Tax Avoidance Nudge of the day

In the backdrop of the Paradise Papers which draws attention to the pervasive nature of tax avoidance strategies by the large corporates, Merryn Somerset Webb writes in FT,

In the meantime, if I were in charge, I would amuse myself by forcing all companies operating in the UK to list in their annual report how much tax they would pay in the UK if they were to simply subtract their UK-based expenses from their UK-earned revenues (no allowances and no profit shifting included) and how much they actually pay. It’s a small thing — but rather like forcing publication of pay ratios and gender ratios it might concentrate minds.

Talk about nudging to curb tax avoidance. Small step, but may be very useful, as she says, to "concentrate minds" and generate popular indignation.

And very nice illustration of corporate and individual tax avoidance strategies by Gabriel Zucman in Times.

Weekend reading links - automation edition

1. John Mauldin's newsletter last week had a graphic which captures what looks likely to be the primary economic challenge of our times. The paradox of increased production with fewer workers!

What makes this scary is the pace at which this is happening. The graphic below shows how the US shale industry has dramatically increased rig count over the past two years without increasing the workforce at all. 

The amazing thing is that this transformation happened in two years; it didn’t take a generation or even half a generation. You were an oilfield worker with what you thought was potentially a lifetime of steady, well-paying – if dangerous, nasty, and dirty – work. And then BOOM! The jobs just simply disappeared. Your on-the-job experience doesn’t translate to any other industries very easily, and now you and your family are on the skids.

2. Ananth points to a nice Bloomberg spotlight on Fanuc, a 45 year old Japanese factory automation company, described in the article as the "planet's most important manufacturer". 

The $50 billion company controls most of the world’s market for factory automation and industrial robotics. In fact, Fanuc might just be the single most important manufacturing company in the world right now, because everything Fanuc does is designed to make it part of what every other manufacturing company is doing... More and more, it’s Fanuc’s industrial robots that assemble and paint automobiles in China, construct complex motors, and make injection-molded parts and electrical components. At pharmaceutical companies, Fanuc’s sorting robots categorize and package pills. At food-packaging facilities, they slice, squirt, and wrap edibles...

Fanuc manages to offer very high savings while maintaining 40 percent operating profit margins, a success... traced to the company’s centralized production in Japan, which is made possible, even though most of its products are sold outside the country, by the 243 global service centers that keep its robots operational. The company even profits from its competitors’ sales, because more than half of all industrial robots are directed by its computer numerical-control software. Between the almost 4 million CNC systems and half-million or so industrial robots it has installed around the world, Fanuc has captured about one-quarter of the global market... Fanuc’s Robodrills now command an 80 percent share of the market for smartphone manufacturing robots.

3. Finally, this New Yorker essay on the march of robots in American manufacturing has this tagline,

Once, robots assisted human workers. Now it’s the other way around.

The la la land of financial market ethics

An FT investigation shows that top executives at Guggenheim Partners, the $240 bn asset manager, invested their client's money in companies with close personal ties to its leadership, without proper due-diligence and in cases even despite red-flags raised by the firm's own compliance department. This case of self-dealing and pursuing transactions against client interests is the latest in the endless series of scandals about governance and ethics violations that have become the norm in recent years. 

While there are elaborate "safeguards" against self-dealing, insider-trading, and the like, they rest of very flimsy, often completely unrealistic, foundations. Consider this,

There is nothing necessarily improper about investing with former business partners or close associates, as long as transactions between the groups are conducted at “arm’s length”, with full disclosure of deal terms to all parties involved in the transaction.

And there are academic apologists who lend the veneer of credibility to such relationships and transactions,

James Cox, a securities law professor at Duke University, says such conflicts are normally policed aggressively by compliance departments and a series of violations would indicate a failure of leadership at any Wall Street firm.

One of the less discussed agency problems with modern financial markets is the conflicts that arise at the intersection of the executive's professional and personal roles. It is a reality that top executives in the largest financial institutions today are simultaneously managing client and personal investments within the umbrella of the same institution and sometimes even the same financial instruments. This naturally raises the possibility of conflict between their fiduciary responsibility and their personal interests. The likelihood of investing client money being dictated by personal motivations is non-trivial.

In fact, given the very high stakes involved, the ease of obscuring personal relationships and making transactions opaque, the thin line between compliance and compromise, the difficulty of establishing culpability for transgressions like self-dealing and insider trading, and the pervasive erosion of corporate ethics, it is difficult to believe that such "arm's length" transactions are likely to be the norm. Adding to this, when executives from financial market titans have been found to have indulged in malfeasance involving cross-selling, self-dealing, asset-stripping, and insider trading on numerous occasions, and have escaped without any personal damage, the incentive misalignment and agency failure is almost complete. 

