Bill Emmott - International Author & Adviser


The City needs its wings clipped, not cut off
The Times - May 17th 2010

Thwacking bankers may be a crowd-pleaser but will not help Osborne to revive the economy or shrink the deficit

Britain spent so long in pre-election mode that it is hard to kick the habit. But it is time to do so, not least when thinking about taxes and the City. Combing through what George Osborne, Vince Cable or anyone else said in the past two years is now pointless as a guide to what the new Government will, or should, do. There is no need for populism any longer. At least for a while we, and the Government itself, can be directed by principles. It is a shocking thought, but let us cherish it.

Yet what should those principles be? Punishment was the populist inclination, emphasised by Mr Cable but also played on by Mr Osborne. Capitalists in general and bankers in particular had got us into this economic crisis, so they should be thwacked with tough rules, limits on their bonuses and higher taxes on their incomes and profits to make sure they pay their “fair” share. But while retribution may have pleased the crowd, the right question to ask now is whether it will actually achieve the objectives of national policy.

Those objectives, one can deduce, include sustained economic growth, a steadily smaller budget deficit and a financial system that is a lot less likely to cause another crisis. So, placing those objectives alongside the inclination towards economic liberalism that people who call themselves Conservatives and Liberal Democrats ought to share, the City and the CBI would be right to protest against measures that are prone to discourage corporate investment or to encourage profitable employers to leave the country. But they would be wrong to oppose measures that deal with the causes of the 2007-09 debacle.

In the first category would fall any increase in corporation tax, which includes special taxes on banks’ profits, any increase in capital gains tax that hit start-up or venture capital investors and entrepreneurs, and indeed the 50 per cent marginal income-tax rate on high earners.

Company taxes are anyway not really paid by companies but by their shareholders, which are principally our pension funds and insurance firms. But also higher taxes, especially amid pressure from investors for higher dividends, drain companies’ financial reserves and may deter capital investment if debt and equity finance have become harder to obtain — which they have.

The case for special bank taxes is part retribution, part the notion that banks are benefiting from a subsidy from taxpayers, part the thought that their profits are excessive. Yet the right question to ask is whether they need the subsidy. If not, stop the subsidy. But if they do, it makes no sense to tax it away again.

An interesting study last week by Smithers & Co, a City research firm, confirmed that banks’ profits have been excessive — since the early 1970s they have enjoyed an average (though volatile) return on equity of 20 per cent, well above that of other companies. You could respond to that with a tax. But that conflicts with the objective of today’s subsidy — to rebuild banks’ profits and capital reserves — and potentially with desires to persuade banks to lend more to businesses. A better solution, more in line with economic liberalism, would be to increase competition.

The independent review that is to be set up by the Government will no doubt consider doing that through Mr Cable’s idea of splitting up the big banks and forcing them to divest their risky investment-banking divisions. Andrew Smithers’s appealingly simpler idea is to penalise size by imposing costlier capital requirements on larger institutions. This would neatly discourage banks from becoming “too big to fail” but also lower the barriers to entry in finance by reducing the competitive advantage that comes from size. Greater competition, driving down profits as well as the price of banking, would also deal with the populist obsession with bonuses.

The 50 per cent marginal income- tax rate just introduced by Labour is a punishment for effort and success, even if it looks “fair”. It will become even more so if capital gains tax (CGT), now 18 per cent, is aligned with income tax. Alignment is a sensible and liberal aim: a tax system that encourages individuals to shift earnings from one activity to another, often artificially, is one that is meddling and distorting. But one that penalises investment by taxing its rewards at 50 per cent is also one that will discourage the essential input of economic growth.

Some of that disincentive can be dealt with by preserving lower rates for entrepreneurs and venture investors. But not all, for that is not the only sort of investment the economy needs. Another method, used in America, is to align short-term capital gains with income tax, but to apply lower rates to gains on assets held for more than (say) one year.

Compared with penal marginal rates for income tax and CGT, other ideas for raising revenue would be more compatible with the broader national project of restoring sustainable growth: higher VAT, either generally or by cutting exemptions, since it also trims consumption; a carbon tax, since it deters polluting activities; or a land tax as advocated once by Winston Churchill and now by Philippe Legrain’s new book, Aftershock.

Much of this analysis will be music to City ears, though they will not like the idea of more competition. Who does? The Government needs to stand firm on that principle, but also on principles that reflect the lessons of the financial collapse: the need for full transparency, for all securities to be traded on recognised exchanges, for nothing to be allowed “off balance sheet”, and for capital requirements that raise the cost of the riskiest behaviour while also bringing it into plain view.

Most likely, the Government will wait to see what new financial rules emerge from the sausage-maker that is America’s Congress. The immediate consequence of those principles, however, is that Mr Osborne’s first meeting tomorrow with his fellow European finance ministers should be less bruising than the advance publicity implies.

The City hates it, but the European “Directive on Alternative Investment Fund Managers” deserves Mr Osborne’s support for its requirement for proper disclosure, adequate capital and registration for hedge funds and private equity funds. Whether or not those particular funds caused the crisis, lack of transparency certainly did. Meddling in what the funds do is a different matter, as are draft provisions aimed at restricting Europeans’ right to invest their money in funds from outside the European Union — which is just protectionism. This provides Mr Osborne with an opportunity for compromise. But he should be getting used to that idea by now.


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