Revisiting the mathematics of economic expectations

The below presentation by Dr Ole Peters opened my mind. If there was one thing I believed was reasonable about economics, it was the assumption that expectation values upon which agents base their decisions are the “ensemble mean” of a large number of draws from a distribution.

Surely there is nothing about this simple method that could undermine the main conclusions of rational expectations? Surely this is a logical benchmark, regardless of whether actual human behaviour deviates from it.

But now I’m not so sure. Below is a video of Dr Peters making the case that non-ergodicity of many economic processes means that taking the ensemble mean as an expectation for an individual is probably not a good, or rational, expectation upon which to base your decisions.

I encourage you to watch it all.

Let me first be very clear about the terminology he is using. He uses the term ergodic to describe a process where the average across the time dimension is the same as the average across another dimension.

Rolling a dice is a good example. The expected distribution of outcomes from rolling a single dice in a 10,000 roll sequence is the same as the expected distribution of rolling 10,000 dice once each. That process is ergodic [1].

But many processes are not like this. You cannot just keep making the same gamble over time and expect to converge to the mean of the result that you get if you made that gamble independently many times.

An example

Peter’s example is this. You start with a $100 balance. You flip a coin. Heads means you win 50% of your current balance. Tails means you lose 40%. Then repeat.

Taking the ensemble mean entails reasoning by way of imagining a large number coin flips at each time period and taking the mean of these fictitious flips. That means the expectation value based on the ensemble mean of the first coin toss is (0.5x$50 + 0.5*$-40) = $5, or a 5% gain. Using this reasoning, the expectation for the second sequential coin toss is (0.5*52.5 + 0.5 * $-42) = $5.25, another 5% gain.

The ensemble expectation is that this process will generate a 5% compound growth rate over time.

But if I start this process and keep playing long enough over time, I will never converge to that 5% expectation. The process is non-ergodic.

In the left graph below I show in blue the ensemble mean at each period of a simulation of 40,000 runs of this process for 100 time periods (on a log scale). It looks just like our 5% compound growth rate (as it should).

The dashed orange lines are 10 sample runs of the simulation. Notably, the distribution of those runs is heavily biased towards low final balances, with a median payoff after 100 rounds of $0.52 Recall that the starting balance was $100, so this is a 99.5% loss of your original balance.

In fact, out of the 40,000 runs in my simulation, 34,000 lost money over the 100 time periods, having a final balance less than their $100 starting balance (or 85% of runs). Even more starkly, more than half the runs had less than $1 after 100 time periods. 

The right-hand graph shows the final round balances of the 40,000 simulations on a log scale. You can read more about the mathematics here.

If almost everybody losses from this process, how can the ensemble mean of 5% compound growth be a reasonable expectation value? It cannot. For someone who is only going to experience a single path through a non-ergodic process, who has a finite budget to play with, basing your behaviour on an expectation using the ensemble mean probably won’t be an effective way to navigate economic processes that are non-ergodic [2].

Peters says the logical thing to do is maximise the average expected rate of growth of wealth over time, rather than the average outcome across many alternatives. In this case, the average rate of growth over time of all runs in the simulation is actually negative 5.03%, meaning it is not a good bet to partake in despite the traditional assessment of expected returns being 5%.

Lessons for Economics

I see two areas of economics where we may have been misled by thinking of the ensemble mean as a reasonable expectation.

First is a very micro level concern: behavioural biases. The whole idea of endowment effects and loss-aversion make sense in a world dominated by non-ergodic processes. We hate losing what we have because it decreases our ability to make future gains. Mathematics tells us we should avoid being on one of the many losing trajectories in a non-ergodic process.

The second is a macro level concern: insurance and retirement. Insurance pools resources at a given point in time across individuals in the insurance scheme in order that those who are lucky enough to be winners at that point in time are able to make transfers to those who are losers. By doing this, risk is shared amongst the pool of insurance scheme participants [3].

Retirement and disability support schemes are social insurance schemes. They pool the resources of those lucky enough to be able to earn money at each point in time and transfer it to those that are unable to.

But there has been a big trend towards self-insurance for retirement. In the US they are 401k plans, and in Australia there are superannuation schemes. The idea of these schemes is that rather than pooling with others at each point in time (as in public pension systems), why not pool with your past and future self to smooth out your income?

You can immediately see the problem here. If the process of earning and saving is non-ergodic and similar in character to the example above, such a system won’t be able to replace public pensions at all. Many earning and saving paths of individuals will never recover during their working life to support their retirement. Unless you want the poor elderly living on the street, some public retirement insurance will be necessary.

Undoubtedly there are many more areas of economics where this subtle shift in thinking can help improve out understanding of the world. I’m thinking especially about Gigerenzer’s idea of a heuristics approach as a generally effective way for humans to navigate non-ergodic processes.

I will leave the last word to Robert Solow, who has had similar misgivings (for over 30 years!) about our assumptions of ergodicity (a stationary stochastic process) which undermine rational expectations.

I ask myself what I could legitimately assume a person to have rational expectations about, the technical answer would be, I think, about the realization of a stationary stochastic process, such as the outcome of the toss of a coin or anything that can be modeled as the outcome of a random process that is stationary. If I don’t think that the economic implications of the outbreak of World war II were regarded by most people as the realization of a stationary stochastic process. In that case, the concept of rational expectations does not make any sense. Similarly, the major innovations cannot be thought of as the outcome of a random process. In that case the probability calculus does not apply.

Footnote [1]. He does not use the term, as it is often used in economics, to describe what is called the term Lucas critique, or in sociology is called performativity. Basically, it is the idea that the introducing a model of the world creates a reaction to that model. Take a sports example. As a basketball coach, I look at the past data and see that three-point shots should be taken more because they aren’t defended well. I then create plays (models) that capitalise on this. But because my opponents respond to the model, the success of the model is fleeting.

Footnote [2]. In theory, if you start with an infinitely small gamble, or have infinite wealth, you could ‘double down’ after a loss in such a process to regain the ensemble mean outcome.

Footnote [3]. Peters himself has a paper on The Insurance Puzzle. The puzzle is that if it is profitable to offer insurance, it is not profitable to get insurance. The typical solution invokes non-linear utility to solve it. Peters offers an alternative. My take is on the economic implications of this is that if people can individually smooth consumption through time for retirement than there is no logic to social insurance.

This is an update of a post from June 2016.

UPDATE (26/03/2017 9.10pm): On Twitter, it has been mentioned that I have simply restated the logic of the Kelly Criterion. This is true. The logic here, and there, is at odds with the naive way in which odds are translated into rational expected payoffs in economics. In fact, adopting the Kelly Criterion when playing the betting game in the above example generates an expected rate of growth of wealth over time of 8.65%, instead of negative 5.03%, and a far higher and narrower distribution of final period wealth outcomes. The paths of the simulation for betting under this condition, and the distribution of final period wealth, are shown in the below graphs. Notice that this strategy is highly effective at both changing the distribution of outcomes AND increasing the overall rate of growth of wealth. Regardless, the very fact that such a strategy is needed tells us that there is a problem with what a rational expected outcome should be for non-ergodic processes

Housing affordability: An honest debate

I spoke on Sunday at an event in Sydney, hosted by Sustainable Australia, called Housing Affordability: An honest debate. A video should be on the Facebook page and is below, as are the notes for my talk.