This was one of the reasons why financial institutions were historically structured as partnerships. As long these institutions remained small, the individual limited partners had enough leverage to keep incentives aligned. Gradually, as these entities have expanded massively, become public, and attracted impersonal institutional investors like pension and insurance funds, the relationship between the principal and agents diffused, and the former's leverage weakened as to become insignificant. 

It would require individuals of increasingly rare personal character to be able to resist the temptations of massive returns and exercise self-restraint in elevating their personal interests over their fiduciary responsibilities. The vast majority, when presented an opportunity, are most likely to fall prey to these temptations. The belief that "Chinese walls" and "arm's length" relationships are effective at deterring malfeasance is just a figment of one's imagination. 

On fertiliser subsidy reform

Scroll has a very good series on why the fertiliser subsidy reform plan involving delivering the subsidy directly to farmers as a Direct Benefits Transfer (DBT) by linking land records, soil health cards (SHCs), and Aadhaar number has had to be shelved, even if temporarily. 

The reform objective was to deliver the exact amount of fertilisers to each farmer based on their respective soil nutrient content as captured in the SHC and their Aadhaar-linked land record details. The reform struggled because of poor quality of land records and SHC data and behavioural challenges. Worse still, even the apparently pure technology play of Aadhaar authentication generated surprisingly high failure rates. 

One of the articles writes about the challenges with getting farmers to accept the SHC reports,

Farmers in Krishna district ignored the soil health card information that appeared on the machines. “When it comes to deciding how much fertilisers should be used, we go by our traditional wisdom and by what other farmers are using,” explained Babu Rao, a farmer in Krishna district. “We understand we might be using too much chemicals. But who will be responsible for the loss if we get poor yield by using less fertiliser?”

... Thousands of farmers and dozens of fertiliser retailers in Krishna and West Godavari district did the same – they ignored the machine’s instructions. “We could not deny what farmers asked for,” explained a fertiliser dealer in G Kundur, a block centre in Krishna. “There would have been riots. Our business would have suffered.”

And the inconsistency between the strategy and objective, and targets and resources,

To issue soil health cards, officials test one sample of soil each from a grid of 10 hectares of land in dry areas and two hectares of land in irrigated areas. Experts say this methodology may not produce reliable data for individual farms since the average size of agricultural land holding in India is 1.1 hectares, with 67% of the land holdings measuring less than one hectare. Soil characteristics change from farm to farm depending on the cropping patterns and fertilisers use in those farms. Data on soil characteristics over larger areas can therefore be misleading when used to determine the inputs required on a specific plot of land... In Krishna district, where 33 lakh soil health cards were generated last year from the 95,000 soil samples analysed, said officials. The four soil testing labs in the district had the capacity to test only 21,000 samples a year. The officials claimed private consultants were hired and the labs ran day and night to complete the job.

It is difficult to believe that this experiment could have turned out any different. Consider the requirements. First, the Agriculture Department had to effectively manage the logistics of soil health data collection - maintaining the soil sample identity, transportation and storage of soil samples, their analysis, and its communication back to farmers. Second, the soil analysis had to be an accurate reflection of the soil nutrient status - the sampling had to be representative enough and the tests had to be effective. Finally, the farmers had to have the faith in the results to be willing to accept its findings. Forget the second and third, there are too many moving parts in the management of SHC logistics itself for a weak state (an even more weak Agriculture Department) to have been expected to  deliver with any degree of credibility. 

And we have not even talked about the challenges with land records - mutation and ownership updation in basic land records, sub-division in survey records, disconnect between registration and ownership, lack of accurate tenancy records, predominance of tenancy and so on. Or with Aadhaar validation - poor connectivity, concentrated load on retailers during the sowing season, training of (1,75,619) retailers, maintenance of point of sale terminals, and so on.

The takeaways. One, it is unrealistic to expect weak states to be able to perform herculean tasks covering millions of people with any reasonable degree of quality. Adding unrealistic timelines only makes the likelihood of success even more remote. Two, excessively ambitious and over-engineered solutions are unlikely to work. Practical considerations and related compromises are important. Three, technology solutions cannot paper over fundamental structural deficiencies like poor quality of land records and weak state capacity. Finally, despite the perception to the contrary, technology solutions are not always easily implemented effectively in scale. 

