Introduction: central banks need fiscal back-up

Even operationally independent central banks are agents of the state.  And like every natural or legal entity operating in a market economy, the central bank is subject to a(nintertemporal ) budget constraint.  Some central banks are owned by the ministry of finance.  The Bank of England, for instance, is owned 100 percent by the UK Treasury. The ECB is owned by the national central banks (NCBs) of the 27 EU member states. These 27 NCBs have a range of different ownership structures.

The Federal Reserve System is not owned by anyone (conspiracy freaks need not bother writing comments to deny this and to attribute ownership of the Fed to the Queen of England, the Vatican, the Rockefeller family or the Elders of Zion). Most of the operating profits of the Fed go to the US Treasury. The twelve regional Federal Reserve Banks issue shares of stock to member banks. However, owning Reserve Bank stock is quite different from owning stock in a private company.  Ownership of a certain amount of stock is, by law, a condition of membership in the System. The stock may not be sold, traded, or pledged as security for a loan; dividends are, by law, fixed at 6 percent per year (which is a lot better, actually, risk-adjusted, than you would get these days on stock in commercial banks).

Even though central banks can ‘print money’ or create money electronically by fiat, they are constrained in their financial operations by two factors.

Insurable risk

When insurance began to develop as an industry, it was soon felt necessary by those trying to enhance the reputation and respectability of the industry to distinguish it from gambling. The outcome of this process is that today, for a financial activity to classify as insurance and to be regulated as insurance, it has to offer products or contracts that protect against loss; gambling seeks or creates opportunities for speculative gain.  More precisely, insurance hedges an open position in order to reduce exposure to risk; gambling creates or increases open positions to boost exposure to risk.  There are a host of deep issues here, such as ‘what is the right metric for risk’ or  ‘the risk to what: financial wealth, consumption, utility’?  I will acknowledge these deep issues, ignore them and proceed.

For the insurance industry, the insurance vs gambling distinction was operationalised using the concept of insurable interest.  An insurable interest is what economists would call an open position that is reduced in size by the insurance contract.  In life insurance, this means that a person or a legal entity can insure the life of a third party only if the value of the life to the party wishing to purchase the insurance is greater than the value of the payout under the life insurance policy.

In property insurance, people have an insurable interest in property they own up to the value of the property, but not beyond that.

Dr Fabrizio Saccomanni, Director General of the Banca d’Italia (the Central Bank of Italia) and I have been engaged in a bit of a ding dong in the ‘Letters to the Editor’ section of the Financial Times.  The issue is whether a recently established collateralised interbank lending scheme (the MIC) promoted by the Banca d’Italia (1) represents a balkanisation of the monetary policy implementation and liquidity management of the Eurosystem (the European Central Bank and the 16 national central banks (NCB’s) of the Eurozone member states), and (2) involves the Banca d’Italia assuming credit risk and therefore potentially implies the need for recourse by the Banca d’Italia to the Italian sovereign, through the Italian Treasury.

To all those readers of this blog who have requested shorter, snappier, less technical and abstruse postings, the following.  I write this blog for me, not for my readers.  Writing things down is the only way for me to communicate effectively with myself about complex issues.  By doing this writing in the form of a blog, I gain the option of taking on board the comments and criticism of those who read my scribblings and feel compelled to respond to it.  I gain this benefit at the cost of having to plough through a lot of stuff that makes little or no sense, in order to uncover the few pearls hidden among the swine.  There are minor vanity/ego rents to having people read what I write, and my consulting income may receive an indeterminate boost from these activities. But all that is secondary to my need to write.  I don’t know something unless I have written it down.

I started this blog quite independently, at http://maverecon.blogspot.com/.  I was invited by the Financial Times to move my blog to their site.  Because of the likelihood of greater vanity/ego rents and the possibility of more frequent intelligent feedback through wider readership, I accepted this invitation.  When the FT lose interest, I will go private again.  I don’t get paid for this blog.

So no, my blogs will not get shorter, snappier, less demanding, less abstruse, complicated and confusing.  My blog postings are and will be excessively lengthy, long-winded, demanding, abstruse, complicated and confusing where the problems are complicated and confusing.  I make no concessions to my readers.  Why should I?  The readers I lose or miss as a result of writing the way I do are the readers I don’t want in the first place.  They can always go to the National Enquirer, Bild or the News of the World.

