« CD WOW | Main | Chris Dillow in The Times »

May 30, 2007

Misunderstanding Ricardo

Err, no:

Tax havens warp the foundations of market capitalism. David Ricardo's theory of comparative advantage says that production should gravitate towards geographically relevant areas: cheap manufactures come from China and France or Chile produce fine wines. But now we have thousands of companies operating from one building in the Cayman Islands, and a former Thai prime minister avoids paying tax on a $1.9bn sale through a British Virgin Islands company called Ample Rich Investments. Small wonder that people lack confidence in the global economy.

While Ricardo and others may indeed have used geographically relevant areas as examples, props for the structure of their arguments, comparative advantage does not depend upon them. It is the totality of the factors of production, of all the natural endowments, the learnt skills, the knowledge and yes, the regualtory and tax regimes, which lead to such advantages.  Tax havens arenot a warping of this, they're a natural reaction to the imposts placed upon economic activity.

Whether we call it tax avoidance or tax evasion, this is also a little odd:

Worse, it destroys wealth and slows growth.

That depends actually. If the money which has avoided (or evaded) tax is put to better use than the government which didn't get it would have done, then it increases wealth and speeds growth. If put to a worse one, then it does indeed destroy wealth and slow growth.

We can all think of examples on either side: a State with insufficient funds to ensure property rights and the rule of law (and the capacity and desire to enforce them if they had such money, not necessarily a given) could indeed speed growth and wealth creation by having that cash. One spending it upon the President's Palace might well not.  On the other side, this money that avoids or evades tax does not simply sit in some offshore lock box. It is, as the author suggests, recycled into other investments which do indeed increase wealth and speed growth.

Which does more is an empirical question, one with clear extremes and a lot of grey areas (according to your and my personal prejudices Bayesian Priors aboutthe efficacy of governmental versus market spending) in between.

We face uncomfortable questions and tensions. Company directors feel under pressure to minimise taxes, but tax is a vital contribution to society, and it is offshore where this all goes wrong, and where our queasy feelings originate.

Britain must abandon its anachronistic domicile rules and end its underhand games to eviscerate the EU's savings tax directive. We should push to reform international accounting standards so that companies must report on a country-by-country basis, at a stroke potentially producing more benefits for the world than a hundred billion dollars in annual foreign aid. But to win the battle against the cancer of tax havens will require much greater commitment to international cooperation, founded on a push for greater transparency. Global debate on these issues is long overdue. New branches of economics are required, asking questions such as how certain aspects of global financial and trade liberalisation foster criminogenic, corrupting environments.

No, the answer is to abolish corporation tax. As only individuals can, in the end, pay tax, tax individuals not companies and do away with the whole structure.
 

May 30, 2007 in Trade | Permalink

TrackBack

TrackBack URL for this entry:
http://www.typepad.com/services/trackback/6a00d8341c2d3e53ef00d8357fb55369e2

Listed below are links to weblogs that reference Misunderstanding Ricardo:

Comments

We ought to get rid of VAT (£80 bn) and Employer's NI (£40bn) before we even start think about reducing or getting rid of corporation tax (£50 bn).

Very few companies go out of business because of corporation tax, there are plenty of loss making companies that would be profitable if there were no VAT or Employer's NI (which have to be paid whether you are making profits or not).

Besides, the Goblin King ran an experiment exempting the first £10,000 of profits from corporation tax and there was of course massive evasion and so this was scrapped again.

Posted by: Mark Wadsworth | May 30, 2007 10:11:57 AM

"David Ricardo's theory of comparative advantage says that production should gravitate towards geographically relevant areas: cheap manufactures come from China and France or Chile produce fine wines.". Ignorant pillock - Ricardo (and Torrens before him) said something infinitely subtler and more interesting. But it takes five minutes to understand, so it's not for the Nurdgaia. Wikipedia is OK on said theory.

Posted by: dearieme | May 30, 2007 10:24:09 AM

>tax is a vital contribution to society

A tax of 10% of income is perhaps vital. App. 40% certainly isn't.

