Normative Narratives

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With Tax Reform, America Must Go “Back to the Future”

Tax reform is not “sexy”, there is no getting around this fact. It is, however, a very important issue, as every government program is funded either by tax dollars or debt. While the specifics of tax policy may be difficult to comprehend, almost everyone has their own beliefs on taxation and the role of government.

Looking at these preferences, the majority of Americans believe the government does not do enough to help poor and middle class people. Relatedly, a full three quarters of Americans feel that the wealthy aren’t paying their fair share of taxes.

Against this backdrop, lets consider Trump’s tax proposal:

  • Fewer tax brackets at lower rates for the wealthiest. The plan sets three tax brackets for individuals — 12 percent, 25 percent and 35 percent — down from the existing seven rates (which top out at 39.6 percent).
  • Lowering the corporate tax rate from 35 to 20%. While our corporate tax rate is too high, due to loopholes the actual rate paid is much lower (particularly for large corporations who can afford the best lobbyists, lawyers, and accountants). Based on actual taxes paid, the U.S. ranks comparatively low among developed countries. The corporate tax rate should only be lowered if the revenue lost if offset by closing the right loopholes. Trump has not specified which loopholes, if any, he plans to close.
  • Cutting the “pass-through” tax rate, which is what individuals who file their corporate earnings as personal income pay, from the current highest income tax rate of 39.6% to 25%. This rate cut would almost exclusively benefit the wealthy, and is one to watch closely-in recent years more and more businesses have begun filing as “pass-throughs” in order to minimize their tax bill.
  • Repeal of the alternative minimum tax, which is essentially in place to ensure wealthy people pay a certain minimum amount as they use their accountants to game the tax code. But it will make the tax code fit on a post card! And thats what matters!
  • A lowering an eventual repeal of the inheritance tax, which is only paid on the largest estates. This is being billed as a move to help family farmers, which is an audacious spin of the issue to be sure.
  • Trump’s plan has been light on details about capital gains taxes. However, there is nothing to suggest his financier-stacked Cabinet (Mnuchin, Cohn) will want to do anything but lower these rates as well.

All these proposed ideas would reduce taxes paid by the wealthy, compromising the government’s ability to further help poor and middle class people. So the question is, if these ideas are so unpopular, how is Trump selling them to the American public?

For some, it is enough to say that lower taxes will promote growth, increase employment, and pay for themselves. People who drink this “supply-side” Cool-Aid are outliers, and notably the vast majority of economists disagree with these claims. But remember, we are talking about many of the same people who disagree with 97% of climate scientists on climate change, so this is actually a consistent (if not irrational) repudiation of “experts”.

Most reasonable people, however, believe what the overwhelming majority of experts in a field conclude. For these people, support for Trump’s plan likely comes from being told they will receive a “massive” tax cut. But when you look at it, the “massive” cuts in Trump’s plan are reserved for those with the highest incomes.

Consider the distribution of income tax cuts, as shown on the table below. 77% of the cuts go to people earning more than $143,100 a year. That is hardly the “middle class”.

It’s more of the same when it comes to corporate tax cuts. According to the nonpartisan Tax Policy Center, “middle-income taxpayers would receive less than 10 percent of the benefit of a corporate rate cut while the top 20 percent would receive about 70 percent. The top 1 percent would see about one-third of the benefits and the top 0.1 percent would get about one-fifth.”

Trump’s plan would increase our national debt by well over a trillion dollars. The IMF has warned the plan will increase inequality and will not lead to higher growth. Wall Street is betting it will lead to greater investments in automation, not workers. The Fed has even waded into the debate to issue a rare warning, saying the proposed plan could lead to high inflation.

For all these negatives, middle class earners will only get a small tax cut, if that. Treasury Secretary Mnuchin admitted some middle class earners may not get any cut at all. This is coming from the man who also said it is “hard to create a system where you’re not going to also cut taxes on the top 10 percent“. Maybe if you are a derisive elitist with zero consideration for societal well-being, who has no business governing, it is difficult to imagine not cutting taxes for the wealthy. For most people, it is extremely easy to imagine.

