. Then there are self-obsessed mavericks such as Boris Johnson who care not one jot for anything other than their own self-interest.

But perhaps the biggest problem over the past two years is that whilst the Brexit referendum was conducted on cross-party lines, with MPs free to campaign as their conscience dictated, the post-referendum process has been conducted along party lines. Both the Conservatives and Labour have tried to play the Brexit process purely for their own advantage and it has been clear all along that the Tories were attempting to “own” Brexit. They surely must regret that decision now. It is becoming clear that any attempt to find a Brexit resolution requires a cross-party consensus. Indeed, I did suggest in May 2017 that the negotiating team should be representative of parliament as whole rather than a single party. But what is now a crisis of government (or governance, if you prefer) clearly requires a different approach. I thus have some sympathy with those calling for the formation of a cross-party government. After all, the first national government of 1931 was formed in the wake of the economic fallout from the crash of 1929, and lasted for two months – perhaps just enough time to find a Brexit compromise. 

The way(s) forward 

I noted two years ago (here) that it was difficult to see how the UK would, in the prime minister’s words, “emerge from this period of change stronger, fairer, more united and more outward-looking than ever before.” Indeed, I pointed out that the UK was likely to be weaker, less united and more inward looking and I take no pleasure in being right about that. Nor, increasingly, can we be sure that Brexit even represents the will of the people anymore. Indeed, it only ever represented the will of just over half of those who turned out to vote. Although I have never been a supporter of a second referendum, the fact that politicians cannot decide what to do next suggests there is a case for putting the argument back to the people. After all, MPs have had three votes on the critical piece of legislation and have rejected it each time. The intellectual case against a second referendum gets weaker by the day.

However, I have long had a sneaking suspicion that the withdrawal agreement could go through at the fourth attempt. After all, the trend is running in the PM’s favour. Here is how it could be done: Assuming that on Monday parliament asks the government to consider a customs union with the EU, and that it agrees to this suggestion, the EU could simply revise the political declaration (the non-binding element of the legislation which is designed to chart the broad course of the future relationship with the EU). The declaration would then be aligned with official Labour policy and the government could put both the withdrawal agreement and revised political declaration before parliament for a fourth time in the expectation that Labour will support it. This would allow the government to deliver Brexit without a long delay as Theresa May evidently wishes.

If that fails, the UK might then have to face up to a general election. The government is clearly exhausted by its unsuccessful efforts to deliver Brexit and as the prime minister said yesterday in the wake of her third defeat on the withdrawal agreement, “I fear we are reaching the limits of this process in this house.” But perhaps the quote which best sums up where we are in the whole sorry mess came from an unnamed cabinet minister who, when asked by a BBC reporter why Theresa May was putting up the withdrawal agreement for a third vote despite the fact she was almost certain to lose, replied “F*** knows. I’m past caring. It’s like the living dead in here.” That at least is something we can all agree on.

Decisions, decisions

Of all the more intractable problems I have encountered, Brexit is top of the list. Every time we think we have found a way forward, reality intervenes to cast us back to square one. It strikes me that one reason for this is that we are thinking about the problem in a binary way, which is inappropriate given the complexity of the issue. As it is conventionally presented in the media – and indeed in parliament – Brexit is a simple case of in or out. The prime minister’s ill-judged attack on MPs last week was a product of this kind of simplistic thinking. But it is wrong. There is a cost associated with each choice and the optimal strategy is to choose the one with the lowest costs. It is thus wrong to think simply of “in” or “out.” The real choice has always ever been between “in” and “what kind of out?”

Rather than trying to solve the problem by looking forward, we can use the method of backward induction which begins by looking at the end point and working back to determine the path necessary to get there. One of the great advantages of this approach is that it allows us to abstract from a lot of the political noise surrounding the current debate. Thus, to answer the question of how to leave the EU with an agreement that minimises economic costs to the UK, we can work out the sequence of events designed to get us to that point. By sequentially going through the outcomes, we end up gradually eliminating all the impossible options until only the possible ones remain. None of them accord with the plans put forward by the most fervent Brexit supporters.