PS Some people say I’m arrogant. No idea where they get that notion.

The interbank markets, secured and unsecured are, respectively, moribund and dead. The reason banks don’t lend to each other in the interbank market is counterparty risk – fear of default of the party they are lending to.  Unsecured interbank lending (for which Libor or Euribor are common price measures) has effectively vanished, even at the overnight maturity.  Secured interbank lending only occurs against very high-grade collateral and mainly for short maturities.  It is quite possible, indeed likely, that unsecured interbank lending will not return on any significant scale – ever.  In that case, Libor and Euribor would have to be replaced as benchmarks for pricing other private lending, by secured interbank lending rates, such as the OIS rate.

When banks don’t lend to each other, they are also unlikely to lend to economic agents that matter intrinsically: households and non-financial corporations.  This has been a problem for a while in the US and the UK as regards bank lending to households, to developers and to firms in the construction sector. It is now spreading rapidly, in the US, the UK and in the rest of Europe, to the non-financial sector as a whole, starting with SMEs, but not stopping there.

To get interbank lending going again, banks must have confidence in each other’s solvency and liquidity.  How can we restore trust in these interbank relationships?  There are a number of options.

  1. Nationalise the banks.  When they have a common majority owner (the state), the state can simply instruct the banks to lend to each other.  Problem solved.  It may come to that in any case, but for those who are not ready for such measures, here are a couple more.
  2. Guarantee interbank lending.  Here the Treasury guarantees interbank transactions, both secured and unsecured.  This should be done against fees that ensure the Treasury an acceptable risk-adjusted rate of return on this activity.
  3. Have the central bank interpose itself as the universal counterparty for interbank transactions.  This is effectively already the case in the overnight market in the UK and the euro area.  When the Fed starts paying interest on reserves (commercial bank deposits with the Federal Reserve System), we will see the same phenomenon there.  In the UK, for instance, banks hold large deposits overnight with the Bank of England at the standing deposit facility (which pays 100 basis points below Bank Rate (the official policy rate) )and borrow either by running down these overnight deposits or by borrowing overnight at the standing lending facility (at a rate 100 basis points above Bank Rate).  The same phenomenon can be observed with banks in the euro area.  That 200 basis points spread (between the standing deposit and standing lending facilities rates) is hefty, but banks prefer it to taking the counterparty risk of other banks, even overnight.  Instead of commercial banks A and B lending directly to each other at longer maturities than overnight, bank A could lend to the Bank of England, and the Bank of England could then on-lend to bank B, more or less ‘on demand’.  This would require the Bank of England  to take a view of what the interbank rate ought to be at all the maturities where it acts as the universal counterparty of last resort – something it has been loath to do.  It could do this either for unsecured transactions or for both secured and unsecured transactions.  The spreads and other fees associated with this counterparty of last resort role would vary with the maturity of the loan, the quality of collateral, and the Bank of England’s assessment of the creditworthiness of the banks borrowing from it.

On July 27, I will be leaving these shores for the health spas of Martha’s Vineyard, where I will remain until August 28, rejoicing in the company of the nattering nabobs of negativism. This blog will lie fallow till early September. The blogging business is addictive. I have done it non-stop since April 2007 and am overdue for a break (as are those who stumble upon my blog). Cold turkey starts now. Enjoy your summer.

Senator Obama calls himself a black American or African American. He is seen as a black American or African American by most of the black/African-American community and probably also by the white community and the other racial/ethnic communities in the USA. By self-identifying as a black American, Senator Obama, who has a black Kenyan father and a white American mother, denies or diminishes the 50 percent of his parental heritage that is white.

Self-identification is, of course, a matter of personal preference and choice. But if I were to self-identify as a black female, a few eyebrows would be raised. When a self-identifying choice makes little sense because of its lack of congruence with easily observable facts, it is open to question, even to criticism.

Seen in the 12th floor men’s room at the New York Fed, right above the urinals, the following sign:

Report All Leaks to

extension 5619

I was sorely tempted to report a recent leak to extension 5619. Somehow I refrained (visions of my mother, my wife and my daughter all shaking their heads). Pity.