So Trump’s plan is unpopular, and those who support it are either irrational, have been misled, or are wealthy and likely to benefit personally. Just like with healthcare, the GOP has no tax reform plan that works for the vast majority of Americans; hopefully its tax reform efforts will meet a similar defeat.

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The Case for Higher Top Rates

Remember, Trump’s plan sets three tax brackets for individuals, down from the existing seven. While the U.S. tax code has become overly complicated due to deductions and loopholes, the complicating factor is not the number of income tax brackets. Like any misdiagnosis, reducing the number of tax brackets would not solve any problems, and would likely make the situation worse.

Republicans in Congress plan on including a fourth higher bracket in their proposal, but this is not enough. There should be even higher brackets and rates for people with 7 and 8 digit incomes.

After a certain point, the higher your income, the less it is connected to working harder, and the more it is related to the risks one takes and the carefully constructed, trade-based global economy in which we operate (infrastructure, government R&D, international peace and trade rules, strong judicial systems, educated workforces, relatively prosperous customer bases, etc.). Notably these characteristics are all, to varying degrees, financed by tax revenue. 

I can already hear people moaning at this point and calling me a socialist, so allow me to clarify with an example. Take someone who manufactures clothing. Decades ago, the owner of this company would more or less be constrained to selling his or her goods domestically. Despite working very hard, their overall earnings were capped (at least by today’s standards). Today, the same person, putting in the same amount of work, can sell their goods all over the world through the internet, earning a lot more money. The work these two owners from different eras put in is roughly equivalent, but the modern day entrepreneur can potentially earn a lot more. In fact, this is half of the story of increasing extreme global inequality.

What about my other point, about these systems being financed to varying degrees by tax revenue? Well this is certainly true of the internet (whose origins were in defense research). It is also true of all of the spending that promotes international peace and fair trade practices (defense spending, development aid, contributions to international organizations like the WTO, etc.).

While the risks people take should be rewarded, the context in which wealth is earned should not be ignored. This is not to say “you didn’t build it” or “you didn’t work hard”, it is simply acknowledging that outside factors play a role in how much wealth one can amass. Ignoring this reality does not make it go away, but it does risk underinvesting in making sure it continues into the future.

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A Quick Lesson on Marginal Tax Rates

I think that much of the opposition to higher tax brackets comes from misunderstanding how marginal tax rates work. When you enter a higher bracket, only the amount you earn over the higher threshold gets taxed at the higher rate.

Lets take a look at a hypothetical numerical example. If the rate below $100,000 is 20%, and the rate above is 30%, when a person earns their 100,001st dollar, only the amount over the threshold–the one dollar–is taxed at the higher 30% rate. The rest, the first $100,000, is still taxed at the lower 20% rate. People do not become poorer by moving into a higher tax bracket.

In recent history, before the Reagan era tax cuts, top income tax rates were around 50%. This seems like a reasonable number if not for its roundness and inherent fairness, but the exact optimal number of brackets and rates is not what’s most important. More important is recognition by people across the political spectrum that the wealthy must pay their fare share of taxes. Based on the survey results cited earlier, most people already do share this belief–it is well past time their elected representatives acted on it.

The tax code should be used neither to venerate the wealthy as infallible job creators, nor to vilify wealth so much as to stifle innovation. Simply put, the tax code must allow us to adequately invest in the very systems which enabled America to become the wealthiest nation in the world in the first place. Anything else is a short-sighted failure of governance.

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“Back to the Future” (With Some Help From Our Friends)

Trump’s base often talks about “Making America Great Again”. To a small minority, this is a thinly veiled embrace of our country’s racially charged past. To others, I’d like to think most people, making America “great” is about (re)creating an economy that rewards anyone who is willing to work hard.

So how can we make sure that, as a country, we can afford to make the investments needed to get back to this “Golden Age”? Not surprisingly, some of the answers lie in the past; America has historically had both more income tax brackets, and higher tax rates for top earners. These were the good old days many low-tax advocates are pining for!

