Quote of the day

“I find economics increasingly satisfactory, and I think I am rather good at it.”– John Maynard Keynes

Tuesday, 22 September 2020

Do corporation tax cuts work.

Cutting corporation tax doesn’t work — but beware raising it now

The Times
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When The Sunday Times and others reported at the weekend that the Treasury was examining tax-raising options before the autumn budget, mainly involving business and the better-off, there was a range of responses. Some saw it as a signal by Rishi Sunak, the chancellor, to show that he was serious about fixing the public finances. Others detected a carefully choreographed routine, in which the Treasury machine is champing at the bit to raise taxes but the prime minister can earn brownie points by rejecting its proposals. Most economists reacted with horror at the idea of big tax increases at this time.

For one observer, George Osborne, one of the suggested tax rises, an increase in the main rate of corporation tax from 19 per cent to 24 per cent, struck a nerve. Cutting the tax was one of his signature policies and no politician likes to see their legacy end in the dustbin.

In a tweet, he railed against The Sunday Times for describing his corporate tax cuts as a “fetish” that had not boosted investment, pointed out that the paper had backed his policy and claimed that it had made the UK “the No 1 destination for investment in the G20”. He was supported by David Gauke, the former justice secretary and Treasury minister, and Sajid Javid, the former chancellor. The Tory government, I should say, is seriously diminished without these three.

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He was right to claim backing for his policy, And, after the Brexit referendum, this newspaper and its Sunday sister called for a cut in the corporation tax rate to 10 per cent. But this government abandoned a planned cut to 17 per cent (from 19 per cent) and its agenda is more Stockton-on-Tees than Singapore-on-Thames.

He was wrong, however, to suggest that cutting corporation tax had a transformative impact on investment. You would think that it should — surely a cut in taxes increases the incentives to investment — but it does not.

The closely followed EY attractiveness survey shows that within Europe, Germany was the favoured destination for new foreign direct investment projects over the period 2012 to 2018, beating the UK. Britain, to be fair, was the favoured European destination for investment in new and existing FDI projects during the period, but this was a position it held, according to EY, from 1997 to 2018. It is hard to argue that this was the result of low corporation tax rates. For much of this period, under New Labour, the main rate of corporation tax was 30 per cent or more.

“When we have probed investors for what drives their decisions, quality of infrastructure and skills were the top two criteria identified in every year,” Mark Gregory, EY’s chief economist, said. “Specific initiatives to boost innovation, education and training, incentives for R&D and support for SMEs are the priorities. For foreign investors, their ability to move tax liabilities [between different jurisdictions] means low corporation tax is of limited benefit.”

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On the world stage, the UK’s low corporation tax rate certainly appears to have been of limited benefit. Every year the United Nations Conference on Trade and Development produces its World Investment Report. It has a broad definition of foreign direct investment. Over time it shows a consistent picture for the 2010s. At the top of its league table for FDI inflows is usually America. Sometimes China is there and Hong Kong, often a conduit for investment in China, is highly placed. The UK reached the giddy heights of second place in 2016, as a result of a large foreign acquisition of a British company. More typically it has been around eighth, as in 2012, 2018 and 2019, or lower. In 2017 it was not in the top 20.

George Osborne made cutting corporation tax one of his signature policies as chancellor
George Osborne made cutting corporation tax one of his signature policies as chancellor
TIMES NEWSPAPERS LTD

Neither does cutting the corporation tax rate do much for domestic investment. Britain has underinvested for years. The recovery in business investment after the financial crisis was unremarkable, until it was snuffed out by the 2016 referendum.

The evidence on this is even clearer in America. In 2017 President Trump cut the corporation tax rate from 35 per cent to 21 per cent. He lit the blue touch paper and waited for investment to explode. It didn’t. A study by the International Monetary Fund by Emanuel Kopp, Daniel Leigh and Suchanan Tambunlertchai found that any increase in investment was thanks to stronger demand, not the corporate tax cut. One reason was that big American corporations already had market power and did not need to invest further to increase it. As the authors put it: “The rise in corporate market power in recent decades appears to have muted the effectiveness of corporate tax cuts as a means of boosting business investment.”

Filippo Occhino of the Federal Reserve Bank of Cleveland, suggested that the effects of the 2017 tax reform on investment were small, a mere 0.2 per cent, and that over the medium term cutting corporation tax may even reduce business investment. “Contrary to the expectation of some observers, the permanent cut in the corporate tax rate may have held investment down rather than stimulated it,” he wrote in a study.

