Hugo Dixon

Why do markets still pay attention to what rating agencies have to say? Following their appalling record predicting the subprime mortgage crisis, it is astonishing and sad that investors still seem to quake when Standard & Poor’s junks Greece and downgrades Spain.

An arriving Martian would find it hard to understand why anybody gives any credence at all to S&P and its rivals Moody’s or Fitch. It’s not just that they were pumping up the U.S. subprime market — for example giving a triple-A rating to Abacus, Goldman Sachs’ now-notorious synthetic collateralised debt obligation — after smart investors saw trouble in the market.

They were late in spotting the wave of corporate debt defaults, including Enron’s, in the early part of the century. And they have been dilatory in calling attention to the current euro zone sovereign debt crisis. Even after S&P’s downgrade of Spain, Moody’s and Fitch, the other big agency, are still rating the country’s debt at triple-A. Ratings agencies are consistently behind the curve.

So why do they still wield influence? There are at least two reasons. One is because they are embedded in the way markets operate. Some investors, for example, are only allowed to buy investment-grade securities. That means they have to sell securities when they are junked. Similarly, ratings are used in determining the riskiness of a bank’s balance sheet and how much capital it needs to set aside.

Ratings are also common in deciding how big a haircut is required when banks and investors pledge collateral. One saving grace in the euro zone crisis is that the European Central Bank has stopped saying that only the highest rated sovereign debt can be pledged as collateral. But ratings are still far too entrenched.

The other reason why markets pay attention when the agencies bark is what could be called the “megaphone” effect. S&P and Moody’s may not be the smartest observers in the market; but they do make a big noise. It’s a bit like shouting fire in a crowded cinema. The agencies aren’t the first to spot the problem; but they sure help create a panic.

It is high time regulators and investors dethroned them from their privileged status.

LONDON/TURIN, Italy (Reuters) – Italian industrial group Fiat SpA <FIA.MI> will spin off its auto business under a new strategic plan, a source said on Tuesday, and shares surged almost 9 percent on the possibility of a demerger.

Analysts said a spin-off would give the Italian carmaker more flexibility to join the consolidation drive in a sector emerging from the worst downturn in decades.

FiatLuca Cordero di Montezemolo also said he would resign after six years as chairman of Europe’s fifth-biggest car maker. The announcement came a day ahead of Fiat’s strategy presentation, its first since teaming up with U.S. car maker Chrysler.

Fiat’s board will vote on making Vice Chairman John Elkann, the grandson of Fiat patriarch Gianni Agnelli, chairman on Wednesday morning, Chief Executive Sergio Marchionne told a hastily-called news conference. Elkann has long been seen as Montezemolo’s successor.

A person familiar with Fiat’s thinking said the company was planning to split off its automotive arm as part of the restructuring.

Fiat, Italy’s biggest industrial group, also will set out plans for the two demerged companies until 2014, said the source, who spoke on condition of anonymity.

Marchionne, respected in the struggling auto industry for his turnaround of Fiat, has said a spin-off will be touched on at the strategy presentation.

THREE-MONTH HIGH

Fiat shares were up 8.86 percent at 10.38 euros at 1549 GMT and hit a three-month high of 10.45 euros before paring gains. The STOXX Europe 600 auto sector index <.SXAP> was up 5.38 percent, driven by positive results from Germany’s Daimler AG <DAIGn.DE>.

A Milan fund manager said Fiat’s shares were boosted by market speculation the company would announce the spin-off on Wednesday.

“A big hedge fund was buying Fiat all day yesterday and that has helped boost speculation about the spin-off,” he said.

A trader said speculation that Ferrari could be included in the spin-off was also helping the shares.

Industry Minister Claudio Scajola said he had spoken to Marchionne about the plan. The center-right government will support it and “unions will do their part” to improve productivity, he said in a statement.

Although best known for its autos, Fiat’s holdings include farm equipment maker CNH Global NV <CNH.N>, the Iveco truck unit and Turin newspaper La Stampa.

