In a recent post, Global Warning, we looked at concerns about the global economy. One of these was about the ineffectiveness of monetary policy to stimulate aggregate demand and to restore growth rates. Despite the use of unconventional monetary policies, such as quantitative easing and negative interest rates, and despite the fact that these policies have become the new convention, they have failed to do enough to bring sustained recovery.
The two articles below argue that the failure has been due to a flawed model of monetary policy: one that takes too little account of the behaviour of banks and the drivers of consumption and of physical investment. Negative interest rates on banks’ holdings of reserves in central banks are hardly likely to push down lending rates to businesses sufficiently to stimulate investment in new plant and machinery if firms already have overcapacity. And consumers are unlikely to borrow more for consumption if their wages are barely rising and they already have debts that they fear will be difficulty to pay off.
As Joseph Stiglitz points out:
As real interest rates have fallen, business investment has stagnated. According to the OECD, the percentage of GDP invested in a category that is mostly plant and equipment has fallen in both Europe and the US in recent years. (In the US, it fell from 8.4% in 2000 to 6.8% in 2014; in the EU, it fell from 7.5% to 5.7% over the same period.) Other data provide a similar picture.
And the unwillingness of many firms and individuals to borrow is matched by banks’ caution about lending in an uncertain economic environment. Many are more concerned about building their capital and liquidity ratios to protect themselves.
In these circumstances, negative interest rates have little effect on stimulating bank lending and, by hurting their balance sheets through lower earnings on the money markets, may even encourage them to lend less
What central banks should be doing, argue both Stiglitz and Elliott, is finding ways of directly stimulating consumption and investment. Perhaps this will involve central banks “focusing on the flow of credit, which means restoring and maintaining local banks’ ability and willingness to lend to SMEs.” Perhaps it will mean using helicopter money, as we examined in the previous blog. As Larry Elliott points out:
The fact that economists at Deutsche Bank published a helpful cut-out-and-keep guide to helicopter 
money last week is a straw in the wind.
As the Deutsche research makes clear, the most basic variant of helicopter money involves a central bank creating money so that it can be handed to the finance ministry to spend on tax cuts or higher public spending. There are two differences with QE. The cash goes directly to firms and individuals rather than being channelled through banks, and there is no intention of the central bank ever getting it back.
So if the model of monetary policy is indeed flawed, prepare for more unconventional measures
Articles
What’s Wrong With Negative Rates?, Project Syndicate, Joseph Stiglitz (13/4/16)
The bad smell hovering over the global economy The Guardian, Larry Elliott (17/4/16)
Questions
- What arguments does Stiglitz use to support his claim that the model of monetary policy currently being used is flawed?
- In what ways has monetary policy hurt older people and what has been the effect on their spending and on aggregate demand in general?
- Why has monetary policy encouraged investors to shift their portfolios toward riskier assets?
- Examine the argument that ultra-low interest rates may result in a rise in unemployment in the long term by affecting the relative prices of capital and labour.
- What forms might helicopter money take?
- Would the use of helicopter money necessarily result in an increase in aggregate demand? What would determine the size of any such increase?
In a recent blog Accelerating interest in the interesting case of UK interest rates we compared the level of the official Bank Rate, which has now been at 0.5 per cent for over seven years, with a representative unsecured borrowing rate. In doing so, we found some evidence that credit conditions might be easing following the credit market disturbance of the late 2000s. Here we take the opportunity not only to review that data again one month on, but also to see whether a similar picture is true for the mortgage market.
Theories of the financial accelerator argue that the macroeconomic environment can affect commercial banks’ lending practices. One way in which this can operate is through the difference between banks’ lending rates and the official Bank Rate. We can think of such interest-rate differentials – or spreads – as a credit premium. The size of the premium may be thought to reflect lenders’ perceived risk of default by borrowers. It is argued by some economists that interest-rate differentials will fall when the economy is doing well and increase when the economy is doing less well. This is because the probability of default by borrowers is seen as smaller when the macroeconomic environment improves.
