Friday, March 20, 2015

Paying twice for water? Not really.

This chestnut is rolled out over and over again.  But saying it repeatedly does not make it true.  Some even go so far as to call it a “quadruple water tax” – Income Tax, VAT, Motor Tax and Water Charges.

For a start money is fungible so it is a fallacious argument.  The only way we can pay twice for water is if we pay the providers of the service twice what they are owed.  This would require paying public sector workers who work in water twice, paying for infrastructure twice and paying twice for the chemicals and other consumables used in the water purification and treatment processes. 

No evidence of such double payments have been presented.  We may pay more money to the Exchequer but if the Exchequer does not use that to pay twice for water then we are not paying twice for water.  If the State collects more money (even under the heading of ‘Water Charges’) and spends the same amount to provide water services then there simply is more money to spend on something else.

However, this reasoning has not stopped the “we are not paying twice” argument being rolled out.  Usually it goes something like this:

Now, the facts: We already pay for water through central taxation. Water charges have been introduced and abolished multiple times. The first time it was abolished was in 1977 before it was re-implemented in 1983 before abolished again in 1997 by the Rainbow Coalition (after much protest and just before a General Election).

So, how was water being paid for? In 1977, it was decided by the Fianna Fáil Government that an increase in income tax, VAT and borrowing would pay for our water usage and maintenance. When water charges were re-introduced, people rightly felt they were being double taxed as there was no reduction in neither income tax or VAT. After the second abolition of water charges in 1997, it was decided by then Minister for Environment Brendan Howlin that water would be paid for by motor tax collected in each area. The increase in motor tax was 5%. Since then there has also been an increase in VAT of 2% (every time VAT has risen, so has the provision for water).

The thing is – most of these tax increases didn’t actually happen.  Here is George Colley delivering the first Fianna Fail budget after the 1977 General Election (if you want a reminder of what they promised see this):

I now come to my proposals for changes in the personal income tax. I have already indicated that the increase in the main personal income tax allowances proposed in the manifesto would be sufficient to improve real disposable incomes significantly, taken in conjunction with the Government target of a wage increase of about 5 per cent. I propose to increase the single allowance by £200, from £665 to £865, and to increase the married allowance by £630, from £1,100 to £1,730.

The abolition of rates on domestic dwellings and the abolition of motor vehicle duties for all but large cars will also mean a good deal more cash in the pocket for the average family in 1978. Savings in motor vehicle duties for a modest family saloon should work out at about £1 a week. Rates savings will, of course, depend on the type of accommodation which a family has. The average savings here should be about £2 a week for a local authority tenant: for a family purchasing a three-bedroomed semi-detached house in the Dublin area the saving could be £4 a week or more.

All in all, therefore, the average family can expect to be at least £9 to £10 a week better-off in terms of disposable income by virtue of these particular measures.

The cost of all these increases in personal allowances will be £63.4 million this year.

Domestic rates were abolished and Income Tax was reduced.  Here is the Minister on VAT.  All we need to say is there were no increases in VAT.  What we can definitely say is that the budget increased borrowing and the outturn over the next following years was even greater borrowing than envisaged:

I opened with a current deficit of £265 million. On the expenditure side I have added about £69 million, allowing for the social welfare savings. From this, however, I am deducting £20 million for unspent balances in the hands of Departments at the end of 1977. This leaves me with a net addition of about £49 million. On the revenue side of the account I have given tax reliefs costing a total of about £91 million. In all, therefore, I am adding £140 million to my opening current deficit, bringing it to £405 million.

To this must be added the Exchequer borrowing requirement for capital purposes of £416 million, leaving me with an Exchequer borrowing requirement of £821 million for 1978, or 13 per cent of GNP—no higher than that envisaged in the manifesto.

If we now roll forward to 1997 when the water charges introduced in 1983 were abolished.  In his speech for the 1997 budget Ruairi Quinn said:

Last month, the Minister for the Environment announced a radical reform of our local government system. His proposals, which I strongly supported, include a new system for the financing of local government. The new funding system involves the abolition of local authority charges to domestic consumers for water and sewerage facilities.

The proposals also involve the assignment of motor tax revenue to local authorities, partly offset by the abolition of the Rates Support Grant.

