Time to rethink the tax system

Looking to next week …

Next week the Chancellor will present the annual UK budget in which he must strike a balance between providing support to the economy in these unprecedented times whilst suggesting that measures will need to be put in place to plug the fiscal gap. Unlike in times past when the purdah period ahead of the budget meant there was complete radio silence on the expected measures, this year the plans have been splashed all over the weekend newspapers. They highlight that the government is planning a “restart” grant scheme to provide funds to allow businesses to reopen after the Covid lockdown and an extension of the furlough scheme through June. In addition, the government is expected to announce measures to support house buying, including a time-limited extension to the stamp duty holiday and help for people hoping to get on the property ladder.

Any message that the government is trying to convey via the media should be taken with a huge pinch of salt. Whilst it is giving the impression that it remains committed to providing support, a £5bn restart fund is chickenfeed in fiscal terms (0.2% of GDP) – as one below-the-line contributor to the FT story sardonically commented, “why not just send a card?” I have noted on previous occasions that the media representation of fiscal aggregates is akin to a form of money illusion if measures are simply reported in absolute terms without giving any form of context. A £5bn fund sounds big to the average punter but it will only deliver a payout of up to £18,000 for the biggest firms. Small businesses will obviously get less and the payout may not even cover the fixed costs of running a business during the lockdown. This is not to say that support is unwelcome but it highlights that the state’s generosity is more limited than ministers would have us believe. Nor is it clear that measures to further inflate the housing market will do much to tackle the UK’s economic woes. Inflating the price of non-productive assets may make voters feel good but it is of questionable economic benefit.

Naturally politicians want to deliver only good news whilst hiding the bad and there has been less discussion of any fiscal tightening measures. However, Chancellor Sunak has promised to “level with people” over the “enormous strains” in Britain’s public finances and warns that the bill will fall due at some point. Matters have been made more complicated by the foolish commitment in the 2019 election manifesto to rule out increases in income tax, national insurance and VAT rates though whether that is adhered to in the long run remains to be seen. One of the measures likely next week is a freeze in income tax thresholds which will push people into higher tax bands as their income rises, although the fiscal effect of this will be limited, yielding less than £1bn in FY 2022-23. There has been some chatter about whether corporate taxes will rise. Whilst this may be postponed to the future as there are genuine questions as to whether this is the right time to be talking about fiscal tightening, it is a measure likely to come onto the agenda sooner or later.

… And beyond

Much of the discussion around fiscal tightening centres around tinkering with existing taxes. But looking ahead, now would be as good a time as any to open up a discussion about the future shape of the tax system. After all the current system largely grew out of a twentieth century economy but given the impact of the pandemic on the structure of the economy and the need to reshape fiscal policy in its wake, it would now seem to be a good time to announce a long-term public consultation on the scope of tax reform. This would build on the excellent body of work conducted by the Mirrlees Review in 2010 and 2011 which was motivated by the fact that the tax system has grown in an ad hoc way and “remains the product of often incoherent piecemeal changes rather than strategic design.”

Although the British system is fairly efficient in an international context, offering relatively few loopholes and opportunities for avoidance, and is on the whole non-intrusive, it is far from perfect. We can broadly categorise measures into easy fixes and ones which require a much deeper level of consideration. In terms of the former category, I repeat my call for a reduction in the benefits taper rate (the rate at which in-work benefits are withdrawn as people take on paid employment) which would eliminate the burden on some of the least well-off in society whilst also increasing their work incentives.

Other relatively easy fixes include increasing capital gains tax to align it with income taxes, as recommended by the Office of Tax Simplification, to ensure equal tax treatment of labour income and wealth income. Another fix would be to limit the rate of pension tax relief to 20%, thus reducing the regressive treatment of pension contributions which currently favour higher rate taxpayers, whilst abolishing the double taxation of interest income would be a welcome vote winner. Finally in terms of easy fixes, there is a case for abolishing the distinction between national insurance contributions (NICs) and income taxes as a way of simplifying the tax system. In fairness this was considered in the 1980s but the then-Chancellor concluded that “the benefits of a combined charge would be unlikely to justify the ensuing upheaval.”