But whilst this is an approach which allows us to look at desired outcomes, methods of voter choice help us to assess how we actually arrive at our choices, however unlikely they may be. Consider a system of single transferable votes in which 650 MPs face four options, A, B, C and D. Suppose they rank their preferences from 1 to 4. If no option commands a majority, the lowest-ranked first choice is eliminated from the ballot and the remainder are subject to a vote in the next round. The attached chart shows the sequence of how this might pan out.

In the first round, options A and D have an equally low number of first preferences but A is eliminated because it has a smaller number of second preferences. In the second round, D again scrapes through on the basis of having more second round votes than C and in the final round it ends up on top because more voters switched their allegiance to D than B, despite the fact that D was never a first choice winner in either of the first two rounds. Imagine now that option D is either a hard Brexit or revocation of Article 50. Although these are not plausible outcomes today, such a voting system demonstrates how they could end up as being the favoured choice depending what other choices are available.

An alternative voting system is the Condorcet method which attempts to force a decision by holding a series of one-on-one votes to determine whether there is one preference that comes out on top. In our example, we thus run six votes (A vs B); (A vs C); (A vs D); (B vs C); (B vs D) and (C vs D). If preferences are transitive (i.e. if A is preferred to B and B is preferred to C, then A must be preferred to C), it is possible to derive a winner. But if they are non-transitive it is not. Imagine, for example, the case where MPs are asked to choose between accepting the Withdrawal Agreement and revoking Article 50 and opt for the former. In a second vote, MPs prefer accepting the Withdrawal Agreement over a hard Brexit but in a third vote they express a preference for a hard Brexit over revoking Article 50. It is thus impossible to derive a series of ordinal preferences. This is known as the Condorcet paradox which we can liken to the game rock-paper-scissors, to which there is no obvious solution.

The work of Nobel Laureate Kenneth Arrow highlighted the problems involved in arriving at optimal choices. He gave his name to Arrow’s impossibility theorem which suggests that when there are three or more options, no ranked voting system can convert the ranked preferences of each individual into an overall ranking which meets a number of specific criteria. Perhaps the most important of these is that one person or group of people cannot be made better off without making others worse off (the Pareto criterion). This is an accurate description of where we are in the Brexit debate given the sentiments expressed on the streets of London at the weekend.

Continuing to put a series of votes to parliament, none of which commands a majority, can ever be guaranteed to find a resolution to the Brexit problem. The very fact that the electoral split in favour of leaving the EU was not much more than 50-50 ought to make us question why MPs can find a resolution when the electorate could not find a solution to the Brexit impossibility conundrum. The government’s approach has been to treat the outcome as a zero-sum game. But as the estimated one million people marching through London at the weekend highlighted, this approach is far from satisfactory. The only resolution to the problem is to buy more time: Kick the can down the road in the hope that society is able to agree on an acceptable compromise. Theresa May gained only an additional three weeks. It’s not enough!

The governance problem

Irrespective of one’s views over Brexit, there can be little doubt that the post-referendum negotiations have done great harm to the UK’s reputation for good governance. The British reputation for pragmatism has been trashed by the ideological positions adopted by all sides in the Brexit debate which threatens to do significant damage to the British economy. Whether a no-deal Brexit will or will not damage the economy is not the point: The mere possibility that it might illustrates that the government is prepared to take risks with the livelihoods of people whose interests they are meant to be serving. This is not good governance. 

The dictionary definition of governance is the process of decision-making and the process by which decisions are implemented. Government is one of the key actors in this area because it sets the institutional framework against which decisions are taken. The United Nations defines eight key characteristics of good governance: It is (i) participatory; (ii) consensus oriented; (iii) accountable; (iv) transparent; (v) responsive; (vi) effective; (vii) efficient and (viii) equitable. In addition, it should be ”inclusive and follow the rule of law [thus ensuring] that corruption is minimized and that the views of minorities are taken into account and that the voices of the most vulnerable in society are heard in decision-making. It is also responsive to the present and future needs of society.”

