Drivel or what?

Sadly, we should in fact expect better from Vince Cable than this. He was professionally trained as an economist after all, actually worked as one. Which is why this little piece of drivel is so disappointing:

A tax on turnover clearly isn’t the perfect solution. Most economists would agree that profit is a fairer basis for taxation than revenue, given that profit is essentially a form of “rent” that would not exist in a perfectly competitive market.

We do not think that profit would not exist in a perfectly competitive market. We think that “excess” profit wouldn’t exist in a perfectly competitive market. Excess here being defined as a profit above the cost of capital.

Think through this for a moment. Modigliani and Miller showed that it doesn’t – or perhaps in some ethereal sense, shouldn’t – matter whether an organisation is funded by debt or equity. We all agree that interest is a cost of having debt, that doesn’t matter bit tells us that there’s also going to be a cost of equity, the return to equity. Dividends (or capital appreciation, if you prefer) is the cost of equity finance, just as interest is that of debt.

Thus, if we assume – as we do and should – that a company should be able, even in a perfectly competitive economy or market, to cover its interest bill we should also be assuming that it should be able to cover a return to equity capital.

Another way to put the same point is that there’s a difference between accounting profit and economic profit. Or, as Vince uses the word, between profit and rent. Accounting profit is something left over to pay equity. Economic profit, or rent in this sense, is profit greater than the cost of capital. UK banks, for example, have for years been making less than their cost of capital – they’re not making an economic profit at all. Some of the tech companies most certainly are making economic profits, rents.

The reason Vince Cable is spouting drivel is because he’s not making this distinction. As, for example, Sir James Mirrlees did make this distinction. But then Mirrlees is a real economist, isn’t he, not a political hack.

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  1. People don’t invest in companies so they get a rate equivalent to a deposit account. They hope and expect to make more money than that. Given a tax regime where no company can make a decent (‘excess’) profit they will not invest. Especially as there is no guarantee on the down side. This is a case where economic theory with its jargon and unreal definitions fails to match reality. In the real world some companies can make excess profits selling the same goods at the same price that makes other companies fail. And again, the punter pays all taxes no matter how you arrange them with the latest pet theory from the vapid pages of the Guardian or the LSE.

  2. I agree “that profit is a fairer basis for taxation than revenue,” and without caring what “Most economists would agree.” It is fairer to tax profit – that is, to hold off taxing a business until it starts making forward progress and producing wealth, then siphon off not enough of that wealth to significantly inhibit it from continuing toward prosperity.

    The “revenue” crowd is exactly those people who see a pile of money – such as the wad in the hands of the attendant at the gas station that makes a penny per dollar of product – and starts salivating about what they could do with that loot. This crowd are the type of person that would kill the goose laying golden eggs, hoping to scoop out the entire supply. They will destroy an economy if you let them.