The effect of interest-rate differentials that are contingent on the macroeconomic environment is to amplify the business cycle. For example, a positive demand-side shock, such as a rise in consumer confidence, which causes the economy’s aggregate demand to rise will, in turn, lead to lower borrowing rates relative to the official Bank Rate. This financial effect further stimulates the demand for credit and, as a consequence, aggregate demand and economic activity. It is an example of what economists called the financial accelerator.
The chart shows the Bank Rate along with the average unsecured borrowing rate on loans by Monetary Financial Institutions (MFIs) of £10 000. Unlike secured borrowing, which we consider shortly, unsecured borrowing is not secured against property.
As expected, we can see that the unsecured borrowing rate is greater than the Bank Rate. In other words, there is a positive interest-rate differential. However, this differential is seen to vary. It falls sharply in the period up to the financial crisis. In early 2002 it was running at 8 percentage points. By summer 2007 the differential had fallen to only 1.7 percentage points. (Click here to download a PowerPoint of the chart.)
The period from 2002 to 2007 was characterised by consistently robust growth with the UK economy growing by about 2.7 per cent per annum over this period. This may point to economic growth can contributing to an easing of credit conditions as implied by the financial accelerator.
The story from 2008 changes very quickly as the interest-rate differential increases very sharply. In 2009, as the official Bank Rate was cut to 0.5 per cent, the unsecured borrowing rate climbed to close to 10.5 per cent. Consequently, the interest-rate differential rose to 10 percentage points. Inter-bank lending had dried up with banks concerned that banks would default on loans. The increase in interest rates on lending to the non-bank private sector was stark and evidence of a credit market disruption.
The interest-rate differential for unsecured borrowing has steadily declined since its peak at the end of 2009 as the unsecured borrowing rate has fallen. This implies that credit conditions have eased. In March 2016 our interest-rate differential for unsecured borrowing stood at 3.8 percentage points, not dissimilar to levels over the past 12 months. Interestingly, today’s differential on unsecured borrowing is lower than the 6.5 percentage point average over the period from 1997 to 2003, before the differential then went on its pre-crisis fall.
Our second chart repeats the analysis but this time for mortgages. The representative mortgage rate is the average standard variable mortgage rate.
Unlike that for unsecured borrowing, the interest-rate differential for mortgages is fairly constant up to the financial crisis. The widely report credit easing in the mortgage market appears to have operated more through amounts lent rather than through price, as evidenced by rising mortgage advance-to-income ratios. (Click here to download a PowerPoint of the chart.)
The second chart shows clear evidence of a credit market disruption from 2009. Hence, the markets for secured and unsecured lending saw credit conditions tighten with interest-rate differentials rising markedly. However, it shows that the higher interest-rate differential for secured lending following the credit market disruption remains. So while the differential has fallen sharply for unsecured lending the situation is quite different in the mortgage market. In fact, February and March 2016 saw the mortgage rate spread at 4.17 percentage points which is an historic high.
Our interest rate data show that interest-rate differentials can vary significantly over time. This is important to understand when we are thinking about the relationships between the macroeconomy and the financial system. Significantly, the data suggest that interest rates on different financial instruments can behave differently such that differences emerge in the patterns of spreads over the official Bank Rate.
The evidence on UK mortgage rates suggests that the market remains affected by the financial crisis and the credit market disruption that arose. Although the level of mortgage rates is historically low – which tends to capture many of the headlines – this masks an historically high premium over the official Bank Rate.