There is nothing uniquely American about these higher historic rates either. According to the Organisation for Economic Co-operation and Development (OECD), “top personal income tax rates in rich nations had fallen to 35 percent in 2015 from an average of 62 percent in 1981.” To put a bow on an earlier point, this is the other half of the story of increasing extreme global inequality.

Now admittedly some things have changed in the past few decades. The rise of information technologies has led to irreversible changes in financial markets. When people can move their money around the world instantly with the click of a mouse, it is important to have some level tax coordination between countries in order to fight tax evasion (in its many forms). In today’s globalized world, countries and international institutions such as the OECD must work together to ensure the ultra-wealthy are not getting a free ride.

If America wants to be able to adequately invest in the very systems that made and continue to make it great, and if we want to be able to give working class people a tax cut without greatly increasing our national debt, we must hold the wealthiest Americans economically accountable.

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Update (12/1/17):

Some elements of the tax bill have changed since I originally wrote this blog, but these were marginal changes. At it’s core, this bill is still the regressive piece of legislation it always was.

According to the non-partisan Congressional Joint Committee on Taxation, even accounting for supposed growth this bill will “unleash”, it will still increase the deficit by 1 trillion dollars over the next decade. That shortfall will ultimately be paid for by reducing spending on popular government programs, and forestall the conversation on any new government programs (think education, healthcare, infrastructure). The only hope is that the Senate and House are unable to reconcile their bills and pass a unified one, but this is unlikely–if there is one thing most conservatives Congressmen believe in, it is making the rich richer and the poor poorer.

For all the talk of how damaging Trump has been to this country, taking a longer view he will ultimately be a flash in the pan. This tax bill, should it pass, would have a much larger negative impact on our country, ultimately leading to lower social mobility for decades to come. The last major tax overhaul persisted for over 30 years–this country (literally and figuratively) cannot afford to have this bill become our new tax code.

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Update (12/22):

The House and Senate reconciled their tax bills, with the final version being signed into law by President Trump. The only silver-lining is that this massively unpopular law may lead to a Democratic resurgence. However, Republicans will do their best, via repressive voting laws and gerrymandering, to stop this from happening.

The American people cannot afford this tax law on the books for a prolonged period of time.  It will leave us further in debt, while compromising our ability to further invest in our people and our infrastructure. We now turn to the 2018 and 2020 elections as a barometer for just how fed-up the American people are by the bait-and-switch “populism” of Trump and the GOP.

 

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Greece, Birthplace of Democracy, Needs A Democratic Lifeline

No More Blood From A Greek Stone:

It appears Greece’s government has come up with a list of reforms it and its creditors can agree upon in return for 4 months of bridge financing to restructure the conditions of a longer-term growth strategy.

By trading structural reforms for fiscal space, each major player (Greece and Germany) is making major concessions in the name of pragmatism. Germany is relaxing its dogmatic belief  in fiscal targets to provide the Greek government with the fiscal space needed to restructure its economy without exacerbating its “humanitarian crisis”. Greece, in return, must officially bring to an end the era of lax tax collection and over-rigidity in the labor market.

Both sides are making major concessions, neither side is 100% happy, and its appears as if middle ground has been found–all signs of a meaningful compromise. One can only hope that when Greece’s list of reforms comes in on Monday, both sides of this debate remain on the same page:

Greece’s list of reforms to be submitted to the euro zone on Monday comprises pledges on structural issues such as tax evasion and corruption over the next four months without specific targets, a government official said on Saturday.

The accord requires Greece to submit by Monday a letter to the Eurogroup listing all the policy measures it plans to take during the remainder of the bailout period.

If the European Commission, the European Central Bank and the International Monetary Fund are satisfied, the Eurogroup is likely to endorse the list in a teleconference without the need for a formal meeting. Then euro zone member states will need to ratify the extension, where necessary through their parliaments.

There will not be specific figures or targets to be achieved tied to the goals, the official said, adding that the two sides had not yet discussed how Greece would be evaluated on the reforms.

