Economic theory’s version of Fermat’s Last Theorem now finally explained

I have just had an article published that has taken five years to finally see the light of day. More formally, “Steven Kates (2015). MILL’S FOURTH FUNDAMENTAL PROPOSITION ON CAPITAL: A PARADOX EXPLAINED. Journal of the History of Economic Thought, 37, pp 39-56.” This is the abstract:

John Stuart Mill’s Fourth Fundamental Proposition Respecting Capital, first stated in 1848, had become an enigma well before the nineteenth century had come to an end. Never challenged in Mill’s own lifetime and described in 1876 as “the best test of a sound economist,” it has become a statement that not only fails to find others in agreement, but fails even to find an internally consistent interpretation that would make clear why Mill found it of such fundamental importance. Yet the fourth proposition should be easily understood as a continuation of the general glut debate. Economists led by Malthus had argued that demand deficiency was the cause of recession and a body of unproductive consumers was needed to raise the level of demand if everyone who wished to work was to find employment. Mill’s answer was that to buy goods and services would not increase employment, or, in Mill’s own words, “demand for commodities is not demand for labour.”

That observation by Leslie Stephen in 1876 was literally the last time anyone had ever made such a positive statement about Mill’s Fourth Proposition. After that, it had been worked over by Alfred Marshall, A.C. Pigou, F.W. Taussig, Allyn Young, Friedrich Hayek, J.M. Keynes and Harry Johnson amongst many others, none of whom could make it make sense. I will write it down again, because it is the essence of Say’s Law. Understanding what Mill meant is the only means I can think of to refute Keynesian theory:

Demand for commodities is not demand for labour.

From the moment I read it in Mill, which I was just reading for fun, I was convinced by both the conclusion and the logic that had come before. I had no idea that it would change my life and give a shape to all of my economics thereafter. It simply says that buying of itself never creates economic momentum, but it is the logic of the argument that is required if you are to see the point. Everyone understood both the proposition and the logic for the entire period from the time of Adam Smith right through to the marginal revolution in the 1870s, but from that moment on has made no sense to anyone, other than me. How odd is that!

So now I have the paper in print, but I doubt anyone will get it anyway. You really do have to go back to Mill and the classics to see not just what they meant, but why it’s true. The alternative is to read my Free Market Economics which is classical economics for the twenty-first century. It is also the first book since the 1870s that has actually discussed and defended Mill’s fourth proposition, indeed all four propositions. I say this as honestly and sincerely as I can. You will never understand how an economy works unless you understand what Mill meant. There is no difficulty in seeing the point since I have been teaching it successfully as part of my course since the start of the GFC, but I also recognise how hard the point is to grasp and hold to in the midst of controversy. But if you can do it, it is worth the effort since Mill’s Fourth Proposition truly is the best test of a sound economist.

Posted in Classical Economics | 44 Comments

Peter Costello bells the tax cat

Our political debate is currently dominated by various plans to increase tax. Front and backbenchers in the Liberal Party have proposals to increase GST, the Treasury wants to increase superannuation taxes, the Financial System Inquiry recently suggested franking credits be removed or limited in some form.

No one seems to think it relevant that on their own, none of these ideas will boost growth or create jobs. We’re having an argument about the wrong issue because we can’t bear to think about the right one.

Is Australia’s problem that we don’t pay enough taxes? Well, go and have an argument about which ones to increase. Is our problem that the economy is not growing strongly enough to take people out of unemployment? Well, let’s talk about the real issue. How do we make our economy more productive? Higher taxes are not part of the answer.

There’s a vacuum in our political debate at the moment and it is waiting for a low-tax Liberal to fill it. If the Liberal Party doesn’t find someone to champion the cause, then senators Leyonhjelm and Day are likely to step in.


Posted in Federal Politics, Taxation | 67 Comments

Q&A Forum: March 2, 2015

Posted in Open Forum | 394 Comments

David Leyonhjelm guest post on the Financial System Inquiry

From The Fin Review

David Murray’s Financial System Inquiry wasn’t sexy when it was released in December. And amidst the debate on leadership, terrorism and the Budget, it is even less sexy now. In this environment, we need to be careful not to let Murray’s central, and most egregious, recommendation sneak into law. That’s the recommendation to force banks to lend less money.

In technical terms, the recommendation is to require banks to have fewer risk weighted assets (which consist mainly of loans) relative to their ‘common equity tier 1 capital’ (which consists mainly of paid-up shares and retained earnings). Murray’s aim is for Australia’s major banks to be ranked in the bottom quarter of world banks according to this measure, a somewhat arbitrary target that would put Australian banks at the mercy of foreign banks’ lending policies.

But the more important point is that government meddling in bank lending is unwise. Unlike government regulators, banks have both the expertise and the incentive to ensure they lend money to people and businesses that are likely to repay it.

Murray argues that banks would take fewer risks if they cared about what their failure would mean for the rest of the economy. But he is only looking at one side of the coin. You could just as easily argue that banks would take more risks if they cared about what their successes mean for the rest of the economy.

Murray cites literature outlining how human behaviour is irrational, but applies this to bankers, not to regulators.

