Wednesday, February 11, 2009

Desperate Times Call for Desperate Means: Government Scrip and Inheritance-Tax-Exempt, Zero-Interest National Bonds

One of the less-noticed features of Yoshimi Watanabe’s Dear John letter to the LDP was his proposal to issue government paper money (in addition to the BOJ paper money and the government-issue coins) and use the funds to prop up the stock market. More recently, an old LDP chestnut, the inheritance-tax-free zero-interest national bond, has been revived by Yoshihide Suga and other prominent LDP MPs. Last Friday, the forces came together in the preparatory meeting for the establishment of the Diet Members’ League to Examine the Issuance of Government Paper Money and Inheritance Tax-Free, Zero-Interest National Bonds. (政府紙幣・無利子国債(相続税減免措置付き)発行を検討する議員連盟; it’s easier on the eye when you have space- and breath-saving kanji, sure, but eschewing katakana altogether?…Wait, is there a political agenda here?) Yoichi “Buried Treasure” Takahashi, the MOF bureaucrat-turned-academic and economic guru to LDP reformists, is the intellectual force behind this, if this report is to be believed. According to the media, the first idea was knocked down by old-school, older, fiscal conservatives such as faction leader and ex-Finance Minister Bunmei Ibuki and current Economic and Financial Regulation Minister Kaoru Yosano and the more expansion-minded Prime Minister Aso and Finance Minister Nakagawa, while the second received a somewhat warmer hearing. Now I have some respect for Professor Takahashi and I’m not an economist, but I have to say no to both. Let me explain:

Both measures are essentially interest-free loans; in fact, with paper money, the government doesn’t even have to repay the principle. That’s why most countries try to take segniorage out of the hands of politicians and leave it to an independent central bank. Otherwise, what you have is “scrip”—more appropriate for provisional governments, rebel regimes, Argentine provinces and mine site canteens.

Now government scrip stays in the monetary base forever unless it is redeemed with BOJ notes or other fungible assets. In fact, if I understand correctly, that is exactly the point—to increase the monetary base to raise prices and push consumption without swelling future debt repayments. But experience during the post-bubble years has shown that increasing the monetary base is like pushing on a string when nobody wants the money. I’m not an economist, but it looks like the measure runs a serious risk of runaway inflation if it is anywhere near effective in goosing demand. I’m siding with the people doing the worrying.

The inheritance-tax-free, zero-interest national bond by contrast has received a respectful nod from the LDP mainstream. Let’s take look at what this means.

The top inheritance tax rate—applicable above a net tax base of 300 million yen (after a maximum 47 million yen deduction)—is 50%, while the going annual interest rate for a maximum-maturity 30-year national bond is a shade under 2%. If we round up the interest rate to 2% and use it as the discount rate, the present value of the principal for a 100 million yen bond comes to 55.2 million yen. So it appears that someone on his deathbed who has a net tax base of more than 400 million can lock in a 5.2 million yen after-inhertance-tax profit on a 100-million yen, inheritance-tax-free, zero-interest bond—the difference between the bond’s 55.2 million present value and the 50 million-yen after-tax cash—for his heirs or other more worthy causes. (It is named inheritance tax but is in effect an estate tax.) Of course it doesn’t quite work that way, since the discount rate, which is equal to the corresponding interest rate, should be progressively higher for each later interest payment—which should be considered as independent cash flows for valuation purposes. Since the face value of a 100-million bond at a 2% interest rate is the sum of the present value of the principal and all the present values of the interest payments, all but the last of which are subject to lower discount rates than the principal, the present value of the principal and hence the present value of the zero-interest bond is lower than 55.2 million yen and likely lower than the 50 million threshold that would begin making the deal attractive at the margins, i.e., to wealthy people on their deathbeds. The terms under progressively shorter maturities improve rapidly for the 300-million-and-over tax base, though, with the effect of the shorter maturities being compounded by the lower discount rates. Note that a ten-year government bond currently carries an interest rate around 1.2-1.4%, a five-year bond 0.7-0.8%.

Now, it will not be difficult to calculate the break-even point for any given life expectancy under any given set of yield curves. Since the government cannot match the maturity of the bonds to the individual purchaser’s life expectancies but must set a single maturity for each issue, it will in principle have to give up more in terms of present value that it loses in inheritance taxes than it gains in interest that goes unpaid. And if the government is to have any hopes of taking in substantial revenue, that giveaway shall have to substantial as well.

And all that for what? Let’s say that the government manages to save a couple of hundred million yen in interest payments per year over ten years on a trillion-yen bond issue. That’s the kind of money that would help my cash flow, but would be lost in a 80-something trillion yen budget. Moreover, these “gains” will be more than cancelled out in the initial years by huge shortfalls in inheritance tax revenue, since purchasers of these bonds will be concentrated on the short end of the life expectancy range. In fact, I foresee a massive concentration of the shortfall coming in the first year of implementation. (Buy, then die quickly, would be the best strategy for people who buy the bond.) And that’s over and above the government giveaway that I referred to in the previous paragraph.

All this begs the question: Why bother? Unless of course, you want to turn it into a no-questions-asked money-laundering scheme—something not totally out of the question.

It is possible that the intent is to placate complaints from the wealthier LDP supporters that the inheritance tax is too high, and that the generally well-off LDP Diet members (if you are taking those annual disclosures of personal assets at face value, I have a bridge to sell you) are inclined to be more than sympathetic to their views. To be fair, I think that the top rate (or the threshold tax base thereof) is excessive, and I swear I have no personal financial interest in this issue either way. But that’s a different agenda that should be met head on, instead of sneaking in a one-off favor to the well-to-do before the DPJ and its allies with their more egalitarian background comes into power.

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