Local authorities will receive in 1997 at least the same amount through Motor Vehicle Duties and the reduced Rate Support Grant as they would have got with the original Grant.

The cost to the Exchequer in 1997 will be £60.5 million.

There was no increase in Motor Tax when it was assigned to the local government in 1997.  There was changes to Motor Tax as part of the 1997 Local Government Act.  Here is then Minister for the Environment, Brendan Howlin discussing the Second Stage of the bill in the Seanad.  First he emphasises that there was no increase in Motor Tax when the funding model for local government changed:

Under section 3, the full proceeds of motor tax income are assigned to local authorities to replace the income lost through the abolition of domestic water and sewerage charges and the rate support grant. I wish to clarify that these proposals do not involve any new tax but a redirection of existing taxation, which will remain local rather than being paid to the Exchequer. This will provide local authorities with full ownership of the proceeds of a single buoyant tax fully protected by law. They will have full control over this resource and it will be a matter for them to decide how to distribute it.

He then goes on to discuss a discretion given to local authorities to increase motor tax within certain bands if they so wish:

The national rates of motor tax are set by central Government and there has been no increase in these rates since 1992 when the Labour Party came into Government. However, is it right that central Government should have such total control over the system of local government funding? It will be recalled that, under the Local Government (Financial Provisions) (No 2) Act, 1983, local authorities had complete discretion over whether to levy domestic service charges and their amount. Such local discretion is essential for the concept of local democracy. If we are to have real, effective local government capable of responding to local needs, it must have some discretion over how it raises the finance necessary to fund its activities.

This is now being provided for under section 9 which provides motor tax authorities with the power from next year to increase the national rates of motor tax on cars and motor cycles by up to 6 per cent, subject to a maximum of 3 per cent next year. Local authorities, at their own discretion, will be entitled to increase motor tax rates for cars and motorcycles by 3 per cent next year and by 3 per cent the following year. After that, they will not be entitled to any further increase unless the base is moved by central Government. This is designed to strike the right balance between the need to give local authorities discretion in raising finance on the one hand and, on the other, the requirement not to impose any significant new form of taxation. Some 6 per cent is the limit to the increase above the national base.

It would take a bit of digging to find out how this discretion was used by local authorities.  The recent experience of the Local Property Tax would suggest they would not use it to raise additional revenue.  It is also the case that this discretion was short-lived and we have returned to a uniform rate of motor tax.  But there was no increase to pay for water.

The third strand of the “paying twice” argument is something to do with “an increase of VAT of 2 per cent”.  The claim is “since then” so presumable this means after 1997.  Here is a table of VAT rates back to 1972.

In Budget 2012 the standard rate of VAT was increased from 21 per cent to 23 per cent so we do have a 2 per cent increase – but there is no mention of water in the entire budget speech.  VAT was increased but not with the stated intention of paying for water. 

With this “paying twice” approach you could take any tax increase and say it was to pay for water.  The fact that money is fungible means this is baseless.  We collect taxes to pay for public services; assigning particular taxes to particular services is rarely useful.  Increasing taxes does not mean we are paying twice for a particular service; it means there is money to spend  on additional services.

We have previously looked at how much we actually spend on water.  It is around €1.5 billion per annum.  Let’s look at the “paying twice” approach to see how far we get in finding the €1.5 billion we spend on water.

We start with the Income Tax and VAT increases of 1977 but as these didn’t actually happen their contribution is zero.  The next is the link between water and Motor Tax and a 5 per cent increase that also did not happen.  But if 5 per cent of motor tax revenue was allocated to water it would be around €55 million.  Finally, there is the 2 percentage point increase in the standard rate of VAT in 2012.  Again this was not linked to water but lets say it was.  The increase was expected to raise €670 million in a full year.

That means we have €725 million available or about half the total spend.  Commercial water charges raise about €300 million so we’re just over the billion mark.  By the logic of the “paying twice” argument we’re not even paying once! – we’re half a billion short.

Where does that come from?  Increased borrowing – about the only source of funding for water the “paying twice” argument gets right.  Borrowing to invest in water infrastructure can be a sound approach.  So why not have a water utility outside the general government sector that can avail of historically low interest rates?  Why not indeed.

