The bad news is that there is a lotof bad news. BP, known to ourpresident as British Petroleum,is destroying the ecology of theGulf of Mexico, and wrecking

the economies of the states that abut it.The eurozone is in a state of chaos asprofligate nations prove unable to repaythe money they have borrowed, creatingthe possibility of another collapse of theinternational financial system.

Tensions in the Middle East and onthe Korean peninsula are rising. Japan’sprime minister has resigned, as hasGermany’s president, unsettling thepolitical picture in both countries, notgood news for those hoping for robustrecoveries in the world’s second andfourth-largest economies, respectively.China’s economy, the third largest,seems to be overheating. Iran’s effort togo nuclear proceeds, unimpeded by UNresolutions or sanctions.

Meanwhile, the American economicrecovery is experiencing a wobble. Only41,000 of the 431,000 non-farm jobscreated in May were in the privatesector, and perhaps 20% of those, by oneestimate, were to help clean up the oilspill. The government hired 411,000temporary and low-paid census takers,bringing the total knocking on doors to564,000. They will soon return to theunemployment rolls or part-time work.No surprise that share prices plungedwhen the bad jobs news was released.

Still, there are signs that the recoveryhas not flamed out. The Organisation forEconomic Co-operation andDevelopment expects the Americaneconomy to grow at an annual rate of3.2% this year and next. Consumers’incomes rose in April, and it is hardlybad news that they decided to save theincrease rather than step up spending.Besides, their refusal to spend comes notbecause of any new gloom: confidenceactually rose last month to its highestlevel in two years as consumers reportedthat their view of the future has becomecheerier. A survey by Deloitte found thatnearly two-thirds said their financialcircumstances were as good or betterthan last year. Which might explain thebig jump in car sales in May.

President Barack Obama’s plan todouble exports in the next five years ismore a campaign talking point than arealisable goal, but exports are pickingup. The Institute for SupplyManagement reports they are at theirhighest level since 1988. Those exportsales helped the manufacturing sectorachieve its tenth successive month ofgrowth. The president of Cyril Bath, amanufacturer of machines used in theaircraft industry, told The Wall StreetJournal: “We’ve got orders coming infrom Europe. We’ve got orders comingin from Japan, China, India and Russia.They’re coming in at record levels . . .”Rational exuberance, one hopes.

It is, however, not for nothing thateconomics is known as the dismalscience. In addition to very weak jobgrowth, economists note that estimatesof fourth-quarter 2009 GDP have beenrevised down from 3.2% to 3%. Thegloomier ones also point out thatconsumer confidence often rises andfalls with the job market, and the lowlevel of job creation last month, plusthe inevitable lay-offs when thecensus-taking is completed, will soonwipe the smiles off consumers’ faces.

Worse still, economists cannot decidewhether to worry about deflation orinflation. With prices already edgingdown, substantial excess capacity in thesystem, and euroland about to withdrawlarge amounts of demand from the worldeconomic system as austerity bites, it is

reasonable to worry that a Japanese-styledeflation is in America’s future. That sortof thing is hard to reverse: knowing thatprices are declining, consumers deferpurchases, which causes prices to fallfurther, which in turn causes consumersto keep their wallets and purses zipped.Result: recession.

Others fear just the opposite. With thegovernment running huge deficits, andthe Federal Reserve printing money, wewill have an inflationary spiral, with thevalue of the dollar declining, saversdevastated, and interest rates soaringas investors demand higher and higherrates for their money, knowing they willbe repaid in dollars with reducedpurchasing power. This explains theflight to gold, widely believed to be ahedge against inflation.

Or, if you prefer your “dismal” to be ofthe imported variety, the tale of woe goeslike this. The declining euro, headedperhaps to parity with the dollar, willstifle America’s export business. AndEurope will also send over a financialcrisis, as its banks take big losses onsovereign debt and on loans to Greek andother enterprises. Already, banks arehoarding money, threatening a seizingup of credit markets on a scale not seensince the collapse of Lehman Brothers.And companies have decided to rein inborrowing, given the uncertainties incredit markets.

Then there are home-grown policydevelopments to worry about. Thefinancial reform bill that will soon endup on the president’s desk, whatever itsmerits, and there are several, will createa bakers’ dozen of new regulatoryagencies, according to my HudsonInstitute colleague, Diana Furchtgott-Roth. It is not likely to produce anoptimally efficient financial sector. Taxincreases are scheduled to hit soon afterthe November congressional elections,costly regulations are being imposed onthe resurgent car sector, and estimates ofthe cost of what has come to be calledObamacare rise almost every week.

