Normative Narratives


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Economic Outlook: Financial Flows,Taxation, and Accountability

The primary function of taxation is to collect revenue to pay for public goods and services. Public goods and services are non-rival and non-excludable, they therefore often suffer from a “free-rider problem” (people benefit from the positive externalities regardless of whether they pay into the cost of the good or not). It is because of this free-rider problem that the private sector cannot efficiently provide public goods, necessitating what is sometimes referred to as the “social contract” between people and their governments (I will give up something, in this case money via taxation, in order to have certain publicly provided provisions). Examples of public goods are basic infrastructure (such as roads), and public services (such as police officers, firefighters, and public school teachers). 

Individual countries decide for themselves at what level taxes should be set, and what should be provided for via taxation. Individual countries also decide to what extent taxes should be progressive or flat. But across the world, in societies as fundamentally different as you can imagine, this general “social contract” relationship exists. Taxes also provide resources for social safety-net programs, which are important for inter-generational income smoothing, social mobility, and reducing inequalities (despite the “47% argument”)

Taxes can also be used for legitimizing purposes. Every modern country has tax collection and income monitoring services (performing similar functions as the IRS in America). One of the major functions of these organizations is ensuring that everyone pays what they are supposed to. A secondary function is to provide legitimacy to ones income; if someone claims large amounts of money with a questionable source, it will raise a red flag, and an investigation will ensue (if the system is working properly).

Taxes can also be used to influence ones behavior. The tax on cigarettes in NY is a good example of this. While the government cannot stop people from smoking, they can make it prohibitively expensive to smoke in hopes that people pursue healthier activities.

These are just some of the general functions of taxation.

As we know here at NN, not everyone plays by the rules, particularly when it comes to taxation. Offshore banking is a huge problem, perpetuating income inequality,  human rights abuses, and robbing governments of resources to fulfill their obligations. Some countries systematically provide rock-bottom tax rates and legitimacy for depositors without properly vetting the source of their money, leading to destabilizing financial inflows that dwarf the countries annual output (Cyprus is the most recent example you may remember).

As governments face difficult choices in the wake of the Great Recession, it has become more and more obvious that greater coordination and accountability are needed between countries to ensure that the world’s wealthiest pay their fair share for the public goods and services that have helped them to amass their wealth (and are held accountable for their role in the Great Recession).

The silver-lining of the Great Recession is that much more focus has been put on destabilizing forces that have accompanied financial globalization (and more recently technological advances which have made high speed / arbitrage seeking investment all the more possible). One example of this is the breaking of secrecy by Swiss Banks. Swiss Accounts are arguably the most famous example of elite tax-evasion; their exposure serves as a symbolic as well as practical turning point in offshore banking history. Another example is the imposition of a financial transaction tax (FTT), even if it has been watered down for now.

Swiss Banking:

“The Swiss government said on Wednesday that it would allow its banks to disclose information on American clients with hidden accounts, a watershed move intended to help resolve a long-running dispute with the United States over tax evasion.

The decision, which comes amid widening scrutiny in Europe of tax havens, is a turning point in what has been an escalating conflict between Switzerland and the United States.

Eveline Widmer-Schlumpf, Switzerland’s finance minister, said the move would enable Swiss banks to accept an offer by the United States government to hand over broad client details and pay fines in exchange for a promise by United States authorities not to indict any banks.”

“Ms. Widmer-Schlumpf declined to say how much banks might have to pay. But she said the Swiss government would not make any payments as part of the agreement. Sources briefed on the matter say the total fines could eventually total $7 billion to $10 billion, and that to ease any financial pressure on the banks, the Swiss government might advance the sums and then seek reimbursement.

“It is important for us to be able to let the past be the past,” Ms. Widmer-Schlumpf said at a news briefing in Bern, Switzerland. She declined to give any details about the program, but said banks would have one year to decide whether to accept the American offer.

American clients whose names are handed over by Swiss banks but who have not voluntarily disclosed hidden accounts to the Internal Revenue Service would probably face criminal tax-evasion charges, lawyers said. Dozens of Americans have been indicted or charged in recent years for failing to disclose their accounts.”

Calling the decision ‘a good, a pragmatic solution for the banks to emerge from their past,’ Ms. Widmer-Schlumpf said, ‘We expect this to create the base for banks to again gain some room for maneuver so that calm can return to the sector.’”

“‘This is an important step for the banks; it will apparently allow them to disclose statistical information, such as the number of accounts with U.S. beneficial owners, the number of accounts with foreign corporations or foundations, and the amount of assets under management,’ said Scott Michel, a tax lawyer in Washington, D.C. ‘The I.R.S. and D.O.J. can use this information as the basis for financial penalties under settlement agreements, which might be deferred-prosecution agreements or non-prosecution agreements.’”

It seems Switzerland wants to shed it’s stigma of an off-shore tax haven, and move forward with a more sustainable and transparent financial sector.