There are a number of more complex questions to be asked of the tax system which require a lot more thought. To the extent that income tax, VAT and national insurance contributions together account for around 60% of revenues there is a case for thinking about ways to widen the tax base. One option would be to consider the possibility of a wealth tax. I did look at this issue three years ago and concluded that there are many practical objections which means it may be more trouble than it is worth. But there are some attractive features, especially in the wake of the pandemic in which young asset-poor people have been forced to make sacrifices to shield older asset-rich people.

Another area ripe for reform is corporate taxation. The standard belief is that there is a case for raising the tax rate which is relatively low in an international context. There is some merit to this but there is a lot more to the issue than simply tax rates. For example, a recent OECD symposium looked at ways to levy tax based on the location of customers rather than legal domicile and there is a big debate around the taxation of digital services which is very much in its infancy. A related issue in the corporate taxation debate is the extent to which debt finance receives more favourable treatment than equity finance. By allowing the tax deductibility of debt interest payments against profits, the base against which corporate taxes are levied is artificially reduced.There is scope to look more closely at this anomaly.

Last word

There are numerous other areas ripe for reform (local authority financing being one of them and I will come back to that another time). As Stuart Adam and Helen Miller noted in a recent IFS report “The parts of the UK tax system that dictate how different forms of income are taxed are of central importance and are not fit for purpose … The tax treatment of returns to investment is a mess … And this is just the start; the list of problems is long.” These are very strong arguments in favour of rethinking the tax system to make it more applicable to the economy of the 21^st century. Just as we need a debate about what we want the state to provide following the pandemic, we need a debate about how to pay for it.

Bitcoin: The search for fair value

 

In late-2017 I wrote a series of posts pointing out the extent to which Bitcoin was highly overvalued and that it was likely to fall back in 2018, which it duly did. But if we thought the digital currency was overvalued three years ago at a rate below 20,000 against the dollar, what should we make of a rate which this week spiked above 57,000?

The boom in context

We should not forget that this is not the first surge in the price of Bitcoin – indeed there have been five documented instances of a bubble prior to the latest one with each boom followed by a bust. Bitcoin started trading in April 2011 at parity to the dollar but by June it was trading at $32 – a gain of 3100% within just three months – although it subsequently collapsed back to $2 by November. In 2012 and 2013, there were three further boom and bust cycles with the final one resulting in Bitcoin breaking through $1000 for the first time. The inevitable collapse that followed meant that it did not break through the $1000 barrier again until early-2017. That year proved to be a watershed for the original cryptocurrency which started the year below $1000 but at one point broke through $19,000 to put the concept of digital currencies firmly into the public consciousness. Arguably the success of 2017 was one of the key factors prompting central banks to take the concept of digital currencies more seriously and their programmes in this regard have since come on by leaps and bounds.

The most recent Bitcoin surge really only got going last October and broke through its previous high just before Christmas. It today stands at 4.5 times the previous peak in December 2017. A number of explanations have been put forward for the surge. One argument that does not hold water is that it is being driven by the search for an inflation hedge on fears that the huge stimulus put in place to combat the Covid pandemic will ultimately spill over into prices. After all gold, which is a more traditional inflation hedge, is down 13% from its peak last summer.

A more plausible explanation is that Bitcoin is finding wider acceptance across the institutional investor universe. For example BNY Mellon recently announcing that it plans to hold Bitcoin and other cryptocurrencies on behalf of its clients, putting it on a par with traditional assets such as US Treasury bonds and equities. Earlier this month, Tesla announced that it has bought $1.5 billion worth of Bitcoin for “more flexibility to further diversify and maximize returns on our cash” and plans to accept payments in Bitcoin “subject to applicable laws and initially on a limited basis.” It is hard to avoid the feeling that there is a momentum effect behind Bitcoin with supply creating its own demand in a modern-day version of Say’s Law. This does not necessarily mean that it is a good investment. After all, in the seventeenth century there was a huge demand for tulips which pushed the price of bulbs to extraordinarily high levels before they crashed back to earth.