Imagine explaining 2017 to someone from 1987
I would like to start today by imagining a conversation. It’s the conversation I would have with my grandfather if I could go back in time 30 years to 1987. It might go a bit like this.

Me: 
Grandad, how are you? I’m so glad I could come back from the future to tell you all about the amazing progress we have made.

Grandad:
Oh, look at how you’ve grown. What amazing things can you tell me all about it.

Me:
Well, remember how you were the first person out of everyone you knew to fly in an aeroplane? Well, in 2017, people fly all around the world all the time. Not only that, you know how you saw a computer once? Now everyone has a computer in their pocket. It’s like every encyclopaedia in the world has been shrunk down. And we can video call anyone, anywhere in the world, anytime. We have clean solar energy now, and China, South Korea, and many countries in Asia have become wealthy and brought their people out of poverty.

Grandad:
That does sound rather fantastical. And how are you?

Me:
Well, I’m 34 now. I got a university degree, and a PhD, so I’m the first in the family for that. And I have a loverly wife and two young boys who are 6 and 9.

Grandad:
Oh how lovely. You must have a beautiful house and garden then with all those grand things the future holds.

Me:
Well. Actually no Grandad. We live in a house smaller that the one Mum and Dad moved into when they were first married. It’s very similar in fact – I don’t think it has been renovated or improved in 30 years. And our garden? I’ve tried, but I don’t want to put too much money and effort into it. Because I rent Grandad. Although I have a university degree, and so does my wife, we can’t buy a house. They cost $1 million in and around Sydney. Even in Brisbane, homes are around half a million. Less if you go out of town, but it’s hard to find work outside of the city. And we have no chance of saving more than one hundred thousand dollars for a deposit when our rent takes up 40% of our income.

And what’s worse, the price of the average house in Australian capital cities went up 11% last year. In Sydney and Melbourne, the average home went up in price in one year by more than the average wage! So saving up for a deposit is like running up the down escalator. You never make progress!

So we are in a pickle. I can’t have a nice garden, because if we do spend the money and time to spruce it up, the real estate agent will see it and realise that they can rent the house for more, then ask us to pay for it by putting the rent up at the end of our lease. And every year, when the lease is up, we don’t know if we can stay anyway. We’ve moved 4 times in the last 10 years. I don’t really think we will ever have a house and nice garden. Probably not even a nice apartment.

Grandad:
What an absurd situation. You have all this technology – a computer in your pocket, world travel – and you can’t have a place with a nice garden to call your own.

How can we change my story?
Despite being absurd, this conversation contains many truths about modern Australia. And it doesn’t have to be this way. The past 30 years could have taken another path.

By many metrics Australia is one of the wealthiest handful of countries in the world. So why are we having an event today talking about the basic challenge of making housing secure and affordable?

If anyone can do it, we should. Many of our wealthy peer countries have established home ownership is a genuine option, and they’ve made law that make renting a secure alternative.

You see, the heart of this story not about housing, but about economic diversity. When wealthy countries ensure that economic investment is made across many different sectors, they establish demand for skilled workers, demand for cheap housing also comes from the companies who need to attract those workers. Mobility, in terms of households moving cities for work, has declined, mostly because of the challenge of finding affordable accomodation.

We could be in a different place today. We could be talking instead about Australia cementing its place as a global manufacturer of solar and wind energy, one of a our natural advantages. We could be talking about how a world class satellite industry and growing remote sensing industry has revolutionised agriculture, and how we’re exporting this expertise to the world. I could have regaled my grandfather with these wonders instead.

The reality however is that Australia has dropped in the world rankings of economic productivity and diversity. Harvard University researchers called Australia a ‘laggard’ of the Asian region, along with Mongolia and Papua New Guinea. We’ve dropped in their rankings from 32 in 1994 to 54 in 2008, and are still declining. Our exports are now dirt. Mostly coal and iron ore. Canada still beats us, ranked 29, but having declined from being ranked 19 just 20 years ago. Canada too has similar housing affordability problems to us.

As a side note, Canada is second place in the developed world in terms of immigration rates. If Australia just decreased the immigration intake to match the rate of Canada over the past ten years, there would be 1.3 million fewer people. That’s three Canberras!

We can actually see part of the cause of our narrowing of our economic base in the pattern of bank lending. Fundamentally, the pattern of new lending determines the patterns of real investment in the economy. It determines where we invest in new manufacturing and production capabilities, or instead take leveraged gambles by reselling homes to each other. That’s why the fast growing Asian countries use State-owned banks to direct investment towards new production facilities that expand their capabilities.

In the early 1990s, over 50% of Australia new bank lending was for business investment. Only 4% was for investor housing. 25% OO housing.

Now? It’s down to 30% for business. Investor housing has jumped from 4% to 20% of lending, and OO lending too has leaped from 25% to nearly 40%.

But it’s worse. 95% if that massively increase investor housing lending is for established homes, up from 50% in the late 1980s. Only 5% is for newly constructed homes, down from 50% a quarter of a century ago. We are directing our powerful monetary system, our bank lending, away from new investment in new housing, towards trading the same homes with each other. Home ownership rates have steadily declined for twenty years.

Why is this?

In many ways it was a conscious political choice. While the decline of our economic diversity, has failed the average worker, it has been a boon for the landlord class. Those who already own land and housing benefit at the expense of those who want access to housing for their own household security.  Those who own the banks benefit too. And we have seen the enormous lengths to which government will go to support the way things are. Every “affordable housing” policy, from FHBG to super access, is designed not to let housing prices fall, and housing become genuinely more affordable.

What can work?
While the main challenge here is political, one thing we can do is have a shortlist of effective policies proposed, analysed, and scrutinised, that are ready to be adopted when the political timing is right.

Let’s start by debunking a furphy. Anyone who says that we need less regulation and freer markets to solve housing affordability is a fool. They have not though this through. They have ignored all the evidence from extensive regulations in wealthy countries that do promote affordable housing.  Australia’s problem come in many way from “market forces”.

I’m an economist, I love markets. But I’m not an idiot.

In terms of the larger economic diversity problems, much of this stems from lobbying pressure to sell the assets of the nation to well-connected interests on the cheap, with these new monopolies doing the rational market thing of constraining output and increases prices. No longer do we have a public sector able to use these institutions to take risks, or invest in new technologies that have obvious public benefits.

Public investment has always laid a platform upon which the private sector has built, innovated, and thrived. We know that the space race of the 1960s had huge economic benefits for the economy broadly. We know the many waves of public investment in our city infrastructure also supported private sector producers in terms of transport, communications, water, energy and health. The same is true today. We actually need to defy market forces if we want to make progress. We need to gamble with public investment for major capital projects – yes, like the NBN – for the future.

For example. it’s not too late to do economic CPR on the manufacturing sector if we want to, and that sector will help us invest in the clean energy and information technology future.

Moving on to banking. We should see new lending and money creation, as a social function. It’s a public good. And we have let this money creation gift that we provide our banks to be used to fund land and housing speculation, rather than new businesses and real investment. This is the natural market outcome in the absence of regulations that direct our monetary system is be used for broad economic goals.