So let’s create a water utility with a €1 billion income stream: 

  • €300 million commercial charges
  • €200 million domestic charges
  • €500 million Exchequer subvention

With that revenue stream the utility can borrow €0.5 billion and we can spend €1.5 billion on water, and maybe more.  Enough of this “paying twice” nonsense; let’s pay once but at least try to do it right.  Actually having water charges linked to water use should be the first step. At the moment we just have a mess.

Thursday, March 19, 2015

The Growth Effect of ‘Contract Manufacturing’

The concept of ‘contract manufacturing’ only began to get some attention after this happened in the second quarter of 2014 [see previous post here]:

QNA v TS

In 2014 the difference between goods exports recorded in the trade statistics and that recorded in the national accounts was €17.6 billion. We could get into the technical reasons for the difference between the two but we will focus on just one point:

  • Only the “value added” in Ireland from the exports contributes to Irish GDP.

We know that MNCs account for around 90 per cent of Irish exports, but equally we know that they account for a similarly large amount of Irish imports (with much of this being royalty payments for intellectual property).  The GDP impact is the much smaller net difference between them and the GNP effect is smaller again when the repatriated profits and retained earnings of these foreign-owned companies are subtracted.

A big issue with the “contract manufacturing” effect in 2014 was that its impact on (goods) exports was very easy to see – as shown above – but its impact on imports was less visible.  When the effect first arose in mid-2014 the CSO indicated that the impact on GDP was not significant due to import outflows (mainly royalty payments). 

However, those who looked at the Balance of Payments didn’t see a clear link.   Some of this may to down to the transition to BPM6 which means that shorter time series are available for some of the BoP series.  Here are the updated figures for service imports in the Balance of Payments.

Service Imports

While there was an increase in service imports in 2014 this really only became noticeable with the release of the Q4 data last week.  However, if we look at royalty imports the 2014 increase is even more noticeable.

Royalty Imports

Royalty imports in 2014 were €10.6 billion higher than in 2013.  While this is the case it is not possible from this to know how much of this increase was due to royalty payments related to contract manufacturing organised by Irish-resident companies that takes place in other countries and how much was due to MNCs paying royalties for activities that take place here.

Usefully, though, the CSO have issued an information note that attempts to throw some light on this.  The note contains the following chart for the last three quarters of 2014 for a subset of companies that engage in contract manufacturing.  The CSO have indicated that “there are currently 16 companies engaged in contract manufacturing” though the number changes from quarter to quarter.

CSO Contract Manufacturing

The chart shows that two of the national accounting adjustments made compared to the trade statistics shown in the external trade data accounting for an adjustment of around €14.5 billion in the final three quarters of 2014.  These figures likely explain the gap shown in the first chart above.

Outbound royalty payments related to these activities were around €10.2 billion in the last three quarters of 2014.  One assumes that this is an estimate by the CSO as outbound royalty payments are reported in aggregate as noted above and are not assigned to particular activities (such as domestic production or external contract manufacturing). 

However, given the data the CSO have it is likely that have a good idea of the relationship between royalty payments and activities that happen in Ireland so are in a position to make a well-informed estimate as to how much is due to contract manufacturing and the like.

The chart shows that there was also around €0.8 billion of other service imports associated with these activities.  That leaves of estimated “gross value added” in Ireland of around €3.5 billion (the green line in the chart above).

However, all the chart does is confirm the CSO’s earlier statements that a significant portion of the inflows from contract manufacturing and merchanting are offset by outflows of royalty payments.  This, of course, was the intention of the note and we can see that this issue had little impact on quarterly growth rates for Q3 and Q4 – the green line is almost horizontal. Unfortunately, what we we cannot see is the impact these factors had on the 4.8 per cent annual GDP growth rate. 

To do that we would need the same data for 2013 but it seems the CSO were happy to make the point that focussing on the impact these activities have on goods exports overstates the final outcome as offsetting royalty imports have to be factored in.  A longer time series is also likely to step further in the realm of guesswork.  In their note they do say:

In the case of the additional products made under contract manufacturing arrangements for Irish companies in 2014 the related addition to value added over and above wages and salaries paid is not particularly significant in explaining the recent growth in Irish GDP (+4.8% in 2014).