More cons than pros

That there is a role for digital currencies is undeniable but I continue to harbour major doubts about the suitability of Bitcoin to meet the claims that its proponents make for it. One claim is that since supply of the digital currency is limited to 21 million units (of which 18.6 million have already been “mined”) its relative scarcity means it has attractive properties as a store of value. But the huge price volatility recorded over recent years undermines claims that Bitcoin acts as a form of digital gold (it may do so in future but that time is not now). I also continue to harbour doubts about the security aspects of Bitcoin, which I have outlined in detail in previous posts. A monetary system residing on computer servers which do not enjoy the backing of a state guarantee is only one hack away from disaster, and as quantum computers become a more realistic prospect it is not inconceivable that they could eventually be used to gain control of the blockchain upon which the currency depends.

If Bitcoin cannot be trusted as a store of value, does it have a future as a medium of exchange? The arguments here are more favourable. But there is a trust issue: After all, it is associated with transactions of dubious provenance when parties wish to remain anonymous (e.g. on the dark web) which may limit its appeal. It is unlikely that most people would want to be paid in Bitcoin, preferring instead the comfort of currency units that they are familiar with. In the words of Janet Yellen, Bitcoin is also an “inefficient” way to conduct monetary transactions largely because “the amount of energy consumed in those transactions is staggering.” The amount of computing power required to “mine” Bitcoin implies that if it were a country it would be in the world’s top 30 electricity consumers, with the University of Cambridge Electricity Consumption Index suggesting that it now consumes more power than Argentina on an annual basis (chart 2).

On the basis of what goes up must come down, it is likely that the huge surge we have seen in Bitcoin prices over recent months will be reversed. Recent experience suggests that Bitcoin has followed a series of Gartner Hype Cycles in which the price surges as initial hype builds, followed by a collapse as disappointment sets in but then recovers slowly as investors climb the “slope of enlightenment” (chart 3). It is unlikely that the current cycle will prove to be any different.

What is fair value? 

Given the massive volatility in Bitcoin of late, it is worth asking whether it is possible to determine an equilibrium price which in turn might give us some steer on where the price goes from here. Based on US data, around 0.2% of total consumer expenditure is financed using Bitcoin[1]. On the basis that consumer spending accounts for an average of 62% of GDP on a global basis and that the IMF forecasts world GDP this year will hit $91 trillion, this implies global consumer spending of $56 trillion. Further assuming that 0.2% of this is accounted for by Bitcoin, this suggests that the total value of Bitcoin for transactions purposes is around $113 billion (note that the market cap of Bitcoin is around $927bn – around 8 times this figure).

Since Bitcoin was originally designed as a peer-to-peer online payment system (see the original Nakamoto paper) I would argue that the value for transaction purposes gives us a fair steer on the current equilibrium value. This turns out to be a figure in the region of $6100 (derived as the transactions market value ($113 billion) divided by the number of Bitcoin in existence (18.6 million)). This does not mean that Bitcoin will necessarily revert to this level. For one thing, the equilibrium value will rise as the level of nominal spending rises. It will also rise if the share of spending accounted for by Bitcoin increases. Current elevated levels can be viewed as an attempt by a forward-looking market to guess future fair value levels.

To give some scenarios of how fair value might evolve, I used estimates based on IMF forecasts to derive global consumer spending out to 2025 and assume that it grows at a rate of 5% per annum thereafter. The supply of Bitcoin is assumed to expand by just over 6% by 2050. If Bitcoin continues to account for only 0.2% of all transactions, the fair value rises steadily to reach around $24,000 by 2050 (chart 4) which is still only half current levels. If, however, we assume that the share of transactions financed by the digital currency increases to 0.5% of the total, the fair value rises to around $57,000 on a 30-year horizon.

This is an attempt to demonstrate that if demand for Bitcoin for transactions purposes increases whilst its supply is fixed in the long-run, the price should inevitably rise. This does not necessarily mean that it will. The whole cryptocurrency edifice may come crashing down if confidence is shaken for some reason (e.g. fraud or the security underpinning it is compromised by advances in computing). It may also be supplanted by central bank controlled cryptocurrencies. But much as I believe Bitcoin is overvalued, if you believe that it is here to stay maybe current elevated price levels may not look out of place in the longer term.

