Sunday, October 09, 2005
Business grabs a bigger slice
Posted by David Smith at 11:00 AM
Category: David Smith's other articles

Cast your mind back, if you can, to 1993, the last time Britain’s economy was growing at its current low rate of just 1.5%. The corporate mood was fragile, with business screaming for interest rate cuts.

Unemployment was widely expected to return to its mid-1980s heights of 3.5m (in fact it stayed below 3m) and the talk was of a “double dip” back into the severe recession the economy had only escaped from the year before.

Now contrast that with the current situation. Boardrooms are not alive with the sound of popping champagne corks but,outside the retail sector, the mood is generally upbeat. Profitability, according to official figures, is at its highest since the end of 1999, the rate of return on capital up to 13% in the second quarter of this year.

The stock market has suffered a Wall Street-generated wobble in the past few days, but overall this year has surprised most analysts on the upside. Early last week the FTSE-100 hit a four-year high; the FTSE-250 index of mid-capitalisation shares an all-time peak.

The various readings on industry’s performance, as always, give a confusing picture. Official figures show that overall industrial production dropped sharply in August. Manufacturing also slipped. But the latest survey data for the sector, from the Charter Institute of Purchasing & Supply (CIPS), suggests a recovery.

So what is really happening? Why are firms doing quite well, when the economy is doing rather badly?

One possibility, plainly, is that the official statistics suggesting growth is at a 12-year low are just wrong. Quite a few economists I know are on the point of tearing their hair out over data revisions from the Office for National Statistics. You come to a view, in good faith, and then the ONS rewrites history and takes your legs away from underneath you.

We have all being burnt by this. A few years ago, with the Blair government in its infancy, the economy appeared to be teetering on the brink of recession. Initial figures showed that the economy grew by just 0.1% in the final quarter of 1998 and fell by a similar amount in the first quarter of 1999.

Had things stayed like that the chancellor’s proudest boast - 52 quarters of continuous economic growth - would have remained a pipedream. But the figures were revised dramatically and now show growth rates of 0.8% and 0.6% respectively for those two quarters.

A second possibility is that business is doing well on the back of a strong world economy, and can take weak demand at home in its stride. Gordon Brown’s alibi for the downgrading of his growth forecasts, high oil prices, did not pass muster. Both the International Monetary Fund (IMF) and Organisation for Economic Co-operation and Development (OECD) continue to predict healthy world growth.

That explains the reappearance of obscenely large City bonuses - jealousy is never an attractive trait. Financial and business services are part of the global economy, driven by global demand; hence their current strength.

It also explains why most larger British companies, outside retailing, are doing well. They are world businesses, earning a high proportion of their profits outside the UK. The FTSE 100, notwithstanding last week’s wobble, tells us more about what is happening globally than at home.

That does not mean Britain is enjoying an export boom. The British Chambers of Commerce, in its quarterly survey this week, will say that export trade remains a struggle for many of its members. UK exporters do not seem to do too well even when their markets are reasonably strong.

There is a third factor, however, that provides a neater explanation of the economy’s current situation. One of the surprises of recent months has been that, even with the provocation of a sharp rise in oil prices, pay has remained very well-behaved.

Wage settlements have remained low and the underlying growth of average earnings, excluding those City bonuses, is a shade below 4%, well within the Bank of England’s comfort zone. Were this not so, no doubt some of the wilder spirits on the monetary policy committee (MPC) would be impatient for higher interest rates.

One reason pay is behaving impeccably is because the job market has been gently softening. Unemployment is still very low, and employment high, but the claimant count has been drifting higher all year. Another explanation, and this one is more reassuring, is that people aren’t responding to the temporary inflation blip caused by higher petrol prices. They believe, rightly in my view, in the permanence of low inflation.

But there is, as Richard Jeffrey, head of research at Bridgewell Securities points out, an economic consequence to all this. While profits have been growing strongly, pay has been increasing only slowly, and real incomes have been squeezed by rising prices. In the jargon, the profits share of gross domestic product (GDP) has been rising at the expense of the employee share.

The slow growth in incomes explains the weakness of consumer demand, along with factors such as the cooling of the housing market (notwithstanding last week’s report from the Halifax of a second successive monthly jump in prices). The growth in real household incomes has slowed from 3% in late 2003 to under 2% now, and is likely to remain depressed.

