Horse Meat, Tax Avoidance and Credit Ratings: Where’s the Regulation?

Economics is all about incentives. Like it or not, free market capitalism revolves around profit (and utility) maximisation.  Embedded in any conventional economics is the market selection hypothesis that any firm whose main goal is not to maximise profits will disappear in the long run (a natural selection of business if you like).

In reality, first best conditions are rarely satisfied leading to market failure, which quickly turns into government failure if the state fails to intervene. I am big believer of a mixed Keynesian government role where the state intervenes in the free market in the presence of such failures. Without the economic jargon, this simply means: if an economy is concerned with key indicators such as fairness, equity and consumer interests then free markets must be propped up by significant and effective regulation.

Yet scandal after scandal emerges from banking to supermarkets. Governments can use such scandals as ammunition in attaining public approval. It is easy for David Cameron to demand Starbucks pay some tax ex-post and demand better regulation of the financial services industry after a financial crisis. Until more of the blame falls on the state in these situations, very little will be done to resurrect a poor regulatory system in many sectors.

I intend on looking at three examples of government failure, all with slightly different twists.

1)   Horse Meat: Incompetence

12 countries have now started DNA testing on high street meat products after horse DNA has been found in numerous frozen beef meals.  With 100% horsemeat found in Aldi and Findus products and 60% horsemeat found in the Tesco Everyday Value Spaghetti, there has quite rightly been public outrage. It is not that horsemeat is dangerous to eat but the fact that the consumer should have the choice over what he or she decides to consume. Supermarkets have a legal responsibility to correctly label the ingredients of their goods.

Most retailers claim that they did not know about the horsemeat. Fine. In fact, probably true. But by no means is this a sufficient excuse given their legal responsibility. So, of course, the consumer is perfectly within his rights to show some indignation towards the supermarkets. However, can we please reserve some of the blame for the regulators? After all, supermarkets are profit maximisers, hence their ongoing existence. They compete fiercely over prices and large scale testing of their products can be very expensive. Supermarkets enter into a prisoner’s dilemma whereby all firms testing would be the most efficient outcome (at the expense of higher prices). However, due to lack of regulation, not testing is a dominant strategy and the only Nash equilibrium. In other words, supermarkets blindly trust their suppliers’ goods in order to stay competitive.

It is only due to poor regulation by the Food Standards Agency (FSA) that supermarkets are even allowed to make this choice. Yes, the FSA are responsible for this epidemic just as much, if not more so, than the retailers. Externalities such as horsemeat are a nasty consequence of unregulated free market economics.

In this case, the government failure is simple. Incompetence. The FSA is responsible for food safety and hygiene. However, if the government wants a thoroughly regulated food industry, then the scale of regulation here needs to be enlarged many times over. Perhaps naivety that meat suppliers would keep a moral code instead of profit maximizing is the source of this incompetence. But any first year economics student can tell you that morality has no place in profit maximisation.

2) Tax Avoidance: Hypocrisy

Starbucks have now bowed to public pressure and agreed to pay £20m in tax to the UK over the next two years after paying no tax on UK sales of £398m previously. The media has blasted Starbuck, Google and Amazon for immoral tax avoidance leading to consumer boycotts. Complicated accounting allows big firms such as Starbucks to book revenue in tax havens, such as Ireland or the Cayman Islands.

The difference with the horsemeat example is that tax avoidance is legal. Therefore conventional economic theory tells us that firms will not only avoid tax but that it is completely rational to do so. I am by no means saying that tax avoidance is morally acceptable. What I am saying is that I am not surprised at all that it happens on a large scale. Are Starbucks any worse morally that any other firm? Maybe, but let’s be a bit more cynical. Firms make choices based on profits and a firm who has chosen not to avoid tax is not necessarily more ethical but has concluded that the potential reputational damage of avoidance is too high.

So why is the government a hypocrite? Because the lack of enforcement is by no means unintentional. This week’s Economist publication explains the US has a tax haven for offshore banking in Miami and the City of London specialises in non-resident tax avoidance.  The point is that governments continually participate in a race to the bottom, chasing the global stock of FDI that stood at $21.1 trillion at the end of 2011. Governments encourage foreign investment by weakening tax barriers and lax anti-avoidance rules are a very opaque method of doing just this. So is it fair that big companies pay no domestic tax? No. But do they add more to the economy domestically than tax revenue? Yes, by a long long way. Google, Amazon and Starbucks combined hire 25,000 UK employees and the state knows this.

The point here is that it is a win-win situation for the state. They set weak international tax laws, encouraging multinationals to locate in their economy and use public outrage at tax avoidance to win votes. As long as the public blame is wholly directed at the corporations, the government can simultaneously generate FDI and impress consumers with promised clamp-downs on tax avoiders in the future. The hypocrisy is rational; the costs of harsher tax laws far outweigh the gains in potential corporate tax revenue (if there is any left at all). It would be much less condescending and deceitful for the state to admit its role in all of this but then again politicians are just as rational as the corporations themselves.

3) Credit Ratings: Knowledge 

This is textbook asymmetric information so I will keep it brief. More specifically, moral hazard. A private market for credit ratings creates adverse incentives that lead to inneffiency. I have never understood how such a vital market can be kept private. For me, credit rating agencies were as much to blame for the financial crisis as the banks that pioneered complicated mortgage backed securities in the first place.

The problem with Moody’s and Standard and Poor is that, as profit maximisers, they wish to maintain market share and keep their clients happy. Thousands of junk securities were rated triple A during the financial crisis. Yes, it may be true that the credit rating agencies did not truly understand the effects or design of securitisation, but they had absolutely no incentive to improve their understanding.  Downgrading their clients’ inventions would seriously threaten their business and hence ignorance was bliss. These views are cynical but not outside the realms of possibility given that the department of justice are currently prosecuting Standard and Poor for fraud.

Why is this a government failure? Whilst the rating agencies had no incentive to understand how securitisation worked, it was definitely in the state’s interest to learn and track the developments in the financial world. By not regulating or understanding securitisation, a market failure of moral hazard very quickly became a government failure.

Why such a vital part of the market that so heavily affects the consumer is privatised I will never understand. However, if it is going to be privatised, then at the very least it should be heavily regulated. The problem here is that nobody, not even the government or banks themselves really understood the cataclysmic effects of securitisation. Perhaps if the state regulated banks’ products more closely, this could have been avoided to a certain extent.

Conclusion

Perhaps I am too harsh towards the state. After all, some regulation, such as competition regulation, usually works a treat. My point is that in some key sectors, regulation is simply not good enough and this needs to be recognised by the public.

Horsemeat, tax avoidance and credit ratings are all unintended consequences of unregulated capitalism and, in my opinion, only the tip of the iceberg. Resurrecting market failures is a government role in a mixed economy, which is why free market economics must be supported by heavy investment in regulating bodies. We must start to recognise the state’s role in these scandals.

Knowledge and incompetence are mistakes that can be learnt from. In the case of tax avoidance, the state must eventually decide between what is fair (everybody paying their fair share of tax) and what is rational (maintaining foreign investment).