We need to massively tighten lending rules for banks to the housing market, and force them to look elsewhere and take risks on genuine productive investment. We could go beyond LVR rules, to loan-to-income rules, that restrict investor lending based on the rental income of the property. We could completely ban investor housing lending except for newly built homes, which do not expand our productive capacity. While it seems extreme, being a wealthy nation where citizens cant afford housing IS AN EXTREME problem!

We should be taxing unproductive activities, and un-taxing productive ones. That means charging for our land and mineral rights. The ACT is six years into a 20 year transition to land value taxation. Loopholes in the PRRT can be closed, and the system expanded onshore as we once tried with the MRRT. As you might now be realising that one of the problems with getting back our economic diversity is the concentration of political power by a few narrow interests. Many came out against the attempt to retain control of mineral right with the MRRT. Expect nothing less next time effective reforms are proposed.

In terms of housing more generally, we could ban foreign purchases altogether. I see absolutely no reason not to. It is clearly a myth that we need the money – after all our domestic lending for housing investment is off the charts! There was around $120 billion if new lending to investors last year. If this was direct to new housing only, it could have funded over 300,000 new homes, far more than one each for our new population over the period. Removing foreign buyers would take a large chunk of the wealthiest potential buyers out of the price-bidding contest for homes. 11% of home buyers in NSW last year alone.

And on the same note, the 50% CGT discount merely serves to increase the payoff from speculation rather than investment and production. It was a mistake. We can admit it. Let’s move on.

Renters
I want renting to be a valid and equal alternative to ownership. To that end my general view is that balance of bargaining power needs to shift towards renters, which would decrease the price-competition that keeps rents high.

There are a number of ways to do this.

Tenancy laws: Remove options for not-fault termination of lease, and limits rental increases.
Vacant homes: Introduce a vacant home tax that would punish owners of multiple dwellings, many of which are held for asset speculation, and kept vacant to time their exit from the market and maximise the sale price by selling it vacant.
Social housing: Broaden the number of state-owned social housing projects, ensuring they are widely integrated into the community. As well as funding them directly, make them part of development conditions for large new subdivisions. This provides an outside option to renters who are no longer being funnelled into the private rental market.

These laws are absolutely standard across the our peers of successful, wealthy, economically diverse countries, like France, Germany, Denmark. If I were in these countries I could have told my grandfather about my beautiful garden, and I could have told him how we have not had to move 4 times.

Before I finish I should comment briefly on supply. Many people see that as the answer, despite the fact that Australia has the most homes per person that any time in history, and has just had the biggest housing construction boom in history. There certainly has been a small effect on rental prices, in the order of a percent or two less growth here or there. But it has done nothing for prices. Sydney prices are up 75% in 5 years.

Nor does rezoning increase supply. It makes no sense to tell a landowner who has for decades decided not to build houses that they can built more densely. It is a pure gift. There are examples of sites rezoned because of the urgency of supply, only for the developer to turn around and tell investors that they want to take 35 years or more to develop. Sure rezone, but if you are doing it for housing supply, make it a condition that homes are built in a short time period. I have seen developers lobby for rezoning and be granted it due to concerns over housing supply, only to then turn around and tell their investors that the housing development will take 35 years and they will sell as slow as necessary to keep prices high.

Additionally, rezoning rights can be sold rather than given away. In the ACT, rezoning rights are taxed at 75% of their market value. In Sau Paulo Brazil, rezoning rights are auctioned months, and they have raised $10 bill USD in 10 years from that.

I will wrap up now.

I would love to have gone back in time and had a different conversation with my grandad from an alternative 2017. One where there was more to life that speculating on housing, and we could laugh at the idea of housing reality television on our screens. We could instead talk about gardening.

But we can learn from these past decades, and if my grandchildren do the same exercise in 30 years, they can tell me about their family, their work and their garden, and their beautiful home.

Controlling futile rental-price competition

In a recent post I explained how home rents are mostly wasted spending arising from futile price competition amongst potential tenants. I likened this to Richard Dawkins’ analogy of energy used to create tree trunks being waste from the perspective of the tree, because the only purpose of the trunk is to win the futile competition for sunlight through investment in height amongst a group of uncooperative forest trees.

I explained how tenants could instead cooperate, by unionising, and exert their bargaining power on landlords to cooperatively reduce rents. This post will look at some examples of how the rental canopy is lowered in practice, and how price competition amongst tenants can be limited by well-written regulations.

The best place to start is wartime. Is such times economic efficiency is a priority, and laws and regulations that cut off wasteful competition are more easily passed.

Almost universally, strict rent controls were put in place across Europe, the US, and Australia, during the major 20th-century wars. These had the effect of containing nominal rental prices despite inflationary pressures from the wartime economic build up. In terms of the primary objective of lowering the ‘rental canopy’, they worked very successfully.

In modern times the main approach to pruning the rental canopy is to enact tenancy laws that restrict the pricing power of landlords for existing tenants. Indeed, almost every wealthy country has laws that improve the bargaining position of tenants, with government agencies tasked with ensuring there is full cooperation amongst tenants, and that landlords cannot sidestep these protective laws. They do this because it works. It reduces rental prices. Even economists know this.

“It is possible to design a set of rent regulations that results in an improvement in efficiency over the unrestricted market equilibrium”
Arnott, 1995

In France, tenancies are secured with an automatic rollover of leases and limits on rent increases set by the L’Indice de Référence de Loyers (IRL), which is currently the consumer price index excluding rent and tobacco. In Germany, tenancies are secured in a similar way, with rental increases limited to local conditions, such as to a maximum of 15% over three years in Munich. In Denmark, there are four different rental control systems, all of which ensure tenant security and limit landlord’s power to increase rents. In all cases, tenant security is assured because landlords must justify the reason for asking a tenant to leave, even when the lease is expired, with very few reasons made acceptable by law, such as extensive renovation, or occupation by the landlord (summaries of European rental laws are here).

Such rules avoid the situation where landlords try to severely hike the rent at the lease expiry, and, if the tenants cannot pay, force them to leave. In the absence of legal protections, landlords are able to squeeze out existing tenants and get new ones at market prices, forcing more tenants into futile price competition with each other. Even the mere threat of this power means that existing tenants are often forced to meet the market price each year. The ‘market’ outcome is that the landlord has all the bargaining power.

In Australia, this situation is the norm. Landlords can increase rents without limit after each contract, typically one year, and ask tenants to leave without any reason at lease expiry.

The graph below gives an idea of how limits on rental increases and a secure rental tenure system can result in tenant paying below market rents. This occurs over time if the rental increase limit is below the growth rate of local market prices. The total value of the benefit from these laws for this example tenant is shaded in grey. For society as a whole, the benefit is the sum for all tenants of the difference in the actual rental price paid to the market rental price.

How big could the gains for Australian renters be if we adopted similar tenancy laws to what is fairly standard n Europe? Let us take the situation of secure tenant rights and coupled with limiting rental price increases to CPI.

In Sydney for example, the housing component of CPI has increased 55% in the past decade, while the CPI itself has only increased 25%. In Melbourne it is 51% and 25%, and in Brisbane it is 50% and 30%. With these figures in mind, a realistic rental price saving of 20% on market prices is possible for long-term tenants in the major capitals.

With $60 billion in total housing rents paid to landlords each year, even small rental savings across a small share of tenants results in big savings. If just one-quarter of tenants made a 20% saving on market rental price, that would amount to $3 billion per year saved. If half of the tenants made those savings, that’s $6 billion.