Montezemolo said he was resigning since his task as chairman was finished and the move was unrelated to the possible spin-off. [ID:nWEB0835] He will stay on as a Fiat board member and chairman of Ferrari, Fiat’s luxury sports brand.

Montezemolo, one of Italy’s best-known business figures and the former head of business lobby Confindustria, denied speculation he would enter politics.

(Additional reporting by Stefano Rebaudo, Nigel Tutt, Ian Simpson and Stephen Jewkes; Writing by Ian Simpson; Editing by David Cowell)

By Hugo Dixon and Richard Beales

Were the investors who lost $1 billion by buying a fearfully complex product sold by Goldman Sachs in the dying days of the credit boom fools or victims? That’s the key distinction on which the U.S. Securities and Exchange Commission’s fraud charges, which roiled the investment bank when they were unveiled on Friday, hinge.

Back in 2007, Goldman sold investors a $1 billion synthetic collateralised debt obligation (CDO). A CDO is a pool of securities, in this case 90 subprime residential mortgage backed securities. A synthetic CDO is based on a pool of derivatives that reference securities rather than the securities themselves.

The SEC’s key allegation is that Goldman marketed this synthetic CDO to investors without telling them that Paulson & Co, the hedge fund, had been involved in selecting the securities that were subject to the bet. What’s more, it didn’t tell investors — or ACA, an independent firm that officially selected the underlying securities — that Paulson was simultaneously placing bets with Goldman that these securities would fall in value.

Goldman’s defence has four elements. First, that it lost $90 million on the transaction. This shows, it says, that “we did not structure a portfolio that was designed to lose money”.

However, the firm has not said how it lost the $90 million. Did it intend to retain a long position or did it just get stuck with it? The answer to the question is crucial in judging the defense. The SEC has produced an email from Fabrice Tourre, the Goldman vice-president who handled the deal, in which the self-christened “fabulous Fab”, said: “The whole building is about to collapse anytime now”. This, at least, suggests that Goldman wasn’t gung-ho about the market. But on the other hand, the fact that the firm went long at all does undermine suggestions it knew the CDO would lose money.

Goldman’s second line of defence is that “extensive disclosure was provided”. It points out that these investors also understood that a “synthetic CDO transaction necessarily included both a long and short side”. The suggestion is that these were big boys who should have done their own homework.

But the SEC alleges a key fact – that Paulson was both betting against the CDO and heavily involved in selecting the underlying securities – was omitted.

This is where Goldman’s third defence kicks in. It admits that Paulson was involved in discussions about the selection but says this was “entirely typical of these types of transactions”. What’s more, ACA – as well as selecting the securities – was exposed to the transaction to the tune of $951 million. As such, according to Goldman, it had an “obligation and every incentive to select appropriate securities.” Paulson, which has not been charged, also says ACA had authority over the selection.

But again there are counterpoints. For a start, Paulson’s involvement, according the SEC, was pretty intimate. In one email, the Fabulous Fab said the portfolio had been “selected by ACA/Paulson”. In another, he says “I am at this ACA Paulson meeting, this is surreal” – a comment that raises the possibility that this type of meeting wasn’t typical.

The SEC also says Goldman knew that a key investor IKB, a bank which ultimately had to be rescued by the German state, would not invest in synthetic CDOs unless there was an independent agent selecting the underlying securities.

The regulator further alleges that ACA believed that Paulson was going to be a long investor in the synthetic CDO. As such, ACA arguably did not mind when Paulson helped it select the underlying securities.

This is where Goldman’s final line of defence — so far — comes in. It says it “never represented to ACA that Paulson was going to be a long investor”. The SEC, however, puts a different gloss on things. It has dug up an email from ACA to Goldman which makes clear that it believed Paulson was going long. The SEC says the Fabulous Fab knew or was reckless in not knowing that ACA had been misled about the matter.

Goldman’s defenders reckon the timing of the charges was motivated more by political considerations than the completeness of the SEC’s case. Be that as it may, the SEC and Goldman are now set to fight this out in court. But even if the charges don’t stick, they will be expensive in terms of time, money and reputation for the investment bank.