Paulson’s subprime mortgage borrower bail out
The Bush administration appears to have converged on a plan to help financially challenged subprime mortgage borrowers sucked into their state of indebtedness through adjustable rate mortgages with very low, up-front borrowing rates, so – called teaser rates – which re-set after two or three years to a much higher level – up to three percent or more above the introductory teaser rates. Many of these subprime mortgage borrowers would no longer be able to afford their monthly mortgage payments following the interest rate resets, and would stand to lose their homes as a result.

The Bush administration proposal, put together in negotiations of Treasury Secretary Henry Paulson with the mortgage industry, freezes the introductory teaser rates for subprime borrowers that are still just about afloat (roughly current on their mortgages, i.e. at most a little bit pregnant), but have credit scores below 660. The proposal prevents the low introductory teaser rates for these subprime borrowers from resetting to higher rates for five years.. Subprime borrowers with a credit score of 660 or higher, who are more likely to be refinanceable with new loans on commercial terms, will be fast-tracked. Josh Rosner, a consultant at Gram Fisher was quoted in the Financial Times of 7 December as saying: “This modification of existing contracts without the full and willing agreement of all parties to those contracts, risks significant erosion to 200 years of contract law”. He is right. By offering a higher ex-post subsidy for those with a lower credit score, it also piles moral hazard on top of moral hazard.

This proposal is a classic example of a politically attractive, economically ugly quasi-fiscal window dressing exercise.

Quasi-fiscal policy measures
Quasi-fiscal measures are government actions that are economically equivalent to taxes or subsidies but are not formally classified as such. They are off-budget taxes and subsidies, often administered by entities other than the general government. I would include in the quasi-fiscal category also all forms of off-budget and off-balance sheet financing by the government, that is, all financial arrangements that increase the net indebtedness of the government but do not, for technical reasons, show up (at least not in the short run) in the conventional government financial accounts. 

Examples of quasi-fiscal measures are non-remunerated reserve requirements imposed by central banks. To the extent that minimal reserve requirements exceed the quantity of reserves that would have been held voluntarily in their absence, they represent a tax, equal in magnitude to the quantity of reserves held involuntarily multiplied by the financial opportunity cost of holding these involuntary reserves. Other examples include price controls on food, which amount to a subsidy on food, requirements to surrender foreign exchange earned from exporting to the central bank at an unfavourable exchange rate, which amounts to a tax on exports or export quotas which depress the domestic price of the exportable good below the world price, which amounts to a tax on the producer and a subsidy to the consumer. Government guarantees provided at less than their opportunity cost are another popular quasi-fiscal instrument.

In the US, quasi-fiscal measures have long distorted the housing market and the market for housing finance. The deductibility of mortgage interest from the Federal income tax is a quasi-fiscal subsidy. With inflation positive and likely to remain so, a further distortion is introduced by the fact that it is the nominal interest cost that is deductible.

Freddie Mac and Fannie Mae, the two Government Sponsored Entities – notionally private listed companies but de-facto Federally guaranteed, engage in securitisation of eligible mortgages and insuring mortgages. Their combined balance sheets at the end of 2006 was about $1.65 trillion, $843bn for Fannie Mae and $813bn for Freddie Mac. The total mortgage credit book of these companies is, however, much larger than their balance sheets. In the case of Fannie Mae, in addition to a mortgage portfolio of $729bn (the unpaid principal balance of mortgage loans and mortgage-related securities held in its portfolio) there also were Fannie Mae Mortgage-Backed Securities held by third parties worth $1,777bn and $20bn worth of other guarantees. The corresponding numbers for Freddie Mac were $704bn for its mortgage portfolio and $1,477bn for its Mortgage-Backed Securities outstanding. The total amount of mortgages and mortgage-backed securities outstanding of the two GSEs is therefore around $4.5 trillion. 

On December 7, 2007, the 10-year US Treasury yield was 4.01 percent and 10-year Freddie Mac and Fannie Mae bonds yielded 4.64 percent. A-rated corporate bonds yielded 5.83 percent and high-yield or junk yielded anything over 7.5 percent. Recently, City Group borrowed $7.5bn from the Abu Dhabi Investment Authority at 11 percent. Let’s be generous and assume that, without the de facto guarantee of the Federal government, the two GSEs would have to borrow from the markets at terms slightly better than Citigroup, say, 10 percent. The annual subsidy provided by the tax payer to the GSEs, and through them to American mortgage borrowers is therefore 5.36 percent of $4.5 trillion or $241 bn. Even if you halve that, it’s still a nice figure. 