EU officials and euro zone ministers said they had no reason to think Greece would not come up with a satisfactory list of measures on Monday night. However, some hawkish countries have insisted that if there are doubts, the Eurogroup would have to reconvene in Brussels.

Structural reforms are inherently difficult to implement. In order to make the difficult task of taking on strong interest groups politically possible, an overwhelming popular mandate is needed. The need for strong public backing becomes even more important during times of high unemployment, when those lucky enough to remain employed are (quite rationally) more afraid of losing their jobs.

According to a recent opinion poll, 68% of Greeks want a “fair compromise” with the EU; even after years of economic suffering, the vast majority of Greeks remain steadfast in their believe in the E.U.. Such support must be seized upon, it will not last forever.

What Greece needs now is a pro-growth, structural reform based bailout plan, not a continuation of its failed blood-from-a-stone internal-devaluation based “recovery”. Reducing it’s primary surplus while collecting greater tax receipts would open up the fiscal space Greece needs to both deal with its humanitarian crisis and create a safety-net for those adversely affected by labor market reforms as the economy readjusts. 

The past 6 years have had a deep psycho-economic effect on the Greek people. With overall unemployment at 26% and youth unemployment at 50%, to go along with a 24% contraction in GDP, the Greek economy has been ravaged. Lack of control over monetary policy (as all members of the Eurozone face) has limited Greece’s policy space, it must be allowed to regain some control over fiscal policy.

Greeks have suffered enough and have learned their lessons–these next four months are an opportunity to prove it. In addition to any external monitoring imposed as part of this deal, the Greek people must prove they can be their own corruption watchdog and can pay their taxes.

Fighting wealthy tax evaders may be a popular political platform and merited on social justice grounds, but in order to pay-down Greek debt without compromising human development, a widespread cultural acceptance towards paying taxes is required. There is no doubt Greece has been too lax in collecting taxes in the past, but this does not need to be an irrevocable problem. Through legislative reform and social accountability, Greece can overcome it’s culture of tax evasion.

Locking in long-term labor market reforms, without driving more people into poverty and exacerbating the “lost generation” of young Greeks, should be the mutual goal between Greece and it’s creditors. In fact, this could be a potential blueprint for other economically depressed European countries to renegotiate their social contracts with the EU. Democratic governance derives its legitimacy from the will of the governed; if peoples basic needs are not met, democratic governance cannot be sustained.

Greece is not in the clear yet. But by finding this acceptable middle ground, the foundations of a sustainable solution for keeping the Eurozone intact may have been laid.

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Reversing the Democratic Recession:

Neither side of this debate should have to pretend that keeping the Eurozone unified is an unimportant political, economic, foreign relations and security consideration. Greece staying in the E.U. is important for Greece, Germany, the E.U. and any country with aspirations of democratic governance:

[Stamford University democracy expert] Diamond adds, “perhaps the most worrisome dimension of the democratic recession has been the decline of democratic efficacy, energy, and self-confidence” in America and the West at large. After years of hyperpolarization, deadlock and corruption through campaign financing, the world’s leading democracy is increasingly dysfunctional, with government shutdowns and the inability to pass something as basic as a budget. “The world takes note of all this,” says Diamond. “Authoritarian state media gleefully publicize these travails of American democracy in order to discredit democracy in general and immunize authoritarian rule against U.S. pressure.”

If anything, the U.S. has been the poster-child for prosperity through democracy compared to the E.U.. Regardless, twin “democratic recessions” of varying degrees on both sides of the Atlantic have compromised the appeal of democratic governance abroad. Spreading Islamophobia, antisemitism, and xenophobia throughout Europe–side effects of Europe’s failed economic policies–compromise the appeal of Western values and galvanize authoritarian and extremist messages. 

ISIS finds itself at Italy’s back-door geographically in Libya. But ideologically, ISIS could not be further away from European ideals. Ultimately, reversing the democratic recession and countering authoritarian and extremist ideals requires. among other things, proving democracy remains a viable path to widespread freedom and prosperity.