It would be nice to be able to quantify “not particularly significant”.  The €3.5 billion of value added for the last three quarters of 2014 in the chart above is significant but we don’t know how it compares to the GVA from these activities in 2013.  For annual growth that is the key.  The CSO conclude their note saying:

Instead the observed growth is more broadly based and reflects improved domestic demand and also the pick up in activity for Irish companies not linked to Multi National Groups.

Finally, for the value added from these contract manufacturing and related activities it is likely that 75 per cent (or more) is operating surplus (profit for foreign shareholders) rather than compensation of employees (wages for Irish employees).  This operating surplus will be counted as a net factor outflow (presumably we do get a 12.5 per cent cut of this! - see below) so the GNP effect of all this is smaller again. 

Corporation Tax on the €3.5 billion of gross value added could be around €250 million depending on what adjustments are made to get the taxable income figure which is ultimately multiplied by 12.5 per cent. 

There isn’t a direct link between tax accounting and national income accounting but they are not entirely unrelated.  They are more related than national accounting is to financial accounting as jurisdictional boundaries influence what is included in each unlike financial accounting where consolidated accounts relates to activities within a firm regardless of where it happens.  Some of the figures used in national accounting for companies are drawn from tax accounting rather than financial accounting, though the subsequent adjustments in national and tax accounting are different. In national accounting it is also the case that what can sometimes be the end figure, such as value added, is actually the starting point and the apparent deductions done above it to get to the final figure are inferred.

Anyway from €3.5 billion of gross value added we will first have to subtract compensation of employees to get gross operating surplus.  GOS is akin to EBITDA (earnings before interest, taxation, depreciation and amortisation) so deductions would have to be made for any interest paid on finance^ and depreciation of assets related to the activity (in tax this will be capital allowances rather than depreciation but the concepts are related). 

A taxable income figure of €2 billion is possible giving the €250 million Corporation Tax figure used above.  We have a limited number of credits for Corporation Tax and it doesn’t appear any them would be applicable for the activities involved.  The R&D credit is a possibility if the research activities take place here but the outbound royalty payments dispels that.  Double taxation relief is not applicable as the profit is sourced in Ireland.

Again we don’t know if this an increase on what was due in 2013 but there should be some dividend to the Exchequer from these activities even if they are yet another previously unseen complication to our national accounts that has now come to light.

^ FISIM interest (financial intermediary services indirectly measured) will be included in the intermediate consumption figure deducted from output produced to get (in an arithmetic sense anyway) gross value added but let’s not go there.

Friday, March 13, 2015

Evidence of Non-Payers

One recurring issue in the mortgage crisis is the issue of non-payers or what are sometimes referred to as “strategic defaulters”.  It is likely that those who are paying nothing on their mortgage have chosen to do as the maximum amount they could pay can be expected to be above zero, even if it falls short of meeting the full mortgage payment.

Do such non-payers exist? Yes.  Here are the data from the last two quarters of 2014 on accounts that are more than 720 days arrears.

720 Days

The above just covers primary dwelling house (PDH) accounts that are more than 720 days in arrears.  There was only a small rise (0.8 per cent) in the number of accounts in this sample so most of the individual accounts are the same in both quarters.

It can be seen that the average amount of arrears rose by more than €2,700 in the quarter - €900 a month.  And this will be dragged down slightly by the accounts that entered this category in Q4 which likely have lower average arrears than those accounts already in the category.

If the arrears on these mortgages are growing by €900 per month it suggests that in many cases very little is being repaid.  With the definitions used it could be the case that there are accounts in this category who are back to making full repayments but have not cleared the historical arrears so the average cannot be construed as applying to all accounts.  But it is clear that arrears are accumulating rapidly on many accounts in this category.

Is there more evidence?  The issue of non-payers was discussed by the Oireachtas Finance committee last year.  Here are some extracts from a meeting with Ulster Bank.

