Krugman rightly points out that one of the most important ways in which a national economy is not like a corporation is because corporations sell the bulk of what they produce to other people while the vast majority of what America and all big countries produce they themselves consume. Turn this on its head and one can appreciate the importance of this distinction:

If corporations sold the vast majority of what they produced to their own employees they would need their employees to be able to buy their product(s). The only way that the company could guarantee the biggest market for its products would be to ensure that all employees had enough income to afford them. The company would have an incentive to take steps to redistribute wealth or, perhaps more effectively, pay its employees a similar amount. Therefore it would not be beneficial for a company to pay its CEO vast multiples of what the other employees earn if as a result these employees could not afford to buy its product(s).

This counterexample explains why (economically, because clearly redistribution is justified on other grounds as well) states engage in redistribution: prosperous economies are those where people can afford to sustain merchants by buying their wares (if anyone doubts this then take a look at the interest swirling around the Christmas retailing figures).

Countries are not companies, but they do share some of the same characteristics. One of the simplest ways in which the two entities are similar is the way in which both have outgoings and income. For the state income comes in the form of tax and outgoings take the form of services. In essence tax is a payment for a service, the state is sometimes in a better position to provide a service (perhaps because of economies of scale or because they can prevent free-riding) than an individual, group or business. In return all individuals are forced (preventing free-riding) to contribute. Although some will balk at this description, perhaps because they pay taxes and have private health care, it is fair (if simplistic).

In this sense a state, like a business, needs to make sure that its outgoings do not exceed its income, otherwise it will need to take on debt and this could threaten the solvency of the state. Krugman perhaps treats this issue too lightly when he discusses the problems of Greece, Ireland and Spain. More importantly though he does not go further and neglects to explain that one of the main reasons that the state is not a corporation is that in many respects it is not exposed to competition and so should be incredibly wary of spending money. It should be wary of spending money because unless it does it in a competitive market environment it is difficult to assess whether it has spent money wisely.

The ramifications of this are important. The Government should ensure that all citizens have access to good quality health care and education but does it need to directly provide these services? No – it might be better that private providers serve customers, while the state pays people so that they can choose these services themselves. The exertion of choice and the market can help improve outcomes (although one does need to ensure that information asymmetries and other market failures are addressed).

It can be damaging to run the state like a corporation, but it can be equally damaging for the state to take on activities best left to corporations or the private sector.

Consider  a middle earner, who gets a job on graduation. The job has a salary of £30,000 and our example retains it for 45 years until retirement, with no fallow periods but no change in salary either. This is the starting point for the illustration. Optimists may foresee a pattern of rising salary or spells of parental leave, whereas pessimists may expect periods of unemployment or ups and downs. In planning terms, the constant, regular salary is an ideal situation, giving our example every chance of planning properly. I have left out inflation.  The illustration has more chance of being understood without it but of course any increase in prices needs budgeting adjustments throughout.

Our subject intends to borrow for a degree and buy a house in the south-east, where job prospects are reasonable and prices lower than in London. Having paid off the mortgage and the student loan, a retirement income of £10,000 seems adequate, similar to a worker on the minimum wage. Two particular circumstances may add to this. The basic state pension may still be in existence and paying its current level of a little over £5,000 each year. Then our subject’s parents may die and boost his income in retirement with the proceeds of the family home. Neither is certain.

Pensions work by paying now and receiving the benefits later. For our aspiring graduate homeowner, two major costs work the other way round. A student loan and a mortgage both defray expenses incurred early on. The student loan may come to £50,000; the house in the south east, £210,000. For this example, I have ignored the interest. Do not try this in reality, because it upsets the lenders. For illustration, the cost of house and degree are greater than the pension pot needed for fourteen years of retirement income, but the payments are spread over a slightly shorter time. Saving and borrowing at the same time seldom work to advantage, so our example middle-earner must choose either to keep a larger mortgage while putting money aside for a pension or to pay off the mortgage and do without years of growth in the pension fund. Simply adding up the totals required will not be far wrong.

Forty-five years of earning, aged 21 (no gap years here) to 66 provides lifetime earnings of £1,350,000. Basic-rate tax and NI reduce that to £1,050,000. Taking out a student loan and a house purchase leave £790,000, effectively £17,500 a year to spend on other things, including saving. Setting aside a little over £3,000 each year will provide a pension fund that provides fourteen years of income at £10,000. The residual income is £14,500. Our middle-earner has a house and a degree and will be able to maintain a standard of living in retirement, but at the cost of having only half a headline salary to spend on anything besides housing.

