Sunday, January 22, 2012

If you want responsible capitalism, change the tax system

The Observer's Heather Stewart has written an economics column which gets right to the heart of how and why Capitalism v.3 is so unfit for purpose: the tax incentives are completely askew, rewarding rent-seeking rather than genuinely productive activity.

Take the leverage buyouts that became the craze among private equity investors in the last decade: few if any of these deals made sense were it not for the debt relief offered on loan finance. As Stewart notes:

"The frenzy of private equity deals that swept through the (British) economy in the noughties was partly because interest rates were unusually low; but it also reflected the structure of the tax system. Companies can claim back debt repayments against their corporate tax bill. That means the 'leveraged buyout' - gobbling up a firm using a loan which the firm itself will then have to repay - has an inbuilt financial advantage over a straight takeover."

Exactly so, and over the years we've met many economists and tax officials who recognise the harmful distortion this creates but shrug their shoulder about the prospect for changing this situation since politicians have had no appetite for taking action. Why not? Well, a quick look at party political funding sources might give a clue.

But the favourable tax treatment given to private equity investors doesn't stop there. In order to encourage their 'wealth-creation', which frequently involves nothing more than debt leveraging companies to reckless levels, cutting staffing numbers, and stripping intellectual property rights to offshore companies, successive governments have allowed private equity managers to treat the bulk of their earnings as capital gains (taxed at 18 percent compared to 50 percent charged as income tax on top-earners).

As Stewart notes in her article, tax frames the way in which economies work. It also shapes the outcomes of economic activity. A well designed tax system will reward certain activities, including investment, and inhibit others (gambling, hydrocarbon abuse, etc). Taxes can also mitigate the harmful income and wealth inequalities that capitalism tends towards.

Any debate about how to reform capitalism must take account of perverse tax incentives at national and international levels. Tax havens are bang at the centre of the problem, as Americans are beginning to realise in the context of revelations about presidential candidate Mitt Romney's tax affairs, which have derailed his campaign in the past week.

Read Stewart's article here.

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