Corporate health risks

Whilst the presentation of the government’s financial plans in many countries is often a dry affair focused on the impact of the fiscal measures on public finances, it is increasingly used as a showpiece political event in the UK as the government tries to put the rosiest possible spin on tax and spending measures. Not only does the UK budget generate a lot of commentary and analysis ahead of the event, but the sheer volume of the material released on Budget Day means that it often pays to avoid instant commentary as the full implications of the measures percolate through. The Office for Budget Responsibility’s Economic and Fiscal Outlook alone represented 222 pages of detailed analysis of the UK’s economic situation, covering everything you might want to know (and a lot that you don’t), and there is a lot more besides.

By general consent, Wednesday’s budget was a “spend now, tax later” affair in which the government plans to continue providing a significant amount of economic support in the near-term but intends to pursue a more aggressive fiscal tightening beyond 2023. Indeed, the fiscal expansion measures over the next two years are offset by a planned fiscal tightening over the following three years and by 2026 the ratio of tax revenue to GDP is projected to reach its highest since the late-1960s (chart 1). The fact that the majority of the fiscal tightening falls on tax increases rather than spending cuts is a recognition that it will be politically difficult to repeat the austerity measures that were implemented in the wake of the 2009-09 recession. Indeed, I have been pointing out for some years that planned cuts in corporate taxes were putting an unnecessary strain on the budget deficit.

The impact of raising corporate tax rates

The primary tax measure announced in the budget was a rise in corporate taxes from the current rate of 19% to 25% in 2023 which would leave it in the middle of the range of a group of 37 countries, rather than significantly below (chart 2). This flies in the face of the low tax orthodoxy espoused by successive Conservative governments over the past 40 years and represents the first increase since 1974, when it was raised from an already-high rate of 40% to an eye-watering 52%. This week’s announcement was driven by two factors. First, in its 2019 manifesto the Conservative party committed to not raising income tax, national insurance or VAT rates, leaving it with few alternatives. Second, there has been growing disquiet in recent years that efforts to slash corporate taxes meant that many companies were getting off lightly at a time when individuals were bearing the costs of austerity.

The OBR highlighted that although the tax rate has been slashed sharply over the years, the share of corporate tax receipts in GDP has fluctuated in a narrow range centred around 3%. This reflects the fact that the tax base has been widened over time, thus offsetting the revenue-dampening effects. In theory, applying higher tax rates to a wider base ought to significantly increase revenue. One concession applied to the latest package is that companies generating less than £50k per annum in profits will continue to pay a tax rate of 19% with a graduated scale applicable on profits above this limit, to a maximum of 25%. The government reckons that 70% of companies will continue to pay a rate of 19%. The fact that the remaining 30% will contribute an extra £20bn in taxes by 2026 compared to estimates made in November (an increase of 31%) suggests that larger companies will be hit hard. Fears expressed in EU circles that the UK would embark on a regime of tax competition to undercut companies in continental Europe appear to be unfounded.

But tax increases have consequences. In the first instance, companies that may be considering whether they need to continue operations in the UK after Brexit may use higher taxes as a reason to move elsewhere. In addition, curbs on corporate profitability may have adverse effects on job creation in the medium-term. Moreover, expectations of reduced future profitability will depress the capacity to pay out dividends, fund buybacks and pay down debt, not to mention reducing the net present value of corporate earnings. All of these factors might be expected to depress UK equity valuations relative to other markets. Raising taxes will, other things being equal, also reduce the capacity to fund capital investment.

Pros and cons of generous investment allowances

In order to offset the worst of the investment problem, the government unveiled a generous two-year temporary capital allowance covering the fiscal years 2021-22 and 2022-23, in which companies will be able to offset 130% of investment spending on eligible plant and machinery against profits. The evidence does suggest that such measures have a stimulatory impact on investment since they reduce the user cost of capital (the tax-adjusted marginal cost of capital). Moreover, tax incentives tend to have a bigger impact on long-lasting assets. At a time when the UK is keen to encourage the switch away from combustion-engine vehicles, which will require significant investment in the infrastructure to support the adoption of battery-powered vehicles, the tax breaks could give this particular project a big shot in the arm.

However, temporary tax breaks suffice only to shift the timing of investment projects rather than leading to a permanent increase. The OBR’s forecast indeed suggests that a big investment surge in 2022 will be followed by only a moderate increase thereafter. Between 2007 and 2016, business fixed investment increased at a paltry annual rate averaging just 1.6%. Between 2016 and 2019, in the wake of the Brexit referendum, it barely increased at all and despite the budget measures introduced last week the OBR’s projections point to growth of just 0.8% per annum between 2016 and 2025 (chart 3).

Moreover, there are particularly high levels of uncertainty at present which run the risk that efforts to stimulate investment may not have the desired effect. Incentive measures presuppose that there is a lot of investment waiting to be brought online. As MPC member Jonathan Haskel noted in a speech yesterday, “residual uncertainty and risk aversion over the recovery are likely to continue to weigh on investment,” particularly in the wake of Brexit. There is also a lot of spare capacity in the economy at present – my own estimates suggest that the output gap this year is likely to average -2.6%, narrowing to -0.7% in 2022. In addition, the tax incentives are only useful if companies generate a profit. In the post-pandemic recovery phase profitability may remain under pressure, although to mitigate this effect the government has extended the loss carry back rules which allow companies to offset past trading losses against profits.

Whilst efforts to boost investment are welcome, one of the drawbacks associated with the tax allowance is that it is aimed squarely at tangible assets but there is no incentive for investment in intangibles which is a problem in an increasingly digital economy. This may continue to act as a drag on multifactor productivity, which in the past decade has posted its slowest growth in a century, which will in turn hold back potential GDP growth. 

Last word

When asked last year whether I expected the Chancellor to announce fiscal consolidation measures in 2021, my response was “it is likely that some form of fiscal consolidation will be announced in 2021 though may not necessarily be immediately implemented.” This expectation has been borne out. It was inevitable that corporates would be asked to shoulder a bigger part of the fiscal repair bill and the government has tried to sweeten the pill by offering generous investment allowances. But the strategy does represent a risk to the health of UK PLC. Like many aspects of budgetary policy, however, we will only know the outcome many years from now.

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.