Sunday, March 14, 2010

On taxation II.

Although in the previous post I mentioned macroeconomic context of taxation as the topic of this follow up post, as a layman I do not want to claim to analyze the issue in depth. My aim is only to pick up some themes  - some frequently mentioned in the public discourse, some totally absent - I find intriguing, nothing more.

The whole problem is centered around the redistributive role and the distortive nature of the taxes in the economy. From this angle taxes serve to channel money (capital) from the economy and from certain parts of society to others. As a discretionary levy on income or capital they nature is to change the incentives of the free market and pulling or pushing the economy out of its natural balance. (However, as some functions of the state are considered as necessary - setting the rules, guarding property rights, carry out judiciary decisions etc. - and their exercising is only plausible with some state revenues to a certain extent this distortion is unavoidable. But the extent is disputable and disputed.)  The first issue to be discussed here is the redistribution, whether it is negative under the present circumstances - i.e. in the crisis and with the necessity of tight fiscal policy narrowing consumption as a driver of economic growth. It is a specific approach, far from claiming universal validity.

An appropriate starting point is the model of the last decade (or in case of the US even the last 25 years) Income and social differences has grown in many Western and ECE countries. In the US it is usually associated with the tax changes, preferring - at least relatively - those in the upper income and wealth categories and in ECE - especially in the last decade - it is a result of the foreign direct investment based growth. (Although the necessity to follow this path and the possibility to find a different growth model is a topic of frequent contradiction, for my post the existence of this model will suffice, and it is not a prejudice regarding the merits of this path.) Nevertheless, as the US economy is based on internal consumption and in the transition countries the long period of subdued consumption led to a widespread desire to acquire the goods neglected during the change. The result - to sum it up simply, thus a bit simplystically - was the growth of credit aimed at consumption as real income growth couldn't serve as the basis of increased consumption. 

But why it is a problem when the growing national income - as in almost every country long and protracted periods of growth characterized the last decade - is not redistributed heavily, thus leading to growing income differences? Leaving aside moral considerations and not claiming that it necessarily fits to every situation one issue was the sustainability of the growth path. It is usually presumed that people with lower income tend to consume more as the ratio of their revenues ad to an extent it is true for additional income as well. This is mainly based on the fact that they usually can not satisfy their needs and desires because they disposable wealth is not enough. To the contrary, those with higher incomes, although spending more nominally, can easily save a higher ration of their income as it is significantly higher than their needs. (It is worth to note that the propensity to consume is influenced by social behavior as well, either on individual level or in societies with higher savings rate the consumption ratio can be relatively low even in lower income categories.) In general higher income of people in lower strata is perceived as a more certain way to drive up consumption, while the opposite is rather advantageous for higher savings. But it also means that if cheap credit is available for everyone, those with relatively low income can afford consumption. However, if one considers sustainability, the latter case is more problematic, as to keep the same growth rate without providing higher incomes means the constant raise of outstanding credit based on the rise of asset values. Conversely, as soon as asset values decline a credit crunch can easily occur. Beyond this "practical" problems it is also a debatable issue whether asset values can rise indefinitely.

A usual counterargument assumes that the economy is a closed system in which revenues are either consumed or saved and saving lead directly to investment increasing production on the long run. Therefore the higher savings rate of upper income categories is not directly affecting growth, as what they save is equally productive as the consumption at the lower stages of the ladder. In a closed system where financial tools are destined to transmit resources from one segment of the society to the other directly it is probably true but, but it is not so easy to determine whether modern savings techniques results in this very straightforward relationship. Moreover, due to the reliance of these savings techniques on the creation of the money in the financial system in order to create profit (it is the very basis of a financial bubble) even the channeling of savings into production is questionable. Not to speak of the difficulties of identifying the destination of such savings in geographical terms. It is probable that savings from Budapest will land in production in Brasil and this uncertainty again reduces the validity of the above mentioned model. The system is far from being closed and the relationship between the sectors are less clear and direct - due to financial innovation and globalization - as it was once. (An important aspect, tackled below is the profitability, whether financial investment brings less, equal or more profit as investment in production.) 