“Western” countries cannot push Greece towards China / Russia for a bailout. We, like Greece, finds ourselves at an inflection point–we must  prove that democracy in a first world country can satisfy peoples basic needs. Failure to do so could lead to a long-term setback in promoting modernization, human rights, and democratic governance in the worlds least developed countries.


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Transparency Report: Republicans Oppose U.S. Law Targeting Offshore Tax Dodgers

Original Article:

At its winter meeting in Washington, the RNC approved by voice vote a resolution in favor of abolishing the 2010 Foreign Account Tax Compliance Act (FATCA), set to take effect in July, marking the party’s first explicit attack on the law.

FATCA will require most foreign banks and investment funds to report to the U.S. Internal Revenue Service information about U.S. customers’ accounts worth $50,000 or more. The law was enacted after a scandal involving Americans hiding assets in Swiss bank accounts to dodge U.S. taxes.

Critics have blasted the law as an unfair government overreach and invasion of financial privacy.

“The Republican National Committee … urges the U.S. Congress to repeal FATCA,” said the measure, staking out a campaign position ahead of 2014’s mid-term elections.

Tax watchdog groups that support FATCA slammed the Republican vote. “It is mind-boggling that a major political party would even consider endorsing a resolution to facilitate tax evasion,” said Heather Lowe, director of government affairs at anti-graft watchdog group Global Financial Integrity.

“Repealing the law would cripple the U.S. and global efforts to fight offshore tax evasion,” she said in a statement.

The Center for Freedom and Prosperity, a group that advocates for lower taxes and financial privacy, praised the RNC vote. “The GOP’s adoption of FATCA repeal to its platform is a major victory for taxpayer privacy rights,” said the center’s Director of Government Affairs Brian Garst.

Repeal is unlikely and the issue was not expected to resonate with average U.S. voters, said lobbyists on both ends of the political spectrum. But they said Republican opposition to the law could help the party raise campaign funds.

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It is certainly mind-boggling that a major political party would endorse such a view. And even if a repeal is unlikely, this issue should “resonate with the average U.S. voter”. In an era of constant budget-battling and debt-ceiling standoffs (the next one is right around the corner), where stimulus spending is unthinkable and welfare programs are constantly coming under attack (even though both are extremely important during an economic recovery), it is important for Americans to understand the main drivers of U.S. government debt. Once you understand these main drivers, it is obvious why this G.O.P. position on FATCA is unconscionable.

A quick simplified lesson: There are two sides to government debt, receipts (tax revenue) and outlays (spending). While there are certain drivers of long-term spending which must be reformed (social security, and medicaid, and defense spending specifically), these long term issues have little to do with economic recovery fiscal policies (government stimulus spending and “automatic stabilizers“).

A few historic graphs from the White House Office of Management and Budget (full tables from 1938-2012 can be downloaded: reciepts_endpenditure_history, reciepts_by_source) tell the story of U.S. government debt.

RECEIPTS, OUTLAYS, SURPLUS/DEFICIT(–)% GDP | PERCENTAGE COMPOSITION——————————————————————|  OF RECEIPTS BY SOURCE
Year GDP (in billions of dollars) Total Individual Income Taxes Corporation Income Taxes
Receipts Outlays Surplus or Deficit (-)
1992 6,242.0 17.5 22.1 -4.7 43.6 9.2
1993 6,587.3 17.5 21.4 -3.9 44.2 10.2
1994 6,976.6 18.0 21.0 -2.9 43.1 11.2
1995 7,341.1 18.4 20.6 -2.2 43.7 11.6
1996 7,718.3 18.8 20.2 -1.4 45.2 11.8
1997 8,211.7 19.2 19.5 -0.3 46.7 11.5
1998 8,663.0 19.9 19.1 0.8 48.1 11.0
1999 9,208.4 19.8 18.5 1.4 48.1 10.1
2000 9,821.0 20.6 18.2 2.4 49.6 10.2
2001 10,225.3 19.5 18.2 1.3 49.9 7.6
2002 10,543.9 17.6 19.1 -1.5 46.3 8.0
2003 10,980.2 16.2 19.7 -3.4 44.5 7.4
2004 11,676.0 16.1 19.6 -3.5 43.0 10.1
2005 12,428.6 17.3 19.9 -2.6 43.1 12.9
2006 13,206.5 18.2 20.1 -1.9 43.4 14.7
2007 13,861.4 18.5 19.7 -1.2 45.3 14.4
2008 14,334.4 17.6 20.8 -3.2 45.4 12.1
2009 13,960.7 15.1 25.2 -10.1 43.5 6.6
2010 14,348.4 15.1 24.1 -9.0 41.5 8.9
2011 14,929.4 15.4 24.1 -8.7 47.4 7.9
2012 15,547.4 15.8 22.8 -7.0 46.2 9.9
2013 estimate 16,202.7 16.7 22.7 -6.0 45.5 10.6