These are all reasonable worries, butall a bit overblown. The more likelyoutlook is for a continued recovery,though the pace is uncertain. TheFederal Reserve is now unlikely toimplement any exit strategy it mighthave, keeping interest rates low.Congress is even less likely to pull thetrio of artificial props — Fannie Mae,Freddie Mac, Federal HousingAdministration — from under themortgage and housing markets.And a new stimulus bill is certain toprecede the November elections. Sogrowth there will be, barring anyshocks to the system. Which, of course,are not out of the question in this veryuncertain world.n Irwin Stelzer is a business adviser anddirector of economic policy studies at theHudson Institute

stelzer@aol.com

Tax fromcapitalgains ...

... and whereit comes

from

Gains subject to CGT (2006-7)

CGT receipts

9

8

7

6

5

4

3

2

1

0

1978-79

SOURCE: HM Treasury and HM Revenue & Customs

£bn

1988-89 1998-99 2008-9

£21.5bnUnquotedshares

£6.2bnQuotedshares

£6.1bnResidentialproperty

£3.4bnOther

physicalassets

£2.8bnCommercialproperty

£1.3bnAgriculturalproperty

£1.0bnOthersecurities

Solutions to the taxingissue of capital gains

On Friday I met two under-firechief executives. BP’s TonyHayward looked tired anddefiant after 45 days fighting acompany-threatening oil spill

in the Gulf of Mexico. Tidjane Thiam atPrudential was cool and amiable, but alsoangry after having his cherished$30 billion Asian deal torpedoed at thelast minute.

Corporate Britain has rarely seen thekind of drama that has engulfed thesetwo. Hayward has become the face of anenvironmental disaster that is one of theglobal stories of the year. Thiam hastried to steer one of the largest takeoversattempted by a British company througha minefield of hostile regulators andcritical shareholders — and failed.

Both face calls to resign. Haywardwon’t even entertain the question, sayinghe hasn’t read a newspaper in weeks and

has only one thought in his mind,capping the gulf gusher. Thiam says heconsidered stepping down, thoughtbetter of it, but will go if shareholdersmake it clear they want him out.

The troubled chiefs are linked by morethan both being put through the mill inrecent weeks. At the end of April, whenThiam was preparing the purchase ofAIA, the Asian arm of AIG, the Americaninsurance group, markets were in a rarepatch of calm. Then came the Gulfblowout, which hit BP shares hard.

Eventually nearly one-third was wipedoff the oil group’s valuation, just whenThiam was asking his institutionalshareholders for support for the£14 billion rights issue he needed. Manyof the institutions would have paid forthe rights by selling part of their holdingsin BP. With its price on the floor, theywere reluctant to do so, putting another

hurdle in the Pru’s way. The gulf spillwrecked BP’s share price and corporatereputation, and helped derail the Pru deal.

The big question now for both of them,even if Hayward won’t countenance itwhile the oil is still leaking, is whetherthey can hang on to their jobs. At the Pru,investors are hungry for a sacrifice. Theyvoiced their opposition to the deal early on,were cajoled into supporting a cut-priceversion and let down at the eleventhhour. Thiam and Harvey McGrath, thechairman, will put a brave face on thesaga at the annual shareholders’ meetingtomorrow, and will say sorry. That isunlikely to be enough.

While Thiam is most likely to get thepush, some shareholders are quietlypointing the finger instead at McGrath,saying the whole board voted in favour ofthe AIA purchase, and that the failures incommunication and investor relationscan be laid at his door. Nothing is likely tohappen quickly, with the Pru’s interimresults in August the next milestone.

Hayward has no problems with hisshareholders. His trial is in the widercourt of American public opinion. Hemay have to go simply to help restore theBP brand in America. BP’s directors —including Hayward himself — took adeliberate decision to make him the focalpoint for the Gulf of Mexico disaster.Fielding the chairman, Carl-HenricSvanberg, would only have confusedmatters, they reasoned, as Americansdon’t understand the division of roles inBritain between chairman and chiefexecutive. It was probably the right

decision in public relations terms butwhen it comes to the crunch it meansthere is only one name in the frame.

Question timeIN More Money than God, his book onhedge funds, the American authorSebastian Mallaby quotes Paul TudorJones, the fund manager, on why theAmerican government was powerless tostop a market crash in the wake of theLehman Brothers collapse. “The questionmarkwould totally create financial panicand chaos,” Jones said. The questionmark he was referring to was theuncertainty created when cracks begin toappear in the facades of institutions. IfLehman had gone, why not Goldman,Merrill Lynch or any other bank?

