Category: Essentials of Economics: Ch 15

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Co-operation needed to avoid evasion

At a cost of €1 trillion to EU states, tax evasion is undoubtedly an area in need of attention. With government finances in deficit across the world, part of the gap could be plugged by preventing tax revenues from going unpaid. Well-known companies and individuals have been accused of tax evasion (and avoidance), but part of the problem is the existence of countries that make such activities possible.

Tax havens not only offer favourable tax rates, but also have in place regulations that prevent the effective exchange of information. That is, they are able to keep the identity and income information of depositors a private affair and are not required to share that information with other governments. This means that other tax authorities are unable to demand the tax revenue from income earned, when it is held in some of these countries. This can deprive the government’s coffers of substantial amounts of money.

In 2000, the OECD produced a report naming so-called ‘uncooperative tax havens’, including Monaco, Andorra, Liechtenstein and Liberia. Since then, all nations on this list have pledged their cooperation and been removed and in a recent step, Andorra has announced a proposal to implement its first ever income tax. This move is partly in response to pressures from EU governments to tackle tax evasion. Furthermore, talks between the finance ministers of tax havens, such as Switzerland and Liechtenstein have been agreed with the aim of improving the flow of bank account information and thus combating tax evasion. The Council of the European Union said:

The decision represents an important step in the EU’s efforts to clamp down on tax evasion and tax fraud”

Countries, such as Switzerland (a non-EU member) are likely to find requests for information difficult to ignore, if they want to have access to EU financial markets. However, any concessions on information provision will come at a significant cost for a country that has long regarded its banking secrecy as an ‘honourable policy.

Reforming policy on tax havens is essential, not only to help tackle tax evasion and thus government deficits, but also to generate investment into countries that don’t offer such favourable tax rates. Investors naturally want to invest in those countries with low tax rates and as such, could it be that countries like the UK suffer from a loss of investment and that the only way to encourage it is to offer similarly low tax rates? International agreement is certainly needed to tackle the worldwide issue of tax evasion and at the moment, it seems as though pressure is building on secretive countries. The following articles consider this controversial issue.

Clock ticks on Swiss banking secrecy BBC News, Imogen Foulkes (21/5/13)
Andorra bows to EU pressure to introduce income tax The Telegraph, Fiona Govan (2/6/13)
Andorra to introduce income tax for first time BBC News (2/6/13)
Andorra to introduce income tax for the first time Economy Watch (3/6/13)
Swiss have no choice but to bow to US ultimatum – Ackermann Reuters, Katharina Bart> (3/6/13)
Austria out front as EU zeroes in on tax evasion The Budapest Times (29/5/13)
EU to start talks with non-EU countries on tax evasion BBC News (14/5/13)

Questions

  1. What is tax evasion?
  2. Using game theory, explain why an international agreement on tax evasion might be needed?
  3. When an income tax is imposed in Andorra, what will be the impact on government revenues?
  4. How might the labour supply incentive change once an income tax is imposed?
  5. How do tax havens affect investment in other countries?
  6. Is there an argument that countries such as the UK should cut its tax rates to encourage investment?
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A J-curve for Japan?

The new Japanese government under Shinzo Abe, which took office on 26 December 2012, has been pursuing a policy of weakening the yen. Using a combination of low interest rates, quantitative easing, expansionary fiscal policy and a declared aim of depreciation, the government has succeeded in driving down the value of the yen.

Since mid-November last year, the yen has depreciated by 28% against the dollar, 30% against the euro and 21% against sterling. The effective exchange rate index has fallen by 22% (see first diagram below: click here for a PowerPoint of the diagram).

But will this depreciation succeed in stimulating the Japanese economy and will it improve the balance of trade? The hope is that the falling yen will boost export sales by making them cheaper abroad, and will reduce the demand for imports by making them more expensive in Japan. The balance of trade will thereby improve and higher exports (an injection) and lower imports (a withdrawal) will stimulate aggregate demand and economic growth.