In “You’re On the Own” by Alasdair Palmer and Peter Morris, a major cause cited for low income in retirement is inadequate savings, where people have been discouraged from putting enough aside, whatever the other drains on their funds. This simplified illustration shows how that can come about. Even someone employed continuously from graduation to retirement can only regard less than half a salary as his or her own. Augmenting disposable income by not saving may be foolish but is very tempting.

A study in published in 2000 by the Institute for Fiscal Studies provided a method for answering the question by looking  at the related matter of the smaller 10% tax credit on dividends in ISAs. It made the point that stronger growth, from which pension funds would benefit, also increased the amounts lost to the change in taxation. Borrowing from their methods, I offer an estimate of the damage done to pension funds by the Chancellor’s decision in 1997, when the credit was 20 per cent.

A 20 per cent tax credit means that a dividend of a pound will be worth £1.25 to the recipient. The IFS envisaged that half of growth would be paid as dividends and half received as capital growth. That may have changed slightly as a result of the tax changes. Extra tax on dividends may encourage companies, especially those with pension-fund shareholders, to use the potential dividend money for re-investment. The pension fund gets the value as capital growth instead, with potential for tax allowances there. Since the ultimate aim of most companies is to get money out of them, little change in dividend behaviour was expected.

The rationale for pensions tax relief is that the same money should not be taxed twice. An employee foregoing part of a salary will pay tax on it when receiving a pension, but gets relief at the time the salary is first paid. In fact, a portion, currently a quarter, may be received as a lump sum without further tax. IFS regarded this as equivalent to a substantial dividend tax credit, amounting to over 10 per cent of the fund value. As for the tax credits themselves, they applied to taxable profits. A company paying a dividend would pay corporation tax on its profits. Dividends would come out of these profits, so they could be regarded as net of tax. The tax credit restored them to the gross amount. Again, when the pension started paying out, income tax rules would apply and tax would be paid on the proceeds from those dividends.

Savers are already used to seeing tax paid twice on an investment. They pay income tax as they acquire the capital in salary, then they pay more income tax on the interest earned by investing the capital. In a sense the dividend tax credit was relief from the equivalent of income tax on interest. Without the credit, investing the money is subjecting the savings to further taxation. There is a case for letting people off in return for planning sagely for retirement, but a similar case applies to day-to-day savings.

The important question is how much Gordon Brown’s decision cost. In reply, I begin by listing assumptions and parameters:

• Tax relief was 20 per cent.
• The credit was abolished in 1997.
• An estimated half of fund’s growth was paid in dividends (often reinvested), not as accumulated capital.
• Typical growth in a pension fund was slightly below 5 per cent per year.

Each year since, a quarter of the dividend-related half of the companies’ growth, which would have attracted a tax credit, received no such credit. If companies are losing money, then the loss to investors is likely to appear all in the capital, without any dividend. This may mean that a 50 per cent pay-out ratio is too small, but only in a few of the relevant years.

The total cost is the compound multiplication of one eighth of the fund’s growth over the period. Morris and Palmer quickly pass from mentioning Gordon Brown’s raid to describing annual charges of 1½ per cent. 1½ per cent each year is equivalent to a tax credit on dividends of 6 per cent, itself constituting half of growth of 12 per cent. Charges on that scale are clearly greater than the tax on growth below 5 per cent each year.

Figures made available by TrustNet for pension fund growth give just over 2000 funds operating ten years or more, with median growth since 2001 of 53 to 54 per cent. Allowing for compound interest and the fact that the money is paid into the fund in regular instalments, the loss to private investors amounts to 0.485 per cent of the gross fund each year. Since the change was made, the accumulated difference by now, 2011, would be around 4 per cent of the fund value. Over the course of the whole plan, that would grow to 12 per cent.

That, then,  is the short answer:

• approximately 4 per cent of the fund since 1997;
• potentially 12 per cent over the course of a whole plan.

Defined benefit funds would have to make that up for their savers, whereas defined contribution investors would choose between higher contributions and lower incomes. Obviously, there is a lot of potential for variation. Funds receiving greater or lesser dividends will lose more or less in tax.

By the standards of some of the losses reported in “You’re On Your Own”, 12 per cent of retirement income is not a huge loss. Table 3 on page 39 and figure 4 on page 40 show some of the others, affecting defined contribution schemes especially. Adding a tax credit line of 12 per cent would bring the overall reduction in table 3, where all the reductions have been multiplied together, to 77 per cent. Gordon Brown’s change hit defined contribution and defined benefit schemes alike, but served to highlight the difference in the two types of schemes. Where employers ran defined benefit schemes, they could respond to the need to make more contributions either by paying up or by reducing the availability of such schemes. Where personal savers were offered only defined contribution schemes, their response to lower returns was often to save less, cutting their charges but cutting their returns as well. The full consequences of that response are set out in the book.