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[1] According to Forbes, $31.2 billion worth of retail products and services were purchased in the past year using cryptocurrencies in the US compared to total consumer spending of $14.2 trillion.

City blues

It has been a source of huge frustration to the financial services industry that it was side-lined during the Brexit negotiations with ministers apparently fixated on securing a deal for the fishing industry. It is a sign of the madness which has infected policymaking over recent years that an industry which – to one decimal place – accounts for 0% of GDP and which employs around 12,000 people, was prioritised over one which accounts for almost 7% of GDP; employs almost 1.4 million people and generates an external surplus which offsets a large chunk of the deficit in merchandise trade. Since the start of 2021 the British financial services industry no longer has unfettered access to its client base in the EU. Whilst there are many who would wish to see the City taken down a peg or two, the industry is of such a scale that a threat to the business model does have potentially major economic implications.

Recent events raise three obvious questions: (i) why did the British government fail to protect an industry in which it enjoys a significant comparative advantage; (ii) how has the nature of trade in financial services changed and (iii) what is likely to happen in future?

Why were financial services excluded from the Brexit negotiations?

The government apparently believed the City was big enough to look after itself, being as it is one of the largest financial hubs in the world. It was believed that the breadth and depth of services on offer could not be replicated elsewhere in the EU and that it made sense for the UK to defend its interests in other areas. I have long thought that this view was criminally complacent. Immediately after the 2016 referendum banks started to make provisions to continue conducting business on the assumption that they would no longer have access to the single market. I did point out in 2017 that financial institutions were not waiting around for government to make a decision. If ministers had been listening to what bankers told them, they would have realised just how much contingency planning was going on and how prepared they were to move business out of London.

How has the nature of financial services trade changed?

Access to the EU single market for financial services is governed by passporting rights. This means that once a firm is authorised in one EU state it can trade freely in any other with minimal additional authorisation. Passporting is based on the single EU rulebook for financial services and is not available for firms based in countries outside of the EU and the EEA, which face significant regulatory barriers to EU market access. As it is now treated as a third country for EU trading purposes, UK-based firms must now rely on regulatory equivalence in order to access the wider market. This works on the principle that the EU considers UK laws as having the same intent and produce broadly the same outcomes as those of the EU. But whilst it does give the UK market access, the degree of coverage is more limited than passporting and it can be unilaterally withdrawn with just 30 days’ notice which is no basis for long-term planning.

Where do we go from here?

For all that the Brexit trade treaty was signed last December, negotiations on financial services are far from done. Both sides intend to agree a Memorandum of Understanding by March 2021 to establish a framework which preserves financial stability, market integrity and the protection of investors and consumers. The issue of how to deal with equivalence determination is also likely to come up.

None of this disguises the fact that in the early weeks of 2021, the UK finds itself skating on very thin ice. It has seen its access to the EU market significantly reduced. Worse still, the EU appears engaged in a form of “land grab” to onshore as much financial services business as possible in a bid to reduce dependence on London as it ultimately attempts to form its own capital market union. To the extent that Brexit was sold as a project to enhance the UK’s global interests, British politicians can hardly complain when the EU responds by looking out for its own interests. It is hard to avoid the view that the City has been hung out to dry, but the fault for this lies squarely with politicians who either did not understand or (worse) ignored the industry and did not look out for British interests during negotiations.

 

There has been a lot of chatter about the erosion of the City’s position since the start of the year. One of the more well-publicised items was the news that Amsterdam’s trading volume in stocks exceeded that of London in January (chart 1). On the one hand the direct impact of this is marginal. It will not cost many jobs because trading is largely done electronically. Nor will there be a significant loss of tax revenue due to the fact that this is a low margin business. But it is symbolic. London does not have an inalienable right to remain the EU’s financial market place and we do have to wonder whether companies planning to list in Europe will necessarily see London as the go-to place in future. According to research by the think-tank New Financial at the end of 2019, 75% of all non-EU bank assets in the EU were held in the UK. By end-2020 it estimates that this share fell to 65% and it is likely to fall further in future. In addition, other parts of the industry are loosening their ties to London with trading of European carbon futures also set to move to Amsterdam.

