Schumpeter

Business and management

Money talks: January 23rd 2012

Coddlers of plutocrats?

Jan 24th 2012, 0:27 by The Economist online

Taxes and the role of wealth shape the debate in the Republican primaries, and hints of a compromise appear in Greece

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Gordon L

One issue with rents is that they are symptoms of economic inefficiently. The rents that Australia derives and proposes to tax are brought about by the fact that China's demand for resources has far exceeded anyone's ability to supply that demand. Eventually the rents ought to disappear has supply catches up as they will.

Where rents are more or less permanent as for example with urban land, they are insufficient to support more than municipal services. None the less as taxes on mobile capital and labour decrease, expect taxes on land (including tolls) to increase.

The other major problem is one of calculating the "deemed cost of capital". The Australian Treasury reckoned that any thing in excess of the risk free rate of return ought to be taxed as "rent". Many would claim that by failing to account for risk, Treasury were seeking to tax profit at the higher rate.

There area great may other technical issues around taxing rent otherwise then by flat rate royalties all of which the Australian treasury came across and few of which were resolved.

While the issue is worthy of discussion in countries were rents make up a major percentage of GDP there are not a great many of these outside of resource economies.

Stephen Morris in reply to Gordon L

Rents are more widespread than commenter “Gordon L” recognises.

To begin with, we must step back and consider what - precisely - is a rent. And to answer that question we must start (as usual!) with Coase and his Nobel Memorial Prize Lecture of 1991:

“. . . what are traded on the market are not, as is often supposed by economists, physical entities but the rights to perform certain actions, and the rights which individuals possess are established by the legal system.”

This insight forms the foundation of an economics far more abstract in conception than that which we usually read in The Economist: one that is concerned with the exchange of rights – all rights - rather than with the narrow fields of production, value, and the allocation of physical resources.

Rights are complicated things because some supposed rights are subordinate to other rights. For example, a firm’s right to dispose of assets might be subordinate to the claims of a creditor who has taken a charge over those assets as part of the security of a loan facility.

Using the generalised rights-based conceptual framework, a rent may be defined as a benefit arising from a “metastable” distribution of rights. A metastable distribution is a pareto sub-optimal [strictly speaking, “rights-based” pareto sub-optimal] distribution which persists over time due to the existence of a transaction cost barrier which prevents it from being negotiated away. (The parallel is with physical metastability.) To extend the physical metaphor, certain conditions (specifically Prisoners’ Dilemma) can act as anti-catalysts: they can magnify a small transaction cost barrier into a very large one.

Absent transaction cost barriers, rentees would negotiate amongst themselves (and possibly with the rentier if the rentier had an absolute – not subordinate – right to the rent) to come up with a new arrangement which left some of them better off without depriving any of an absolute - not subordinate - right.

In fact, under the “legal system” most rights are subordinate in some way. Of course, this immediately invites the question of how to determine the “initial” distribution of rights, the legal system. This topic has been discussed many times here on The Economist: for an arbitrary group of individuals the only logically consistent means of determining the initial state is through a “democracy eigenfunction”, described here.

The only initial state solution which avoids the problem of infinite recursion and converges is one in which the distribution of rights is determined by an aggregation device which has itself been chosen directly or recursively from an original “non-privileging” aggregation. And that “non-privileging” aggregation will be democratic.

We now see that under the generalised definition, “windfall rents” are not limited to natural resources. In many areas of rapid technological development, it is arguable that most of the profit is actually windfall rent. The economic benefit would have arisen anyway merely by virtue of the new technology having come into existence. The issue is whether the benefit manifests itself as lower costs or is appropriated as private profit.

It is illustrative to compare two cases:

- Microsoft’s “compatibility monopoly” on personal computers; and

- Tim Berners-Lee’s internet protocols.

Microsoft didn’t do anything wonderful in producing Windows. Amongst the IT community its software has never been highly regarded. There were technically superior operating systems that might just have easily been a world standard. Microsoft happened to be at the right place at the right time, and Bill Gates had the cunning to see how he could appropriate the economic benefit of a compatibility monopoly as private windfall rent. The operating system was sold at a price far in excess of marginal cost, and far in excess of that required to incentivise software developers. (Indeed, it arguably had the perverse effect of attracting excessive capital into the “tech-boom” as others tried to replicate the windfall rent.)

In contrast, Berners-Lee’s protocols – which had arisen as a by-product of work at CERN – were made available royalty-free, and the benefit has manifested itself directly to internet users everywhere.