We are reaching a similar position onsovereign debt. First came Greece, thenPortugal and Spain. Now the questionmark is hovering over Hungary and even,if you believe some bloggers thisweekend, France. The euro is now at afour-year low against the dollar andFrançois Fillon, the French primeminister, didn’t help its cause when hesaid on Friday that he saw only “goodnews” in having parity between the twocurrencies. To get to parity, the eurowould have lose about one-sixth of itsvalue. If one of the eurozone countries isforced to default on its loans, with Greecebeing the obvious candidate, Fillon mayget his wish sooner than he expects.

The G20 has this weekend done its bestto shore up confidence in sovereign debt,

praising the eurozone countries for thesafety net they have put in place to rescuestricken members. That doesn’t eraseJones’s question mark, however. The onlything that will is evidence that austerityprogrammes are biting, and debt iscoming down to manageable levels.

Derailing bonusesTHE railways are a seasonal business. Inautumn, there are leaves on the line andin winter it’s the wrong kind of snow.Summer brings the controversy over theexecutive bonuses at Network Rail,which owns and maintains the network.Despite being an odd corporate animal,

with no shares and loans borrowingguaranteed by the government, NetworkRail has a quoted, company-styleremuneration scheme, which hands outbonuses of up to 100% of base salary.

Politicians, unions and, sometimes,passengers don’t like the idea, saying it’snot right for a company that relies ontaxpayer support to pay such sums, andin any event my train was late yesterday,and what are they doing about that?

The decision on payouts will be madeat the end of the month. Already theopening shots have been fired. PhilipHammond, transport secretary, last weekfired off a letter to the directors sayingthey should bear in mind the generalmood of public sector restraint beforeloosening the purse strings. NetworkRail, meanwhile, is talking up its record,perhaps in an attempt to forestallcriticism if it does pay out. Iain Coucher,the chief executive (who has a base salaryof £613,000) says the company is makingbig savings, and improving reliability.

The company’s regulator has somenice things to say about it, but feels it’stoo early to judge on the crucial point ofefficiences. “At this stage it is not clear towhat extent Network Rail has made realprogress to deliver this requirement,” isthe lukewarm conclusion. With theregulator not standing by the companyand the secretary of state giving it a clearwarning, the remuneration committeeshould think twice before handing outany bonuses.

dominic.oconnell@sunday-times.co.uk

The Institute for Fiscal Studies wasfounded in the late 1960s largelyout of frustration with the waycapital gains tax (CGT) wasdesigned and implemented in

Britain. Over the subsequent four decadesCGT has been attacked, substantiallyreformed and attacked again roughly every10 years. Our new government is only thelatest to try its luck.

The coalition has promised to “seekways of taxing non-business capital gainsat rates similar or close to those applied toincome, with generous exemptions forentrepreneurial business activities”. Thissuggests the tax rate on assets such asshares, second homes and works of artcould rise significantly.

The Liberal Democrats see this as a goodway to raise money for income-tax cuts,but also as a move back towards the ration-al CGT regime put in place by Nigel Lawsonin 1988. However, some backbench Toriessee it as an attack on the middle classes anda betrayal of Conservative values. DavidCameron has told critics to “calm down”until they see the details.

At first glance, CGT looks unimportant.It is forecast to raise £2.7 billion this year —just 0.5% of the Treasury’s total revenue.Some critics argue from American and Brit-ish experience that increasing CGT rateswould actually cost the government reve-nue, but swings in CGT revenues from yearto year often reflect the pre-announcementof rate changes and expectations of wherethey might go next. And we should notlook at CGT revenues in isolation: perhapsthe key role of the tax is to underpin themuch bigger revenues we get from incometax and National Insurance.

CGT is applied to the increase in the val-ue of an asset between its acquisition anddisposal. This sounds simple, but the devillies in the many attendant details. Forexample, to which assets should it apply?Which part of the gain should you tax? Andshould the tax rate be uniform or vary withthe type of asset, the length of time it hasbeen held or the income of its owner?

Different chancellors have answeredthese questions in different ways. WhenJames Callaghan introduced CGT in 1965, itwas a flat rate of 30%. Geoffrey Howe intro-duced indexation allowances in 1982, ensur-ing that only gains in excess of inflationwere taxed. In 1988 Lawson began taxinggains at the taxpayer’s marginal income-tax rate. This was probably as good as it got.