Traditionally Japan has run balance of trade surpluses, but since July 2012, it has been running monthly deficits – the longest run of deficits since 1980. But depreciation cannot be expected to turn this position around immediately. Indeed, theory suggests that the balance of trade is likely to deteriorate before it improves. This is known as the J-curve effect and is illustrated in the second diagram below. As page 768 of Economics, 8th edition states:

At first a devaluation or depreciation might make a current account deficit worse: the J-curve effect. The price elasticities of demand for imports and exports may be low in the short run (see Case Study 25.1 in MyEconLab). Directly after devaluation or depreciation, few extra exports may be sold, and more will have to be paid for imports that do not have immediate substitutes. There is thus an initial deterioration in the balance of trade before it eventually improves. In Figure 25.12 [the second diagram], devaluation takes place at time t1. As you can see, the diagram has a J shape.

Evidence suggests that the first part of the ‘J’ has been experienced in Japan: Japan’s balance of trade has deteriorated. But there is debate over whether the balance of trade will now start to improve. As the article by James Saft states:

But a look at the actual data shows Japanese companies, like British ones during a similar bout of currency weakness in 2008, appear to be more eager to use a newly competitive currency to pad profits through higher margins rather than higher export volumes. Thus far, Japanese exporters appear to be doing just that. Despite yen falls the price of Japanese exports in local currency has barely budged.

“Japanese companies have not actually cut the foreign currency prices of their exports. Just as with the UK exporters, the Japanese have chosen to hold foreign prices constant, maintain market share, and increase the yen value and thus the yen profit associated with yen depreciation,” UBS economist Paul Donovan writes in a note to clients.

The extra profits earned by Japanese companies from export sales may be stockpiled or paid out in dividends rather than reinvested. And what investment does take place may be abroad rather than in Japan. The net effect may be very little stimulus to the Japanese economy.

As stated by Saft above, the UK had a similar experience in the period 2007–9, when sterling depreciated some 27% (see the second diagram). The balance of trade improved very little and UK companies generally priced goods to markets abroad rather than cutting overseas prices.

But times were different then. The world was plunging into recession. Now global markets are mildly growing or static. Nevertheless, there is a danger that the upward slope of the J-curve in Japan may be pretty flat.

Articles
Weak yen a boon for investors, not Japan Reuters, James Saft (14/5/13)
Japan’s Trade Data Suggest Even Lower Yen Needed Wall Street Journal, Nick Hastings (22/5/13)
2 Misunderstandings About Japanese Trade Seeking Alpha, Marc Chandler (22/5/13)
Japanese trade deficit widens Financial Times, Ben McLannahan (22/5/13)

Data
BIS effective exchange rate indices Bank for International Settlements
Japan’s balance of trade Trading Economics
UK Trade, March 2013 ONS

Questions

  1. Explain the J-curve effect.
  2. Why is there some doubt about whether the Japanese balance of trade will improve significantly?
  3. What will be the consequences for Japanese growth?
  4. If foreign currency prices of Japanese exports do not change, what will determine the amount that Japan exports?
  5. What other measures is the Japanese government taking to stimulate the economy? What will determine the size of the multiplier effects of these measures?
  6. Using data from the ONS plot the UK’s quarterly balance of trade figures from 2007 to the present day. Explain the pattern that emerges.
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Shortages in Venezuela – what’s the solution?

A simple model in economics is that of demand and supply. Through the price mechanism, signals are sent between consumers and producers and this interaction results in an equilibrium market price and quantity. However, what happens when the market for a good or service is in disequilibrium?

When a market is in equilibrium, demand equals supply. However, as we discussed in a previous blog concerning baby milk in China (see Milking the economy), markets are not always in equilibrium. If demand exceeds supply, a shortage will emerge and to eliminate this, the price must rise. If, on the other hand, supply exceeds demand, there will be an excess supply and thus the price must fall to restore equilibrium.

The market in question here is toilet paper in Venezuela! A severe shortage of this product has emerged in recent months, with shops running out of supplies. In a bid to relieve this shortage, the country’s Minister of Commerce has received approval for a $79 million credit, which can be used to import this basic product in short supply. Fifty million rolls will be imported to help fill the shortage that has emerged. The shortage is not just a problem for toilet paper, but also across a range of basic consumer goods. The article from Reuters comments that:

The government says the toilet paper shortages, like others, are the results of panicked buying and unscrupulous merchants hoarding the goods to artificially inflate prices.

