Thursday, 9 December 2010

The Wonder of Money

I've recently been thinking about printing my own money. Searching for inspiration, I visited the coin and note collection at the Ashmolean Museum in Oxford. What a delight! The coins date back thousands of years and vary in design and pattern reflecting the society and culture. Why restrict yourself to a circular coin when, like the Chinese, you could strike coins in the shape of knives that you can hang from your belt?! 

Why we use money. Humans have a long history of using money. Without it people can barter their goods with one another - I'll give you one of my sheep for your sheaves of corn - but in such a system problems arise. What if you don't want a sheep but a pig, what if your sheaves are only worth half my sheep, or what if my sheep has become too old? Money overcomes these problems because it is divisible, allows for indirect exchange (i'll pay you for your corn and you can use that money to buy a pig from a third party), and is a non-perishing store of value . Well designed money should also be durable, portable and easily stored, which explains why money is often small and made of long lasting materials. (I should mention that there are alternatives to exchange economies. Societies evolve in enumerate ways! See gift economy.)

Money is at the foundations of our economic and social life. Any monetary system can only work if, as a community, we trust and respect it. A society might be willing to trade with commodity money, like shells or gold, for example, if shells and gold are considered desirable and valuable. Fiat money, which we have in the UK, relies on the trust of society alone. Pound sterling doesn't represent any physical commodity but gains value by virtue of people's perception and faith. Lose confidence and the value of the money in our economy evaporates. 

Money as evil. In his second treatise on civil government, John Locke wrote that money ultimately leads to inequality. In a barter system a degree of economic equality is imposed on us because we are each physically constrained by the amount of labour we can put in to take goods from nature, and tradeables generally have a shelf life. Money, however, can be earned or appropriated and kept forever. The resulting inequality is a good reason to have a state if it can realign wealth in the economy. Professor Mary Mellor goes further and believes that money should be a common resource to which we should all have fair access and decide democratically as a society where to allocate it.

Control of the money supply. Money is far from public today. Officially it's the Royal Mint and the Bank of England who create money but that makes up a tiny amount of the digital money that we actually use in the UK. It is the high street banks who, through their lending decisions, effectively have power over the money supply and they also direct where it goes. They have private incentives to allocate money where it will make them the most amount of profit, which is often in conflict with public interest.

I don't plan to create a real currency. I'm designing fliers to advertise a debate on the future of banking. Banks form the system in which our money flows and it has proven to be poorly designed. More information on this to come. If, however, anyone is interested in starting a local Oxford Pound do let me know!

Saturday, 4 December 2010

Corporation Tax

Corporations, like Vodafone, are undoubtedly avoiding tax. Unlike tax evasion, tax avoidance lies within the law but it is, arguably, unfair. Our government could have taken this weeks publication of the 'corporate tax roadmap'  as an opportunity to address this problem. Despite raising the issues, the document reveals that the government intends to maintain a system ridden with loopholes that enable the richest corporations to scheme out of paying tax in this country. 
Why tax avoiding happens and is not illegal. Multinational corporations have many operations - HQ, sales, shareholders and activities (development, HR, marketing) - that can be located all over the world. This makes things complicated when a national government wants to impose a tax on the profits that corporations make in their country. First, it has to be decided at which level of operations a corporation's profit should be taxed. The current global practice is to tax the activities section of a corporation. The implication of this is that the HQ of a corporation like GlaxoSmithKline needn't face any tax by the UK government even though it is located here. What if profits are sent back to HQ from subsidiary operations? In a credit system, like the US uses, profits repatriated to the US will be taxed unless they have already been taxed in another country.
As you can imagine, corporation tax in a global world economy quickly becomes very complicated. Designing a national corporate tax system is challenging and countries have taken varying approaches. In line with most other countries (other than the U.S.), the UK uses an exemption system whereby only profit that is generated in the UK is taxed. In recent decades, too, governments have been reducing corporate tax rates in a competition to attract big business. The resulting differences enable corporations to manipulate their capital flows in order to avoid tax. It is not illegal because their behaviour is not always observable and generally not verifiable. 
How to avoid tax. In the case of Vodafone the relevant avoidance is simple profit shifting; it has allegedly been pouring profits made in the UK (and probably elsewhere) into a subsidiary firm in Luxembourg to dodge UK tax payments and benefit from the lower Luxembourg tax rate. In trying to recoup the lost tax revenue HMRC faced problems verifying that Vodafone was in fact tax dodging. In court, Vodafone claimed that the government was discriminating against outward investment to other EU countries, which is inconsistent with the EU treaty! (Of course, they just happened to invest in a tax haven!)
Another way corporations can avoid tax is through debt.  The government's roadmap discusses this at great length. Let me give one example of how it works [see diagram]. Imagine that a UK based corporation sets up a company in the Cayman Islands (known as a controlled foreign company (CFC)). The UK entity can exploit the lower tax rate in the Cayman Islands in order to reduce the amount of its profit that is taxed at the high UK rate. How? The UK entity borrows money from the CFC and pays back interest. This interest is tax free in the UK, and though it is seen as profit to the CFC, it faces a much lower tax rate in the Cayman Islands. As a result, this lending strips profit out of the UK in the form of interest and the corporation holds onto the majority of the profits in the CFC based in the Cayman Islands. 