– The author is a Reuters Breakingviews columnist. The opinions expressed are his own –

Fears of a hung parliament following the UK’s general election may be overstated. With Nick Clegg, leader of the Liberal Democrats, Britain’s third largest party, performing well in the first prime ministerial debate, sterling has received a mild knock. Investors do not like the uncertainty that goes with a hung parliament. While many European countries are used to coalition government, the UK is traditionally a two-party system – with government swinging between Labour and the Conservatives.

Added to this uncertainty is the fact that none of the three parties has come up with a credible plan for cutting the government’s deficit, which stands at 12 percent of GDP. One fear is that valuable months could be lost in horse-trading over forming the next government. Another is that a minority government could embark on a populist, but expensive, programme to prepare the ground for a second election later this year.

The hung parliament scenario is really two sub-scenarios. In the first, the party with the largest number of seats would govern on its own. This is probably what would happen if the Tories were the largest party. Such a government might well be unstable.

The second sub-scenario is a majority formed through a coalition with the LibDems. This is more likely if Labour emerges as the largest party. That’s because it has offered to change the system for electing MPs – something the LibDems and their predecessor parties have wanted for decades. Indeed, during Thursday’s debate, Labour’s Gordon Brown several times dangled this olive branch.

A formal “Lib-Lab” pact would still need to come up with a credible deficit reduction plan. But arguably this would be easier with a coalition that had been supported by over 50 percent of the electorate. What’s more, if it did not have overall power, Labour would have a ready-made excuse for abandoning pledges made in its manifesto, which would otherwise tie its hands in confronting the deficit.

If there is a hung parliament, it will be better to hang together than hang separately.

Europeans won’t be amused by the alleged Goldman Sachs scam. ABN Amro, and therefore ultimately Royal Bank of Scotland, ended up losing $841 million in the allegedly fraudulent collateralised debt obligation investment concocted by the investment bank. Meanwhile, IKB, the bust German bank, lost nearly $150 million.

These European banks were some of the biggest financial mugs in the last years of the credit bubble. But the allegations levelled by the Securities and Exchange Commission don’t concern the folly of the buyers and insurers of subprime mortgage investments. Goldman is accused of misleading investors. The UK and German states, which bailed the banks out, will be livid if the case is proved. Goldman denies the charges.

The UK government could be the biggest loser if the allegations turn out to be true. After all, it had to rescue RBS only two months after the Scottish bank paid Goldman $841 million to unwind a guarantee it inherited when it acquired part of ABN Amro, the Dutch bank, according to the SEC. Of course, the hole at RBS was much bigger than that. Still, there must be a risk that the issue could become a political football given that the UK is in the midst of a tight election campaign in which banker-bashing is a popular activity among all the main parties.

The Germans won’t be happy either if the SEC’s charges are proved. Again, IKB’s problems ran deeper than its purchase of the investment marketed by Goldman. But it was only months later, in the summer of 2007, that the bank was rescued at huge cost to the German taxpayer.

Many European politicians are already suspicious about Goldman after revelations that it perfectly legally helped Greece hide the true extent of its debts just before it joined the euro. These new allegations, concerning activity that may have directly hurt the pockets of two of the region’s biggest and most powerful governments, could scarcely have come at a worse time.

– The author is a Reuters Breakingviews columnist. The opinions expressed are his own. –

 Crisis, what crisis? That could be motto for the election manifestos published by Britain’s main political parties this week. Neither Labour nor the Conservatives addressed the country’s fiscal crisis head-on.

Instead, they have sought to bribe the electorate with promises.

There are some good ideas in the manifestos. But there are too many promises to cut taxes and not to touch spending – as well as a general lack of urgency. Once one puts the pledges into categories of good, bad and ugly, there are too few in the former bucket.

OVERALL DEFICIT

The two parties are promising roughly the same fiscal squeeze over the course of the parliament. Labour says it would halve the deficit, which is standing at 167 billion pounds or 12 percent of GDP, over four years. The opposition Tories say they would reduce the bulk of the deficit over five years. But such cuts aren’t deep enough. What’s more, neither party has been prepared to say how they will achieve them.