Articles
Bank warns EU vote may hit growth as it holds rates BBC News, (14/4/16)
Carney issues a warning as interest rates are held Belfast Telegraph, (15/4/16)
Bank Of England Leaves Interest Rates On Hold Sky News, (14/4/16)
UK banks plan to boost lending to households but not firms – BoE Reuters, (13/4/16)
Mortgage rates reach record lows as threat of Bank Rate rise evaporates Telegraph, Tara Evans (1/4/16)
Data
Bankstats (Monetary and Financial Statistics) – Latest Tables Bank of England
Statistical Interactive Database – interest and exchange rates data Bank of England
Questions
- Why would we expect banks’ borrowing rates to be higher than the official Bank Rate?
- How might banks’ credit criteria change as the macroeconomic environment changes? Explain your answer.
- As well as the macroeconomic environment, what other factors might lead to a change in the interest-rate differential between banks’ borrowing rates and the official Bank Rate?
- How would we expect a credit market disruption to affect the interest-rate differential?
- Explain how the financial accelerator affects the change in the size of the economy following a positive demand shock.
- Explain how the financial accelerator affects the change in the size of the economy following a negative demand shock.
- What is the impact of the financial accelerator of the amplitude of the business cycle?
- How might regulators intervene to minimise the effect of the financial accelerator?
- Why might explain the high interest-rate differential on mortgages that continues to persist following the financial crisis?
- Analyse the ways in which the financial system can stabilise or destabilise economies.
Evidence of widespread tax avoidance has featured heavily in the news recently. Furthermore, recent developments also suggest that avoiding taxes has become an important motivation for merger and acquisition (M&A) activity. For example, Pfizer, the US pharmaceutical giant that producers Viagra, has for a while been looking to expand through M&A. Following a failed 
attempt to merge with the British pharmaceutical company AstraZeneca in 2014, it instead agreed late last year to merge with a company called Allergan. This was set to be the largest healthcare merger ever, worth over £100bn.
What is key about Allergan is that, whilst it is run from the USA, it is legally registered as being based in Ireland. It has been strongly argued that the key motivation for the merger was tax avoidance with Pfizer’s strategy described in this way:
They look for a likely partner based in a country with a lower corporate tax regime and suggest a merger. When the merger goes through, the company based in the US moves its HQ – but not the bulk of its operations – to the low-tax jurisdiction, where it books the bulk of its profits. At a stroke, the company’s tax bill is cut.
This practice is sometimes referred to as an inversion. It has been suggested that over the past five years around 40 completed mergers have been motivated by similar objectives.
However, policy makers, in particular in the USA, where corporation tax is high, have increasingly become aware of the practice. President Obama recently made clear that:
If corporations are paying less tax, only one of two things can happen. The US will have less to spend on schools, roads and public health, or taxes will have to be raised on the country’s middle class.
In 2014 some tightening of the tax rules took place, but with limited effect. Then, earlier this month President Obama implemented a series of new rules to attempt to prevent the practice. He stressed that these new rules would help to deter companies from taking advantage of:
one of the most insidious tax loopholes out there, fleeing the country just to get out of paying their taxes.
Almost immediately the Pfizer-Allegan merger was abandoned and Pfizer was required to pay a break-up fee of $150m to Allegran. The parties involved were far from happy and the chief executive of Allegran stated that:
For the rules to be changed after the game has been played is a bit un-American.
However, a spokesman for the White House responded that:
I think it is difficult to have a lot of patience for an American C.E.O. trying to execute a complicated financial transaction to avoid paying taxes in America, talking about what it means to be a good citizen of the United States.
As has been highlighted, the decision to immediately abandon the merger provides a clear indication that the business case and potential synergies arising from combining the two companies were far less important than the benefits from tax avoidance.
Where does the abandoned merger leave Pfizer? One option will be to consider alternative mergers. Perhaps reflecting this possibility, the share prices of foreign rivals such as AstraZeneca and GlaxoSmithKline increased following the announcement that the Allegran deal had been abandoned. However, an alternative under serious consideration appears to be the opposite strategy of shrinking Pfizer’s operations. It has been argued that this would allow the company to be become more focused.