The reasons are complex — to do with limits on interest deductibility and the scheduled amortisation of R&D spending — but confirm that the assumption that cutting corporate tax rates will boost investment does not work. Does this justify reversing the Osborne corporate tax cuts? A rise from 19 per cent to 24 per cent, almost the 26 per cent that Jeremy Corbyn proposed last December, would raise £17 billion annually after a couple of years. But economists are right to say that timing is everything. The chancellor may want to lay down a marker this autumn for future fiscal consolidation and repairing the public finances — that is entirely right — but whacking business immediately with a tax rise when it is emerging groggily from the deepest recession in living memory would make little sense and would do more harm than good.

David Smith is Economics Editor of The Sunday Times david.smith@sunday-times.co.uk

Monday, 21 September 2020

Best way to spend ££Bns?

Matthew Lynn

A new deal needn’t be green

Britain is seeking measures to revive its Covid-ravaged economy. It should choose from a broader palette 

WE CAN BUY OUR GREENERY FROM THE MAN NEXT DOOR

President Macron of France (pictured) is betting big on a €100bn reboot of the economy that will focus on green technologies. The EU’s new €750bn coronavirus rescue fund will also focus on environmental projects. In Germany, Chancellor Angela Merkel has pledged  €40bn for a green recovery fund.  Joe Biden, if elected as president of the US, has said he will spend big on a “green new deal”. Massive green stimulus packages are all the rage, and there will be those arguing that Britain should do something similar. That would be a mistake.

THE PERILS OF OVERINVESTMENT

Not that there’s anything wrong with green technologies. Climate change  might or might not turn out to be quite  the global emergency it is cracked up  to be. But most green energies deliver cheaper power, cleaner air and less pollution, and it is hard to see anything not to like about that. Sustainable manufacturing and farming will be more durable, more local and, again, usually cheaper as well. It will be far better if we are all driving electric cars, living in solar heated homes, eating lab-grown meat, with vegetables from a vertical farm on the side, while getting deliveries from a battery-powered drone. If anyone can work out how to make an electric-powered plane, preferably drawing its power from the sun, then so much the better.

But one thing is surely clear. We are about to see massive over-investment in the sector. Every country around the world is using the Covid-19 recession as a reason for sinking vast sums of government money into one green project after another. Factories are going to be built to build batteries by the tens of millions. Wind and solar farms, barrages to capture tidal power and geothermal plants, are going to be built across Europe to create vast quantities of renewable energy. Research and development labs will be set up across the continent to create the technologies that will make fossil fuels about as relevant to the 21st century as horses were to the 20th. If it is green, and renewable, and reduces carbon emissions in one way or another, it is going to receive vast quantities of investment over the next five years. 

The result? It will be the same as in every other industry when there is a massive wave of investment. There will be too much capacity. It happens all the time in the commodities market. It happened in the telecoms bubble of the 1990s. It has happened in steel, in cars, in shipping, and in countless other industries. Too much stuff is made, and prices inevitably crash. Fast forward five years, and they will be giving away solar panels to put on your roof for practically nothing. Electric car batteries, one of the main reasons why petrol-free vehicles remain relatively expensive compared with their traditional rivals, will be as cheap as chips. For the relatively minor cost of some undersea cables, the UK will be able to buy Macron’s and Merkel’s green electricity for practically nothing. The billions of green investment will be generating vast quantities of the stuff, and since you can’t store it, you might as well sell it off to the British for whatever they are willing to pay (which since we will probably be the only buyer won’t be much). 

FOCUS ON WHAT WE’RE GOOD AT

The right strategy for the UK is to forget about making any green investments of our own and launch our own economic stimulus before the end of the year, focusing instead on all the industries the rest of the world is ignoring right now. Such as? Consumer goods, where there is plenty of scope for technology-led innovation, the creative industries, fintech, and the law and education, where there could be a huge space for artificial intelligence to revolutionise the way services are delivered. We are pretty good at all of those, and can strengthen our lead while everyone else is ignoring them. In a few years’ time, we will be able to buy all the green energy and technology we need at a fraction of their cost – and we won’t have to lose tens of billions in the process.

Friday, 18 September 2020

Developing economies - Central Europe

 Useful material looking at interdependence, economic development etc. Some good context for essays:


ANALYSIS

Frederic Guirinec

The challenge for central Europe

PICTURESQUE POLAND HAS BECOME A MANUFACTURING POWERHOUSE

After years of being Europe’s fastest-growing region, the Visegrád Group’s economic model may be reaching its limit. But the region still offers rare value, says Frederic Guirinec

The Central European economies of Poland, the Czech Republic, Hungary and Slovakia – known as the Visegrád Group (see box) – have seen strong average annual growth of 5% since they joined the EU in 2004. The real GDP of the area has more than doubled over this time, driven by foreign investment in capital-intensive industrial production: in 2019, Poland was the leading destination for greenfield foreign direct investment (FDI) in the bloc, with $21.8bn (£17.4bn) invested, compared with $19.2bn in Germany and $15.7bn in France, according to fDi Intelligence.