The Tories do seem more determined than Labour to control the deficit. Next year, they would freeze public-sector pay for all except the lowest-paid one million workers. And they would even start cutting elsewhere this fiscal year — promising an emergency budget within 50 days of taking office and measures to cut spending by 6 billion this financial year. But they won’t say how they’ll do this, except that they will cut waste.

They have also promised to set up an independent watchdog to vet whether the government’s spending plans were sustainable. This would only be able to make recommendations — so it can bark not bite. That said, it might help get the government onto the fiscal straight and narrow.

But the Tories also have a really bad idea — reversing the government’s “tax on jobs”. Going back on the increase in National Insurance Contributions (NICs) would cost 6 billion pounds a year. Given the state of the public finances, that is irresponsible.

Labour scores 1 bad idea for lack of urgency on the deficit, and no good ideas at all.
The Tories score 2 bad ideas, but also have 2 good ideas.

TAX/BENEFITS
NICs aren’t the only Tory tax promise that will cost money. The Conservatives would introduce a new tax credit to encourage marriage. And they’d raise the inheritance tax threshold to 1 million pounds. It really doesn’t make sense to shell out more money when the government is bleeding red ink.

Labour is better on inheritance tax — promising to freeze the threshold for four years. But it has also made an unfortunate pledge not to extend the reach of Value Added Tax. Various goods — notably food and children’s clothing — don’t qualify for VAT. By putting these off limits, Gordon Brown has denied himself a useful lever for addressing the deficit.

The Tories do have one good idea on tax: simplification. They want to streamline the current cat’s cradle of tax and benefits. Their one big specific idea is to cut corporation tax to 25 percent funded by abolishing complex reliefs and allowances. They haven’t spelt out what they mean by this, so there could be nasty surprises. A radical — and welcome — proposal would be to phase out the tax-deductibility of interest payments.

The Liberal Democrats, which may be influential in a hung parliament, have one bad idea – raising the threshold before income tax is paid to 10,000 pounds. The country just isn’t in a state to finance such generosity. But they also have a good idea on simplification. They’d align the rates of capital gains and income tax. That wouldn’t just raise money. It would stop rich people going to elaborate lengths to convert income into capital to cut their tax bills.

Labour: bad ideas 1; good 1
Tory: bad ideas 2, good 1

HOUSING
Both Labour and the Conservatives especially have made unfortunate promises on housing. They’d abolish stamp duty on homes worth less than 250,000 pounds. Housing is already wildly under-taxed; it doesn’t need further subsidies. The Tories tax cut would be permanent. At least Labour’s would last only two years. And Labour would simultaneously raise stamp duty on properties worth over 1 million pounds — so there would be no revenue loss in the short run and actually a gain in the medium term.

The Liberal Democrats have a good-ish proposal on housing: a “mansion tax” of one percent a year on properties worth over 2 million pounds. This may seem as a way of bashing rich people. But the current system of property taxes — the council tax — actually benefits those in expensive houses. A mansion tax would level things out.

Labour: bad ideas 1; good 1
Tory: bad ideas 1; good 0

PENSIONS
Labour and the Tories have both made the same bad pledge on state pensions: they’d increase them in line with average earnings from 2012. One of the reasons that Britain’s finances aren’t in an even worse mess is because Margaret Thatcher severed the link between state pensions and earnings in the 1980s. This U-turn is retrograde.

That said, the Conservatives also have two good ideas. Firstly, raising the state pension age from 65 to 66 for men from as early as 2016, and for women from 60 to 66 from as early as 2020. And secondly, capping pensions for public-sector workers at 50,000 pounds a year. Public-sector pensions are extraordinarily generous. It is a shame that Tories’ haven’t been more radical. But these are still steps in the right direction.

Labour also has a useful pension idea — scrapping the default retirement age of 65. That should make it easier for people to hang onto their jobs as they age, instead of needing early pensions.