It remains to be seen in which direction Pfizer will go. However, what this example clearly illustrates is the impact changes in regulatory policy can have on firms’ strategic decisions.
Articles
Collapse of $160bn Pfizer and Allergan merger shocks corporate US Financial Times, Barney Jopson, David Crow, James Fontanella-Khan and Arash Massoudi (6/4/16)
It’s off: the end of Pfizer’s $160 billion Allergan merger The Atlantic, Krishnadev Calamur (6/4/16)
Pfizer and Allergan terminate $160bn merger following US tax crack-down The Telegraph, Julia Bradshaw (6/4/16)
Questions
- Who do you think will be the big winners and losers from the merger being abandoned?
- Why do you think break-up fees are used in merger deals?
- What are the pros and cons for Pfizer of continuing to pursue M&As rather than downsizing?
- Are there any alternative strategies it might consider?
Research published by the Institute for Fiscal Studies shows that graduates from wealthier family backgrounds earn significantly more than those from poorer backgrounds. If you compare the 20% of graduates from the richest backgrounds with the remaining 80%, the average earnings gap in 2012/13, 10 years after graduation, was £8000 per year for men and £5300 for women. Even when you take graduates in similar degrees from similar universities, there is still a gap of around 10% between those from richer and those from poorer backgrounds.
The research also shows that in 2012/13, 10 years after graduation, the median earnings for economics graduates was the second highest of any subject (just behind graduates in medicine) and that at the 90th percentile economics graduates had the highest earnings (£93 900 for women and £121 400 for men) of any subject. In fact, graduates in economics were the only males at this percentile earning over £100 000. (Click here for a PowerPoint of the chart.) As the Press Release to the IFS working paper states:
For males, it is estimated that approximately 12% of economics graduates earned above £100 000 some ten years after graduation; by contrast,
6% of those studying medicine or law earned more than £100 000.
For females, it is estimated that approximately 9% of economics graduates earned above £100 000 some ten years after graduation; by contrast, just 1% of those studying medicine and 3% of those studying law did so.
For some subjects, graduates earned little more than non-graduates.
Those studying the creative arts had the lowest earnings, and indeed earned no more on average than non-graduates.
The research also shows that earnings vary substantially by gender and university. For those earning £8000 or more, the median earnings for male graduates 10 years after graduation was £30 000 (compared with £21 000 for non-graduates), whereas for women it was £27 000 (compared with £18 000 for non-graduates).
Earnings are substantially higher for graduates from some universities, such as Oxford, Cambridge and the LSE. “At the other end of the spectrum, there were some institutions (23 for men and 9 for women) where the median graduate earnings were less than those of the median non-graduate ten years on.” Differences in graduate earnings by university tend to compound the difference by students’ family background as those from poorer backgrounds disproportionately attend universities with lower average graduate earnings by discipline.
The following articles consider the findings and their implications for higher education policy
Articles
Graduates from wealthy backgrounds reap earnings benefits Times Higher Education, John Morgan (13/4/16)
Graduate Earnings Guided By Parents’ Wealth, Institute For Fiscal Studies Report Finds Huffington Post, George Bowden (13/4/16)
Graduates from poorer backgrounds earn less than richer peers on same course, major international study finds Independent. Oliver Wright (13/4/16)
Richer students have higher graduate income, study finds The Guardian (13/4/16)
Want a Higher Salary? It Helps If You’re a Man With Rich Parents Bloomberg, Robert Hutton (13/4/16)
Economics graduates are in the money Why Study Economics? Economics in Action blog (15/4/16)
IFS paper
What and where you study matter for graduate earnings – but so does parents’ income IFS Press Release (13/4/16)
How English domiciled graduate earnings vary with gender, institution attended, subject and socio-economic background IFS Working Paper W16/06, Jack Britton, Lorraine Dearden, Neil Shephard and Anna Vignoles (13/4/16)
Data
Free Online Statistics – Students & qualifiers Higher Education Statistics Agency (HESA)
Applications and acceptances for types of higher education course – 2015 UCAS
What do graduates do? Higher Education Careers Services Unit
Questions
- For what reasons are graduates from rich backgrounds likely to earn substantially more than graduates from poor backgrounds?