However, this steady growth could soon be under threat due to dependence on western Europe’s capital and markets. The global economic recession may reveal structural issues with the region’s economic development and point to what must change if these countries want to become more than a destination for low-cost, high-quality manufacturing.

COPING WITH COVID-19

Central and eastern Europe have coped well with the pandemic. Governments had time to observe the spread in western Europe and learn from other countries, closing their borders early to significantly limit the pandemic. Now lockdowns are being lifted and activity is increasing steadily. Google’s Covid-19 community mobility reports indicate that life is returning to normal: by the end of June, retail and recreation mobility was back to pre-lockdown levels, especially in the Czech Republic (compared with 48% below normal in the UK) and transit and work mobility is crawling back up (-20% versus -50% in the UK). 

The Polish economy, which represents more than half of the GDP of this region, contracted by 0.5% during the first quarter – a better outcome than in most large European economies. The damage was obviously greater in the second quarter and overall the economy is forecast to contract by 4.6% in 2020, according to the IMF. This would be the first recession in Poland since 1994. Still, the government has designed a very large support programme worth PLN212bn (£42.5bn or 9% of GDP) and hence the country is likely to see one of the smallest peak-to-trough falls in GDP in Europe. The strong challenge that Warsaw’s mayor Rafal Trzaskowski posed to incumbent president Andrzej Duda in the presidential election was much more about social values than the government’s handling of the pandemic and its related economic impact (see politics & economics).

RELYING TOO MUCH ON THE NEIGHBOURS

The Achilles’ heel of central Europe is its dependence on Germany. The region is often seen as the German hinterland – it generates between 25% and 30% of trade with its larger neighbour. This means that in this crisis it will benefit indirectly from the massive economic stimulus in Germany, which amounts to €1.1trn (30% of German GDP) when including guaranteed loans. However, being so closely linked to one neighbouring economy raises the area’s vulnerability to external shocks and also risks restricting its long-term development too closely to what suits Germany’s needs.

The Visegrád economies offer skilled labour at much lower cost than western Europe. Despite a 35% increase since 2012, total labour costs in the manufacturing sector stand at €11 per hour on average, well below the average of €32 per hour in the eurozone, according to Rexecode, an economic research institute. That said, the declining supply of skilled labour is becoming a significant bottleneck. Since joining the EU, two million Poles have emigrated, forcing the country to rely on more low-skilled immigration from Ukraine. Indeed, Poland has welcomed a record number of migrants in recent years.

“THE ACHILLES’ HEEL OF CENTRAL EUROPE IS ITS DEPENDENCE ON GERMANY”

The vehicle industry is an outstanding example of the strengths and limitations of this growth model. These four countries produce 3.3 million cars a year, equivalent to British and French car production combined: car manufacturing represents 40% of Hungary’s exports. The factories are not simply assembly facilities that put together parts made elsewhere: large investments by firms such as Audi and BMW also ensure integration into the global supply chains of multinationals and contribute to technological transfer and an upgrade of physical infrastructure. But foreign ownership of these facilities means that key decisions are still made elsewhere. 

OPPORTUNITIES FOR INNOVATION

So the region needs to develop its research and development (R&D) capacity if it is to become more than a convenient location for manufacturers. Unfortunately, R&D spending remains very low in the region, at under 1% of GDP in Poland and Slovakia. Only the Czech Republic has achieved more, at 1.7% – in line with the UK, but well below Germany’s 2.9%. On the plus side, the Visegrád economies have avoided falling into what economists call the middle-income trap, where rising living standards and wages in fast-developing countries mean that they lose their competitive edge (low labour costs) without developing the skills needed to move up the value chain. Instead, the region can draw on a rich and robust industrial heritage that leaves it capable of innovation. Its advantages include a long tradition in education of technical universities and a multilingual workforce, similar to Switzerland and Germany.