He ignores the perverse incentives that influence government regulators, who get little credit when the financial system is humming along nicely but plenty of blame if a bank gets into trouble. This motivates regulators to put banks in straitjackets, even if it stops them from lending money to people and businesses with good prospects.

The odd thing is, Murray’s recommendation would actually make banking less safe. It reinforces the silly and dangerous idea that the role of government is to attempt to reduce the risk of bank failure. This leads to the conclusion that a bank failure is partly the government’s fault, in which case the government has an obligation to compensate the bank’s depositors, creditors and even shareholders. So, contrary to Murray’s claim that he wants to reduce implicit guarantees, his recommendation entrenches the idea that the Government will bail out a failing bank.

A bank failure is undeniably a traumatic event. The bank’s shareholders and depositors take a hit, as does any other bank (along with its shareholders and depositors) that lent money to the failed bank.

But a bank bail out doesn’t avoid this pain; it just redistributes it. Instead of the pain being concentrated on those who decided, directly or indirectly, to invest in a bank that made the wrong calls, the pain is spread across taxpayers who made no such decision. And instead of some of the pain falling on foreigners who invest in Australian banks, it would rest entirely with Australians.

A bank failure takes time to clean up. Administrators are brought in, court cases proceed, and various depositors, creditors and shareholders would rely on taxpayer-funded welfare while they wait to get some of their money back.

But this period of pain pales in comparison to the lingering pain associated with bank bail outs. Japan’s stagnation following its bank bail outs in the early 1990s clearly shows what to expect.

What Murray should have done is acknowledge that the banks already have an incentive to avoid failure. He should have acknowledged that government efforts to reduce the risk of bank failure generate government responsibility for any subsequent failure. And he should have recommended that options to bail out banks ought to be closed off, including through removing the discretion of the Reserve Bank to bail out a bank without parliamentary approval.

Murray’s belief that bank bail outs should remain an option, and his faith in the effectiveness of regulation, should come as no surprise. Murray is a former banker, and his report was prepared by bureaucrats from agencies that regulate the banks. The lesson we should draw is that the financial industry shouldn’t be reviewed by insiders wedded to the idea that the industry is special and needs special regulation. It should be reviewed by outsiders who are intelligent enough to understand the industry but are not captured by it. The Productivity Commission may be a better choice.

David Leyonhjelm is Liberal Democrats Senator for NSW

Posted in Rafe | 40 Comments

Little Brother is watching you

Posted in Hypocrisy of progressives, Take Nanny down | 6 Comments

A clayton’s tax policy

The ALP have just announced the tax policy you have when you don’t have a tax policy.

Federal Labor will announce plans on Monday to recoup almost $2 billion by clamping down on multinational tax evasion as it begins pushing back at demands that it details alternative budget savings.

In its largest policy to be unveiled so far, Labor will announce a four-pronged strategy that will benefit the budget by more than $500 million a year and raise at least $1.9 billion in its first three years of operation.

Those pesky foreigners not paying their tax.

So let’s have a look at the detail:

The first element will be to make changes to the current thin capitalisation rules to reduce the amount of debt against which companies can claim tax deductions in Australia. Presently, companies can claim up to a 60 per cent, debt-to-equity ratio for their Australian operations.

Under Labor’s policy, a company’s tax deduction would be assessed on the debt-to-equity ratio of its entire global operation. For example, if a company averages a debt-to-equity ratio across all its subsidiaries of 30 per cent, them it can only claim tax deductions of that level in Australia.

The thing is this; Labor were in office just 19 months ago and didn’t propose this policy. Good thing too – this would require foreign investors to place more equity in Australia rather than debt. To the extent that they don’t want to do that the quantum of foreign investment in Australia would fall. To be sure, some people would like that outcome, but I’m not convinced that any elected government would be sufficiently unwise enough to implement this particular policy.

The second element will be to stop companies using hybrid structures to reduce tax by aligning Australia’s tax rules on hybrid entities and instruments with the rules of other nations. This will reduce opportunities for companies to double-dip by claiming tax exemptions in some countries and deductions in others.

Tax harmonisation is something we hear about a lot and see little actual harmonisation. The devil is in the detail.

Mr Shorten will also promise to bring forward by a year plans to improve compliance through third-party reporting and data matching.

I’m not sure what this means – the start date is July 2016. Shorten is in no position to bring a start date to July 2015. In any event the processes are not yet likely to be in place.

The fourth element will be to increase funding to the Australian Taxation Office by $67 million to investigate and pursue multinational profit shifting.

My favorite – the compliance dividend. The Rudd-Gillard government gave this a red-hot go. They really did – almost every year funding to the ATO was increased in the expectation of vast revenue dollars materialising. So how did that work out? This is only speculation, reading between the lines at the AFR:

In effect Swan is “spilling” what looks like the entire senior ranks of the ATO. It looks like a complete clean-out of the top two management levels.

“Someone is pretty pissed off with the Tax Office,” one ATO official said, a comment that seemed to be reflected throughout the organisation. “Perhaps the ship has lots of leaks but taking out the captain at this time is not the right thing to do.”