The security given by these tenant protections also means that tenants are able to invest in improving the property – with curtains, lights, gardens and other beautification projects – without fear of losing their investment because they will soon be forced to leave. Indeed, unlike Australia, tenants are often obliged to bring their own curtains, lights, and sometimes kitchens, when they rent a new home in countries with such well-established tenant protection laws.

Adopting world’s best tenancy rights would undermine futile rental-price competition and be a $3 billion win for Australian tenants.

Bullshit financialisation

That’s what I’m calling a class of nonsense policies designed specifically to not address a social problem, but to rake profits from those facing the problem. They disguise a grab for economic rents as a solution. But when you actually think about them as solutions for a specific problem, you meet irreconcilable logical errors that reveal their true nature.

Retirement savings
We know that in terms of real goods and services, private compulsory retirement accounts are useless. We also know that $20 billion per year is creamed off in fees and charges on superannuation accounts. And yet, this bullshit continues.

Error: Buying shares and bonds with superannuation is good, yet buying property with superannuation saving is bad because it inflates prices.

Why: Both are bad. They funnel money into a set of asset markets that would mostly be used instead to buy goods and services and make new investments. The economy is no larger and no more able to support consumption by retirees.

Housing
If you want more housing, your build it. Instead, governments tweak the funding settings for social housing, tweak rules about town planning, buy equity in homes, and provide cash gifts to homebuyers.

Imagine running the military. You want more helicopters. Do you give out helicopter production permits to manufacturers, provide a government guaranteed line of credit to manufacturers of helicopters, buy equity in helicopter hire companies, and give cash grants to people who are buying existing helicopters from each other? No. Because it's bullshit.

Error: Rezoning land to allow greater density is good. Forcing rezoned landowners to actually build homes is bad.

Why: Because these policies are not about supplying more housing. They are bullshit financialisation.

Healthcare
This one is a little more US centric. Instead of simply providing health care, they are proposing to get the government to match payments into individual healthcare savings accounts. It’s bullshit. It’s not an insurance program because insurance only works when you have a diverse pool of participants – you can’t self-insure against catastrophic events, which is sort of the point.

In Australia, money is funnelled into private health insurance using tax system incentives to the tune of $5 billion a year. For every dollar given by the public to the private hospital system, it provides only 40 cents worth of equivalent care compared to the public hospital system. From a health perspective, it's 60% wasted money. So why do it?

Error: People don’t have enough money to pay for healthcare, so to solve that we get people to pay for their own healthcare. Or, we don't have enough money to boost the public health system, so we instead pay $1 of tax money for 40 cents worth of health care in the private system.

Why: Because these policies are not about healthcare, but scraping exorbitant fees for ‘managing’ the money in savings accounts and health insurance accounts.

Privatisation and public-private partnerships (PPPs)
Privatisation, and partial privatisation in the form of PPPs, is about nothing more than removing both debts and assets from the government books, then lying to the public by only talking about the debt side of the equation.

Error: Government has no money, so it sells its assets to pay off debts, leaving it with no money.

Why: Because these policies are about putting monopoly enterprises in the hands of the private sector so that they can make stupidly high profits.

Summary
This is just a taste of the bullshit financialisation in the economy. It is likely to get worse before it gets better.

Why do journalists ignore facts on immigration?

When foreign supermarket chains ALDI and Costco entered Australia, did Coles and Woolworths welcome them with open arms?

What a silly question. Of course not. The entry of foreign competitors undermined their pricing power. So much so, that recent RBA research credited the entry of ALDI with a 13% reduction in grocery prices.

Good for customers, bad for business. It’s simple economics.

When foreign competitors enter the labour market, should local workers welcome them with open arms?

Of course not. More competition reduces the pricing power of workers, depressing their wages.

Good for business, bad for workers. It’s simple economics.

Depressing wages is a terrific thing for the owners of capital - landowners, miners, banks, and other businesses - who love to promote the story that immigration is an overall economic win. Yet they conveniently ignore that this overall outcome only occurs because their profit gains outweigh the losses to wage earners.

For the past decade, Australia’s big business lobbyists have provided the “skills shortage” and “ageing” myths as cover stories for their calculated raid on wages through record high immigration levels.

Even pro-immigration Canada is not even in the ballpark of Australia’s population growth.

So it puzzles me how so many journalists, politicians, and other media commentators, can buy into the lobbyist’s story. Can they not separate the humanitarian logic of supporting refugees, who make up a tiny fraction if immigrants, from the economic logic of mass immigration?

Take Bernard Keane. He writes for Crikey. His latest article carries the tagline:

Businessman Dick Smith attacking immigration as a threat to our economy is both wrong-headed and encourages anti-immigrant sentiment in the community.

I sort of see his point. Keane reckons that talking about immigration could stoke racial tensions, and that is a bad thing. But that logic leaves no opening to have any discussion about important policy questions surrounding our immigration system.

Not only this, he employs the same false rebuttals to Dick Smith’s economic arguments that Waleed Aly tried on The Project a couple of months back.

Here’s Aly.



And here’s Keane.

Immigration can’t halt the ageing of the population, but it can slow the decline in participation, which — far from impoverishing us — will support economic growth.

But they are both wrong. On both points. And what is more surprising is that they both have stuck with these views despite the clear evidence. It’s almost as if they won’t let the facts sway them.

Keane quotes a 2006 Productivity Commission report to support his view, which found that

…the overall economic effect of migration appears to be positive but small.

But that report mostly supports Dick Smith’s view, which is the standard economic one. It concludes with:

The distribution of these benefits varies across the population, with gains mostly accrued to the skilled migrants and capital owners. The incomes of existing resident workers grows more slowly than would otherwise be the case.

While it may well be the case that there are small overall gains, the distribution of those gains also matters. Working class wage-earners suffer a loss, while wealthy capital owners, and the skilled immigrants themselves, benefit.

And what about housing? Keane mocked Smith about his view that high immigration rates are contributing to elevated housing costs. He says:

Blaming migrants is the “they take our jerbs” argument of housing affordability.

I wish the Productivity Commission could clear this one up too. Oh, here. Look.

Urban land owners, in particular, might benefit from increased land values or rents.

Aly and Keane both make the point that immigration is helping to solve population ageing, which leads to a decline in the share of the population actually in the workforce (because of more retired people). Yet that too is a myth. Here’s the Productivity Commission to tell us about it.

Despite popular thinking to the contrary, immigration policy is also not a feasible countermeasure. It affects population numbers more than the age structure.

Not surprisingly, immigrants age as well.

The economic analysis Bernard Keane used to try and discredit Dick Smith actually supports all of Dick Smith’s fundamental points.

I don’t know why this is so hard to fathom. Keane and Aly aren’t arguing for open borders, which would be the natural conclusion of their arguments. So they implicitly realise immigration policy is a choice, and that it has economic and social consequences.

Making a proactive choice about immigration policy isn’t being anti-immigrant, nor is it anti-refugee. Australia’s absurd immigration policy choice has been to lock up the neediest refugees, while at the same time adopting an immigration policy that has been off the scale in global terms, and affecting local wages.

Keane and Aly can go on ignoring economic reality. They can paint as racist everyone who understands that population and immigration outcomes are the result of policy choices. But they can’t change the facts.