The coming pensions crisis

The decades long secular decline in real interest rates has been taking a toll on savers. The pay-as-you-go, defined benefit pension schemes of many local governments, other public entities, and older corporations have promised very high returns whose realization may be difficult in this environment. Hyper-aggressive wealth and asset managers have massive funds under management that promise long periods of high returns, even after excluding their exorbitant management fees. 

The business models in pension funds, insurance, and asset management look likely to be upended by the persistent and declining trend in interest rates. 

A McKinsey Global Institute report last year made alarming prognosis about investment returns in developed markets over the next two decades when compared to the past thirty years. 

Accordingly, the MGI report estimates that for US and Western Europe, annual return on equities and fixed-income securities could be respectively 150-400 and 300-500 basis points lower. Its implications include,

A two- percentage-point difference in average annual returns over an extended period would mean that a 30-year-old today would have to work seven years longer or almost double her savings to live as well in retirement.

And in the medium term and even including emerging markets, as the seven-year return predictions of Jeremy Grantham shows, the likely real returns are mostly in the negative territory.

The biggest victims of this low return environment are likely to be pension funds, especially the defined benefits plans offered by government agencies and legacy plans of the big private corporations. A world with low yields for the foreseeable future compounds the problems for pension funds across the world. In recent years, the dynamics of demographics – rising share of aging populations – has already been exerting pressure on these pension funds, many of which are grappling with massive underfunded liabilities. They now have to earn sufficient returns not only to prevent the funding gap from widening further , but also make incremental returns to bridge their deficits. But the low return environment leaves them without enough to meet even the first objective. Further, the older towns and cities have been facing the problem of stagnant or declining populations which put pressure on their tax and other revenue sources.  

A study published by AQR Capital Management finds that defined contribution (DC) pensioners have to double their current savings to achieve the same target retirement income replacement ratio (RR) of 75%. The historical real return of 7.5% from equities is expected to decline to 5%, and that from bonds from 2.5% to 1%, thereby generating a two percentage points lower annual return of 3.5% on a standard asset allocation of 60% US equities and 40% Treasury Bonds. This means that the worker now has to save 15% a year, not the current 8%, to reach the same RR. On a 2.5% real return assumption, the contributions would have to rise to 19% overall!  

California Public Employees’ Retirement System (CalPERS), the biggest US public pension fund with nearly $300 billion of assets, posted just 0.6% gains for the year ending June 2016 compared to the 7.5% return required to meet its payment obligations. This has also brought down its average investment returns over the past two decades to 7%, below its target. About 60% of US pension funds assume a return of 6-7.5%.

The Hoover Institution, a Stanford University think tank, estimates the under-funded US public pension liabilities to be $3.4 trillion. Wilshire Consulting, an investment advisory, estimates that the funding gap of public pension plans in US rose from 23% in 2014 to 27% by mid-2015. As yields stay very low and dependency ratio rises, these liabilities are likely to balloon. Mercer, the consulting firm, estimates that pension deficits of UK’s FTSE 350 companies rose by £21bn to £119bn in just June 2016, almost entirely due to the fall in gilt yields. 

In fact, estimates for the US S&P 1500 companies by Mercer reveals similar disturbing trends. As on August 31, 2016, the estimated aggregate deficit of $570 bn represented a worsening by $166 bn from the $404 bn deficit at the end of 2015. Aggregate funding level of pension plans supported by these companies stood at 77 per cent.

Or as Larry Fink, the Chairman of world’s largest asset manager BlackRock, in his annual letter to shareholders last year, said,

For example, a 35-year-old looking to generate $48,000 per year in retirement income beginning at age 65 would need to invest $178,000 today in a 5% interest rate environment. In a 2% interest rate environment, however, that individual would need to invest $563,000 (or 3.2 times as much) to achieve the same outcome in retirement.

John Authers has said that for “US public employee pension plans, the three percentage points could more than double their deficit, from $1 trillion to $2.5 trillion”. The corollary of this is that these people will now have to cut back on their consumption to save atleast enough to maintain the same level of post-retirement income.

John Mauldin has initiated a series of posts on the looming pensions crisis in the US. As he writes, most of the public pension plans are not fully funded. In fact, as the graphic below shows, the extraordinary monetary accommodation has had a devastating effect, quintupling the the total unfunded liabilities in state and local pensions over the decade. 

Mauldin has dire predictions about the pension plans of city governments in the US, with very bitter consequences for those societies.  

Pension plans cover over 15% of many city budgets, with some having more pensioners than workers. The pension costs of Los Angeles Police Department rose from just 5% of general fund budget in 2002 to 20% today, forcing the LAPD ranks to fall to below 10,000 in 2013 against the required 12500. Similarly, New York today spends more on pensions than it does on building and repairing schools, bridges, parks, and subways. 