To this massive subsidy benefiting households borrowing against eligible residential property, the Treasury now proposes to add a further subsidy, whose amount is as yet unknown, but which will be small compared to the massive subsidy provided through the two GSEs. For those fortunates whose teaser rate get extended for five years, the subsidy is the difference between the level that would have been effective following the reset and the teaser rate. There is a corresponding tax on the lending institution or on the current owners of securities backed by the mortgages whose rates have been frozen. The subsidy on borrowers whose refinancing will be fast-tracked (and the corresponding tax on the lender or the investor in mortgage-backed securities) cannot be determined until we know the actual terms of the fast-tracked re-mortgaging and find a way of computing the counterfactual mortgage cost without the government-imposed fast-tracking. 

I can see little justification for these interventions in housing finance. There may be positive externalities associated with home ownership and with owner-occupation of residential dwellings. That would provide an argument for subsidizing home ownership or owner-occupancy. It would not provide an argument for subsidizing borrowing secured against residential homes. 

If the information provided to the financially distressed subprime borrowers was incomplete, misleading or outright dishonest, there should be recourse to the criminal justice system. For those subprime borrowers who bet on being bailed out by ever-rising house prices, the adagium: “you break it, you own it” applies. They gambled and they lost. There is no argument based on fairness or efficiency for allowing them to stay in homes they cannot afford without a subsidy. Foreclosure and repossession were designed for just such occasions. The fact that we are approaching an election year should have no bearing on this. Unfortunately it does. This bailout of the imprudent and the short-sighted is unfair to the prudent and far-sighted. It also creates terrible incentives for future overborrowing. 

The bailout proposed for the subprime market is wrong for two reasons. First, because it is a bailout. Second, because it is a bailout implemented with quasi-fiscal instruments rather than with explicit fiscal instruments: a tax on investors in subprime mortgages (or securities backed by them) and a subsidy to subprime mortgage borrowers. Quasi-fiscal instruments are opaque and non-transparent. They serve and are intended to hide the true nature and the real cost of what the government is up to. They kill accountability for the use of public resources. It redistributes not through explicit taxes and transfers but by interfering with the price mechanism. That is why it is so popular with opportunistic politicians everywhere. 

Every politician wants to finance his or her pet projects and hobby horses in an off-budget and off-balance-sheet manner. The public sector knew and applied most of the tricks performed by corrupt and criminal private sector outfits like Enron long before Enron became a household word. Take, for instance, Gordon Brown’s International Finance Facility. This is an off-budget and off-balance sheet arrangement or special purpose vehicle (SPV) that securitises future development aid commitments of the UK government.

The off-balance-sheet vehicle borrows against these future aid commitments to finance development today. Whether it is a good idea to rob future poor Peter to pay today’s poor Paul is an important issue, but not the one I wish to focus on here. What the SPV permits the government to do, is to borrow today without having it show up as borrowing in the government’s financial accounts. The earmarking of future aid commitments will, of course, constrain future government budgetary elbow room, but for myopic and opportunistic politicians, there is no difference between 10 years from now and the next millennium.

The quasi-fiscal measures proposed for the subprime borrowers and lenders have the advantage of never showing up in the government budget. The implicit Federal government guarantees for the debt of Fannie Mae and Freddie Mac are a contingent liability. Even if they are not priced and accounted for in today’s government balance sheet, they could pop up in tomorrow’s Federal Budget and balance sheet should default threaten the GSEs. Of all the governments I know, only New Zealand attempts a comprehensive accounting for contingent assets and liabilities. That remarkable country indeed provides most of the information required for a construction of a comprehensive government intertemporal budget constraint.  Many of the financial shenanigans of governments would become much harder to perpetrate if they were forced to take the long view in the presentation of their accounts. Unfortunately, the kind of quasi-fiscal raid proposed by Mr Paulson for the US subprime market would not be captured even by a New Zealand-style comprehensive balance sheet of the government. Through direct government interference in price setting and through the government-imposed rewriting of long-term contracts, fiscal policy is conducted without leaving a trace in the government’s budget, today or tomorrow.

Argentina and other emerging markets dominated by populist governments are frequent users of government-created price distortions in the pursuit of electoral and other political advantage. In Argentina, the authorities rolled back and capped utility prices. In the US, the authorities prevent interest rate resets in the subprime mortgage markets. Is Argentina the new economic model for the Bush administration?