Jim Brown: Since last summer, the number of customers in arrears who have not engaged with us and are not making any contribution to their mortgage has reduced significantly from 35% to 14%.  This number is still unacceptably high. It is not fair to all other people who pay their mortgage that someone makes no contribution to the cost of their accommodation. We have no choice other than to pursue these customers through the legal route. Having said that, the primary intent of legal action is to encourage meaningful re-engagement so we can help. Any customer can take themselves out of the legal process at any stage by meaningfully re-engaging. We are pleased to advise the committee that almost half of our customers entering the legal process have re-engaged with us. Unfortunately, that means the same number are not engaging despite the seriousness of the situation.

Stephen Bell: They [borrowers to whom Ulster Bank has issued legal proceedings] are not meeting their repayments and are not responding to phone calls or letters. When the point is reached whereby over an extended period no repayment has been made and there has been no response to any letters or phone calls and, on occasions when we have sent an experienced adviser to the property, no response in that regard, we then have few options open to us. I would point out that we made a clear commitment that we will have an Ulster Bank representative at every court hearing so that if the customer does present there is an opportunity to engage with him or her and discuss the options in terms of recommencement of meaningful payments.

Stephen Bell: The 14%-15% who we said have neither engaged nor paid for an extended period constitutes another approximately 2,300 customers.

Jim Brown: As mentioned, there is a significant group of customers who have not made any repayments at all for up to two years or longer and refuse to engage with us. The only route available to us in this regard is the court process.

Stephen Bell: It is a matter of considerable regret to us that in some of the cases that are going through the legal system at the moment, the last payment we received was in 2007. These are extraordinarily long cases whereby the court process has run for such a long period that the eventual losses to both the customer and the bank have escalated beyond all recognition. These customers would have been provided with every possible opportunity to engage with us and reach an alternative solution.

Stephen Bell: The figure I have mentioned relates to both buy-to-let houses and primary dwelling houses. The initial number of cases was 14,231. In 2,354 of those cases, we have received no payment and had no engagement.

Maybe we won’t take a banks word for it.  Here is a research paper from the Central Bank that looked at the set of loans that were permanently modified in the PCAR banks (AIB, BOI, PTSB).  There are some great details in the paper but the the last sentence of the introduction sums up what we are looking for.

Finally, this analysis indicates that approximately 11 per cent of permanently modified defaulted loans consistently make no repayment after modification.

It is also one case but here is some correspondence between a borrower and Start Mortgages.  The central point is that the lender is seeking confirmation of the borrowers expenditure on food, clothing and medicine which seems unnecessary (but is in line with the Code of Conduct on Mortgage Arrears).  However, the first letter from the lender contains the following:

I also note that the customers have not made a payment since January 2014 and payments should be resumed as soon as possible.

Call it what you like, but there are a significant number of mortgage accounts on which no payments are being made.  What other option is there but to issue legal proceedings against these borrowers?

Resolving the Mortgage Crisis

The mortgage arrears crisis rumbles on.  It is a failure on many sides that the problem persists.  There needs to an increased focus on the issue of sustainability, and in particular what should happen if a mortgage is unsustainable. 

One approach to sustainable is that the mortgage balance is decreasing, or at least non-increasing, with a high likelihood of being repaid over a 15 to 25 year period (depending on the age or circumstances of the borrower).

The course of action that should be taken is relatively straightforward and needs to

  1. Every effort should be made to make a mortgage sustainable.  This can involve interest-only periods if the problem is temporary or more permanent, and costly approaches, such as:
    • split mortgages with a portion of the loan warehoused at low or no interest, or
    • interest rate reductions with the banks temporarily reducing rates to one per cent, or lower if necessary, in order for the repayment of the borrower to reduce the balance.
  2. If the mortgage cannot be made sustainable the mortgage should be ended, the property repossessed, and a residual, if any remains, should be cancelled in a short period (two to three years).

It really does not need to be more complicated than that. Interest rate reductions have been favoured here since November 2010 (and also April and June 2011)

Of course, around half of mortgages are outside of the state-owned banks and we cannot compel them to offer generous interest rate reductions to their customers.  It is likely that a publicly-funded scheme will be necessary to pay the interest to the banks.  The State can negotiate with the banks  on the total interest paid but the objective should be to reduce the interest rate faced by the borrower to one per cent or less.  Some of the previous posts went through some mechanics of achieving this.

