Author: Awareness News

Inflation has been making headlines all around the globe, as prices increase at unprecedent rates. But how is inflation measured? Are the measures presented by policy makers trustworthy?

Inflation has always been a hot topic of discussion – and a particular favourite of central banks all over the world. Indeed, with price stability as one of the core objectives of virtually all central banks across the globe, it comes as no surprise that inflation targeting is seen as the key guiding point for monetary policy.

So, if inflation is such a key determinant of economic activity in the eyes of most central banks, how do they go about measuring it? Multiple measures are generally and simultaneously used, with the most common being undoubtedly the CPI (Consumer Price Index) – used for example by the FED in the US – as well as its EU counterpart, the HICP (Harmonised Index of Consumer Prices), favoured by the ECB.

One may ask to what extent are all these measures able to fully capture the actual inflation that is being felt in the economy, and what role do central banks play in assessing inflation and its respective expectations, seeing as the ultimate decision of when and how to act when it comes to inflation targeting falls entirely upon them.

Measuring Inflation – From the CPI to more complex metrics

Most Central Banks stated primary objective is to maintain price stability. In the Euro Area and in the U.S., the European Central Bank and the Board of Governors of the Federal Reserve normally have their eyes set on a long-run target of 2% annual inflation. For Central Banks to keep track of the effect that their monetary policy is having on current inflation they need measures of… well, inflation[1]! Unfortunately, there is not one which is truly accurate or one which could take everything into account, and commonly used measures, such as the CPI (Consumer Price Index), are regularly subject to criticism of their methodologies and their over or under-estimation of inflation, depending on when and who you ask.

The CPI is one of the most mentioned measures of inflation and, generally, consists of, at a first stage, obtaining a set of weights to give to different expenditure items based on the consumption pattern of the average consumer (In the U.S., the U.S. Bureau of Labour Statistics, which publishes the CPI, calculates this based on its Consumption Expenditure Survey). Next, in the case of the U.S., for example, the U.S. Bureau of Labour Statistics obtains data on the prices of over 90,000 goods. Based on the previous weights, the index is then calculated and with it, we should get an idea of how the price of the average consumer’s basket of goods has changed.

However, there are many pitfalls associated with its interpretation, especially in the context of informing monetary policy. For example, a considerable percentage of consumers’ income is spent on energy consumption. As has become quite apparent recently, these commodities are subject to wild price fluctuations. However, despite being largely caused by factors other than the monetary policy of Central Banks, the recent price increase in energy has reflected strongly on the CPI. To combat this, we may remove energy and food (which may also be quite volatile) items from the CPI and present only the Core CPI.

And we may go even further and say that, in fact, the Core CPI may still be providing a biased estimate of inflation due to large changes in specific items and that, instead, we should look at the Trimmed CPI, which has the top 8% and bottom 8% biggest price increases and decreases chopped off. Others may say that we should look also at the Median CPI which measures the price change of the 50^th percentile good on the basket list.

Taking all these different measures into account we can build a better, more complete picture of whether recent inflation measured by headline CPI in the U.S. is simply related to wild swings of a few items due to supply shocks, or whether it is a broad-based, demand-driven phenomenon resulting from expansionary monetary policy.

Beyond the usual metrics – The importance of Inflation Expectations

The focus of Central Banks to meet their inflation targets is highly correlated with inflation expectations. These are simply the rate at which people expect prices to rise in the future. They matter because actual inflation depends, in part, on what we expect it to be. Let’s say that everyone expects prices to rise at a 4% rate over the next year; then, businesses will want to raise prices by at least that amount, and so will want workers to increase their wages. All else equal, if inflation expectations rise by one percentage point, actual inflation will tend to rise by one percentage point as well.

This means that for Central Banks it is important to anchor expectations at their inflation targets. The absence of anchoring, in a period of high inflation, can create a wage-price spiral. This term defines the cause-and-effect relationship between rising wages and rising prices. The wage-price spiral suggests that rising wages increase the demand for goods and cause prices to rise. These price rises will then increase the demand for higher wages and the cycle repeats.

Conclusion

Most of the younger European generations have never experienced high inflation. Still, the inflation rate was not always stable and low. In the ’70s, with deregulation of the international monetary system and two oil shocks, inflation had climbed to values never seen before (around 12% – 13%) only declining in the next decade (80’s). With some fluctuations over the years, this measure has seen a downward trend over the years laying down values between 0.18% in 2016, 1.7% in 2018 and 0.5% in 2020. 

This trend can be changing. In the past months, inflation has been alarmingly increasing, now reaching values that are further away from the usual target, with the EU currently registering around 3.6% inflation rate and the US a concerning 5.4%.

The fact that inflation is rising is not entirely unexpected, as expansionary monetary policies such as the ones that have been conducted for the past year and a half as a response to the COVID-19 pandemic – characterized by massive bond-buying initiatives that provide ample injections of liquidity in the economy and incredibly low interest rates – are usually followed sooner or later by a rise in inflation as demand starts to pick up once again. Coupled with this, the skyrocketing energy prices that come as a natural response to the global energy crisis that we are currently facing have also contributed to pushing this raise in prices even higher.