Labour: bad ideas 1; good 1
Tory: bad ideas 1; good 2

SOCIAL SPENDING
Both Tories and Labour have fallen over themselves to pledge more money for the National Health Service. Of course, the NHS is a national treasure. But how will the government cut its deficit if the biggest-spending department is off limits?

Labour compounds the error by also treating schools as a sacred cow. What’s more, it has promised to give old and needy people the right to free care in their own homes. The best thing that can be said about this potentially extremely expensive proposal is that it will be phased in, with the big bills only hitting in the parliament after next.

The Tories have promised to protect various perks for the elderly, including winter fuel allowances, and free bus passes and television licences. The Tories have missed an opportunity to scrap universal allowances in favour of more cost-effective help for those who really need it.

Labour: bad ideas 3; good 0
Tory: bad ideas 2; good 0

CITY PRACTICES
Both Labour and the Tories have the same good idea about banks: tax them in proportion to how much they rely on hot money. Rightly crafted, this would not only raise money but also give banks an incentive to operate more safely. The Conservatives, though, are taking an unnecessary risk by promising to do this even if other countries don’t follow suit. That potentially could undermine the UK’s financial services industry. Labour’s multilateral approach is wiser.

The government’s approach on takeovers, though, would be bad for the City and industry. It would require a two-thirds majority of shareholders to vote in favour of any bid. Putting grit in the sands of the takeover machine could protect underperforming management from external discipline.

Neither party has got financial regulation quite right. Labour would try to stop future crises by modifying the failed tripartite system comprising the Bank of England, the Financial Services Authority and the Treasury. The Tories would abolish the FSA and hand its banking powers to the BoE. But the BoE didn’t exactly cover itself with glory during the crisis. A better solution would be to keep the FSA regulating individual banks but create a new independent committee — comprising the BoE, the FSA and some maverick outside voices — to prevent bubbles.

Labour: bad ideas 2, good 1
Tory: bad ideas 2, good 1

CONCLUSION
Sadly, this rough assessment of the parties’ biggish ideas finds 19 bad proposals, against 10 good ones. Labour has nine bad ideas and only four good ones. The Tories have an edge of sorts, with ten bad ones compared to six good ones.
But neither party is really pulling out the stops. Given the risks the economy faces, the failure of imagination and courage is a great shame.

(Editing by Chris Hughes and Aliza Rosenbaum)

How can a country support debt of over 100 percent of GDP for many years and then suddenly start spiralling towards insolvency? That question of sovereign debt maths is not merely academic. It is highly relevant to the likes of Greece and Italy.

The answer is that size of the sovereign debt burden is not everything when it comes to keeping up with interest payments. No matter how high the ratio of debt to GDP may be, it does not need to increase as long as the government has two factors going its way: the “primary” budget balance — the balance before interest payments — and the growth rate of nominal GDP.

To see how these play out, consider two countries. One has a moderate debt load, 50 percent of GDP, which carries a 4 percent average interest rate. If the budget is in primary balance, the government will still run a deficit of 2 percent of GDP, which is 4 percent (the interest rate) of 50 percent (the debt). As long as nominal GDP grows by 4 percent, the ratio of debt to GDP stays the same.

The other country is highly indebted, with a debt/GDP ratio of 100 percent. Assume it also pays an interest rate of 4 percent. With a primary budget balance, its fiscal deficit is 4 percent of GDP. However, as long as nominal GDP keeps growing at 4 percent a year, the ratio of debt to GDP stays the same — 100 percent.

In effect, the highly-indebted government doesn’t pay a penalty for its profligacy, as long as growth keeps up and interest rates stay low. Greece and other heavily indebted countries benefited from such a happy environment for years.

But the equilibrium is fragile. It can be disturbed in three ways: nominal GDP growth can decline, interest rates can go up or the country can start running a primary deficit. The pain is much worse for highly indebted countries like Greece, which has managed all three at once.

Start with growth. Imagine nominal GDP growth drops to zero. If nothing is done, the debt/GDP ratio will rise by 2 percentage points in the moderately indebted country, but by 4 percentage points in the highly indebted one.