Tapir relief

Like many other animal lovers, I support tapir relief.  All four species of tapir are endangered.  Subsidising the bodily functions of this prehensile-snouted odd-toed ungulate (closest living relatives horses and rhinoceroses) is obviously a worthy use of public funds.


True animal libertarians may argue that tapirs can perfectly well relieve themselves, without government assistance or special incentives. The sign below, found in the Belize City Zoo, supports this argument.

Tapirsign_2Nevertheless, I am convinced that a sound utilitarian case for tapir relief can be made. There are bound to be positive tapir externalities meriting a subsidy or regulatory intervention (e.g. tapirs are considered cute, and not just by other tapirs).  In the unlikely case  that  an externalities-based case for granting fiscal favours to the tapir cannot be made, the proponents of the new (or indeed the old) paternalism can no doubt find failings in the cognitive skills of the tapir, or weaknesses in his capacity for long-term commitment, that would warrant a tax break.

Taper relief


There is, however, no case in fairness, efficiency or paternalism for the continuation of taper relief in the UK capital gains tax regime.  Chancellor Alistair Darling deserves brownie points (he won’t get any Brown points) for attempting to simply the unholy mess that is the UK income tax and capital gains tax regime.  Taper relief is a singularly pointless and distortionary feature of the UK capital gains tax, one which benefits not the tapir, but a different collection of mammals, ranging from owners of small businesses to owner/managers of private equity funds. Although, like the tapir, often pig-like in shape and keen to put their snouts in the trough, they are in no way endangered or in need of special tax advantages, either for efficiency reasons or because of fairness concerns.

I have argued elsewhere that, because of considerations of fairness, efficiency, tax compliance, tax administration, evasion and avoidance, the only  income tax, capital gains tax and corporate profits tax regime that makes sense would have the following features: (1) It adds all labour income, capital income (dividends, interest etc.) and capital gains together and applies a single tax schedule to this total, regardless of its composition; (2) It abolishes corporation tax or makes it into a pure withholding tax.  This means that taxes paid at the level of the company can be fully offset against the personal capital income (interest, dividends) tax liability. 

I would add the following: (3) It fully indexes the entire income tax structure (allowances, bands and capital gains); (4) It consolidates employers’ and employees’ national insurance (social security) contributions into the personal income tax; this could both raise the average income tax rate (across all income tax payers) and lower the highest marginal income tax rate;  national insurance contributions themselves would, of course, no longer exist as a separate tax; (5) It makes all interest income taxable, and allows all interest paid (on mortgages, credit cards, other loans) to be deducted from taxable income (in view of (3), only real interest payments should be deducted); and (6)  It imputes the implicit rental value of owner-occupied accommodation as income.

It would be possible, by deducting the value of inflation-corrected saving from taxable income calculated according to (1) through (6), to turn this into a consumption tax, but I would be happy with either.

Chancellor Darling’s proposals unfortunately took one step backward at the same time that he took a step forward by proposing the abolition of taper relief and its replacement by a single 18 percent capital gains tax rate. That is because he also proposed the abolition of the last remaining bit of indexation of capital gains, which means that you now pay capital gains taxes even if the nominal capital gains that are taxed do no more than make up for the erosion by inflation of the real value of your assets. 

But the abolition of taper relief can be viewed as a helpful first step on the road towards a promised land where all income is taxed according to the same tax schedule.  If nothing else changed, this means that in a sensible world, the highest marginal tax rate on capital gains would be the same as on labour income and dividends (assuming corporation tax is abolished).  Currently this would be 40 percent, but with the other changes I am proposing, the highest common marginal rate could be lower.

The two key features of taper relief are that the capital gains tax rate is (1) lower the longer an asset has been held and (2) lower for business assets than for other assets.  Neither feature makes any sense.

Should the owner of an asset be encouraged to hold it as long as possible?
The answer is a clear and unambiguous: ‘no’.  Especially when it comes to business assets whose effective deployment requires entrepreneurial and managerial skills, there is no presumption that the current owner is the best owner/manager.  Bad owners (that is, owners who either are poor entrepreneurs and managers themselves or who are poor at selecting good managers) should be encouraged to sell as soon as possible.  Good owners should hang on to their assets.  Governments have no way of knowing who the good or bad owners are.  There is no presumption that the current owners are the best possible owners -  something that is a necessary condition for encouraging long-term ownership of (business) assets. I would have thought that when the current owners are bad owners, both they themselves and the market of possible interested buyers of their business assets would be at least as likely to figure this out as the government or some government-sponsored agency.  The presumption underlying taper relief that, left to their own devices, owners of assets, and especially owners of business assets, would dispose of these assets too soon is not based on a single thread of evidence.