At least two consequences of this state of affairs have an impact on the considerations regarding the desirability of taxes and redistribution as a means to drive consumption. As the need to enhance competitiveness seems to grow instead of decreasing - due to the structural problems export is the favored way to create a current account surplus and cut down debt/to GDP ratio - wages can not be raised significantly (or only net wages through tax cuts, but the limitations of such measures to raise net income was the topic of my previous post) and it will limit the growth of consumption. If this driving force of the economic activity would need to be enhanced - and this is a matter of further consideration - the only feasible way seems to be redistribution as it would channel wealth from sectors of the respective societies where it is even not necessarily plays the role of being the source of investment to sectors where it could serve as a resource of consumption. (However, as the environment is rather inspiring deleveraging, getting rid of existing debts through savings it is far from being certain.) But beyond this - and probably more important - the validity of the model of government outcrowding is less plausible as it is treated in the public discourse. (This model relies on the assumption that private income is either consumed - that way poured into the economy - or saved - and the savings are directed by the financial institutions to the economy as sources of investment. The government's intervention - through collecting taxes - hijacks valuable resources and detours them. Although it is acceptable to a certain extent, if the government removes too much money from the private sector - especially if it happens through deficit spending covered by borrowing. In this case it usually assumed that less risky - and sometimes more profitable government bonds are more attractive to investors than company's bonds or savings accounts. Therefore the government collect and redistributes the money that would otherwise flowing swiftly into the economy. (The extensive taxation  has similar effects, as in this case the government directly expropriates the money it needs.) However, in the light of the globalization and the less than sure utilization of private savings as investment or domestic investment it is very doubtful. 

Firstly, as long as cheap credit flooded the world both the government and private sector was capable to draw on significant resources, irrespective of the prospects of return. No real outcrowding effect was detectable for example in Hungary, albeit one can ague that interest rates were higher than would have been without government imbalances. But - due to cheaper foreign currency denominated loans - private sector was capable to finance itself despite the huge volume of government sector borrowing. Secondly, nothing can ensure that savings not absorbed by government sector will be utilized by the private production sector. Even though some impact of government imbalances on the distribution of scarce resources can not be denied the original - and even today very popular - model of direct outcrowding seems less plausible. (Or, more precisely, it became pro-cyclical. While excess liquidity existed outcrowding was not a real issue. but after the collapse of the financial markets it reappeared in an enhanced form. But this time not the individual governments affected the economy, but those states that has the ability to borrow in their own currencies. Therefore, US government and Treasury bonds replaced ECE government bonds in the portfolios of investors.) But it means that the relationship is more refined as usually perceived and as a consequence it is dangerous to assume that reduction of government debt will result in a similar rise in private investment or consumption. (Especially as imbalances has to be dealt with and deleveraging is a universal phenomenon.)

This is not independent from the other important issue, how far taxes are distortive regarding economic activity and whether tax cuts in the EU are measures to release economic forces from their captivity or rather government subsidies that should be banned just as direct government subsidies are. The starting point is again the concept that taxation - even if it is undeniably necessary - is a distortion of the market, regardless of its extent. Even if better or worse tax systems can be conceived in this sense this idea clearly creates a binary opposition, taxation opposed to the tax free economy.  And if someone presumes market distortion as bad or at least disadvantageous taxation can not be seen as acceptable, only tolerable at best.  A tax free economy should be treated as better suited for optimal distribution of scarce resources than an economy with taxation. As a consequence any kind of change in the tax system is rather a redirection of this distortion, a change of who is affected positively and negatively but not the removal of negative effects in itself. But as long as distortion of the tax system exists why not to treat this redirection identically to the direct susbidies? It expresses preferences just as subsidies do, it forms obstacles in the development of certain industries - some of them would be in a more advantageous position without the taxation - while offering more favorable conditions for others. 

Beyond these rather general considerations one can also ask whether tax modifications inside the EU can be justified? Even if one would argue that there are more market friendly and less market friendly tax systems and therefore modifications of the system reducing distortion can be designed (and it would be a serious counterargument to the above line of reasoning) it wouldn't eliminate a twofold problem inside a perceived common, single market, like the EU. Firstly, as even this counterargument would accept the possibility of tax modifications with negative effect on the economy (and serving as indirect subsidies), every single step would have to be judged individually from this perspective. Even though a common framework of taxation exists its effects are rather moderate, well reflected in the diversity of VAT system, even if the EU regulations set - nominally - a very strict limitations on their variations. But another problem - already tackled in one of my previous posts - persists: whether modification of the tax system is acceptable at all in a common and single market as the EU is usually seen? 