Futile rental-price competition

In his famous book, The Greatest Show on Earth, Richard Dawkins’ presents a Forest of Friendship story, which contains within it a powerful idea that has broad implications for how we develop important social, economic, and political institutions. I want to show how this idea provides clues about how to tackle excessively high home rental prices, and offer some suggestions about how to do just that.

Here is Dawkins.

Imagine the fate of a hypothetical forest - let's call it the Forest of Friendship - in which, by some mysterious concordat, all the trees have somehow managed to achieve the desirable aim of lowering the entire canopy to 10 feet. The canopy looks just like any other forest canopy except that it is only 10 feet high instead of 100 feet. From the point of view of a planned economy, the Forest of Friendship is more efficient as a forest than the tall forests with which we are familiar, because resources are not put into producing massive trunks that have no purpose apart from competing with other trees. 

But now, suppose one mutant tree were to spring up in the middle of the Forest of Friendship. This rogue tree grows marginally taller than the 'agreed' norm of 10 feet. Immediately, this mutant secures a competitive advantage. Admittedly, it has to pay the cost of the extra length of trunk. But it is more than compensated, as long as all other trees obey the self-denying ordinance, because the extra photons gathered more than pay the extra cost of lengthening the trunk. Natural selection therefore favours the genetic tendency to break out of the self-denying ordinance and grow a bit taller, say to 11 feet. As the generations go by, more and more trees break the embargo on height. When, finally, all the trees in the forest are 11 feet tall, they are all worse off than they were before: all are paying the cost of growing the extra foot. But they are not getting any extra photons for their trouble. And now natural selection favours any mutant tendency to grow to, say 12 feet. 

And so the trees go on getting taller and taller. Will this futile climb towards the sun ever come to an end? Why not trees a mile high, why not Jack's beanstalk? The limit is set at the height where the marginal cost of growing another foot outweighs the gain in photons from growing that extra foot.

The futile competition Dawkins describes is a natural instinct. Civilised society builds institutions to help avoid the negative consequences of such instincts, with rationing systems that foster genuine large scale cooperation.

One particularly important part of the economy where our institutions no longer prevent futile competition is in the housing market. I am not just referring to the house and land asset market, where speculation runs regularly runs rife. Rather than mutant trees, it is speculators who try to bid just a little more for each home, wasting resources by overpaying for land. These always end in spectacular crashes where the greatest fool - the last speculator - makes the greatest loss. But they also bring down the real economy as well!

I am talking of something more mundane. The rental market.

Here too there is a forest canopy. It is an invisible rental price curve, a rental canopy if you will, that expands across the world’s cities, supported not by heavy wooden trunks, but by the wasted resources used by tenants to pay to access the land. While Dawkins’ trees chased a bigger piece of sky, renters chase a better piece of the land.

The diagram below shows the basic idea. The green line is the current “rental canopy”, which is higher near city centres, and falls with distance. At half the height is an orange line, which is one possible height of the rental canopy, if a cooperative institution could be developed to stop the futile price competition amongst renters. The grey shading shows the economic gains for renters from an increase in cooperation.

So why don’t tenants cooperate like a Friendship Forest?

The benefits are clear. In Australia, there are around 2.7 million renting households paying $60 billion per year in rent or $22,000 per household. Halving the rental price saves $30 billion of previously wasted resources by renters, generating massive efficiency gains for them.

Large-scale cooperation could happen in practice in the following way. Each renter sends a copy of their lease that shows their current rent to a central organisation. The organisation tells each renter only to pay half the rental amount on the lease to their landlord, and that from now on it will set the rental prices. Because the organisation negotiates on behalf of all tenants, it is a monopoly supplier of tenants to the landlords and can set the rental price.

Let us call this organisation a Tenants’ Union.

If there are no “mutant”, or “rogue”, renters who opt out of the union and outbid rental prices by negotiating directly with landlords so they access a better home for themselves, the system will work. It is a genuine Friendship Forest. If this cooperative institution could drop the “rental canopy” by half it would save each renting household $11,000 per year.

This is great news. It is a perfectly possible and realistic thing that can be done.

But there is another side to the Tenants’ Union story. The landlords who own these 2.7 million homes would earn $30 billion less per year. In Dawkins’ story, the landlords are the animals who benefit from inhabiting the trunks, the loggers who cut them for timber, and others in the ecosystem who lose their benefits if not for the resources contributed by the futile competition amongst canopy trees.

So that political reality would need to be negotiated.

The rest of the story happens within the Tenants’ Union itself. To avoid futile competition, they must enforce a non-price way to ration the better (and worse) homes amongst potential renters. If they can’t do that, they simply shift the futile price-competition from outside the organisation to inside it.

I should be clear that any such system would not be perfect either. We are therefore comparing an imperfect system of rationing through futile price-competition, costing renters $30 billion, or an imperfect alternative system, that might make the choices of renters more limited, but will benefit tenants $30 billion every year.

So what sort of non-price rationing system could our Tenants’ Union employ? I can think of a few.

1. Queuing
A list is made of people who want to rent a home of a particular type, in a particular location, with new people added at the bottom. Each time a property becomes available, it is offered to the first person on the list. To retain a degree of choice, each person on the list might get 3 veto choices - homes that become available at their turn, but which they could choose not to take, and stay at the top of the queue and wait for the next home.

The more effective this system is at reducing prices, the longer the queues.

2. Lottery
Each time a home becomes available, a lottery is run, with a period of a few weeks in which potential tenants can get a ticket. The winning ticket gets the home. This can be expanded to run in batches at set intervals to overcome problems of having tickets in multiple lotteries at once.

The more effective this system is at reducing prices, the more people contesting each lottery.

3. Need
Homes would go to people based on an assessment of the household's needs. Criteria could include rental history, income, family status, age, other other metric deemed fair and reasonable. Such assessment can be used to determine qualification rules for lottery or queuing systems.

Other methods could, of course, be implemented. But to make any of them effective at undermining futile price-competition, secondary markets would need to be outlawed, and this rule rigorously enforced.

There are some final points to consider to counteract the likely arguments against this idea, all of which are inherently arguments in favour of futile price competition.

First, rationing without prices is itself futile, because "capitalism". Yet in the most important areas of society in all capitalist economies, price competition is strongly avoided. In the courts, we ration by queuing, and ration juries by lottery. In politics, we use elections to ration positions of power. In healthcare, we ration public services based on assessments of need. Spouses are allocated to each other through non-price rationing.

Second, non-price systems limit choices for tenants, and that is bad. Yet price-competition also limits choices for tenants. The bottom half of tenants by income already are excluded from choosing the top half of rental homes because of prices. These non-price systems provide much broader choices to the lower income households.

Overall, it should be clear that price competition over nature’s scarce resources - be it the sunlight in the forest, or access to the land in the housing market - is usually futile. Human societies overcome this by developing institutions that use non-price ways to ration resources. Taking a stand against price-rationing in the rental housing market by developing institutions like those discussed here could save tenants billions of dollars a year.  We should look into it.

Book review: The Econocracy

I have just read a fantastic economics book. In entertaining detail, it outlines many issues in the economics profession that I feel strongly about [1] Like the authors, I want my discipline to evolve into one that is much better than it is; more practical, humble, and diverse. So why did I finish the book feeling less than upbeat?