The more that labour costs are held down, the better the implications - within reason - for company profits. What’s bad for household finances, up to a point, is good for corporate finances.

The normal thing to happen now would be for firms to start investing more aggressively. They seem curiously reluctant to do that; in cash terms business investment is close to record lows as a share of GDP. That’s Britain’s growth problem - when consumers were awash with cash they were happy to spend it. Firms aren’t. Is that because they fear the chancellor will hit them with higher taxes? Perhaps.

PS Brian Reading, the veteran Lombard Street Research economist, reminds us that when it comes to tax ideas, there is little new under the sun. Nearly 40 years ago, before George Osborne, the current shadow chancellor, was born, he and Lombard Street colleague Charles Dumas worked on a flat rate income tax for the Tory party.

The party’s tax advisory panel, chaired by Iain Macleod (chancellor for a few weeks in 1970 before his untimely death), proposed such a tax, as well as replacing purchase tax with Vat, and the various capital taxes and stamp duties with a single wealth tax.

Sir Edward Heath, however, was too timid to take most of their ideas up, choosing only to adopt the Vat recommendation. The flat tax idea has thus been gathering dust since in a filing cabinet somewhere in the basement of the Conservative Research Department.

Despite the fact that it was his baby, Reading thinks it is no longer a runner. His Lombard Street paper is called “Flat tax: an idea whose time has gone”. The problem is the way the tax burden now falls.

In the late 1970s, when the highest tax rate was 98% (on earned and unearned income combined) - and the tax avoidance industry enjoyed its finest hour - 50% of income tax revenues came from the top 22%. Now, mainly as a result of the Thatcher tax cuts of the 1980s, 50% of revenues come from the top 10%. A flat tax would benefit this group but leave everybody else facing a higher rate and would, says Reading, be “political suicide”.

But he thinks one 40 year-old idea still has merit; replacing inheritance tax, capital gains tax and stamp duties with a single 1% wealth tax. Something for Osborne’s commission on tax reform, to be launched this week, to think about.

From The Sunday Times, October 9 2005


So Brian Reading thinks his 40 year-old idea still has merit. Perhaps his idea should be read out loud in the style of the 60’s Bob Newhart sketch, Introducing Tobacco to Civilisation:

“So let me get this straight, Walt… you’re gonna replace inheritance tax … right, Walt?… that few people need pay when they die… and capital gains tax that not many people pay… and stamp duty that people only notice when they buy themselves a bigger house (with an eye to a tax-free capital gain) … right, Walt?.. and you’re gonna replace them all, right?.. with a 1% wealth tax that everyone has to pay?… Well, this may come as kind of a surprise to you, Walt, but the voters are gonna tell you to shove your idea up your nose and set fire to it.”

The only tax changes voters will accept today, IMHO, are tax cuts based on cuts in government spending. Ken Clarke, please take the stage.

Posted by: David Sandiford at October 11, 2005 12:34 PM

Mervyn King seemed to be getting his jab at the media in first before the November MPC meeting, with his Gateshead speech:

“The lower prices for many consumer goods and the higher cost of oil are both the result of globalisation. Having benefited from the former we are now experiencing the latter. As a result, our import prices are no longer falling as rapidly as they were, and, indeed, over the past year even the prices of non-oil imports have risen.

And more and more spending is on services. The proportion of expenditure in the basket used to calculate the CPI accounted for by services – especially health, education and financial services – has risen from 36% in 1997 to over 46% this year. Since inflation of services is higher than that of goods it is not surprising that CPI inflation has risen as the share of spending on services has itself risen. Interestingly, the increase in the share of services is much less evident in the basket for the RPIX measure of inflation – from 38% to 41% over the same period.

For the UK economy, monetary policy cannot ensure that output will grow at a constant rate. But in the medium term it can deliver low and stable inflation.”

The last bit looks like a swipe at media articles that argue interest rates should fall because GDP growth is low.

Well, his case for holding rates should be helped by a surprisingly large jump in Sept. inflation when the numbers are released next week.

Posted by: David Sandiford at October 12, 2005 06:44 AM