This is the second part of a short series on personal pensions.

Morgan begins with the somewhat odd claim that ‘many economists do not believe an increase in money supply will increase the level of output’ (presumably higher real GDP). In fact, this is one of the few ideas that seem to command a consensus amongst economists from the left and the (neo-liberal) right. The UK may have done as much as can be done with the money supply (the rest of our problems are structural) but a lot of economists seems to the think that both the US and the Eurozone should be doing a lot more to increase their money supplies even now. Increasing the money supply is meant to combat the demand for money holdings, thereby stimulating spending (and hopefully some investment!).

Instead, Morgan suggests reducing rents through a Government price control that caps the rental price at some percentage of the renter’s income. The idea here is that you stimulate spending by allowing those with a greater tendency to spend (renters) to keep more of their money than the property owners they are renting from. This may or may not be true, but his suggested policy won’t achieve this transfer of spending power. This is because it will encourage property owners to do the following:

1.    Find high-income renters and avoid low-income renters like the plague, since they will be prohibited from charging the market rate for their property to low-income renters.

2.    If that activity is prohibited (on anti-discrimination grounds, for example), they will begin renting their property informally to friends and family rather than on an open market basis, with the real market rent provided unofficially or through in-kind exchanges.

3.    Avoid investing in low-income property areas and fail to refurbish old properties since owners won’t be able to compete for higher rents on quality if the price is already set.

4.    Forget about renting altogether and just treat any additional property as a second-home for their own occasional use.

5.    Abandon housing that isn’t worth renting at the price level set by the Government, and unsaleable for the same reason.

Worst of all, with no market price signal in the affected areas, property developers will not respond to low-income demands for housing. Even fewer affordable houses will be built, compounding the supply problems we have right now. If recent housing benefit reforms may force a few families to move home, this policy would ensure that they had nowhere to move to.

This isn’t theory. Last year, I was lucky enough to visit the city of Porto. As beautiful a city as it is, there were a number of strange aspects to it. This included a massive surplus of high-street bank branches (almost at every street corner) and a number of large residential construction developments just outside the city centre (two sides of Portugal’s housing and credit bubble). But most strangely of all, along the banks of the river Douro was a series of small but once-attractive riverfront flats and houses, now either dilapidated or completely abandoned. Some looked like they could just do with some retiling; others looked like they had been burned out in a civil war. This was in the centre of a still fairly productive city.

The reason for this scene is rent control. The owners of these houses can’t rent these properties at their market price and they can’t sell them to others for the same reason. So if the owners don’t have a use for them (as holiday homes, for example), they lie abandoned and unusable.

So how do you really help renters and the economy? At this stage, the problem of housing is so acute that even some social housing construction would be better than nothing. But the best solution would be to de-regulate the planning system (as the Government is doing, falteringly but partially, at the moment) and allow competing property developers to supply enough houses until rents and house prices become affordable to those on lower incomes. If you want to capture the rents off property owners and stimulate the economy, then that is achieved easiest by introducing a property tax and using money gained from that to cut taxes for those on lower incomes. But rent control is the absolute last thing you need if you want to help those on lower incomes.

The Financial Times, using the Office for Budget Responsibilities methodology has estimated that the structural deficit for 2011-12 will be £12 billion, or 25 per cent, higher than previously expected. This is down to the fact that the level of spare capacity in the British economy, and propensity for growth, is lower than expected, at 2.6 rather than 3.9 per cent of national income for 2011-12. In short, cuts in spending are not being matched by growth; although the UK may soon be spending less, we are unfortunately not making enough, and as a result debt levels are not falling by as much as was previously projected.

What the British economy needs is more news similar to that concerning Jaguar Land Rover. The question (hopefully) filling the minds of civil servants and ministers is: how can the British Government act to encourage and help more companies replicate Jaguar Land Rover?

Interestingly Jaguar Land Rover’s chief executive Dr Ralf Speth cited ‘strong support’ from the Government as one of the reasons for the intended investment. This support came in two forms: the new site is located within a planned ‘enterprise zone’ and the project is reportedly benefitting from a government grant of £10 million through the Grant for Business Investment Scheme.

Ministers have trumpeted about the importance of Government support in this project, as one might expect them to. However, they may have a point. Clearly Jaguar Land Rover, a company with resilient profits and increasing revenue, despite the wider financial circumstances, can afford to invest. However for companies like Jaguar Land Rover it is more often a question of where, rather than whether, to invest? The answer to this question needs to be Britain, and often the way to get such an answer is to support investment using public resources. Spending money to make money.