- Why are graduates in economics likely to earn more than graduates in other subjects, especially those in the top percentile of earners from any given subject?
- How might marginal productivity help to explain the differences in earnings of different graduates?
- What are meant by ‘soft skills’. Why may students from richer backgrounds have better soft skills in the context of (a) university admission and (b) getting a job on graduation?
- Why are female graduates likely to earn less than male graduates with the same class of degree in the same subject?
- What could be done by (a) universities and (b) the government to increase social mobility?
- Do you think that the findings of the research have implications for the way students’ study is funded? Explain.
Tax avoidance has been in the news since the publication of the Panama papers, which show the use of offshore tax havens by rich individuals and companies, partly for tax avoidance, partly for money laundering and other criminal activities – some by corrupt politicians and their associates – and partly to take advantage of lower regulation of financial dealing.
There are many tax havens around the world, including Switzerland, Hong Kong, British overseas territories (such as the British Virgin Islands, the Cayman Islands and Bermuda), Jersey, Singapore and certain US states 
(such as Arizona, Delaware, Nevada and Wyoming).
Here we focus on tax avoidance. This is the management of tax affairs by individuals or firms so as to avoid or minimise the payment of taxes. Tax avoidance is legal, unlike tax evasion, which is the practice of not declaring taxable income.
In a statement from the White House, directly after the publication of the Panama papers, President Obama spoke about the huge international scale of tax evasion and tax avoidance:
“A lot of it is legal, but that’s exactly the problem. It’s not that [people are] breaking the laws, it’s that the laws are so poorly designed that they allow people, if they’ve got enough lawyers and enough accountants, to wiggle out of responsibilities that ordinary citizens are having to abide by.
Here in the United States, there are loopholes that only wealthy individuals and powerful corporations have access to. They have access to offshore accounts, and they are gaming the system. Middle-class families are not in the same position to do this. In fact, a lot of these loopholes come at the expense of middle-class families, because that lost revenue has to be made up somewhere. Alternatively, it means that we’re not investing as much as we should in schools, in making college more affordable, in putting people back to work rebuilding our roads, our bridges, our infrastructure, creating more opportunities for our children.”
Tax avoidance, whether in tax havens, or through exploiting loopholes in the tax system may be legal. But is it fair?
Various principles of a tax system can be identified. These include:
|
|
| • |
Horizontal equity |
People in the same situation should be treated equally. For example, people earning the same level of income and with the same personal circumstances (e.g. number and type of dependants, size of mortgage, etc.) should pay the same level of income tax. |
| • |
Vertical equity |
Taxes should be ‘fairly’ apportioned between rich and poor. The rich should pay proportionately more taxes than the poor. |
| • |
Equity between recipients of government services |
Under the ‘benefit principle’, it is argued that those who receive the most benefits from government expenditure ought to pay the most in taxes. For example, it can be argued that roads should be paid for from fuel tax. |
| • |
Difficulty of evasion and possibly of avoidance |
If it is desirable to have a given tax, people should not be able to escape paying. |
| • |
Non-distortion |
Taxes alter market signals: taxes on goods and services alter market prices; taxes on income alter wages. They should not do this in an undesirable direction. |
| • |
Convenience to the taxpayer |
Taxes should be certain and clearly understood by taxpayers so that they can calculate their tax liabilities. The method of payment should be straightforward. |
| • |
Convenience to the government |
Tax rates should be simple to adjust and as cheap to collect as possible. |
| • |
Minimal disincentive effects |
Taxes may discourage people from working longer or harder, from saving, from investing or from taking initiative. It is desirable that these disincentives should be kept to a minimum. |
Of course, not all these requirements can be met at the same time. One of the most serious conflicts is between vertical equity and the need to keep disincentives to a minimum. The more steeply the rich are taxed, it is argued, the more serious are the disincentive effects on them likely to be (see the blog post from 2012, The 50p income tax rate and the Laffer curve). Another is between vertical equity and equity between recipients of services. Some of the people most in need of government support are the poorest and hence pay the least taxes.