The limited size of local economies encourages firms to roll out products and services to global markets quickly. Hence central Europe has become Europe’s fastest emerging start-up ecosystem, raising $1.8bn in 2019 compared with $1bn in 2018, according to PFR Ventures, a venture-capital investor backed by the Polish government. This has so far created eight unicorns (start-ups valued at more than $1bn), including GitLab, Grammarly, Bitfury and Bolt. With dynamic hubs such as The Heart and Google Campus Warsaw, Poland has been ranked as the seventh most-attractive country for start-ups globally by Ceoworld magazine – just behind Germany. This environment is drawing heavyweight foreign direct investment: Microsoft announced a $1bn investment in a new data centre in Poland, Google is planning a similar $2bn project and SK Innovation – part of one of South Korea’s largest business groups– is to invest €335m in producing components for lithium-ion batteries.

“STOCKMARKET VALUATIONS FOR THESE COUNTRIES ARE AMONG THE LOWEST IN THE WORLD”

The four countries may also be able to decrease their dependence on Germany if they integrate their economies more closely with each other. Trade within the region currently represents less than 60% of trade with Germany. However, since 1990 growth has been encouragingly inclusive: unemployment fell sharply and wages increased. So economic growth is increasingly driven by domestic demand as households benefit from these favourable trends in the labour market. The Visegrád economies are also coordinating more closely with their neighbours through the Three Seas Initiative (which includes 12 countries that link the Baltic Sea, the Adriatic Sea and the Black Sea), as well as pursuing major regional infrastructure upgrades such as a 1,800km link from Gdansk on the Polish coast via Vienna in Austria to Bologna in Italy.

CHEAP WHATEVER HAPPENS

Importantly, even if these economies do not evolve as much as they should, their stockmarkets are cheap enough to be compelling. Valuations are among some of the lowest in the world: the cyclically adjusted price/earnings (p/e) ratio (Cape – see page 15) for the Czech Republic is eight, Poland 8.5 and Hungary 12.5. Poland is the largest of the four and is the one that attracts the most attention from investors. CD Projekt is the current darling of its exchange: this video-game publisher has seen its share price rise 350% over the last three years following the huge success of The Witcher 3 and there are high hopes for its upcoming release Cyberpunk 2077. Last month, its market capitalisation passed that of Ubisoft, Europe’s biggest games firm. CD Projekt now looks pricey on a p/e of 154, but is an encouraging example of Poland’s ability to produce successful tech firms. A cheaper play in the IT sector is banking software provider Asseco Poland (Warsaw: ACP), on a p/e of 17.5. I first recommended this in MoneyWeek in 2017; its shares had failed to impress until recently, but have done better in the last few months.

The Czech electricity producer CEZ (Prague: CEZ) is one of the ten largest energy firms in Europe. It generates good cash flows and offers a decent dividend yield of 7% (6% net of dividend withholding tax). In Hungary, pharmaceutical firm Gedeon Richter (Budapest: RICHTER) enjoys a 17.8% operating margin and carries no net debt. London-listed regional drinks firm Stock Spirits (LSE: STCK) is performing well and remains relatively good value compared with multinationals such as Diageo or Pernod Ricard, on a p/e ratio of around 17.5. 

Fund investors should be aware that eastern Europe funds often include (and are dominated by) Russia, but the Amundi MSCI Eastern Europe ex Russia (Paris: CE9) is an exception. It has around 68% in Poland, 22% in Hungary and 10% in the Czech Republic. Poland is the only market large enough to have a dedicated ETF, iShares MSCI Poland (LSE: SPOL).

A brief history of the Visegrád Group

The Visegrád Group is an alliance of four central European states sharing common values and economic interests: Poland, the Czech Republic, Hungary and Slovakia. The group was created in Visegrád, Hungary, in 1991, to strengthen military, cultural, economic and energy cooperation among its members, including pursuing membership of Nato and the EU. The choice of name refers to the congress of Visegrád in 1335 between John I of Bohemia (in what is now the Czech Republic), Charles I of Hungary and Kazimierz III of Poland. Their main purpose was to settle the dispute over the Polish throne limiting the armed conflicts, encouraging diplomatic custom and to create new commercial routes to bypass the Habsburg empire in Vienna.

All four countries joined the EU at the same time in May 2004 and the region has since become a major economic centre. Together, the Visegrád Four have a population of 64 million inhabitants – similar to Italy, France or the UK – and a GDP of $2.13bn in purchasing power parity (PPP) terms (which accounts for differences in the cost of living), similar to the $2.24bn GDP of Italy.

All four countries have a PPP GDP per capita greater than Portugal and Greece. The figure for the Czech Republic, the wealthiest, is $40,585 according to IMF estimates, putting it broadly in line with Italy ($41,582). But GDP per capita at market exchange rates remains much lower, ranging from $14,900 for Poland to $23,200 for the Czech Republic, providing further room for catch-up growth.