Government expenditures will go down when we experience full economic recovery (and not just a recovery for the top 1%)–that’s why welfare programs are known as “automatic stabilizers”. What will not automatically change are tax receipts, which are at their lowest levels since 1950. The American public has been paying a fairly constant portion of total federal taxes over the past 6 decades through income taxes–between 40-50%. Corporate taxes have fluctuated wildly; between 1940 and 1967 they made up 20-30% of federal tax revenue, since 1980 they have hovered around 10%.

The American public continues to pay its fair share, while corporations get a pass (and actually get huge bailouts and subsidies). America, in reality, has a regressive tax system. This low effective corporate tax rate stems largely from tax loopholes; a difficult problem to address rooted in corporate lobbying (money buys influence buys loopholes). Overcoming this problem will take an overhaul of the government tax code and a change in the current lobbying system, neither of which is an easy task.

Much less contentious should be targeting offshore cash holdings. While loopholes at least (allegedly) contribute to job creation, offshore tax evasion is a crime which robs the U.S. of vital tax revenues with no benefit to society. But even this “slam-dunk” reform is being challenged by the G.O.P.

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Privacy Narrative:

I thought it was interesting that the Center for Freedom and Prosperity, a conservative think-tank, used the privacy narrative to justify the G.O.P. stance on FACTA. This reminded me how Matt Taibbi, in his book “Griftopia”, explains how the wealthy sell financial sector deregulation to the lay-man.

According to Taibbi, financial regulation is equated to local / state level government regulation–the average person, who experiences government overreach in their day-to-day lives, feels for the “poor banker trying to earn a buck”. Of course this equation is false; however, many people do not know enough about our political system to understand this fallacy, especially when their favorite news outlets are driving this false narrative home.

It seems that something similar is being attempted with this privacy narrative. One of the main issues of the day is NSA “spying”. Perhaps conservatives are trying to latch onto this privacy narrative to drum up popular support for repealing FACTA. I think this is a tougher sell, although financial deregulation sounded like an impossible sell until pundits begin selling it. It is therefore important to expose this fallacy to the general public before the narrative hits the newsroom.

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Next time you hear an argument about “fiscal responsibility”, remember the G.O.P is the party of offshore tax evasion. Social spending programs and the tax code need to be overhauled; these issues will take time to remedy and must be addressed with care, they cannot be attached to short term issues like economic recovery or the debt ceiling.

Enabling offshore tax evasion by repealing FACTA benefits nobody except those who engage in offshore tax evasion–this should not be a contentious issue. Those who engage in such activities do not deserve our understanding or support, regardless of your stance on NSA surveillance.


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G20 Kicks-Off Today, A Number of Hot-Topic Issues to be Discussed by World Leaders

G20 Russia 2013

From the international financial and monetary systems to international tax-evasion to armed conflicts, the worlds leaders are getting together to figure out how to minimize human rights violations and hold parties accountable for their violations.

The ultimate goal is to put in place global and national policies needed for sustainable human development in the 21st century–an ambitious goal indeed! Difficulty must not deter our normative visions for the future; as a global community we must attack these issues proactively and in a preventative nature whenever possible.

I urge the NN community to stay up-to-date on G20 related news. I will be sure to write a blog upon the conclusion of the G20 leaders summit.


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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.

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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.

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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.’”

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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.’“

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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.

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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).

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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)

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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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