D’Ascenzo’s departure comes at a time when the three second commissioner positions are due to change as well.

“Is it coincidence? It’s a hell of a coincidence,” a senior tax adviser in the private sector says.

The announcement came two days after Swan released the Mid-Year Economic and Fiscal Outlook which showed that forward revenue estimates had dropped $160 billion since 2008.

Much of that reflected the continuing global financial malaise, with other tax revenue losses from concessions overseen by the government.

But there also appears to be a perception by government that the ATO has disappointed in some revenue areas – though Swan had nothing but praise for D’Ascenzo in announcing that his seven-year term would not be renewed.

and reading between the lines at Crikey:

D’Ascenzo gratefully accepted the role of chair of the government’s cross-agency pursuit of rich tax cheats known as Operation Wickenby. In that role he presided over agencies such as the Australian Crime Commission and the Australian Federal Police. The $430.9 million investment by the government has struggled to gain success with only $351 million dollars collected by audit action. On top of that we have had allegations of Wickenby leaking the personal tax affairs of prominent Australians to the media, and the botched criminal investigation into Paul Hogan and John Cornell which cost taxpayers $30 million. Who can forget when Hogan was detained in paradise by an ATO departure prohibition order because he was a flight risk?

You have to wonder if the government was becoming weary of the negative publicity.

I don’t know if the inference of those two sources is correct or not – but I think there is little tax revenue to be had from a compliance dividend.

Bill Shorten’s argument here is just rubbish:

How can we ask Australians to work hard and pay tax if we let big multinationals off the hook? How can Australian businesses compete if they pay more tax at home than big multinationals?

He knows full well that there is a distinction between legal incidence of taxation and the economic incidence of taxation. All taxes are ultimately paid by people – the question is, which people?

Here is a paper from the Australian Treasury explaining these issues and guestimating the incidence of Australian company taxation:

The welfare effects of a 1 percentage point cut in the company tax rate are shared between company owners and workers. Estimates from the main scenario, which includes economic rents, suggest that in the long run only around one-third of these benefits accrue to the owners of capital, with the remaining two-thirds flowing to households primarily through higher wages.

The economic burden of the corporate tax is (mostly) borne by Australian households. So tax policies that increase the corporate tax burden impact Australians more than they do foreign owners of capital.

All up the ALP have announced a policy that will adversely impact foreign investment into Australia, adversely impact Australian households, with substantial components that couldn’t be implemented anyway.

Posted in Federal Politics, Taxation | 31 Comments

Monday Forum: March 2, 2015

Posted in Open Forum | 1,128 Comments

The Thermometer Effect

I have discovered the reason for the apparent contradiction between falling temperatures wherever anyone lives and the well-known fact of global warming. It is what I describe as “The Thermometer Effect”.

The Thermometer Effect – the temperature in any location will be between 1-3 degrees lower than it otherwise would have been wherever a thermometer is present. The actual presence of a thermometer will cause the temperature to fall until such measuring devices are removed or stop recording. The thermometer effect may be expected to increase in intensity over time.

Here is the proof. As is universally understood, because of greenhouse gases, temperatures must continuously rise and have been doing so. At the same time, there have been lower than forecast temperatures recorded across much of the world. The only conceivable explanation is due to faults in the measuring devices used.

As one example, we have the data below which are taken from the United States.

NOAA: 2185 cold records broken or tied in past week – 1913 Low Min Records Broken & 272 tied in 7 days. This even includes the following examples of an extreme thermometer effect:

Many records broken by over 30F.

These are clear examples of The Thermometer Effect. Although, on average, temperatures are getting warmer across the globe, such warming does not occur in places a thermometer is found, and therefore the measurement of air temperatures is well below the air temperature wherever temperature readings are not being taken. Had the temperature in those other locations been taken into account, the actual overall rise in temperatures would have been unmistakeable.

Posted in Global warming and climate change policy | 43 Comments

“… still a thumping loss”.

Mark the Ballot aggregates the polls using several techniques:

If an election was held now, it would still be a thumping loss, just not as thumping as early February.

Here is the data:

Mark the ballot 1

Here is one pretty picture (Mark has others – they all tell a similar story):

Mark the ballot 2

By contrast the betting market has the government slightly ahead:

Coalition $1.70; ALP $2.12.

That is an improvement from the 50:50 odds of a few weeks ago.

So how to explain the difference? Betting markets tend to be forward looking – so that implies the betting market is either pricing a leadership change or improved performance by Tony Abbott. I have little confidence in the latter, so I suspect the former is the case. The contenders for a leadership change are Malcolm Turnbull at $1.40 and Julie Bishop at $6.50. Abbott himself is at $4.

Posted in Federal Politics | 95 Comments

Cheaper, efficient power to the people

In The Australian today:
“Between 2008 and 2014, electricity transmission and distribution costs increased by some $400 per household in Queensland and New South Wales, where the poles and wires are government-owned, but by around $250 per household in the privatised systems of Victoria and South Australia.”

Posted in Uncategorized | 32 Comments