“‘Resolution of the conflict ‘has taken longer than it should have, with a lot of otherwise avoidable damage suffered on the Swiss side,’ said Robert Katzberg, a white-collar criminal defense lawyer in New York with Swiss and American bank clients. ‘But it now appears the end is in sight.’”

Financial Transaction Tax: It is no secret that irresponsible lending practices perpetuated financial bubbles around the world which eventually led to the Great Recession. One way of holding financial institutions responsible for their role in the Great Recession, while also raising revenue governments desperately need, is a financial transaction tax (FTT). CESR is a great resource for background info on the financial sectors role and human rights implication of The Great Recession, as well as the FTT.

A recent NYT article is critical of a watered down FTT in the works in Europe. While I agree it is disappointing the tax has been significantly reduced, the introduction of any FTT is a movement in the right direction. An incremental approach may be the best way to introduce this important new policy, and give it a real chance to work (instead of leading to large-scale capital flight to non-FTT countries):

“European countries planning a tax on financial transactions are set to drastically scale back the levy, cutting the charge by as much as 90 percent and delaying its full roll-out for years, in what would be a major victory for banks.

“Under the latest model, the standard rate for trading bonds and shares could drop to just 0.01 percent of the value of a deal, from 0.1 percent in an original blueprint drafted by Brussels. That would raise only about 3.5 billion euros, rather than the 35 billion initially forecast, a senior official said.”

“The tax may now also be introduced more gradually: rather than applying to trades in stocks, bonds and some derivatives from 2014, it may apply next year only to shares. Bond trades would not be taxed for two years and derivatives even later.

The roll-out could be scrapped altogether if, for example, the tax pushed traders to move deals abroad to avoid paying it.”

“The Financial Transaction Tax (FTT) resurrects an idea first conceived by U.S. economist James Tobin more than 40 years ago and has been symbolically important for politicians to show they are tackling the banks blamed for causing the financial crisis.”

‘You can introduce it on a staggered basis,’ said a second official. ‘We start with the lowest rate of tax (0.01 percent) and increase it bit by bit.'”

“‘The risk is that if you have some countries not participating, you have some shift of business from the countries in the tax to the countries without the tax,’ said one official, familiar with French government thinking. ‘This step by step approach can make sense.’

There is also the issue of which financial assets should be included in the proposed FTT:

“Within the group of 11 countries, Italy and France have expressed concerns about widening the tax beyond shares to government debt as both believe it could discourage investors from buying their bonds.”

I agree with Italy and France on this issue. The main reason many Euro countries are facing such crippling austerity is due to a “sovereign debt crisis“. These countries cannot afford to borrow sustainably, forcing them to make painful cuts which have led to a double-dip recession and high unemployment throughout Europe.

The FTT could potentially add to the borrow costs governments face if it included bonds as well. If however, a tax included everything except bonds, it would have the effect of lowering government borrowing costs. Making other financial transactions more expensive would make bond purchases more profitable by comparison (assuming financial institutions will pass on some portion of the tax to the customer, which is a pretty safe assumption). While the difference would be marginal, even a marginal decrease in borrowing costs can unlock millions if not billions in government resources.

What we see is the international community slowly working to make financial globalization more accountable and sustainable. While we may be frustrated with the slow rate of progress (as the author of the NYT article clearly is), it is important to realize that we are making meaningful progress.

Despite the political and economic cynics out there, who in their great “wisdom” will tell you nothing is happening to hold powerful interests accountable for their role in the financial crisis, we have as a global community learned lessons (albeit incredibly hard learned lessons) and are taking steps to ensure we do not repeat our past mistakes.

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Economic Outlook: The Ripeness of Cyprus


That ripeness refers to the need for Cyprus to diversify it’s economy. Ripeness may not be the right word, as Cyprus is not willingly taking these measures but rather having them imposed, but what else rhymes with Cyprus? (Lack of ripeness, like with this peach, is often a good indicator it is time to throw out said peach, no?)

“Cyprus has a huge banking system — assets around 8 times GDP — based on a business model of attracting offshore money with high rates and good opportunities for tax avoidance/evasion.”

The problem with such a large banking sector is that it creates asset bubbles and leads to  a loss of competitiveness in other sectors. As Cyprus now faces the inevitability of having to diversify its economy away from the banking sector, it faces the difficulty of having wages that are uncompetitive with the rest of its neighbors. It is difficult to be competitive in export industries with a high cost of labor and a high cost of living, as these costs ultimately fall on producers making their goods less competitive. A high cost of living also depresses tourism, as people will choose to go to cheaper destinations.

Transitioning to export based growth is tough in today’s economic conditions, even when labor costs constitute a comparative advantage. This is due to a slump in global aggregate demand, particularly with Cyprus’s current trading partners—EU countries. The EU remains mired with high unemployment and recessions (which are currently hitting Cyprus particularly hard as well), meaning that finding markets for diversified exports would be difficult. The high unemployment (14.7%) and recession conditions (-3.3% GDP growth Q4 2012) mean that Cyprus cannot rely on its domestic markets to buy its goods either.

