On How to Keep Tax Payers Honest (or almost so)*

One line of investigation in the problem of tax evasion has been introduced by B. Singh who studied the question of the ‘Optimum probability of detection’ which must be set (or be believed to be set) in order to induce the lax payer to declare income fully (‘complete honesty’). However, detection is costly and the achievement of an ‘optimum rate’ may therefore be ruled out on the grounds of economy. On the other hand, the penalty rate is set by legislative action, which is relatively costless. In contrast to Singh we take the probability of detection as given and study the ‘prohibitive penalty rate’, generally for any desired minimal level of evasion and more extensively where the desired evasion is zero. The formulae for the prohibitive rates are derived for each of three penalty functions, and the corresponding rates calculated for a selection of probabilities of detection on the basis of the current Australian taxation schedules. The calculations involved are simple and may be readily made for other countries.     

CEO Overconfidence and Corporate Investment

We argue that managerial overconfidence can account for corporate investment distortions. Overconfident managers overestimate the returns to their investment projects and view external funds as unduly costly. Thus, they overinvest when they have abundant internal funds, but curtail investment when they require external financing. We test the overconfidence hypothesis, using panel data on personal portfolio and corporate investment decisions of Forbes 500 CEOs. We classify CEOs as overconfident if they persistently fail to reduce their personal exposure to company‐specific risk. We find that investment of overconfident CEOs is significantly more responsive to cash flow, particularly in equity‐dependent firms.     

Options for ERM Entry

After years of being blocked, UK entry to the Exchange Rate Mechanism now looks very probable either later this year or early next. But if the issue of entry is largely settled, the form of entry remains open. We examine the different dimensions of this question, and consider five separate options for entry. We consider two strategies driven largely by political considerations, but reject them as too high risk. We also reject the 'deep-discount' option as being far too inflationary. Instead we argue for entry at a relatively high exchange rate in line with or slightly above the current market rate. With entry next spring, we would favour a narrow band. But if entry is in the autumn, entry in the lower half of a broad band is more appropriate, leaving greater room for manoeuvre in interest rates. But a move to narrow bands in the course of next year would then be required to give maximum anti-inflation benefits. On this strategy ERM entry will provide appreciable benefits in bringing down inflation, but it will not be costless: as our forecast suggests, the economy will undergo several years of depressed growth of output. But this should lay the basis for steady growth combined with low inflation from 1993 onwards.     

Productivity and Inflation: a Paradox

In his Budget speech, Mr. Lawson drew attention to the greatly improved record of productivity growth in UK manufacturing:
"During the 1960s, and again in the 1970s, growth in manufacturing productivity in the UK was the lowest of all the seven major industrial countries in the world. During the 1980s, our annual rate of growth of output per head in manufacturing has been the highest of all the seven major industrial countries."
Ironically this success in regard to productivity may cause a problem in regard to inflation if the UK moves to a fixed exchange rate policy within the EMS. In this Viewpoint we report the consequence of such a move and also describe the possible required rise in the exchange rate if price stability is to be attained. We show that price stability requires the exchange rate to rise (i) to offset world inflation and (ii) to compensate for the productivity gap between the traded and non-traded sectors.     

Why has inflation fallen?

There is no doubt that the most encouraging aspect of Britain's economic performance in recent years has been the fall in inflation from a peak of over 20 per cent in June 1980 to a current rate of about 5 per cent. The speed at which inflation fell has taken many forecasters (including ourselves) by surprise. In this Economic Viewpoint we ask why the inflation rate has fallen. If we can understand why it has happened we are better placed to answer questions about the future. In particular we can try to decide whether the success in reducing inflation will be maintained and whether further cuts in inflation will be consistent with a fall in unemployment.     

The UK Balance Sheet

With net overseas assets of well over $100bn the UK is now the world's second largest creditor nation after Japan. This has come about because the UK current account benefited from large-scale oil revenues from 1980 onwards, which produced a series of current surpluses. Fortunately the funds were invested overseas at a time of significant recovery in world equity markets. As a result of the increase in its external assets, the UK now receives £5bn p.a. or more from interest, profit and dividend earnings on these assets - a valuable cushion to the run-down in oil revenues.     

Coping with oil price shocks - the case of Japan

The world economy has now suffered two major oil price shocks. Although the percentage increase in 1973-74 (OPEC I) was much larger than in 1979-80 (OPEC II). the potential effect on the level of world prices - and hence on the real economy - was about the same in each case. One lesson that was learned from OPEC I was that the impact of the oil price increase on individual economies depended on the policies followed by each country. For example, in the UK the inflation rate rose to 27 per cent in 1975 whereas in West Germany - which was just as dependent on imported oil - inflation rose to 7 per cent. In this Economic Viewpoint we consider the example of one country - Japan - which changed its policies between the two events. As a result it changed from being one of the least successful to being one of the most successful in coping with the oil price increase.     

The Recession of 1980 and its Causes*

During 1980 total output fell by 5% per cent and manufacturing output by 16 per cent. By May 1981 manufacturing output was 20 per cent below its 1979 peak level. in this Briefing Paper we use the London Business School model to explain the current recession. We conclude that the main identifiable came was the rise in the price of oil. but output was also affected by the increase in VAT and the reductions in public investment. Those cawes directly explain a reduction in output of about 3 per cent in 1980 compared with what might otherwise have happened. We suggest that additional links (not fully incorporated into the model) increased the impact of those shocks and led to the severe fall below potential output. The first part of the paper describes briefly the events of I979 and 1980. in the second part we ask how far the economic developments were predictable and in the third part we set out our explanations.