Since the key problem, which the government highlights, is the tax relief on interest payments we would expect the government to restrict interest relief. 
No Change. The government rejects the option to change the interest relief rules because "they are considered by business as a competitive advantage". Ha! - They are acknowledging that the relief rules mean that tax can be avoided! The government claims that the aim of their corporate roadmap is to achieve  'the most competitive corporate tax in the G20'. If they really want that, then the most sensible and direct option would be to reduce corporation tax. The message from the corporate road map paper is that if you're clever enough you can dodge tax payments. 

Monday, 29 November 2010

The Alternative Vote

Why the bread or the lily?

The choice between either bread or a lily is an analogy Lionel Robbins (An Essay on The Nature and Significance of Economic Science, 1945) uses to describe the problem of scarcity that we face as individuals and society.

"The time at our disposal is limited. There are only twenty-four hours in the day. We have to choose between the different uses to which they may be put. The services which others put at our disposal are limited. The material means of achieving ends are limited. We have been turned out of Paradise. We have neither eternal life nor unlimited means of gratification. Everywhere we turn, if we choose one thing we must relinquish others which, in different circumstances, we would wish not to have relinquished. Scarcity of means to satisfy ends of varying importance is an almost ubiquitous condition of human behaviour"

Very broadly, Economics is the science that studies what best to do when we don't have enough of what we need or desire. Deciding where to allocate scarce resources can be very difficult but it is a reality to be confronted. Robbins describes the problem poignantly:

"There are cases when it is either bread or a lily. Choice of the one involves sacrifice of the other, and, although we may be satisfied with our choice, we cannot delude ourselves that it was not really a choice at all, that more bread will follow. It is not true that all things work together for material good to them that love God. So far from postulating a harmony of ends in this sense, Economics brings into full view that conflict of choice which is one of the permanent characteristics of human existence. Your economist is a true tragedian."

Higher Education

The reaction to Lord Browne's Independent Review has concentrated on funding and tuition fees, missing a vital dimension to the debate about the future of higher education policy. Behind every spending decision should lie two factors: 1)the cost and 2) what you get in return for your money. The second factor, what students (or more precisely, graduates) are going to get in return for their money, has not been given enough attention. What should the universities' side of the bargain be?

Port Meadow

'Make Oxford Paris' read one banner at the Oxford Education Campaign protest a few weeks ago. My personal fantasy is the return of universities as they were in the 1960's. Then there were, on average, 19 students in a lecture and 4.2 in a tutorial. My impression is that universities were communities of learning rather than the factories that some resemble today. As an Oxford student this may sound like your reality rather than a day dream but it isn't sustainable in the current system. Chris Patten, the Chancellor of our university, spoke out earlier this year about the great gap in funding, which means that the university is running at a loss. 

It is a feature of developed economies that the cost of services like education rise over time. This phenomenon, called the 'cost disease', was diagnosed and explained by economist William Baumol. To understand the ailment, first consider how the manufacturing industry has the potential for large productivity increases. Advances in technology mean that a car, for example, can now be almost entirely built by a machine, and quickly too. Unlike manufacturing, we cannot standardise the education process or create faster automated teaching machines. The human touch is crucial. 

There have been some technological innovations, like e-learning, but the time it takes to prepare a lecture or mark work will never change. Whereas costs can fall in a manufacturing sector that is experiencing productivity rises even when there are pay rises, education becomes more expensive every time teachers get pay increases because there is no concomitant increase in productivity. Wages nevertheless do increase in the education sector to maintain a pay differential from the increasing wages in the productive sectors. 

The key lesson to take from Baumol's Cost Disease is that an ever larger proportion of an economy's money will have to be pumped into education each year to maintain any given level of quality. An increasing student population only exacerbates this, which is relevant in the context of UK higher education. In 1963 there were 31 universities and 120,000 students. Today there are 152 universities and 2m students. 