The results are hiring freezes which lowers the quality of service delivery and cut backs on the coverage of a variety of services. All this in turn results in higher crime, poor student learning outcomes, declining quality of utility services and so on.

In a different context, India faces an altogether different problem with its pensions. A recent RBI report on household financial savings describes a "ticking pension time bomb". Unlike the US, here it is just that only 7.4% of the working age population is covered by a pension program compared to 65% for Germany and 31% for Brazil. Or unlike UK where private pension investments make up more than 95% of GDP, it is less than 1% in India. The report found that more than 50% of households plan to depend on children for support during old age and 77% do not expect to retire or have not actively planned for retirement.

For India, with its favourable demographic pyramid with rising youth population, this is the right time to encourage savings so as to beneficially smooth inter-temporal financial needs. A recent report by the World Economic Forum reports a global unfunded pension gap of $400 trillion by 2050 for eight countries including India. It estimates India's annual savings gap to grow by 10% and reach $85 trillion by 2050. 

Accounting industry fact of the day

The erosion of values and institutional relationships that underpin capitalism has been a constant theme of this blog. The cozy and entrenched relationship between big businesses and and their auditors is another example. 

Sample this,

All but three of the US’s 500 largest companies use the Big Four accounting firms — Deloitte, PwC, KPMG and EY — and many of them have used the same one for decades. According to data compiled by MSCI, 42 of the big US companies that disclose auditor tenure have hired the same firm for more than 10 years, with an average of 24 years on the job. The UK’s 300 biggest companies are similar — 44 per cent of auditors have been on the job for more than 10 years, with an average tenure of 17 years. Most companies like dealing with the same auditor year after year — fewer things have to be explained, and audits can be completed faster. But critics say these long-lasting relationships can become too cosy and lead auditors to lose their scepticism. They point to UK telecoms group BT, which endured two accounting scandals in nine years while using PwC, whose work is now being probed by the UK accounting watchdog (PwC says it is co-operating, and BT has now changed auditors after 33 years). US lawmakers, meanwhile, have asked for an investigation of KPMG’s work for Wells Fargo during that bank’s fake accounts scandal. KPMG, which has had the account since 1931, has defended its work.

In recent months, the US, UK, and EU have taken some tentative steps to usher in greater transparency into auditing. They include bidding out audit contracts after ten years, changing auditors after 20 years, disclosing auditor tenures, and outlining "critical audit matters" and their resolution. 

Maybe there are compelling reasons, but I struggle to understand why auditors should not be procured by bidding every three years. It is more likely a case of captured regulators choosing the convenience of corporate interests over the concerns of conflicts of interests.

Update 1 (24.09.2021)

Auditing industry fact of the day from India

Bulk of the large listed companies in India prefer the network firms of the big four professional services firms—Deloitte, KPMG, PwC and EY—for statutory audit from among the more than 2,300 statutory auditors in the country, official data showed, indicating their apparent concentration in the premium segment of the audit market. On the other hand, close to 70% of all the statutory auditors in the country contend with just one audit client, as per data available from audit regulator National Financial Reporting Authority (NFRA). The network firms of the big four audited 522 companies in FY19 representing 75% of the market capitalisation of the 5,023 listed companies for which data is readily available, NFRA data showed. This represents about 10% of the listed companies by number. On the other hand, 1,578 auditors audit only one company each accounting for a small fraction of the listed companies.

And this on the. rules, 

Under the Companies Act, listed companies, public companies with paid up capital of ₹10 crore and above, private limited companies with paid up capital ₹20 crore and above and all companies with ₹50 crore and above borrowings from public institutions irrespective of their paid-up capital have to mandatorily rotate individual auditors after five years and audit firms after ten years. The cooling off period between two assignments is five years.

China high-speed rail graphic of the day

FT reports that China is engaged with 18 high-speed railway projects worth $143 bn across the world. A snapshot is below.

I think that unlike the other sectors like telecommunications, roads, power, and even normal railways, this one is unlikely to take off. It is has less to do with Chinese failings or limitations, but the simple fact that in most of these countries high-speed rail, besides being simply unaffordable is also unlikely to even close to being commercially viable.

Interestingly, none of the Chinese contractors, including the large China Railway Corporation (which alone has debt of $558 bn), were among the eleven companies who won the first round of bids for seven contracts worth £6.6 bn tendered out in the first phase of UK's London to Manchester High Speed Rail (HS2) project. The winning bids were from Costain, Strabag, Skanska, Vinci, Balfour Beatty, Carillion, Eiffage, Kier etc.