In a speech last week, BoE Governor Andrew Bailey bemoaned the current state of affairs. He noted that “the UK has granted equivalence to the EU in some areas, but the EU has not done likewise to the UK.” Bailey also noted that the EU is attempting to hold the UK to “a standard that the EU holds no other country to and would, I suspect, not agree to be held to itself.” He concluded that the UK cannot allow itself to be a rule taker in financial services given that the assets of the sector are ten times that of UK GDP. Bailey is no tub-thumping Brexiteer and the BoE has consistently warned of the risks to London’s financial position resulting from Brexit. It will give him no pleasure to point out that its worst fears have been realised.

There is no doubt that the current arrangement on financial services trade is detrimental to the City’s interests. New Financial notes that there are 39 different types of equivalence arrangement but reckons that the UK has so far been granted two compared to 23 in force between the US and EU (chart 2). Matters do not appear likely to improve anytime soon since the EU has no incentive to offer the UK a better deal without a compromise in other areas which would undermine the regulatory independence that many politicians were seeking. Chancellor Rishi Sunak recently suggested that the City could use this opportunity to generate a 1986-style Big Bang 2.0 but this is not a view shared by Andrew Bailey, who noted last week that the UK should not “create a low regulation, high risk, anything goes financial centre and system. We have an overwhelming body of evidence that such an approach is not in our own interests, let alone anyone else’s.”

Quite what happens next is unclear. London still has advantages in terms of its network of related services and is still home to the global insurance industry. It also has a head start in fintech and has made great strides in green finance which put it ahead of many continental financial centres. But although the UK possesses large and deep financial markets only half the City’s wholesale business is derived from UK customers, with 25% coming from the EU. I have been making the point for many years that since financial services are a global industry, the threats to London also emanate from New York and Asia. Although the City is not about to collapse, it is difficult to see how a business that depends on barrier-free trade will enjoy the same pre-eminence as before. There were many in the City who voted for Brexit in 2016. I warned them at the time to be careful what they wished for. Now they may be about to reap what they sowed.

A perspective on the UK economy

Former Bank of England Governor Mervyn King once said that the true meaning of the Christmas story will not be revealed until Easter, by which he meant that the lags in data releases mean that it takes a while before we can paint an accurate picture of what is going on in the economy. Although advances in real time data capture have significantly reduced the information lags, it is nonetheless the case that year-ahead forecasts produced in December often provide an inaccurate picture because they fail to incorporate events occurring at the end of the year. This is certainly true of the 2021 outlook which was derailed by the lockdowns which were intensified across Europe in early-January.

Here in the UK, the release last week of preliminary Q4 GDP estimates UK showed that the recent lockdown had a considerable impact on the growth profile. The monthly figures showed a contraction of 2.3% in November as lockdown conditions were reimposed followed by a rebound of 1.2% in December as they were eased slightly. Overall, fourth quarter growth came in at +1.0%. For 2020 as a whole, GDP declined by 9.9% which was the largest contraction since 1709 (when it declined by 13%). This was broadly in line with expectations formed last spring and did not come as any particular surprise. But a more intriguing question is how do we now view the outlook for 2021 in the wake of a tightening of lockdown conditions in January which will almost certainly have resulted in a sharp decline in activity last month?

One view of the world was put forward by the BoE whose latest forecast, released on 4 February, looks for a contraction of 4% for the first quarter of 2021. The BoE also expects a considerable rebound in activity in Q2 and Q3 with quarterly growth rates averaging around 5%, as the economy has “enormous amounts of pent-up financial energy waiting to be released, like a coiled spring” according to its chief economist Andy Haldane. To the extent that households engaged in a lot of involuntary saving in 2020 with the savings rate averaging around 16% versus an average of 9.4% between 1963 and 2019, he has a point. But my concern is that the psychological impacts of 2020 may be slower to fade with the result that saving over the next couple of years remains at elevated levels.