Should business assets be taxed more lightly than non-business assets?
The answer is again a clear and unambiguous ‘no’, based on the absence of any efficiency or equity argument in favour of this feature of taper relief.  A building owned by a small firm owned by an owner-entrepreneur  is not more or less  valuable from a social point of view that a similar building owned by  a ‘natural’ person, or indeed that same building owned by an investment fund specialising in property.  This feature of the tax system distorts investment decisions and decisions on whether or not to incorporate.

A number of other spurious arguments in favour of the continuation of taper relief have been made:

"We were promised….".
The then Chancellor Gordon Brown introduced taper relief in 1998 with the declared purpose of encouraging entrepreneurship, long-term investment and risk-taking in the UK.  Abolishing it now would be unfair, a breach of promise, and amounts to confiscation of profits resulting from a commitment to investment that took place only because the investor trusted the promise of the Chancellor.

Well, tough luck and/or more fool you.  Clearly it would be better if the structure of taxation, benefits, regulations and other factors relevant to investment decisions and under the government’s control were (a) sensible and (b) stable over time.  Stability of tax structures matters.  Sometimes it is better to have a second-best tax system that is stable over time than a first-best one that is at risk of getting changed frequently.  However, the distortion associated with taper relief is such that its elimination makes welfare-economics sense, provided that it is not followed by a sequence of further changes in the opposite direction.   

Furthermore, governments act on behalf of the sovereign. This means, in non-legal language, that they can do what they jolly well like.  A government cannot credibly commit itself to a specific course of future actions.  It can certainly not commit its successors.  Anyone who believes that any particular government decision or legislative act is irreversible, is terminally naive and should not be in business.  In the case of the 1998 Chancellor Gordon  Brown, this applies with special force.  Gordon Brown was pretty good at ensuring overall macroeconomic and financial stability.  He was also a maniacal micro-structural tinkerer.  There wasn’t a single economic or social problem or Gordon Brown was addressing it with a handful of tax incentives, a few subsidies and some regulatory measures.  Each budget would contain literally hundreds of such micro-tinkering measures.  And there would be different ones each budget, often reversing or neutralising other measures contained in the same budget or in earlier budgets. 

Any change in any feature of the tax system, the subsidy system or the regulatory framework will be, at least in part, a surprise to the private economy.  It will benefit some and hurt others, including persons, households, small and large firms, that had made investment decisions on the basis of guesses about the future tax, subsidy and regulatory regimes that were falsified by the government’s subsequent actions.  Unfortunate, painful and inefficient, perhaps unfair.  But an intrinsic feature of the the political landscape since the beginning of time.  The notion that the UK small business community is entitled for the rest of time to the most favourable tax treatment bestowed on it at any time in the past, is rather silly.

Encouraging risk taking
Then there is the notion that low rates of capital gains taxation encourage risk taking and that risk taking needs to be encouraged.  Let’s take the last one first.  Risk is bad.  Other things being equal, we want less of it.  More risk makes sense only if it is offset by a(n at least) compensating increase in expected returns.  To say that the government should encourage risk-taking is as silly as to argue that the government should encourage the pursuit of lower expected returns.

Is there too little risk taking in the UK economy?  Features of the corporate legal environment, especially limited liability, create incentives for excessive risk taking, because losses that would, with unlimited liability, result in negative equity, are not in fact borne by the entrepreneur under a limited liability regime,  Do businesses  overestimate risk and underestimate expected returns?  Entrepreneurs are congenial optimists who tend to overestimate returns and underestimate risk.  Managers of quoted companies that have but a limited equity stake in the firm, face a large number of incentives affecting their behaviour towards risk, not all of which point towards excessive caution.  The net effect will depend on the capital structure of the firm, the governance structure of the firm, including the relationship between management and the board(s),  the remuneration package of the manager, the market for corporate control in which the firm operates, and the nature of the managerial market place.  The case that there is too little risk taking in the UK economy, relative to the expected rewards on offer, has not been made effectively by anyone.