For these reasons, Cyprus has been reluctant to admit that it must abandon its unsustainable reliance on the financial sector. Cyprus tried to secure an EU bailout by imposing a tax on banking deposits—a measure that Cypriots forcefully rejected. It seems that ultimately Cyprus will have to agree to spare small depositors (average citizens) and force large depositors (who are often foreigners who go to Cyprus as a tax haven) to take a large “haircut”. This would undermine confidence in Cyprus’s banking sector, leading to capital flight.

Cyprus could impose capital controls to prevent capital flight, as Iceland did in a similar situation. This, along with uncertainty of Cyprus’s future in the EU, could mean less FDI (uncertainty is a huge deterrent to investment, especially in the case of a potential EU-exit) which Cyprus will need to diversify its economy due to high levels of debt (84% GDP as of Q3 2012) and high borrowing costs (7% interest rates on long term bonds).

Cyprus is currently at a crossroads, a point summarized nicely by Paul Murphy at FT Alphaville:

“Big depositors in Cypriot banks stand to lose circa 40 per cent of their money here, which has drawn plenty of fury and veiled threats from Russia.”

“Cyprus now has a binary choice: become a gimp state for Russian gangsta finance, or turn fully towards Europe, close down much of its shady banking sector and rebuild its economy on something more sustainable.”

So how are Cyprus’s prospects for economic diversification? Actually, this is a potential bright spot in an otherwise dismal picture (for data, see end of the post):

Cyprus has increased its spending, per person, at all levels of schooling over recent years. There has also been a shift to more advanced technological manufacturing, which could be a growth industry (High-technology exports as % of manufactured exports have risen from around 4% in 1990 to close to 40% in 2010). Energy production, specifically a natural gas field adjoining the Cyprus-Israel border, has been discussed as a potential growth sector.

The problem is such exploration requires large upfront costs and profits will not be realized for at least a few years. Given Cyprus’s high borrowing costs, an immediate bailout is needed—Cyprus simply cannot afford to wait for its economy to diversify, even if it was able to secure the funding needed explore it’s gas fields and / or avoid a Euro Zone exit.

Luckily, Cyprus has been laying down the seeds of economic diversification, but those seeds are not ready to sprout. Economic diversification will be painful, based on the composition of Cyprus’s labor force (agriculture 8.5%, industry 20.5%, services 71% (2006 est.); presumably a large portion of people in the services sector work in financial services).

Compounding the problem; “There’s still a real estate bubble to implode, there’s still a huge problem of competitiveness (made worse because one major export industry, banking, has just gone to meet its maker), and the bailout will leave Cyprus with Greek-level sovereign debt.”

Cyprus needs the troika (IMF, ECB, and EC) to provide emergency liquidity to allow its economy time to diversify. There will inevitably be some growing pains—hopefully harsh austerity is not imposed as a condition for receiving these loans, although recent history suggests it will be. Some internal devaluation will be needed to make Cypriot wages competitive again—something that is politically and socially undesirable (as wages tend to be “sticky”) but an inevitable consequence of losing control of monetary autonomy (being in the EU, Cyprus cannot devalue it’s currency to increase export competitiveness)

Cyprus has been investing in human capital, and already has the infrastructure for export based growth through its advanced system of ports, what is needed is stimulus spending to help mobilize Cyprus’s factors of production away from the financial sector.

Just like a child who knows he must do something he doesn’t want to do, Cyprus initially faced it’s unfortunate reality by trying to return to its security blanket—the financial sector. Ultimately, Cyprus needs to be weaned off the teat of the financial sector—even Russia, the biggest loser if large depositors take a loss, has stated it will not extend financing to Cyprus until it secures troika financing (Cyprus pursued Russian financing as an alternative to a troika bailout, presumably to allow it continue with its unsustainable banking practices, in exchange for preferential exploration rights by Russian firms of Cyprus’s natural gas fields. These talks thankfully did not bear fruit, as they would’ve moved Cyprus in the wrong direction; doubling down on an unsustainable financial sector while compromising its most obvious means of economic diversification–it’s natural gas reserves).

It is important to avoid a Euro Zone exit, as this would undermine investor confidence which is needed alongside troika loans to allow Cyprus to diversify its economy. Ultimately, investors will react favorably if Cyprus admits its financial sector is unsustainable and commits to economic diversification. A sustainable economic outlook will attract investment, especially in an industry as profitable a natural gas exploration, but also in other sectors due to low taxes (10% corporate tax rate in Cyprus–lowest in the EU, can help offset the current high wages in Cyprus and temper the social costs of internal devaluation).

Uncertainty and trying to hold onto an exposed unsustainable financial sector will drive away investors. Everybody can now see that Cyprus will have to force a “haircut” on large depositors. The sooner Cyprus “takes its medicine”, the sooner it can get on the path to sustainable economic development.

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