The book is called The Econocracy: The perils of leaving economics to the experts. It is about how the general population has been excluded from public policy debate by an inward-looking economics profession. More than this, the profession is fundamentally failing, having grown in the past three decades to become nothing more than ideology masquerading as science.

Econocracy is written for people with some economics training, or with a keen interest in economics. Or perhaps even someone who is simply concerned about public policy debates being hijacked by economists and their jargon would appreciate it, and I can imagine there are many such people!

I would summarise the main story of the book as follows

1. Economics is now the default method of analysis in serious social and political debate, undermining the legitimacy of other modes of analysis, making anyone who doesn’t understand economics and its jargon unable to participate in the major political debates of our time.
2. Despite the great power granted to economists, the discipline has become nothing more than a narrow ideology, with that last defining theoretical battles happening back in the 1970s, and little openness to criticism or new ideas since.
3. Changes in how economists and their discipline function could benefit democracy. These changes are 
a) economists training their next generation in a more pluralist way, giving them exposure to many methods of analysis to avoid the ideological indoctrination that is economics education and 
b) economists being less insular by reaching out to the public to promote a culture of “citizen economists”, who have sufficient understanding and confidence to bring their groups to the table and participate effectively in policy debate.

I will admit my bias upfront and say I needed no convincing of the first two points. Let me see which part doesn’t quite inspire me as much as I expected.

What is an econocracy?
In the words of authors - Joe Earle, Cahal Moran and Zach Ward-Perkins (EMW) - an econocracy is

A society in which political goals are defined in terms of their effect on the economy, which believed to be a distinct system with its own logic that requires experts to manage it.

I am totally on board here. Making policy in order to nurture a thing called an economy is bizarre, bordering on meaningless. The slightest scrutiny reveals that the economy is whatever economists assume it to be.

When we think of Gross Domestic Product, probably the main measure of the ethereal thing we call the economy, we are actually thinking of a measure whose definition has changed dozens of times. The latest change of note is the inclusion of illegal drugs and prostitution in the European Union official GDP statistics. So is crime now part of the economy? And if so, is it good or bad to have more of it?

Examples like this are common, yet routinely ignored. They reveal that when you define an economy, you are making moral judgements about what is good or bad for society. Economic growth is only good if you agree with the hidden moral judgements that sneak in when you define the economy.

Bringing insights like this to the surface can connect economics to a broader audience. Many people want to put forward their views in political debates about what constitutes a good, and just, society, but are bamboozled by economics jargon, which seems to leave no place for them. Cloaking policy debates in economic jargon limits participation from those who simply want to express their valid moral judgements about how society should be run.

Not only is the economy now the exclusive subject matter for experts who hide their moral judgements, these experts often hide their financial interests as well. If you have seen the 2010 film Inside Job, you would know how prevalent this is, particularly in the economics profession. I can personally attest to the troubles of even getting economists to recognise that they may have ethical obligations. But perhaps that is because their training was so narrow and uncritical.

Fixing a failing discipline
The decline of critical thinking in economics is beautifully told in the chapter entitled Economics as Indoctrination. For anyone considering studying economics, and for its many of teachers, this chapter will resonate.

EMW make their case that economics courses are best described as indoctrination by presenting the results of a curriculum review they conducted covering 174 economics modules at seven Russell Group universities. Their data is revealing and provides indisputable evidence that the discipline trains its newcomers in a narrow, uncritical, and unrealistic way.

As a teacher of economics, their survey results were fascinating, but not surprising. Multi-choice questions and lack of critical thinking seem to dominate assessment at the two universities I have taught at, while neoclassical methods of optimising representative agent models are the default, and sometimes only, approach taught. If anything, this chapter is a call-to-arms for teachers of economics everywhere.

EMW propose that teaching in a more pluralist and critical way is the answer. Many of the core parts of an economics course would be kept, and some replaced with a more diverse set of ideas and methods. No longer would material be presented uncritically as religious icons to be believed, not challenged, but each idea would be pulled apart and rigorously scrutinised.

However, the battle for change in teaching cannot be underestimated. Just look at the profession’s reaction to the efforts of EMW and their allies at the Post-Crash Economics student group.

The main reaction as has been “change without change”. A group of alternative reformers agree with EMW that the teaching of economics is poor (though in the quality of the teaching, not the content), and have endeavoured to fix it with better teaching materials, producing an updated textbook for the 21st century called Core Economics. Unfortunately, this group missed EMW’s central critique - the content should also change!

EMW respond to the Core Economics project in their book. But I don’t think they quite see it as the defensive strategy of a powerful group that it is in reality. To me, this reaction is a signal of the political and financial power of the status quo in economics, and the enormous challenge ahead.

There are other problems I see with their pluralist solution. Teaching a pluralist curriculum requires teachers who actually understand alternative non-neoclassical approaches to economics in all their nitty-gritty detail, so they can be equally taught in a thoughtful and critical manner. There are very few of them.

And to make space for this type of pluralist teaching means dropping parts of the current core economics modules. Which ones should go? Egos will be damaged in this process.

I have personally tried to improve my teaching multiple times, only to find that dropping particular materials and including other new material, combined with more critical and reflective assessment pieces, has been frowned upon by others in the school. Particularly if they are teaching modules later in the course that build on the material that I chose to drop. Some kind of collective choice needs to be made about what topics to drop, and what to keep. And it is inescapable that such a choice will signal to many professors in positions of power that their careers have been wasted on things the discipline now considers to be nonsense, and not worth teaching.

Having an academic tribe that conforms to the same approach gives that tribe power. Notice the book is not called “sociologocracy” or “political science-ocracy”. Disciplines that do teach a variety of methods in a pluralist way typically end up losing credibility to outsiders because of the infighting within the discipline about fundamental issues.

I would recommend the book Economists and the Powerful: Convenient Theories, Distorted Facts, Ample Rewards, by Norbert Häring, which explains how neoclassical economists and their methods become powerful because of a feedback loop between the theories they created, and the support of the political classes who benefited from those theories. Economics as a discipline is now very powerful, and its uniformity maintains its power.

These incentives mean that change needs a grand coalition, rather than a slow evolution of improving the curriculum one module at a time. Past efforts of student groups have sought similar reforms in economics for nearly thirty years without success. I don't think EMW see the sheer size of the political challenge their proposed reforms face. I do. And that's probably why it is hard for me to get too excited.

Reaching out
To shift society away from an econocracy to a democracy, EMW also see benefits from economists as a group reaching out to the public to make accessible the technocratic analysis of themselves and their peers. A survey the authors conducted of 1,500 adults across the UK found very low levels of economic literacy in the general public, meaning the economic jargon being sprouted by politicians and the media each day is not actually communication useful information to voters.

I agree wholeheartedly with this proposal. It only takes a few economists to reach out and teach active community groups to be savvy about, rather than intimidated by, economic analysis. And if such efforts result in greater participation from community groups in all spheres of life, it may undermine the demand for bogus economic analysis by vested interests who use it as a shield against criticism.

This idea has promise because it generates change outside the discipline. I simply do not see a way for economics to reform itself from the inside. The only way to change, that I see, is for the rebels and reformers to form a new discipline. Perhaps reaching out to the public is the start of that, which will develop a network of ‘citizen economists’ who are able to share knowledge, and through their networks and organisations, create a demand for work of people trained in this new discipline.