Opposition critics say the problem is caused by the currency controls, created a decade ago by late socialist leader Hugo Chavez, and years of nationalizations that weakened private industry and left businesses unwilling to invest.

With shortages across a variety of products, the President has begun to work closely with business leaders to address this situation. The following articles consider this basic market, the intervention and consequences.

Venezuela hopes to wipe out toilet paper shortage by importing 50m rolls The Guardian (16/5/13)
Venezuela ends toilet paper shortage BBC News (22/5/13)
With even toilet paper scarce, Venezuelan president warms to business Reuters, Eyanir Chinea (22/5/13)
Toilet paper shortage in Venezuela to end after lawmakers back plans to import 39 million rolls Huffington Post, Sara Nelson (22/5/13)
Venezuela’s toilet paper shortage ended; 3 other basic goods that went scarce in the country International Business Times, Patricia Rey Mallen (22/5/13)

Questions

  1. Using a demand and supply diagram, explain how equilibrium is determined in a free market.
  2. Illustrate the shortage described in the aticles on your above demand and supply diagram. How should the price mechanism adjust?
  3. What types of government intervention have led to the shortages of such basic consumer goods?
  4. How have currency controls created a problem for Venezuela?
  5. With an increase in imported products, what impact might there be on Venezuela’s exchange rate and on its balance of payments?
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GDP and development

The link below is to an article by Bill Gates, founder of Microsoft. He argues that per-capita GDP is a poor indicator of development, especially in Sub-Saharan Africa.

The problems with using GDP as an indicator of the level of development of a country are well known and several alternative measures are in common use. Perhaps the best known is the United Nations Development Programme’s Human Development Index (HDI), where countries are given an HDI of between 0 and 1. HDI is the average of three indices based on three sets of variables: (i) life expectancy at birth, (ii) education (a weighted average of (a) the mean years that a 25-year-old person or older has spent in school and (b) the number of years of schooling that a 5-year-old child is expected to have over their lifetime) and (iii) real gross national income (GNY) per capita, measured in US dollars at purchasing-power parity exchange rates (see Box 27.1 in Economics 8th edition for more details).

But although indicators such as this capture more elements of development than simple per-capita GNP or GNY, there are still serious shortcomings. A major problem is the lack of and inaccuracy of statistics, especially when applied to the rural subsistence and informal urban sectors. The problem is recognised and some countries are trying to address the problem (see the second article below), but the problem is huge. As Gates says:

It is clear to me that we need to devote greater resources to getting basic GDP numbers right. … National statistics offices across Africa need more support so that they can obtain and report timelier and more accurate data. Donor governments and international organisations such as the World Bank need to do more to help African authorities produce a clearer picture of their economies. And African policymakers need to be more consistent about demanding better statistics and using them to inform decisions.

Another problem is how you convert data into internationally comparable forms. For example, how are inflation, exchange rates, income distribution, the quality of health provision and education, etc. taken into account?

How GDP understates economic growth The Guardian, Bill Gates (8/5/13)
States’ GDP computation report out soon, says Nigeria statistics bureau Premium Times (Nigeria), Bassey Udo (9/5/13)
Michael Porter Presents New Alternative to GDP: The Social Progress Index (SPI) Triple Pundit, Raz Godelnik (13/4/13)

Questions

  1. By accessing the Human Development Index site, identify which countries have a much higher ranking by HDP than by per capita gross national income. Explain why.
  2. Why is expressing GNY in purchasing-power parity (PPP) terms likely to increase the GNY figures for the poorest countries?
  3. Explain the following quote from the Gates article: ‘I have long believed that GDP understates growth even in rich countries, where its measurement is quite sophisticated, because it is very difficult to compare the value of baskets of goods across different time periods’.
  4. Why is GNY per capita, even when expressed in PPP terms, likely to understate the level of development in subsistence economies?
  5. Explain whether the rate of growth of GNY per capita is likely to understate or overstate the rate of economic development of sub-Saharan African countries?
  6. Why are the challenges of calculating GDP or GNY particularly acute in sub-Saharan Africa?