Neither the compatibility monopoly nor the internet protocols could have been deterred by removing the privatised windfall profit. They were developments just waiting to happen. In the absence of transaction costs, rentees might be expected to negotiate amongst themselves to remove the windfall component. To that extent they are rents.

Incumbency and political rents are discussed here.

Stephen Morris in reply to Gordon L

Regarding uplift rates, the use of the risk-free rate as the uplift rate assumes that government would reimburse abandoned businesses an amount equal to the tax rate multiplied by the final negative balance. In effect, the state becomes an equity partner in every business. However, in practice, this creates enormous sovereign risk as investors question the credibility of the government’s undertaking to make such large reimbursements (especially as they would typically occur during recessions when governments are running deficits).

Practical rent taxes are more likely to rely on uplift rates which incorporate a risk premium.

An alternative - or complementary - approach is to carry out several parallel calculations with several different uplift rates, and to apply higher rent tax rates as higher threshold rates of return are achieved.

It is worth remembering that such a system actually reduces risk for most businesses. It removes the risk that business taxes will be levied before the undertaking has achieved a minimal rate of return. It ensures that most tax is levied on non-deterrable windfall, incumbency and political rents.

I might add that I don’t hold out much hope that broad-based rent tax will in fact be introduced in Australia.

The existing resource rent taxes are actually a stalking horse to replace state mineral royalties (which flow mainly to outlying states) with a central government royalty (which may be used to buy votes in the bigger metropolises).

Likewise, the big business lobby is using the extension of rent tax as a stalking horse in their campaign to abolish all tax on big business by abolishing company tax altogether. Moreover, even though dividends are in principle taxable in the hands of shareholders at their respective tax rates, in practice they may be retained within the company thereby deferring tax indefinitely and reducing the present value tax rate.

Tax on small business will remain. If a small business is unincorporated, it is already taxed at (much higher) personal rates.

If a small business is incorporated and represents predominantly the labour of the proprietor, then existing provisions for taxing employee-contractors will ensure that the company is taxed at the proprietor’s individual rates.

Also, if zero company tax is ever introduced we may expect to see the re-introduction of "undistributed profit tax". Undistributed profit tax applies to small companies - but not big companies - which fail to distribute all or most of their annual profit as dividend (so that it may be taxed immediately at personal rates). In Australia, undistributed profit tax was abolished with the introduction of dividend imputation, but if ever zero company tax rate were introduced it would almost certainly be reinstated to ensure that small business couldn't benefit from it.

Under the system of “government-by-politician”, tax law - like all law - is made for the benefit of those who own the politicians. And that itself is a rent!!

Gordon L in reply to Stephen Morris

"Likewise, the big business lobby is using the extension of rent tax as a stalking horse in their campaign to abolish all tax on big business by abolishing company tax altogether."

If in fact there are enough rents out there to replace company tax then its replacement would be a good thing. The tax wedge on investment would disappear. I don't think that there are and in any case as your remark around parallel calculations and differing up-lift rates (which taxpayers would arbitrage to beat the band) a systemic attempt to tax all rents is probably too hard.

While in Australia the company rate of 30% is above the top personal marginal rate, it is well below the rate that super funds (which represent most shareholders domestically) pay. So the claim that company tax is being used by Australian big business to avoid tax by withholding dividends is rather dubious. Overseas owned business as a rule don't distribute, but as payment of company tax entitles them to distribute tax free (no dividend withholding tax) it does not seem to be much of an issue.

When it had a "classical" double tax company tax system (dividends not deductible to the company, but fully assessable to the shareholder) Australia had an undistributed profits tax and a flourishing industry for avoiding it. One reason that we moved to imputation was the failure of that system both in terms of revenue and efficiency.

Stephen Morris in reply to Gordon L

If in fact there are enough rents out there to replace company tax then its replacement would be a good thing. The tax wedge on investment would disappear.

Well, at least there is some agreement there!!

I don't think that there are . . . .

Whether or not there are enough rents (which – under the metastability definition - is ultimately a matter of the subjective preferences of the rentees aggregated in the absence of transaction costs), there is no doubt that a rent tax could be constructed which would raise exactly the same amount as existing company tax. It is simply a matter of adjusting:

a) the uplift rates (which can be reduced right down to the zero, effectively replicating the existing company tax); and

b) the tax rate or tax rates levied on surplus.