The crucial question is what is regarded as ‘fair’. What is vertically equitable? According to the second article below, people’s preferred tax rates depend on how information is presented. If information is presented on how much tax is paid by the rich, people generally feel that the rich pay too much. If, however, information is presented on how much income people are left with after paying tax, people feel that the rich still have too much and ought to pay more tax.
The majority of people in the UK feel that tax avoidance, although legal, is morally wrong. According to the results of an HMRC survey in 2015, “the majority (63%) of respondents felt that the use of tax avoidance schemes was widespread. However, the majority (61%) also responded that it was never acceptable to use a tax avoidance scheme. The most frequent reason given as to why it was unacceptable was that ‘it is unfair on others who pay their taxes’.”
In making judgements about the fairness of tax, people generally have inaccurate knowledge about the distribution of income, believing that it is more equal than it really is, and about the progressiveness of the tax system, believing that it is more progressive than it really is. Despite this, they want post-tax income distribution to be more equal.
What is more, although people generally disapprove of tax avoidance, it is the system that allows the avoidance of taxes that they want changing. As long as it is possible to avoid taxes, such as giving gifts to children to avoid inheritance tax (as long as the gift is made more than seven years before the person’s death), most people see no reason why they should not do so themselves.
The following articles look at tax avoidance and people’s attitudes towards it. They are all drawn from The Conversation, “an independent source of news and views, sourced from the academic and research community and delivered direct to the public.”.
Articles
Explainer: what are ‘tax havens’? The Conversation, Tommaso Faccio (5/4/16)
When it comes to tax, how do we decide what’s fair? The Conversation, Stian Reimers (8/4/16)
Six things a tax haven expert learned from the Panama Papers The Conversation, Ronen Palan (6/4/16)
Documents
The Panama Papers The International Consortium of Investigative Journalists
Exploring public attitudes to tax avoidance in 2015: HM Revenue and Customs Research Report 401 HMRC, Preena Shah (February 2016)
2010 to 2015 government policy: tax evasion and avoidance HMRC/HM Treasury (8/5/15)
Questions
- Distinguish between tax avoidance and tax evasion.
- Give some examples of tax avoidance.
- Look through the various principles of a tax system and identify any conflicts.
- What problems are there in having a highly progressive tax system?
- What is a ‘shell company’? How can it be used to avoid and evade taxes?
- What are bearer shares and bonds? Why were they abolished in the UK in 2015?
- What legitimate reasons may there be for a company or individual using a tax haven?
- To what extent might increased transparency in tax affairs discourage individuals and companies from engaging in aggressive tax avoidance?
- What light does/can behavioural economics shed on people’s perceptions of fairness?
- How might the use of absolute amounts or percentages influence people’s thinking about the fairness of a tax system? What implications does this have for politicians in framing tax policy?
- In the principal–agent problem, where the principals are the tax authorities and the agents are taxpayers, why does asymmetric information arise and why is it a problem? How do the tax authorities seek to reduce this problem?
In a recent post, Global Warning, we looked at concerns about the global economy. One of these was about the ineffectiveness of monetary policy to stimulate aggregate demand and to restore growth rates. Despite the use of unconventional monetary policies, such as quantitative easing and negative interest rates, and despite the fact that these policies have become the new convention, they have failed to do enough to bring sustained recovery.
In these circumstances, negative interest rates have little effect on stimulating bank lending and, by hurting their balance sheets through lower earnings on the money markets, may even encourage them to lend less