Gordon Brown abolished indexationallowances for gains after April 1998 andintroduced “taper relief”. This gave taxpay-ers an increasingly generous discount ontheir CGT bills the longer they held theassets (with a bigger discount for businessassets than non-business ones). He madetaper relief more generous in 2000 and2002, before Alistair Darling announced in2007 that he would abolish the relief andimpose a flat rate of 18% — returning to thepre-1982 system. Business lobby groupscomplained that this would increase therate paid on long-held business assets, forc-ing him to create “entrepreneurs’ relief”,

which cuts the rate to 10% on the first £1mof lifetime gains for some business assets.

Looking back, most of these changeshave been attempts to balance two compet-ing objectives: the desire to minimise thescope for tax avoidance created when capi-tal gains are taxed more lightly thanincome, and, second, the desire to keep cap-ital taxes as low as possible to avoid discour-aging saving and investment. The nowLord Lawson and the Liberal Democratsput more emphasis on the former, whilethe last Labour government and the cur-rent Conservative critics of the coalitionput more on the latter. These critics alsoargue that many small investors have beensaving in non-business assets in the expec-tation of generous tax treatment and thatit would be unfair to withdraw it now.

The Liberal/Lawson view has much torecommend it. The tax system should notdistort people’s behaviour in a costly waywithout good reason. From this several les-sons follow.

First, the tax rate on capital gains shouldbe aligned with the rates on earned and div-idend income, ideally with a single tax-freeallowance. Different tax rates encouragepeople to be paid in more lightly taxedforms and to move into occupations wherethis is easier. Using anti-avoidance rules torestrict how people are paid in particularcircumstances is much less attractive.

Second, CGT should not discriminatebetween business and non-business assets.People should be left to decide unbribedwhether to put their money into a bankaccount, housing, shares, or into their ownbusinesses, based on their own judgment

of the risks and returns involved. There isan argument for taxing shares more light-ly, however, because company profits thatgive rise to capital gains have already beensubject to corporation tax. We should bewary of the argument that investing inone’s own business is a virtuous act deserv-ing of subsidy in a way that investing insomebody else’s business is not. Peopleshould decide whether and how to build anenterprise on the basis of its commercialfundamentals, not its tax treatment.

Third, we should not try to bribe peopleinto holding assets for longer than theywould otherwise wish to do — economicwelfare is best served by having assetsowned by the people who value them most.The previous government justified taperrelief as a way to discourage short-termism,but encouraging people to hold assets forlonger than they want is not the same asencouraging companies to undertake pro-ductive investments that may take a longtime to pay off.

Fourth, we should tax real gains ratherthan the illusory gains from inflation, sothere is a strong case for reintroducingindexation allowances.

But what of the twin objections that allthis would discourage future investmentand penalise past saving?

High CGT rates certainly discourageinvestment, but reducing them is not nec-essarily the best way to encourage it. Capi-tal allowances, including schemes such asthe Annual Investment Allowance aimedat small firms, are more effective waysbecause they specifically reduce the taxrate on capital investment rather than on

the other factors that generate capitalgains. But the Conservatives want toshrink capital allowances to help pay forcuts in the main rate of corporation tax.

An alternative approach would be toreintroduce indexation allowances, notjust for inflation but also for the minimumreturn that someone would require toinvest a pound today rather than spend it.This would move us closer to an “expendi-ture tax” system that would not distort lev-els of saving and investment, especially ifaccompanied by similar changes to incometax and corporation tax.

Aligning CGT and income-tax ratesmore closely would, of course, anger peoplewho have been saving in assets that cur-rently attract generous tax treatment. Butthere was never any guarantee that thispreferential treatment would remain inperpetuity, especially given the regularityof CGT changes in the past. Various possi-ble transitional arrangements could easethe pain, but all would be costly, complicat-ed and of questionable fairness.

The uncomfortable truth is that the coali-tion partners will have to inflict a lot ofpain and disappoint quite a few expecta-tions over the next few years as they clearup the fiscal mess they have inheritedfrom Labour. Hopefully they will have thecourage to move towards a more rationaltax system as they do so, rather than sim-ply scrambling from one short-term fix tothe next.n Robert Chote is director of theInstitute for Fiscal Studies

David Smith is away

IRWINSTELZERAMERICANACCOUNT

AGENDADOMINICO’CONNELLBUSINESS EDITOR

All we can seeis the clouds inthe silver lining

Gulf spill poured cold water on Prudential deal

ROBERTCHOTEECONOMICOUTLOOK

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2009 2010

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SOURCE: Yahoo

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4 BUSINESS