If it is accepted that any move towards rent taxing is “a good thing” for removing the “tax wedge on investment”, then a change in the direction of rent tax should be preferred, even if the uplift rate is below the cost of capital. At least there would be some shelter as opposed to none under the existing system.

a systemic attempt to tax all rents is probably too hard

I wasn’t aware that we already lived in the best of all possible worlds.

. . . the claim that company tax is being used by Australian big business to avoid tax by withholding dividends is rather dubious

There may have been a misunderstanding here. No such claim was made. The claim was that if there were a move to zero company tax then:

a) there would be an incentive to retain dividends in order to defer tax indefinitely; and

b) there would be a reintroduction of undistributed profits tax (which only ever applied to smaller companies) to prevent smaller businesses taking advantage of the zero tax regime.

- - - - - - -

p.s.

On a tangential matter, one could make the case that Super Funds do not “represent most shareholders domestically” because – bizarre as it may sound - most superannuation fund members (especially younger ones) probably do not have a beneficial interest in their fund.

One could make the case that the superannuation system is a fraud (as discussed here). It has failed in its ostensible aim of increasing savings rates. Its real aim was always to provide industry protection for the funds management industry. (I was there as a young investment banker when it was being introduced back in 1985!) The age at which lump sums can be withdrawn has been raised and will continue to be raised until they are abolished altogether. Younger Australians will only ever see a pension, and that will be equivalent to the pension they would have received from a government scheme (without the enormous overhead costs of the private system). So in that sense they have no beneficial interest.

Any surplus remaining on death will be recovered by the government on the grounds that it has received “concessional tax treatment” and it would be “unfair” to allow it to pass to the deceased’s heirs. The only beneficiaries are the fund managers and related industries which continue to levy their management fees. But that was always the intention.

The practice of sovereigns taxing their subjects under the guise of “investment” has a long history.

There is a famous story of William Kiffin, a successful merchant in the reign of Charles II. Charles - ever in need of money - asked Kiffin for a loan of 40,000 pounds. Not to be caught, Kiffin immediately countered that it would be beneath the dignity of the King to be in debt to his subject, and offered him instead a free gift of 10,000. When asked why he had given away 10,000 pounds, Kiffin replied he that hadn’t: he had just saved himself 30,000!

More commonly, sovereigns achieve the same end by issuing bonds and then debasing the currency.

Steven Spadijer in reply to Gordon L

Some observation(s):

1. a number of German colonies in Asia (e.g. Kiaochow aka. Chiaochou China) during the hey-day of the German Empire levied a 6 % flat land tax (with some minor levies here and there), and they ran a budget surpluses (of course, the Japanese then the Communists took over that is where the comparatively successful experiment ended). Today, Singapore and Hong Kong do derive much of their revenue from land rents, albeit not as idealized as a flat land tax.

2. In a fiat currency, tax does not "fund" government expenditure so taxes should be assessed by references to the efficacy and efficiency, not their revenue raising capacity per se;

3. There are many forms of rents - land, natural resources, electromagnetic spectrum, radio waves, IP etc - that could fund the modern state. Indeed, if you are abolishing taxes on investment and labour, then I think the need for welfare payments would fall. Likewise, in the case of land tax, the Henry George Theorem suggests aggregate expenditure on infrastructure equals aggregate rents - so if you build a road then the uplift in land values could compensate for it.

Of course, the best experiment is to actually try all of the above!

Gordon L in reply to Stephen Morris

I don't see the point of removing company tax (and replacing it with rent tax) if you intend to force companies to distribute so that profits can instead be taxed in the hands of shareholders. There is a history of undistributed profits taxes in Australia and it is not a happy one. As it is, company tax is a kind of flat rate withholding on domestically sourced company profits that can be used as a credit towards shareholder tax on distribution.

Regarding superannuation, you are right about the current media strategies that depict Australians all becoming millionaires from their superannuation savings.

In official mode though governments have been honest in stating the need to create personal savings as a response to the demographic bulge that will result in there being one retiree for every taxpayer. The government recognised that it will not be able to afford to fund the retirements and responded with the superannuation. It could have tried to create an enormous government fund like the Future Fund for it future retirement obligations but correctly saw that this would be both impractical and politically impossible.

I reckon that it is to the credit of Australia that it looked over the horizon, did not like what it saw and responded before the crisis took place. Permitting retirees to splurge tax advantaged super savings and then go on a government pension immediately afterwards would defeat the purpose of the system so it is natural that this is severely discouraged.