Posted by: Blithering Bunny | May 30, 2007 10:26:22 AM

"there are plenty of loss making companies that would be profitable if there were no VAT or Employer's NI (which have to be paid whether you are making profits or not)."

VAT is paid by individuals but collected by companies. No company is tipped into losses by VAT.

Employer's NI is, on the other hand, very nasty. A tax on economic activity that does often tip a company over the edge into losses (and sometimes then into bankruptcy).

Posted by: Kay Tie | May 30, 2007 11:04:39 AM

Kay Tie, a barrister told me recently that when he worked in insolvency, the largest creditor was usually HMRC - either VAT or Employer's NIC. That's the practice.

As to the theory, if you don't accept that businesses are forced into losses by VAT, just draw yourself a little supply/demand chart, then draw a new supply curve a bit higher up to reflect the VAT and then think about what has just happened to gross output.

The legal fiction that consumers pay VAT and companies just collect it, or that Employer's NI is borne solely by employers is of course just fiction.

Posted by: Mark Wadsworth | May 30, 2007 11:12:53 AM

"Kay Tie, a barrister told me recently that when he worked in insolvency, the largest creditor was usually HMRC - either VAT or Employer's NIC. That's the practice."

Oh yes, of course. That's because there's a demand for cash, the cash can't be produced, and so they kick the doors in. But losses are not produced by cash flow: they are produced by accruals of costs exceeding accruals of revenues. VAT never makes it on to the P&L because it is a cash flow issue only (albeit with severe consequences for getting it wrong).

As to the argument that VAT causes a business losses because it affects elastic demand, well, you might as well argue that the £/$ exchange rate is a tax on the same basis.

Employer's NICs are, however, a direct tax on a company's operations, not on profits. As such they are highly damaging to a business that isn't making much revenue and can terminate the business prematurely. I do most of my work in hand-to-mouth start-ups on the VC treadmill and it is desperately depressing to see 11% of the salary bill go into the grasping hands of the Revenue when the business is loss making and desperately trying to claw its way up the greasy pole to profitability. All start-ups that fail have at least a few nails in the coffin hammered in by employer's NICs.

Posted by: Kay Tie | May 30, 2007 11:30:23 AM

However, VAT collection and accounting does impose a cost on new businesses. It'd be nice if that cost of doing business could be eliminated.

Tim adds: Worth noting that VAT collected is often used as a source of working capital for young businesses. You collect it now and pay to HMT in 90 days or so....and you can stretch that to 180 very easily.

Posted by: Marcin Tustin | May 30, 2007 11:37:09 AM

Kay Tie, glad we agree on Employer's NIC at least.

"As to the argument that VAT causes a business losses because it affects elastic demand, well, you might as well argue that the £/$ exchange rate is a tax on the same basis."

Why would I argue the latter? What's that got to do with it?

Even if, in a perfect world, all businesses forecast correctly and none ever go bankrupt, it is a plain and simple fact that turnover taxes reduce consumption/production (which in the case of tobacco, alcohol & petrol might be A Good Thing). So conversley, if we phased out VAT, there's be more people doing more stuff and prices would come down and there'd be more jobs etc.

I like your example of loss making businesses having to pay NIC, that is my whole point, loss making businesses have to pay VAT as well, let's not pretend that the consumer bears the cost (I guess in economic terms that VAT is split 50/50 between producer and consumer).

Posted by: Mark Wadsworth | May 30, 2007 11:55:00 AM

"Why would I argue the latter? What's that got to do with it?"

Exchange rates suppress demand too. The £ rises, you can't export because your $ prices have risen. Something forcing your $ prices up with no gain to you is just like a consumption tax.

"So conversley, if we phased out VAT, there's be more people doing more stuff and prices would come down and there'd be more jobs etc."

Yes, assuming the overall tax take reduces as well. But if the tax just gets shifted to income tax (for example) then it doesn't change consumption much (OK, so it changes the distribution of winners and losers).

The theory of the shift to indirect taxes (apart from the pseudo-moral one of thrift) is that it is harder to evade indirect taxes. That was before carousel fraud was invented..