The problem at the moment is that the Government is, quite rightly, concerned about levels of public spending. Nevertheless this should not result in a wholesale rejection of the idea of public investment. One thing the Government needs to do is to prioritise certain forms of spending. Tax rebates, allowances or loan guarantees to encourage firms to invest are perhaps better than grants. Forgoing government revenue is always more efficient that just recycling taxes. Grants should still be used, but perhaps only where the financial benefits are tangible, as in the Jaguar Land Rover case.

As well as spending wisely, the Government also needs to ensure that its powers to intervene in the British economy are not limited by the EU. It was mentioned that Jaguar Land Rover benefitted from the planned enterprise zones. Unfortunately the effectiveness of the new zones could be limited by EU state aid rules, if the Government does not make the effort to ensure otherwise. Under current plans the maximum amount of business rate relief a business can benefit from is capped at £275,000 over five years, furthermore only businesses setting up production in a zone covered by an EU regional aid area can benefit from increased capital allowances.

While EU rules can undoubtedly circumscribe the British Government’s actions, they do not pose an insurmountable barrier. Many other European states successfully navigate the rules. The British Government must work harder to do the same.

Samuel Johnson once remarked that ‘nothing focuses the mind like a hanging’, let’s hope that a similar crisis serves the Coalition. The performance of the British Government, in improving the effectiveness of public spending, and working effectively within the parameters of the EU rules, needs to improve.

Stewart Lansley’s report for the TUC on ‘Britain’s Livelihood Crisis’ documents how many middle and low-income jobs have witnessed below-average growth in real levels of remuneration since the late 1970s. According to the report ‘skilled motor mechanics’ witnessed earnings growth of just 34% between 1978 and 2008 compared to a median of 57%. Some occupations have even witnessed declining levels of remuneration, for instance ‘fork lift truck drivers’ have seen their wages fall by 5% over the period. In contrast professionals, those in high-income jobs, have seen above-average growth, solicitor’s earnings rising by 114%.

Moving from employee remuneration to industrial competitiveness, the CPS analyses a number of international studies, noting Britain’s movement down the league tables. Looking at the ‘Global Competitiveness Report’ and the ‘World Competitiveness Yearbook’ Ryan Bourne and Jon Wilson highlight how, since 1997, the UK has slipped from 7^th to 12^th in the former, and 9^th to 22^nd in the latter.

If both the TUC and the CPS are right then Britain is becoming a less competitive place to do business, where some employees are suffering below-average wage growth. Can the CPS and TUC find common cause in addressing some of Britain’s economic woes? Not likely, this is clear when the reasons for these problems are discussed.

The TUC believes that Britain’s ‘livelihood crisis’ is the result of the country turning away from ‘welfare capitalism’ and embracing ‘market capitalism’ in the 1980’s. Deregulation and the acceptance, by both political parties, of the need for freer markets, has resulted in growing inequality. The cure – a ‘post-market model’ in which the Government intervenes in the economy to create more evenly-spread economic growth.

In contrast, if the CPS accepts the TUC’s diagnosis of the problem (which I doubt it would), its remedies certainly differ. For the CPS Britain’s economic future can only be secured by lowering taxes, removing restrictive (in particular employment) regulations and shrinking the size of the state and the deficit. In short the CPS wants a fuller expression of ‘market capitalism’. Providing support for their conclusion the authors of the report cite Britain’s fall down the ‘Index of World Economic Freedom’, from 5^th to 16^th between 1997 and 2011, as indicating how economic freedom is tied to economic growth.

It is perhaps unsurprising that the TUC and the CPS disagree and perhaps both would feel the other is incorrect, both in their diagnosis and proposed remedy. However, a more worrying thought is that both are correct. The TUC correct that market capitalism creates inequality, the CPS correct that market capitalism is necessary for strong economic growth (which the TUC concedes has occurred in Britain since the 1980s). If this is the case then one of the inherent characteristics of a dynamic market economy is a high level of inequality. I am aware that sceptics of such an idea will point to the Scandinavian economies as evidence you can marry economic growth with relatively equality, but this does not necessarily mean that Britain can replicate their success.

Of real concern is that if both the TUC and the CPS have diagnosed the current situation correctly, then solving Britain’s problems may involve a trade-off between economic growth and equity. Rarely is such a trade-off discussed, commentators on the right and the left preferring to argue that their solution can increase everyone’s utility. I for one, hope that one side, or indeed both, is correct and that economic growth and equality can be achieved. However, if they cannot, it could be time to discuss where priority should lie.