Call this new disciple something catchy, then agree broadly on its scope, some guiding philosophies, then add in some ethical standards. Get the major institutions of the country involved, like the Bank of England, to give it credibility. With some luck, this rebel group will soon develop a reputation as being the superior discipline to economics, or what would soon become known “out-dated economics”.

Anyone who has studied powerful informal groups and networks knows that radical change usually comes from outside, while insiders go down clinging to their old beliefs and denying that reform is necessary. The book itself the work of three outsiders; students from Manchester who were able to see the tribe with clear eyes, and a clear head.

I can only hope that with such bright and critical minds as theirs entering the discipline, that the time may be ripe for change, either from within the discipline, or with new leaders rising up to change it from outside. Whatever the case, while I finished the book a little glum, I have finished this review much more upbeat, ready to push for change wherever I can.

fn [1]. I have a PhD in economics, teach graduate economics courses at The University of Queensland, and consult widely for non-profit groups to help them participate in policy development. An important disclaimer is that I have also been peripherally involved with Rethinking Economics, a group very much aligned with the reform efforts of the authors and their student group Post-Crash Economics. The authors provided me a complimentary copy of the book.

Value capture now a serious debate in Australia

The Department of Infrastructure and Regional Development has released a discussion paper about value capture; an idea that the incremental gains to land values that arise from new public investment can be captured n some way to fund that investment.

I have made a very brief submission to this policy development process (reproduced below).

What is surprising is how far the debate about land value taxation has moved in the past 5 -10 years. Just a decade ago any talk of taxing land values was dismissed by 'very serious people' as the crazy idea of 19th century eccentric (yes, I'm referring to Henry George), and also argued to not be technically possible in reality (which was a bald-faced lie).

To capitalise on this new political climate of acceptance of taxing land, I have made the absolutely crucial point in this submission that we already have well-functioning system of land value taxes in every state, which automatically perform the function of capturing land value gains from public investment! However, these systems are clogged up with politically expedient exemptions. These exemptions could simply be closed in order to get a system that is a near perfect implementation of the idea of value capture.

So here's my submission, which responds to 13 question raised in the discussion paper in order.

How can we make better use of Value Capture?
Submission 

Dr Cameron K. Murray
The University of Queensland
Tuesday, 24 January 2017

1. What factors would cause beneficiaries, in particular property owners, to see a value
capture charge as ‘just another tax?’ How can these factors be overcome?

Every loser from a tax change will whinge. The trick is perhaps to simply remove exemptions from existing land taxes and then sell it as ‘fixing loopholes’. There is no obvious reason why a special “value capture” tax should exist, when a tax on land values, which already exists in all States (with far too many exemptions) will automatically provide the funding mechanism sought by arbitrarily drawn “value capture districts” or other measures.

2. Are there examples of mechanisms currently being used in Australia or internationally which provide a clear nexus between payments and the benefits provided by the infrastructure?

The Gold Coast Infrastructure Levy is supposed to do that. But there is no good policy reason to do so, because the factors that determine land prices in an area are much more broad than the type of things that get categorised as infrastructure. And it is also the case that some infrastructure will have negative effects on nearby land prices due to noise and other externalities.

There is also no ability, even if governments promise it, to isolate and earmark certain revenues for certain expenses, given politicking and accounting trickery. Forget about it. Use it as a selling tool if you must, but don’t pretend it is the reality.

3. Which mechanisms are currently being used which have weak links between payments and benefits?

Promises.

4. In providing funding to projects, should the Commonwealth set a condition that any contributions levied by state or local government on surrounding landowners are dedicated to the project?

Forcing the states to choose catchments affected by infrastructure is going to open up political battles that don’t need to be fought. There is no clear accepted method for determining catchment boundaries, and catchments are likely to vary project by project, depending on the pre-existing infrastructure, and type of activities occurring in the local area.

Certainly a less politically sensitive way to do this is to add a charge on new development only within an arbitrarily defined catchment, avoiding much of the blow-back from existing owners and residents.

5. How can governments accurately estimate the incremental value uplift generated by infrastructure projects as compared to uplift due to ordinary market growth?

Highly detailed data on property sales or land values is necessary. Even then, it is still very difficult to isolate the marginal value gains statistically, given the challenges of properly identifying the timing of value effects. I have recently undertaken such an analysis on the Gold Coast Light Rail.

6. When identifying beneficiaries, how should governments determine the geographical boundaries around new infrastructure assets? Should governments focus on all properties directly around the new assets, within the wider region or at a city-level?
 
Every time a boundary is drawn it will generate conflict near the boundary as some landowners win, and some miss out, financially. A better way is a city-wide levy, which makes sense for network-style infrastructure, such as rail, where expanding the network benefits people not only at the new station, but on the rest of the network who now have access to that new station.

7. How can governments design processes which cause beneficiaries to reveal their
willingness to pay?

This is unnecessary. Simply incrementing up the rate of land value taxes in general, and removing exemptions, will automatically capture incomes from land value gains which arise from public infrastructure investment of all types, and at levels which are perfectly in proportion to the willingness to pay of land market participants.

Additionally, there is an interaction on some modes, like rail, between ticket prices and the effect on land value. If trains were made free to ride, land values nearby would rise to reflect the reduced cost of living in that locations (and vice-versa).

A general recurring tax on land values automatically responds in both directions to any such effect, reducing tax burdens on those suffering negative effects, and increasing it on those who gains positive economic benefits.

8. Could we adopt an approach in Australia of holding popular votes in relation to large
infrastructure projects and their funding mechanism?

That would be possible only if there was already a system in place to generate a shortlist of viable candidate projects that could then be voted on.

9. Who would be best placed to organise such votes? Local councils? Transport
authorities? Others?

Given the large size of many new infrastructure projects, these seem a task for the States, though some large councils could independently conduct such a voting system. Although if it was a decision on funding by the Commonwealth to choose between alternatives generated by the State, the Commonwealth could run votes locally.

10. Would the Commonwealth be justified in linking funding to evidence of popular
support and willingness to pay?

This is difficult. Many people can’t think about how they will behave in the future, especially when infrastructure is a new mode that they are not yet familiar with. You are asking for trouble to justify funding on this basis of elicited willingness to pay from survey data based only on early proposals.

11. Are there examples of other successful approaches to seeking community
acceptance for value capture mechanisms?

Not sure.

12. Should there be different approaches to obtaining proof for different beneficiaries?

No. As above, broadly applied land value taxes automatically identify landowning beneficiaries. Obviously users benefit as well, and user changing is widely accepted in rail (tickets), road (tolls), and other transit infrastructure. However, it is a social and political choice as to whether users, or external beneficiaries, such as landowners, should pay more.

13. Are there examples where re-zoning, integrated planning and value capture funding have been well implemented? Are there examples of missed opportunities?

Australia has a great working example of land value taxation in the ACT, specifically a transition towards much higher rates of land value tax. The ACT also capture land value gains from rezoning in its lease variation charge, getting around 75% of the value gains from rezoning (in addition to 100% of the value gains from rezoning rural to urban uses through the functions of the Land Development Authority. See this paper for analysis of the ACT example

Sau Paulo, Brazil, also has regular auctions of rezoning rights used to fund local infrastructure, and has raised over $USD 2 billion in the past decade (see here).