Looking closer at the detail

All told, the BoE expects GDP growth to average 5% in 2021 which is admittedly lower than the November 2020 forecast of 7¼% but for my money still feels a little bit on the high side. The National Institute (NIESR) shares this view with their latest forecast showing a GDP rebound of just 3.4% in 2021. These differences of view are not hugely far apart in the grand scheme of things, given the magnitude of the output collapse last year. In a bid to give my own assessment I have put together my own structural model of the UK to produce a medium-term outlook (the details of which are shown in the table below).

 

The BoE forecast suggests that output will reach pre-Covid levels by Q1 2022 whereas NIESR believes it will take until end-2023 to get back to these levels. History is on NIESR’s side. Following the major recessions of the past 50 years it has taken an average of 15 quarters for output to recover to pre-recession levels. My own forecast is pretty close to the NIESR projection with GDP forecast to reach the Q4 2019 peak in mid-2023. One of the reasons for my relative pessimism is I believe there will be a substantial degree of economic scarring that will hamper the pace of recovery – it is unlikely that we can simply flick the switch and the economy will get back to normal once the Covid crisis is over.

That said, the damage to the labour market may be rather more limited than I expected at the outset of the crisis. Latest labour figures suggest that the unemployment rate stands at only 5%: Back in the spring of 2020 I expected the jobless rate to be around 7% by year-end. This is due in large part to the fiscal support provided by the government which obviously has consequences for public finances (see below). I now look for a peak in the unemployment rate around 7% in late-2021, having at one stage expected it to reach 9%. Nonetheless, many businesses have struggled over the last 11 months, and assuming that we do start to see the economy opening up from Q2 onwards many of them will in effect have lost a full year of revenue. That is unlikely to be the sort of hit from which they can easily recover and my employment forecast suggests we will not get back to the pre-Covid peak in a hurry (chart).

Brexit poses additional challenges which are unique to the UK. Although we do not have much hard evidence to indicate the extent of the impact, there is plenty of anecdotal evidence which points to the difficulties facing export-oriented industries in particular. A recent report that the volume of exports going to the EU from British ports last month was 68% down on year-ago levels may overstate the impact which we can expect to see in the official data but it is clear that trade flows have been badly disrupted – and not all of it is due to Covid. Moreover, to the extent that leaving the EU single market will impose a long-term cost to the UK – NIESR estimates, for example, that it will reduce GDP levels by 3.5% in the longer run – this is another factor mitigating against those forecasts which look for a quick return to pre-Covid levels of output.

The public finance problem

One of the biggest consequences of the recent economic environment is the impact it will have on public finances. On the basis of evidence for the first nine months of fiscal year 2020-21, it is possible that public borrowing will come in rather lower than the £394bn projected by the OBR in December (for the record, my own forecast looks for a figure of £312bn or 14% of GDP). It ought to prove possible to reduce the deficit quite swiftly in the next couple of years as pandemic-related expenditure is cut back. In the medium-term, however, the pace of deficit reduction will not prove quite so easy with the result that on a five-year horizon it may prove difficult to get it back below 5% of GDP.

There has been a lot of concern expressed in recent months about the high level of public debt which the UK will have to carry post-Covid. Although the debt-to-GDP ratio now stands at 99.4% – the highest since the early-1960s – current debt levels are not out of line with historical experience with the debt ratio averaging around 100% of GDP over the past 300 years, and having reached a peak above 250% at the end of WWII. With a large chunk of the UK’s debt stock currently held by the BoE and continued strong demand for gilts in the primary market, we do not have to immediately worry about imposing fiscal austerity in order to bring public finances back into line. But in the next few years we will require a discussion about what measures the government will need to take (spoiler alert: it will require some form of tax rises rather than relying on spending cuts as was the case post-2008, a theme to which I will undoubtedly return).

Last word

Although my own projection paints a less rosy scenario than that of the BoE, as I have noted many times before the only thing we can say with certainty about any forecast is that it will be wrong (in whole or in part). I do not claim to have any unique insight that makes my own forecast “better” and the broad shape of the projection is similar to that of the BoE. But I maintain that the degree of scarring may mean that the recovery proves to be a slower affair. We do not fully understand the psychology of economic shocks. We are likely to learn a lot more in the coming years.