The tax burden

Fascinating article in the Guardian by Polly Toynbee , called
cooling the cutting fisticuffs – take a long, hard look at tax . What the article claims, and what I found particularly interesting, is that the bottom 10% of earners pay 46% of their income in tax, while the richest 10% pay only 34% of their income in tax. What is more, the top fifth of earners take 51% of the national income while the bottom fifth take 3%. This comes from a report by a centre-left pressure group called Compass , and I have no real reason to doubt its veracity.

Apparently the reason for this discrepancy is that the highest earners can take some (or most) of their income in the form of capital gains which is only taxed at 18%. So even though their salary is taxed at a high rate, their actual salary only makes up a small fraction of their total earnings – most of it coming in the form of capital gains. When I first read this I immediately thought that although this may be true, most low earners effectively recover what they lost through taxes in benefits, but I think this doesn’t really make a difference. The public sector makes up something like 40% of the UK’s economy. If we want to sustain what the public sectors offers people in the UK, we have to roughly recover 40% of the total income. We could of course decide that the public sector should only make up 30% of the UK economy which we could achieve by privatising some parts of the public sector, but I happen to believe that this would not be improve things in any way.

So assuming that we accept that the public sector is going to make up about 40% of the UK economy, how do we fund that? Well a simple way would be to take 40% of everyone’s income. This could be through both direct and indirect taxation, but at the end of the day we need this to fund the public portion of the economy. What you could then choose to do is to take a slightly higher fraction of the top earners’s income, leaving those on lower incomes with more money. You can even give some of money back to the lowest earners through benefits since they take such a small fraction of the total income, that this won’t really have a significant impact on government revenue. What you certainly don’t do is take less than 40% of the highest earners’s income. They take such a large portion of the total income that this will have a huge effect on the total amount of government revenue. How can we possibly expect to both sustain the public sector – which I think we should be doing – and draw down the deficit if we don’t at least tax the the highest earners at a rate that will give the government sufficient revenue.

In some sense this isn’t even a discussion about what is fair or not, it seems logical that the simplest way to ensure that government revenues are sufficient is to start by making sure that the highest earners are taxed appropriately. If not enough is recovered from the highest earners, it becomes increasingly difficult to get the remainder of what is required from the lowest earners since they take a smaller fraction of the total income. It seems ridiculous that we are only taking 34% of the total income of the top 10% of earners in a country that intends to have a public sector that makes up 40% of the economy. The top earners presumably would argue that they don’t rely on the public sector to the same extent as the lowest earners, but this is nonsense. Also, in an average sense, something like 40% of their income presumably comes from the public sector. In fact, since they take such a large fraction of the total income, more than 40% must come from the public sector and so taxing them at a higher rate, to a certain extent, is simply recovering public money.

Goldman Sachs

It has been reported that Goldman Sachs will make a record profit in 2009 and will consequently pay record staff bonuses, setting aside as much as $18 billion. Personally I find this obscene, as do many others, and was really hoping that the banking industry would show some restraint and try to illustrate that they recognise the damage that has been done to the world economy by their risk taking.

On the other hand, some argue that this is simply capitalism working and if they choose to distribute some of their profits amongst their staff, that is entirely up to them. In principle this is fine, but I thought I would try to see if their was some reason why this argument wasn’t quite correct. In the past few years Goldman Sachs has had revenues of about $50 billion. It may be slightly higher in 2009 since there are fewer banks operating, but it probably isn’t more than $100 billion. The bonus pot is about half of their total profit, suggesting a total profit of $35 billion. This means that their profit is something like 35 % – 70 % of their revenue (depending what their actual revenue is). How does this compare with other large companies. Well, I quickly looked up Toyota and in the last few years they’ve had revenues of about $220 billion and profits of about $15 billion, about 5 % of their revenue.

The above isn’t particularly statistically significant. I thought I would try to have a slightly deeper look at this. I downloaded data for the top 100 companies (by revenue) in the world and worked out the average percentage profit. It is about 6.5 %. When I do the same for the Banking sector only, it turns out to be 9.5 % (it is the same whether I take the top 20, top 25 or top 50 banks in the world). This may not seem like a lot, but it does suggest that the banking sector operates in a way that allows it to make a larger percentage profit – in general – than most, if not all, other industries.