Company tax confuses economists

Basics

To think about company tax, we have to first understand it. These taxes apply to a type of entity run by humans with its own set of accounts called a company. That entity typically aims to make a profit each year, by making sure its revenues are above its costs, with some costs able to be amortised (or smoothed) across time in an accounting sense through depreciation, and in a financial sense, through borrowing and repaying debts. 

Across Australia, company profits were about $230 billion in 2015-16, and company tax revenue was $65 billion.

Companies in Australia pay tax on their profits at 30%. If these profits are then transferred to the company owners, through a dividend, the owners of the company are credited for the tax already paid by the company and pay the difference between the company tax and their marginal rate.

So we have two important situations to consider if we want to know the effect of a company tax. First, the situation where a company pays all profits to its owner in a year. In this case, because the tax is credited against the tax payable by the person (or people) who own the company, the effective company tax rate is zero. It ceases to be of any relevance to any decision making internally (profits, or whatever objective, are still maximised) or externally (owners of companies can compare company performance before tax).

If this was the case all the time, company tax would be a none issue. With it or without it the net effects are the same, and if we err on the side of simplicity, we would get rid of it. There are no distributional or efficiency effects to worry about.

But the second case, where the company retains their profits on their own accounts, gets really interesting. And confusing for economists. Because it all happens in their big blind spot - financial assets.

An example
Let's simplify some more. In this second case, the company makes a $100 profits, they pay the company tax rate of 30% on it each year, then simply accumulate the remaining 70% of profits (the after-tax profits) in their own bank account.

The table below compares the with and without company tax scenarios where one year's profits are saved as assets on the company books and are therefore assets on the owner’s books.

Notice what happens when we remove the company tax. It makes it easier for companies to accumulated assets with tax-free incomes, and thereby increase the wealth of their owners. Company tax is simply another way to tax wealth accumulation but on unrealised capital gains.

The "economic" logic
Now hold on there, says the little economist floating over my shoulder. Why would anyone want to own a company that increases in value without ever getting a dividend? What crazy economics is that?

It’s the type of economics that acknowledges that financial and asset markets even exist! After all, what purpose is there to run a business, or own a financial asset, except to accumulate wealth? If people weren’t interested in such things, there would be no super-rich people, they would have cashed out all their assets and spent the cash on faster cars, better aeroplanes, or bigger houses.

It’s the type of economics that acknowledges that people will own vacant land without building on it because it is an asset whose value rises over time.

It’s reality.

But things get crazier still

The economic consensus is that taxing companies is bad because it reduces investment in new machines, buildings, vehicles, ships, and other capital equipment, thereby reducing the rate of growth of the economy. After all, it means it costs companies more to save a year’s income in their own accounts before spending it on new machines next year.

It’s one of those ideas that seems plausible on the surface. But in fact, one great way to avoid company tax is to make less profit by investing now in new machines and equipment—the exact economic incentive most economists claim comes from removing the tax!

A company that is not investing like crazy is likely to have more profits—they are probably lazy monopolists. I can think of a few, like Telstra, the banks, and some of the big miners.

I’m serious. Here’s a plot of Amazon’s profits. Notice the period of low and negative profits. That’s what you get when you are investing heavily in warehouses, robots, servers, IT, and other large capital projects that are the things that make us more productive in the future. It’s an example of avoiding company taxes by investing!

Source: Business Insider

And yet, cutting company taxes is a love-in. Treasury likes it. Many think-tanks like it. Here’s Nick Gruen liking it. But they are all wrong. And they are wrong because their model conflates physical capital—machines, vehicles, buildings and equipment—with financial arrangements. You can’t tax a tractor. You tax only the profits of an entity that may own a tractor to help earn its revenue. The new tractor is a cost that reduces taxable profits!

If the company buys too few tractors, its profits will be lower because it couldn’t earn the revenue. If it buys too many, its profit will be lower because its costs are higher. The optimal investment in tractors that maximises profit is the same, whether you keep all the profit, or just a share of the profit because the rest is taxed.

The reason that so many economic models show efficiency gains from company tax cuts is… because they assume it in the first place! They assume that any additional profits kept by the company will all be used to invest in new machines and equipment.

So the efficiency gains all but evaporate if you don’t assume them and actually look at how company taxes actually work.

Gifts from the people
Lastly, what about the distributional effects? I have shown in the table above how company owners will be able to accumulate wealth in the company entity and avoid taxes altogether. But The Australia Institute has gone further and shown that the major beneficiaries are the big banks, who get $7.4 billion over the next ten years, as well as the US government through its tax system, because of offsetting arrangements used for companies who have already paid tax in other countries, like Australia!

Cutting the company tax will be a multi-billion dollar gift from with working class to the super-wealthy. If it goes ahead, prepare for Australia to catch up to the world in our political backlash against the establishment!

UPDATE:
The below meme came across my screen on Facebook. Don't know if it an real quote but the argument is true.

Quick views on Trump (did we forget Brexit already)

When the Brexit vote stunned the world’s elite (obviously it didn’t stun the millions who voted for it) I wrote about some simple lessons that are too easily ignored in “normal” times. 

With Trump winning the US election, perhaps it is again worth reflecting on how the world’s elites misread the public mood so badly.

1. Elites seem to believe the public will eat up their lies, but then they deludedly thought that exposing Trump’s lies would bring him down. Facts Don’t Matter. To either side!
 Look at the lies from celebrities promising to leave the country. Anyone could see through it!
2. Again, technocrats underestimated human tendencies to blame outsiders for their woes. Despite being a believer in multiculturalism, the basic reality is that high levels of immigration reduce labour’s bargaining power.

3. This disconnect is clearly seen in the way the media “looks to the markets” as a way to gauge views on political decisions like this (see top image). That’s total crap. No one gives two hoots about the financial markets unless they are part of the wealthy elite. In fact, this is a victory for his supporters who see, quite legitimately, that the worship of financial markets has distracted politicians from the needs of the vast majority people who have not a cent at risk in those markets.
4. The Australian media portrayed the land down under as a country of moderates who were disappointed about Trump’s win. That’s complete nonsense. While it may reflect the reaction in my social circles, and maybe yours, just remember that Australia already has a more inhumane immigration policy than what Trump proposes, and already has whole bunch of nut cases elected to government at all levels. Trump would be amongst like-minded friends in the halls of most Australian governments. 

5. It’s almost like the elites were speaking Latin, and the masses speaking english. The elites simply couldn’t understand Trump’s appeal, and their lack of appeal. He lies. He objectifies women. That signals he is a normal human being. Unlike the faux outrage, most common people realise humans, god forbid, pursue each other for sex. He talks about a wall along the Mexican border and everyone goes crazy. Almost as if they forget there is already a bloody wall! There are about 1,000km of barriers, fences and walls on that border!

6. The US is already a country taking political prisoners, torturing whistle-blowers, invading countries on false pretences and against the will of international organisations, and conducting mass surveillance on its own citizens. They already deport illegal immigrants and have a border wall. The political classes failed to punish anyone on Wall Street after the financial crisis, yet also then failed to take on public investment programs to support the wage-earning classes. They already have police killing black people routinely. What exactly is Trump going to do?