Every member state became a member of the economic community with a given architecture of its own national economy - brought in line with a set of regulations of the community - and joined this peculiar organization while it also had its own internal economic architecture. As soon as the integration was carried out - for example derogations were phased out - it was perceived to be part of this single common market. How far unilateral modifications of this internal architecture can be acceptable and when does this activity start to be contradicting to the idea of fair competition? The treaties are rather silent in this regard. They identify a series of fields were larger unity and conformity of the member states is expected an others were it is not desired rather arbitrarily? Why is it an aim of the EU to form a currency union - theoretically leaving no opt out for anyone - while tax systems are considered as almost exclusive territories of responsibility of national governments? It inconsequential at best. If the union is a given common market than every single unilateral deviation from the pre-existing conditions should be treated not only in the context of the respective member state, but in the context of the union as a whole. Favoring ones own country can be disadvantageous for others and such moves are considered as contrary to the idea of the common market in many cases. Why not in the case of taxes? Even in the case of tax cuts? Anyway, individual companies made decisions earlier according to given conditions and a deliberate change in these conditions undermine their reasoning, resulting in very real disadvantages that could not have been presumed.

Unfortunately not only the existence of the EU makes the practice of constant tax cuts a bit dubious from the perspective of a common market. Tax cuts can be interpreted as very direct subsidies for companies and their owners in the context of the difference between financial markets and investment into production sectors too. One of the reasons of the financial investments stronger appeal compared to investment into production (noteworthy is the growing share of financial companies from the GDP of the US in the last two decades) was the higher return on these asset classes. Seen from this angle tax cuts or tax rebates for companies are nothing else than premiums on this investment to make it competitive and attractive enough. But in essence it is the same as giving direct subsidies. The state gives public money to private companies in order to counter market forces' effect on their activity. Moreover, to the extent this assumption is true even the perceived results of such tax cuts and advantages - more investment in the private sector because of the higher return - can be questionable. If the tax advantage is just an investment premium to complement profit it is not certain that the additional income will be used this way. 

However, the matter seems to be complicated by the possibility to trade shares of individual companies on the markets. The rates of these shares are usually seen as a good reflection of their real market value, based on their activity. therefore on their real return in the form of excepted dividends. But it is not necessarily the case, it is an epistemological problem. Shares are traded as if they would reflect real activity, but it is not necessarily the case. In many individual cases it turned out that the company was capable to deceive the markets. (Remember the Enron.) Sometimes it is even beyond the individual companies and whole systems can fall victim of such practices, like the banking systems in Spain or ECE today, with their huge mortgages not written off or reduced to their real value (expectable return) rather kept overvalued in their books. In any case the possibility that the markets has only a chance to follow developments in companies and react to them with a lag - despite every kind of sophisticated means to evaluate their performances - because ultimately they have to rely on information supplied by those companies. And even if the markets are seemingly following real developments there is always a chance that their reaction is exagerrated. Who can really decide whether the volatility of oil prices in he last two-three years properly reflected the supply and demand and was not distorted by "speculation", the actions of market actors who only trade with virtual oil?

As long as the markets can rely on money creation in order to acquire different assets and trade them the very existence of the capability of banks to create money consists the chance to drive a bubble, completely distorting prices, dissociating them from "real return". And the same bubble devalues the investment in other sectors than the financial. And if the rising stocks themselves provides return for investors - thorugh derivatives, transactions like swaps etc. - not the dividend of companies, making the relationship between real activity and investment return even loser. As long as this situation exists, investing otherwise is crazy, making such premiums as tax cuts inevitable to attract capital. 

A logical solution would seem a regulatory drive making financial assets less alluring and redirecting capital to other sectors. It would necessarily mean a devaluation of financial assets as well, because the expected return on them would immediately decline making their present value lower. Unfortunately it would mean a devaluation of those funds that will finance the pensions of the next generations, the life insurances of individuals etc. On the other hand one have to face the reality: if the growth of financial markets in the last years was the result of a bubble than excess liquidity has to exist in the system. Up to this moment this excess liquidity was not removed, rather moved between different entities. Central banks and governments stepped in and took over private debt (one of the embodiments of this excess liquidity) and transformed it to public debt. But it is not elimination. Could it be seriously hoped that the problems would be resolved without its removal from the system? At the moment the solution preferred by markets seems to be fiscal austerity, cutting wages (but not reducing the debt covered by those very wages) and prices not only in order to generate growth through export, but in order to reduce the public debt that was grown substantially by the takeover of private debt. The issue is whether it is the optimal solution in terms of distributing the pain between social actors (as there is hardly any painless way to resolve the problems) or inflation, restructuring and other alternatives would offer socially more acceptable ways out of this mire. It certainly deserves wise judgment and a broader horizon than that of the "experts" and "analysts". Unfortunately even broader than the horizon of the usual politicians.

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