Countries can keep that key ratio from increasing, by running compensating primary surpluses. That means moving from balance to a surplus of 2 percent of GDP for the moderately indebted and from zero to 4 percent for the heavily indebted. The higher the debt level, the more the government’s belt will have to be tightened.

But such budgetary squeezes tend to put further downward pressure on GDP — making the debt burden even heavier. Imagine that actual GDP falls by a quarter of a percentage point for every budget surplus increase of one percentage point of GDP. The 4 percent fiscal squeeze would then knock GDP by one percent in the profligate country, while the modestly indebted country’s GDP would fall half a percent.

Next, interest rates. Investors jack up interest rates to compensate for the risk that the population will not stomach a humungous budget squeeze. Foreign buyers are likely to be more demanding than patriotic domestic ones. As the proportion of expensive debt increases, the government’s interest bill rises, potentially starting a debt snowball.

Finally, the government’s budget. While the state would ideally be aiming for a budget surplus, recessions normally lead to higher deficits. As business activity drops off, tax revenue falls and more people qualify for government benefits. This is the worst moment for markets to turn hostile.

When all three factors — economic contraction, higher rates and rising deficits — come at once, they easily start fuelling one another in a vicious cycle. If the profligate country has to pay a 6 percent interest rate instead of 4 percent and recession and belt-tightening have cut nominal GDP by 2 percent, a primary surplus of just over 8 percent is required just to keep the ratio of debt to GDP stable.

That is a huge move, and may be too much to bear politically for the sort of country which has historically run big deficits. Investors have good reason to fear some sort of debt work-out. They then don’t push up the interest rate they are prepared to lend at — they stop lending completely.

–  The author is a Reuters Breakingviews columnist. The opinions expressed are his own  –

 The UK should not waste its fiscal crisis. As Britain embarks on its election campaign, this is a perfect opportunity to engage in radical tax and spending reforms designed not just to restore the country’s fiscal balance but to boost its long-term productivity and competitiveness.

It is, of course, necessary to cut the deficit, which is currently running at an unsustainable 12 percent of GDP. It is also important that spending cuts rather than tax rises bear the brunt of the belt-tightening. Otherwise, the UK will find that companies and rich people are increasingly driven off-shore.

The two main political parties — the Labour government and
the opposition Conservatives — broadly buy into this. However,
neither party has spelt out what spending it would cut and where
it would raise taxes. Nor have they given any inkling of seeking
to take advantage of the crisis to push through deep-seated
reforms. They are unlikely to do so during the coming campaign,
fearing that too much detail will scare the voters.

GUIDING PRINCIPLES

Nevertheless, the next government, faced with the immensity
of its fiscal challenge, will be forced to slaughter at least
some sacred cows. What then are the principles that should guide
it?

First, simplicity. The current tax system is a patchwork
quilt of loopholes, allowances and special arrangements. This is
an incentive to engage in elaborate contortions to avoid tax.

While perfectly legal, such activity is socially wasteful. Tax
lawyers and accountants benefit — as do the rich who are the
only people who can afford their expensive advice. Everybody
else loses out.

A second principle should be low headline tax rates. The
highest earners have just started paying 50 percent tax on
income above 150,000 pounds. This is a bad advert for the UK. Of
course, there are lots of ways for high-earners to cut their
effective tax rate. But it would be far better to close the
loopholes and limit the allowances — and compensate taxpayers
with lower tax rates.

Yet another principle should be that the government should
have no business subsidising the lifestyles of the middle class,
let alone those of the rich. Sure, there is a vital role in
helping out the poorest members of society. But many benefits
and tax breaks also help those in the middle and at the top of
the economic tree. Cut these, and tax rates can drop
substantially.

Finally, government needs to think long-term. Some action
does need to be taken to rein in the deficit in the short run.
But not all the belt-tightening has to come through in the next
parliament, which could last up to five years. Slow-burn reforms
that cut spending or bring in money over a horizon of five to 10
years — or even longer — are extremely valuable.