"loss making businesses have to pay VAT as well"

No, a business never pays more VAT than it collects in. As Tim points out, there's even an interest-free loan aspect to it (unless you are a net reclaimer of VAT).

Posted by: Kay Tie | May 30, 2007 12:19:02 PM

"loss making businesses have to pay VAT as well"

Kay Tie, let's take one of your start ups, it might have salary costs £100,000 and sales in first year or two of £50,000 (assume no other costs).

So although it is making a loss of £50,000, it has to pay £8,750 VAT and £8,000-odd in NIC. (Sure, if its customers are VAT registered traders, the VAT flows through, different topic)

Sounds like a recipe for disaster to me.

I am mulling over an idea that start ups are allowed to offset corporation tax losses against taxable salaries, so at end of year, the start up from above gets a refund of half the PAYE it paid (so a company pays no more in corp tax plus PAYE than a partnership would have paid in income tax, assuming all the employees were salaried partners).

Posted by: Mark Wadsworth | May 30, 2007 12:35:15 PM

VAT at 17.5% is applied to the gross sales of £50,000 giving £58,750 (as you imply). The extra £8,750 sits in a bank account until given to the Revenue (you have assumed no other costs and hence no input VAT). Note that the sales (and losses) are calculated on gross values.

"I am mulling over an idea that start ups are allowed to offset corporation tax losses against taxable salaries"

That's kind what the R&D tax credits do. OK, so it's not open to all companies, and there are so many controlling hoops to jump through it's a real pain to claim, but you can surrender losses for a cash payment from the Revenue, capped at the PAYE paid.

I like your idea better (why is there anything inherently good about R&D compared to investing in advertising or plant, for example?). But it is open to abuse (because losses are so easy to manufacture) and the Revenue would have to be smart about patrolling it - something they've shown little aptitude for in VAT, income tax credits, etc.

Posted by: Kay Tie | May 30, 2007 12:59:25 PM

Agreed, R&D tax credits are shit and will go. Scrapping Er's NI gets the net cost down to slightly less anyway -

Worked examples:-
1) Large company pays £100 salary plus £12.80 Employer’s NI and claims extra tax relief at 30% on 25% x £112.80; the R&D rebate is £8.46, £4.34 less than the NI paid.
2) Small company claims extra relief at 19% on 50% x £112.80, so gets R&D rebate of £10.72, again less than the Employer’s NI.

I am reassured that you like my idea, don't worry about avoidance, this system works for partners' salaries, no fundamental reason why it shouldn;t work here.

Posted by: Mark Wadsworth | May 30, 2007 1:40:05 PM

Actually, that was daft example, at £50,000 (assuming your customers are not VAT-registered) you wouldn't bother registering for VAT.

But then, in year two, let's say that sales go up to £70,000 (just over registration threshold) and the start up then has to charge VAT (assuming it knows of increase at start of year etc).

Can it cheerfully put its prices up by 17.5%? Are the customers suddenly happy to pay 17.5% higher prices? That's a heck of a lot.

In truth, the VAT burden is shared between start up and customers, maybe the start up hikes gross prices by 9% and takes the rest on the chin. Don't tell me that doesn't eat into profits.

Posted by: Mark Wadsworth | May 30, 2007 2:23:14 PM

As Mark points out the implementation of VAT cut-in is a dreadful bind just as tiny companies are beginning to move forward.

Even if you push it out to 10x that amount, the cut-over is still a mess. If you want to avoid the shock, it needs to be from 0.

Begs the question if the entire mechanism and concept of VAT is not a dogs breakfast.

If companies are taxed on turnover and that B2B transactions can be offset against that claim of turnover then the admin would be simpler and no cut over point.

Arg! Taxing turnover! Well, VAT is basically doing just that but that the State gets first dibbs. At least this way, you avoid the "what have you missed" VAT man claim to the company asking "what have we not offset?". This way you halve the admin (you still need to account B2B in VAT land due to claiming BACK the VAT).

Posted by: Roger Thornhill | May 31, 2007 2:17:23 PM

Actually, the above could be seen as just a matter of nauance.

Posted by: Roger Thornhill | May 31, 2007 2:20:40 PM