There may be too little risk capital available for launching new firms or new ventures by existing firms.  Capital gains taxation, however, is a very inefficient instrument (both from the point of view of its ability to correct the distortion that is targeted and from the point of view of the revenue effects for the tax authorities) to address the problem of the inadequate availability of external finance.  Capital gains taxation means taxing capital gains on the existing stock of capital assets.  Reductions in capital gains taxes benefit owners of existing capital assets.  Expectations of future low capital gains tax rates will have a favourable effect on investment today, but lower capital gains taxes today only increase the returns to investment decisions already made.

If governments want to boost investment, the revenue-efficient way is to work at the margin of new investment, say through a marginal investment subsidy, or through an investment tax credit, accelerated depreciation of new investment etc.  If governments want to encourage the availability of external finance for new firms and, more generally, for those enterprises whose access to external finance is inefficiently constrained, lower capital gains taxes (which come at the end of the investment process) are a singularly ineffective means to achieve this.  Measures to encourage venture capital funds that can pool the risk of many (hopefully imperfectly correlated) investment projects are one.  So are measures to strengthen the rights of external financiers vis-a-vis the owner-entrepreneurs. 

Encouraging small business
After the incredible lobbying power of the agricultural sector in advanced industrial countries, the cult of the small business is, to me, the second most incomprehensible feature of the industrial political-economic landscape.   Small businesses are ‘the seed-corn of economic growth’, ‘the backbone of the economy’, ‘the engine of growth’, the ‘well-spring of innovation and dynamism’, the ‘life-blood of the nation’.  Perhaps.  To me, the key feature of small businesses is that they are small.  And small is small.  Other things being equal, I would rather have a lot of medium-sized businesses, and much rather a lot of large businesses than a lot of small businesses.

Most small businesses stay small.  A lot die quite soon following their birth.  A few grow and become medium-sized businesses.  Very few grow and become large businesses.  Then, every 30 years or so, there is a Microsoft or Google. 

Are small businesses discouraged from growing and becoming medium-sized or large by capital gains taxes?  Most small businesses probably want to stay small.  I have a very small business, with two shareholders, two directors and two employees – my wife and myself.  I definitely neither expect nor want the business to grow significantly.  It does what I intended it to do.  I don’t expect to retire on the capital gains I will make from selling the business.  Most small businesses I am familiar with fall into that category.

There is a chronic tendency to romanticise and dramatise the role of the small business and the solitary entrepreneur.  Let’s face it, business is mostly boring; very little of it is glamorous, creatively challenging or intellectually exciting.  It’s mostly hard work – grinding and grafting.  Rather like farming or paid employment, in fact.  There is a small chance that an entrepreneur will be quite a bit worse than the wage slave, and an even smaller change that (s)he will make a staggering fortune and end up creating a lot of jobs for other people.  There is no clear evidence that, in the field of small business, the private risks are significantly greater than the social risks or the private returns much lower than the social returns.

Again, if there is a problem facing small businesses, it relates not to the taxation of capital gains, but to the cost and availability of external finance.  Much of this is due to the fact that new businesses have no track record on which to base a request for a bank loan or an injection of equity from a venture capital fund.  That problem should be tackled right at the point where the distortion arises. Subsidising small loans to small businesses that have never received a loan before, might help.  So would the possibility of postponing for a number of years the payment of business-related taxes by start-ups, while ensuring that in present discounted value terms, all taxes get paid in due course. But the selection criterion would be not size, but being new.

Granting small businesses special privileges (such as the rumoured proposal for a £100.000 tax-free allowance for capital gains from the sale of a business on retirement) is putrid pandering to the lobbyists from the UK small business community.  It is a waste of public money and unfair to those retirees who have only non-business assets to sell.  To belabour the obvious: assets are assets; the identity of the owner, whether they are business assets, personal assets, assets held in the investment portfolio of  an insurance company, or state-owned assets is irrelevant.  And small is small.  Not inherently good. Certainly not better than medium-sized or large.  And most definitely not obviously deserving of capital gaints tax breaks. 

I hope the current Chancellor will be able to see off his predecessor in this matter.  If we are ever going to get an income tax structure in the UK that is transparent and understandable, let alone simple, the original reforms proposed by Alistair Darling are a good place to start.    

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website