This is far better than a “mortgage-to-rent” type scheme and has the added advantage of being temporary rather than permanent.  In time the borrower’s repayment capacity may improve and they will be able to pay more of the capital and, in turn, more of the interest (but on a reduced capital amount).

Will some undeserving non-payers benefit from reduced interest rates? Yes. But the priority has to be help those who could meet their mortgage with some assistance and to provide a way out for those who can’t reduce their mortgage even if it made almost interest free.

As stated in these cases the mortgage should be ended, the property repossessed and any residual debt, if any, should be written off in a short period.  Will some undeserving non-payers benefit from the cancellation of the residual debt? Possibly.  While the cancellations should be widespread some consideration should be given to the borrower’s ability to pay as a poorly-designed system that allows people to walk away from their obligations without consequences will lead to other problems.

Writing off debt that can never be repaid is what should happen.  We don’t need a public scheme for this. If banks have lent money to people who can’t repay it they have to absorb the losses.  But we do need to accept that repossessions are part of the solution of the mortgage crisis.

So lets get interest rates down for those that are in some difficulty and allow those who are in over their heads to make a fresh start.

Thursday, March 12, 2015

Government Bonds held by the State-Owned Banks

A lot of attention has been given to the Irish government bonds held by the Central Bank of Ireland and the benefits that arise from the recycling of interest payments back to the Exchequer.  In a vein similar to this are the substantial holdings of Irish government bonds by the ‘covered’ or Irish-headquartered banks.  A breakdown of the overall interest bill is here.

Originally the covered banks were AIB, Anglo, BOI, EBS, INBS and PTSB but now only AIB, BOI and PTSB remain.  This chart shows their combined holdings of Irish government bonds since 2008.

Cov Bonds

It can be seen that around nil in the run-up to the crash in 2008 but increased substantially during the crisis and now the banks have a holding with a market value of around €19.4 billion. 

This is significant because both AIB and PTSB are almost fully state-owned so the interest paid on these bonds does not leave the broader government sector.  There are similar benefits with BOI but to a lesser extent as that is now 14 per cent state-owned.

The recent interim financial reports for 2014 from the banks allow us to see the breakdown of this €19.4 billion across the three banks.  Some extracts from the reports are reproduced below the fold but the relevant figures for end-2014 are:

  • AIB: €9,107 million
  • PTSB: €3,857 million
  • BOI: €6,409 million
  • Total: €19,373 million

These are market value figures.  The face value is probably around 15%-20% less given than the current yields are much less than the interest coupons.  Still it is likely that between them AIB and PTSB hold around €10 billion of government bonds.  If the average interest coupon is 4 per cent then €400 million of the annual interest bill is going to state-owned banks.  It doesn’t have the full circular nature back to the Exchequer as with the interest flows to the Central Bank but it not a net loss to the State either.

It could also be considered that the money the government used to bailout the banks was borrowed from the banks themselves.  And hopefully we will be able to pay this money back by selling the equity stakes we have built up in the banks so the interest expenditure never leaves the government sector.

It is also worth noting that the banks will have made significant profits on these bonds.  Their holdings grew rapidly from mid-2011 and roughly doubled (from €9 billion to €18 billion) over the next 12 months.  Two things are notable about this period when the banks purchased these bonds on the secondary market.

  1. The summer of 2011 was when AIB and PTSB received most of their recapitalisation funds from the state (following the March 2011 PCAR exercise).
  2. It was the period when the yields on Irish government bonds were at their highest.

The banks used the recapitalisation funds, in part, to buy Irish government bonds and have made large profits on them.  The table from AIB’s annual report shows an “unrealised gross gain” of €1.3 billion from it’s holding of Irish government bonds. 

We can imagine this being roughly double, around €2.5 billion, across the holdings of the three banks. Not only are we not paying interest to third-party investors on the money used to bail out the banks, the banks actually made a profit by using the money to buy Irish government bonds on the cheap from such investors.

Here are the extracted tables. First AIB (pdf page 265):

AIB Bonds

And PTSB (pdf page 22):

PTSB Bonds

And finally BOI (pdf page 154):

BOI Bonds