Lionel Robbins, another economist, led the first review of higher education undertaken in 1961 and the advice he gave to the government built upon the following principle: universities should be accessible to all who wish to attend and are qualified by ability and attainment. Accordingly, the student population had to be able to expand. If the student population was fixed, then a rise in the demand for higher education would create competition for places and that would threaten the access which Robbins' principle commanded. Teamed with the coming of age of the baby boomers, the university population began to swell. Public funding, however, was not so bountiful and as a result of the pressures on university coffers the student to staff ratio more than doubled from 8:1 in 1963 to 17:1 in 1999.  If labour input is an indicator of quality, then something has been lost in higher education. 

Despite the fall in labour input, the prestige of British universities has risen in past decades. To an extent British students benefit from this; their degrees are recognised worldwide and international fees subsidise their studies. However, the research output has only been made possible by diverting resources from teaching. The Research Assessment Exercise, for example, allocates funding to departments based on their research output, which gives academics the incentive to substitute time that they could spend teaching for time writing papers. In the 1960's PhD students rarely took tutorials as they do now. 

The incentives to produce research are now so embedded in the academic labour market that it will be hard to reverse, but they could be counteracted by recognising and rewarding high quality teaching. (In fact, I'm just going to take this moment to thank my former lecturer at the University of Bristol, Gervas Huxley, for sharing with me some of the ideas that I have expressed here. He was voted 'the best of Bristol' lecturer in a recently established competition, which is an example of an effective and low cost way to reward brilliant teaching.)

"Economics is the science that studies human behaviour as a relationship between ends and scarce means which have alternative uses" wrote Robbins. It would not be impossible to implement my sixties university utopia but we know from Baumol that it would require directing drastically huge amounts of funding to higher education. Where would that sort of money come from (students? the tax payer?) and at what cost (what services/alternatives would have to be foregone as a result?)? Robbins also wrote that "Economics brings into full view that conflict of choice which is one of the permanent characteristics of human existence. Your economist is a true tragedian." I'm not convinced there has to be a tragedy. Inspired by fantasy we should discuss, within the constraints of the funding available, what we want to get out of higher education. Equipped with realistic demands on the quality and character of our higher education, we will be in a stronger position to avoid being short changed and disappointed. 

Hard Times?

It is the beginning of term and you might quickly become miserable about the important expenditures to be made on big nights and new outfits. Once university fees are paid there seems so little money left and every penny spent is just more that you owe the government. A little economic analysis, however, reveals that a student's finances are no nightmare. In fact, they make a lot of sense. 

The starting salary of an Oxford graduate is on average £24,000 which builds up to £40,000 within just 5 years and it is these longer term statistics, according to Nobel prize-winning economist Milton Friedman, that you should focus on when making spending decisions. The central idea of his Permanent Income Hypothesis is that people spend according to what they think is their average income. It is common sense that on pay day you know not to spend all of your wages because they have to last until the next one. Friedman simply extends this idea over a larger time frame. He thinks that people should not only divide their income equally from month to month, but from year to year in order to achieve a constant standard of living over their lifetimes. Any fluctuations in income can be smoothed by saving in periods of unusually high income, and borrowing in times of financial woe. 
This is what students do; the moderate amount of debt they take on today increases their future expected income which will more than cover the cost of their loan. And the loan provided by the government is in fact a good deal. The cost of borrowing from a private bank starts at around 8%, exceeding the upper end estimates (4.4%) of the government's rates this year. This is the best loan of your life!

If you take Friedman's reasoning further, then you find that students are conservative in their spending patterns. This is because the education that you are paying for now significantly raises your lifetime income. Those of you who are very optimistic about your future earnings (I'm talking to the business and engineering students out there, sorry arts students) can afford to spend much more now! Unfortunately, you are, as they say in the parlance of economics, 'credit constrained', because no bank is willing to lend you a significant amount of money (at least, not at a decent rate). If you could borrow relative to your expected income (more) oxford students would be driving sports cars and holidaying in the Bahamas. Since you are credit constrained the next best thing to do is what your parents probably advised - divide your funds evenly across the period of constraint. 

From experience, I doubt that many of you will behave in line with homo economicus and keep to a strict weekly budget. Humans exhibit strong tendencies to be myopic and spendthrift at the expense of their future selves. With this in mind, when making spending decisions today, you might want to take into account the number of meals that you will be eating out of a can come the end of term. Apart from this, you should feel confident about your financial situation.