What would applying these principles mean in practice?

DON’T BE RETIRING

The current matrix of pensions policies have crimped the
UK’s productivity, created a government liability that is
unsustainable, and don’t even provide a good pension for the
people at the bottom of society.

There are three main culprits. First, the official
retirement age is too low. Men can collect their state pension
at 65, while women can still do so when they turn 60. This is
despite the fact that life expectancy keeps rising and many
people are living well into their 80s and beyond.

Second, the state gives generous pensions for public-sector
employees. The net present value of this liability is now 65
percent of UK GDP, according to actuaries Towers Watson — and
it’s not even included in the official debt figures.

Third, tax perks for pension saving benefit the fairly well
off who don’t really need an incentive to save for their old
age.

There are three solutions:

* The official retirement age should be raised to 70 for
both sexes over the next 20-30 years. Thereafter, it should be
further increased automatically as life expectancy improves.

This wouldn’t just save the state money; it would encourage
people to work for longer, so increasing the economy’s
productive capacity. Both the Conservatives and, to a lesser
extent, Labour are planning to increase the pension age. But
neither is nearly as radical as this.

* The government should close final-salary pension schemes
for both current and new public sector employees. That way, its
liability will at least stop rising.

* The raft of costly tax incentives for private-sector
pensions should be swept away. Instead, there should be a simple
incentive focussed more on those at the middle and bottom of
society. My colleague, Neil Collins, has proposed an excellent
plan for achieving this: the buy one get one free pension. Under
“Bogof”, any money put into a pension scheme (up to an annual
limit that is meaningful for the poor but peanuts for the rich)
would be matched pound for pound by the state.

CAPITAL IDEA

The capital gains tax (CGT) regime is another perk for the
wealthy. The rate is now only 18 percent, way below the new top
rate of income tax of 50 percent. Not surprisingly, high-earners
are using their ingenuity to turn income into capital gains
wherever possible.

This distortion in the tax system is unsustainable. The best
solution would be for people to pay the same CGT rate as their
income tax rate. To make this palatable, though, the top rates
of income tax should simultaneously be cut.

Another useful reform to CGT could be to modify the annual
tax-free allowance, currently 10,100 pounds. Oddly enough, this
is higher than the 6,475 pounds tax-free allowance under income
tax, which matters more to ordinary people. It wouldn’t be fair
to abolish the CGT tax allowance completely, as some people live
largely off capital gains. But one option would be to have a
single allowance of, say, 8,000 pounds, covering both income and
capital gains. Combine this with the equalisation of income and
capital gains taxes and the two taxes would essentially be
unified. Over time, it would also raise a significant sum of
money.

AN ENGLISHMAN’S HOME

The biggest middle-class perk of all is the generous fiscal
treatment of housing. The best element of this is that people do
not have to pay tax on the capital gains they make on their
homes. They are also no longer taxed on the imputed income they
receive from living in their homes. And there isn’t much of a
local property tax either. Local government rates used to be
roughly proportionate to the value of homes. But Margaret
Thatcher abolished those and replaced them with the poll tax.
Although that was ultimately killed off, the current council tax
is only loosely linked to property values.

The result of all this is the British love affair with
houses. Unfortunately, the infatuation is unhealthy. Young
people leverage themselves up to get on the housing ladder,
fearing that, if they don’t, they’ll find themselves priced out
of the property market. Not surprisingly, housing booms and
busts have featured prominently in each of the last two
recessions, with a knock-on effect on banks, which sometimes
have to be bailed out.

But the damage doesn’t stop at macro-economic instability.

The tax advantages of housing have distorted people’s savings
decisions. The bulk of the British people’s savings goes into
their homes. Not much is left over to recycle to investment in
industry.

What’s more, the whole system gives people a very odd idea
about the work ethic. During the last upswing, some homeowners
were regularly making more money from the annual capital gains
in their homes (which are untaxed) than from what they made at
work (which is taxed). This is unfair on those who either can’t
get onto the property ladder or don’t want to run up excessive
debts.