While the funds management industry is a power in Australia now, it was practically non-existent in in 1985. So it could hardly have been the intention of the architects of superannuation to directly benefit the funds industry.

Stephen Morris in reply to Gordon L

I don't see the point of removing company tax (and replacing it with rent tax) if you intend to force companies to distribute so that profits can instead be taxed in the hands of shareholders.

This discussion is proceeding at cross-purposes. There are two quite distinct issues here:

a) how a tax system might be developed to promote economic efficiency (and possibly reduce inequality as a by-product); and

b) how a tax system actually will be designed under a corrupt system of government.

The answer to (a) is:

i) to introduce a rent tax;

ii) to not introduce undistributed profits tax; and

iii) to allow rent tax to generate a franking credit to set against personal income tax levied on dividends.

The answer to (b) is:

i) the company tax rate will be set to zero; and

ii) undistributed profits tax will be re-introduced for small companies but not big companies.

Under the system of “government-by-politician”, tax law – like all law – is made for the benefit of those who own the politicians.

While the funds management industry is a power in Australia now, it was practically non-existent in in 1985.

Speaking as an investment banker from 1985, all I can say is that this proposition is false:

a) the funds management industry wasn’t non-existent in 1985;

b) it lobbied for the introduction of a tax system and compulsory saving system that would promote its own expansion and profitability; and

c) it succeeded!!

Australians will be no better off as a result. The only winners are the fund managers, which was always the intention.

Under the system of “government-by-politician”, superannuation law – like all law – is made for the benefit of those who own the politicians.

Stephen Morris

Why does The Economist refuse to discuss rent taxes?

Come to think of it, why does The Economist refuse to discuss rent?

The increase in inequality in the past two decades is arguably due to rents (windfall rents, incumbency rents and political rents) flowing to the fortunate few.

After all, it is difficult to become a multi-billionaire operating in a truly competitive market!

The theory of rent taxes is well known and they are used in various places around the world, usually in the oil and mining industries. Australia is currently investigating a broad-based rent tax that would replace traditional company tax.

The principle of cash-flow rent tax is simple:

a) all expenditure is recorded as an outgoing without the traditional distinction between “revenue” and “capital”;

b) all income is recorded as an incoming, again without distinction between revenue and capital items;

c) if there is a negative balance at the end of any accounting period, this is “uplifted” at the deemed cost of capital; and

d) upon achieving a positive balance (which means, in effect, that the undertaking has covered its cost of capital) tax is levied on that amount (which is the return in excess of the deemed cost of capital). Being a tax on “super-profits” this could arguably be levied at a much higher rate (while reducing the tax rate for most businesses).

This paper produced by the Australian Treasury explains the various ways in which this principle can be applied.

And here is an example of the calculation for the existing Petroleum Resource Rent Tax.

Such a tax could achieve the dual aim of lowering business taxes for most businesses while reducing inequality.

And yet The Economist steadfastly refuses even to acknowledge the existence of rents.

It is beginning to get a reputation as a predictable mouthpiece of rentiers.

This echoes the Henry George argument which says one should tax rents (but particularly land given it is an inelastic input in the production process) while abolishing taxes on labour and capital.

Curiously, this raises the issue of the Canton of Zug. They pretty much reduced corporations and income taxes to ridiculously low levels. The result? While the GDP per capita of that canton is approximately 110 000 per person (despite in the 1960s being one of the poorest cantons in Switzerland), there have been growing complaints about escalating rents and the general rich-poor divide (and lack of affordable housing etc). Likewise, when Maggie Thatcher introduced "enterprise zones" (massive tax cuts so people would invest in certain areas) inequality rose. Why? a) Land speculators simply brought land and held it idle, waiting to sell it on a rising market; b) rents exploded. Cutting taxes on labour and capital simply benefits the rentier landlord class.

The solution seems very simple: introduce a very high land tax so a) landlords put any idle or underutilized land to productive use, forcing them to erect NEW buildings to discharge the liability that comes with a land tax (or sell the land and give it to someone who will); and b) deals with infrastructure windfalls. It will be interesting to see what they do - but as Henry George observed, growing economic growth comes with the paradox of rising inequality - due to higher rents (which eat away at wages).

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In this blog, our Schumpeter columnist and his colleagues provide commentary and analysis on the topics of business, finance and management. The blog takes its name from Joseph Schumpeter, an Austrian-American economist who likened capitalism to a "perennial gale of creative destruction"

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