Maybe the above is fine, I don’t really know. Personally I have a problem with it. Although banks compete amongst themselves, unlike many other industries, there isn’t really an alternative to banking. We don’t have to buy a car, we could use public transport or ride a bike. If, however, we want to buy a house or invest some money, we need to use a bank (there may be some exceptions, but this is generally true). Is the reason that banks can attain larger percentage profits than comparable industries in other sectors because they have the brightest most capable staff, or simply because the type of competition they face is different to what other industries face. Personally I favour the latter interpretation. I don’t know how to change this, and even if there is a way to do so, but it is my opinion that our economy would be better off if more of the money remained in industries that actually build things and develop new technologies than being swallowed up by banks and divided up amongst their staff and investors.

Investment banks

It has recently been announced that a couple of banks (Barclays and HSBC) have managed to make a few billion pounds profit in the first 6 months of this year. Most of the profit has come from their investment bank divisions and like many – I suspect – I am disappointed that these banks are now considering paying out substantial bonuses at the end of this year. Firstly, I’m not really convinced that their employees are so brilliant that they really deserve the kind of bonuses that are being predicted (although this is a rather subjective view). Secondly, the argument that they’ve done really well and deserve these bonuses may be correct in some sense, but without taxpayer intervention these companies probably wouldn’t have survived. To assert that these profits are simply a consequence of their talented staff seems slightly simplistic. Some humility and an acknowledgement that without public money this profit would not have been realised would at least make me feel like they have realised how much damage their unregulated business practices have done to the UK and the World’s economy.

What I must admit that I do not completely understand is why investment banks are actually allowed to operate in the way that they do. Maybe I should be more honest and say “in the way that I think they do”. Why do we need investments? From an economic point of view, some people have good ideas, but have no money. Others have money, but don’t have any good ideas. Those with the money then invest that money with those with the ideas and if everything goes well, they both make money. There is generally some risk involved so the investors could lose their money, but the potential returns generally make the risk worth it. By and large, the investor can choose their level of risk. Low risk would generally imply smaller returns and high risk would imply – assuming it all works well – high returns.

Investment banks then presumably came about – initially – to provide a way for investors to invest their money. Of course part of the goal is to make money for the investor, which seems perfectly reasonable. However, the profit is meant to result from this money actually doing something such as providing capital for someone with an idea. Today, however, it seems like the goal is simply to make money in any possible way. Not only does this include what appears to be effectively a form of gambling, but also potentially artificially influencing the share price (by for example dumping lots of shares on the market) in order to make money at a later stage.

It’s seems that in general there is an acceptance that this is all fine. If these investors – and the investment banks themselves – make money this will stimulate more growth. It’s not completely clear to me that this is quite correct. Firstly, the stock market seems to update share prices on a very short timescale. Money can therefore be made on the basis of short timescale fluctuations in share prices. This seems slightly odd in that these changes cannot truly reflect changes in the value of the company. Of course, if someone makes money, others will lose money so one could argue that this money just comes from other investors, but where is the benefit in this? How does the economy benefit by allowing people with money to make money on the basis of somewhat random variations in the value of shares? This money presumably hasn’t spent long enough in the system to have any real positive effect on the economy and presumably this type of trading doesn’t actually generate any real income (i.e., it just transfers money between investors).

One could argue that even though this money moves between investors, it does stay in the system and therefore does contribute to economic growth. Even this isn’t entirely clear since what presumably is required to really make money is a long term investment that can provide some kind of stability to a company. What’s more, a significant chunk of this money goes directly to the investment bank who, as we have seen can make billions of pounds of profit in only a few months. Where’s the benefit in this? Investment banking is just a service industry. Why are we so pleased that a company that doesn’t really directly generate any economic growth is able to make such huge profits. Surely our economy would benefit more if this money was located with companies who actually do something that can generate real growth.

Ultimately I would quite like to see much more regulation producing a system that requires that investors do more to make their money and that when they make money it reflects a wise investment that has lead to real economic growth, rather than simply clever trading that takes advantage of short timescale, random fluctuations in share prices. I’m sure there are plenty of arguments against what I’ve said, but I would be very keen to hear them. Of course, these kind of changes would need to be global rather than national. It’s also possible that one reason why the UK doesn’t want to consider any significant changes is that the money made by these investment banks may actually be coming from outside the UK, hence making money for the UK economy. Despite this, I still think that our economy as a whole would benefit from a more regulated system in which investments are actually aimed at generating economic growth, rather than simply making money for the investor as quickly as possible.