There are various ways in which housing’s fiscal
featherbedding could be mitigated. The government has just made
a modest move by raising stamp duty on properties worth one
million pounds or more from four percent to five percent. The Liberal
Democrats, the UK’s third largest party, have proposed an annual
mansion tax of one percent on properties worth more than two million
pounds. The best way of dealing with housing’s peculiar fiscal
advantage, however, would be to charge people CGT on future
gains made from property sales. This wouldn’t just remove a
major economic distortion; over time it would also generate
significant revenue.

VAT ATTACK

Another area ripe for reform is Value Added Tax. This is
currently levied at 17.5 percent. One of the top options for
raising money for the exchequer is to bump this up to 20
percent.

But this is not the best way forward. The only reason VAT
has to be even 17.5 percent is because swathes of goods and
services are tax-exempt — notably children’s clothing, most
food and books. A better alternative would be to sweep away the
tax-exempt categories and lower the rate.

Such a reform might provoke howls of protest from the
anti-poverty lobby on the grounds that it would be regressive.
After all, poorer people spend a greater proportion of their
income on food than rich people. However, it’s not going to be
possible to restore order to the public finances without some
sacrifice from poorer people. What’s more, most of the reforms
being advocated here would hit the middle classes and rich. Tax
reform packages need to be viewed in the round.

FAMILY VALUES

It is normally bad when the state tries to influence how
families are run. The Tories have a particularly wasteful idea.
They want to restore some version of the married person’s tax
allowance, hoping a tax break would give people an added
incentive to either get or stay married. Quite apart from
whether it is sensible to encourage what are presumably the most
borderline marriages, any money thrown at this pet scheme would
be better deployed either cutting income tax rates or the
deficit.

In a similar vein, the UK pays all mothers a weekly benefit
of 20 pounds for their first child and more for subsequent kids
– regardless of whether the mother is a Goldman Sachs managing
director or the dustman’s wife. This is barmy. By all means, be
even more generous to the dustman’s wife. But focus this benefit
on the really needy and recycle the savings to lower borrowing
and tax rates.

CORPORATE ACTION

Tax breaks and loopholes aren’t just a feature of the
personal tax system. Corporation tax is riddled with them. The
most important, and most damaging, is the tax-deductibility of
interest payments. This favours companies with hefty leverage –
most notably leveraged buyouts, commercial real estate
developers and banks.

The recession should have rammed home the dangers of
excessive debt. The solution is to phase out this corporate tax
perk over several years and to make countervailing cuts in the
rate of corporation tax. This would not raise any additional
revenue. But the tax system would no longer be distorted in
favour of debt rather than equity, and the whole economy would
be healthier. Ideally, such a reform would be introduced in
tandem with similar moves by other leading economies.

BANK BASHING

Banks are every politician’s favourite whipping boy. It’s
not surprising, therefore, that the main parties have backed the
idea of a levy on bank balance sheets.

In principle, this is an excellent proposal. The
justification is that banks relying on short-term hot money
endanger not just themselves but the taxpayer who has to bail
them out. It is therefore not only legitimate but sensible to
apply a levy proportionate to the size of their short-term
wholesale funding. After all, this would give them an incentive
to rely on safer retail deposits or long-term funding. Such a
levy could raise up to four billion pounds a year, according to
Reuters Breakingviews calculations.

That said, it is important that the UK doesn’t move
unilaterally. The International Monetary Fund is working on
proposals for a globally-coordinated tax of this nature. If the
big economies adopt some such tax, as seems increasingly likely,
Britain has nothing to fear. But the Tories have been unwise to
say they will go it alone if necessary.

CONCLUSION

None of the parties fighting May’s election has embraced
anything remotely as far-reaching as this package of proposals.
But, then again, neither Labour nor the Tories have said very
much about what they would do to tackle the deficit. One of the
two — or possibly a coalition with the LibDems if there is a
hung parliament — is going to have to decide. The parties
should remember that one of the advantages of a crisis is that
they will be able to push through changes which would otherwise
be deemed too radical. They shouldn’t waste the opportunity.