Measured in terms of these criteria, the post-Brexit decision-making process fails on a number of counts. Arguably the post-referendum process fails on the consensus criterion (i), although Brexit supporters will argue that the referendum was the greatest act of participation in British democratic history outside of an election. But there can be no doubt that the pre- and post-referendum process was not consensus oriented (ii). Unless the government puts the terms of its deal to the electorate, there is a case for suggesting that the accountability principle (iii) is also not satisfied – recall that the electorate did not express a view on the nature of Brexit. I would argue that the process also fails on point (vi) – such has been the inability of the government to make a case that will satisfy all parties, that it is clearly not effective. And it clearly was not efficient (vii) because the process has absorbed so much legislative time that the government has not had time to devote to other pressing policy areas.

On the plus side, the process does satisfy the transparency criterion (iv) though only because the courts forced the government to cede parliament a role in determining the course of Brexit. Whether the other points will ultimately be satisfied, only time will tell. But given the fact that younger voters voted heavily in favour of remaining in the EU, it is clear that “the future needs of society” have not been taken into account.

All these things matter because the UK’s view of itself is bound up with its reputation for stability. Italy has had 65 governments since 1946; the French political system was reconstituted as recently as 1958 whilst the Federal Republic of Germany is only 70 years old. Britain prides itself on its parliamentary democracy which has remained substantially unchanged over 300 years and whose direct roots can be traced back to the 13th century. It was supposed to be unthinkable that a Greek-style crisis of governance could ever happen in the UK. But it has. This does not mean that the UK is immediately about to fall apart at the seams (though it sometimes feels like it). But there are likely to be longer term consequences which will act to its disadvantage.

For one thing, the UK’s reputation as a business-friendly environment has been badly damaged. One thousand days after the referendum and with just nine days to go until EU membership is due to lapse, businesses have no idea about the nature of future trading arrangements with the EU. As a result of this mounting uncertainty, businesses have cut back on investment. We do not need to rake over the coals of what is happening in the car industry but Japanese manufacturers did warn in 2016 that they set up shop in the UK in the 1980s to ensure access to the EU, and that an abrupt departure would have ramifications for their future business decisions. 

Financial institutions which are already suffering from low interest rates, an inflated cost base and ever more stringent regulation, could not afford to wait around for governments to decide on the nature of the financial passporting regime and have been planning for more than two years how to secure business continuity. Around 7,000 jobs and £800 bn in assets (10% of total UK bank assets) have moved out of London to other European financial centres. It is highly unlikely that they will come back. And I have long expressed concerns that business that might otherwise have come to London will bypass it altogether. There are indeed indications that firms are opening their first European offices in the EU rather than the UK (Kroll Bond Rating Agency and Norinchukin Bank to name but two). 

The nature of the UK could itself be subject to change in future. Scottish voters predominantly rejected Brexit, as indeed did Northern Irish voters. The SNP’s raison d’etre is to push for Scottish independence from the rest of the UK and I have long believed that 10-15 years after the first independence referendum, which took place in 2014, there would be a push for a rerun. I stand by that view, particularly if Scotland is dragged out of the EU against its will. The question of whether Northern Ireland will remain part of the union in the longer term is also relevant. The DUP, which has played such a big role in the Brexit drama, gained only 36% of the vote at the general election two years ago and the vote share of pro-Union parties was only narrowly ahead of nationalist parties which would support a united Ireland. Many Irish commentators believe that a united Ireland is inevitable in the long-run – they may well be right. 

Many of these issues could have been avoided if the Brexit process had not descended into factionalism which prevented pragmatic decisions from being taken quickly. With the executive and legislative arms of government at loggerheads, the question has naturally arisen as to whether the system of government is broken. But it is not the institution of government which is the problem. It is those who are managing the process. Only today we have had the Leader of the Opposition walk out of a meeting of party leaders because of differences of opinion with other participants whilst the Prime Minister blames parliament for the UK's current predicament. This is not the behaviour of political leaders.

For a medium-sized country such as the UK to have held a prominent position on the world stage long after its military and financial clout have been diminished speaks volumes for its judicious application of soft power. But as one Italian journalist said to me recently, “I used to look up to the Anglo Saxon system of government compared to my own. Now I no longer do.” The damage caused to the UK’s international may not easily be repaired – if indeed it is repairable at all.