Nevertheless, even though the inflation values that exclude these energy fluctuations are a bit more promising (EU = 1.8% and US = 4%), they are still off from the recommended ones (especially the US), which indicates that a Central Bank intervention should be imminent, particularly from the FED where the scenario appears to be worse. Still, Central Banks are in-between the sword and the wall. On one side we see rising inflation pressure but, on the other side, there is still an economy that is recovering from the impacts of the pandemic crisis. Nonetheless, it is clear that the current landscape would not be sustainable for long, so it could be said that the Central Banks’ reluctance to act upon it will inevitably have to come to an end in the near future.

[1] Central Banks also often look at measures of inflation expectations to guide their monetary policy.

Sources: EBC, Investopedia, IMF, Trading Economics

Diogo Almeida

João Baptista

Inês Lindoso

João Correia

Tax revenue keeps civilization afloat but not all taxpayers play by the same set of rules. While some wealthy and well-connected people have avoided paying trillions of dollars in taxes, you are left to cover the bill.

            The Pandora Papers are a leak of almost 12 million documents that uncovered hidden wealth, tax avoidance and money laundering by some of the world’s rich and powerful. These include the King of Jordan, the presidents of Ukraine, Ecuador and Kenya, the prime minister of Czech Republic, and more than 130 billionaires from Russia, the United States, Turkey, and other nations. This leak comes years after the well-known Panama Papers.

            This is made possible by tax heavens. These are generally countries or places with low or no corporate taxes that typically limit public disclosure about companies and their owners. Independent countries like Panama, some areas within countries like the U.S. state of Delaware, or territories like the Cayman Islands are examples of such.

What is offshoring: technicalities and legalities

When investigations such as this come to light, talks about tax evasion or money laundering inevitably lead to discussions about the practice of offshoring and its legalities and technicalities. Offshoring can be succinctly defined as the practice of moving economic activities (be it a company or a bank account, etc.) from the country of origin towards a foreign jurisdiction overseas, separate from the one where the beneficial owner resides. Therefore, in its simplest form, as the name indicates, offshoring is primarily a geographic activity of moving operations from one country to another. However, the legal intricacies and moral aspects that revolve around it make it an activity quite frowned upon in the international community. 

Offshoring offers a number of enticing advantages to those who practice it, such as simpler corporate regulations and possibly lower costs for companies going offshore, as well as better asset and lawsuit protection. Moreover, and perhaps the biggest reason why people choose to move their enterprises and records of less than morally righteous business deals to countries such as Panama or the British Virgin Islands has to do with the tax benefits those countries provide to outsiders, as well as a promise of financial privacy and confidentiality that many appreciate in order to keep their financial transactions under the radar.

Concerning these taxation benefits, most of the so called “Tax Heavens”, terribly appealing to offshoring practices, allow these foreign entities to usufruct from an entirely different fiscal system from the national one, having to pay much less taxes (and in some particular cases none at all) and to collect tax-free capital gains from the operations conducted.

However, and as ludicrous as it may seem, the issue lies in the fact that this practice of moving operations from one country to another mostly to pay less taxes is entirely legal in many cases. In fact, despite all the scandal surrounding the Papers, most of those indicated are not infringing any law – rather they just opt to adhere to a judiciary and fiscal system quite different from the one in their home country. Hence, while tax evasion is illegal, tax avoidance by moving to a different jurisdiction is entirely legal, only not very morally accepted by society.

Why is this practice legal then?

That is a rather difficult question to answer as these offshore tax heavens have existed for many decades and not much seems to have been done to end them, despite all the investigations that have revolved around them in the past few years. In the end, it is very much the issue that many of the power players who could actually have a say in putting a stop to these practices – such as politicians and influential personalities – are also those that benefit the most from it, making it clear that it is really not much in their interest to limit offshoring in the near future.

From the Panama Papers to the Pandora Papers

The Pandora papers are similar to its predecessor, the Panama Papers, in that they both revealed the inner workings of offshore loopholes and shed light on many of the dealings that some high-profile, well-known figures engaged in.

Both the Panama and the Pandora papers consist of millions of files, 2.6 TB and 2.94 TB worth of information, respectively, which included legal and financial documents detailing many of the activities and property purchases of high-profile individuals, including billionaires, politicians, and world-leaders.

The Pandora papers were obtained and compiled by the International Consortium of Investigative Journalists (ICIJ) from a variety of different sources of information: 14 in total. ´

Meanwhile, its predecessor, the Panama Papers, came from a single source: Mossack Fonseca. Mossack Fonseca was a law firm and provider of corporate services, located in Panama (therefore, Panama Papers) that specialized in offshore financial services and that, before the leak, had a very relevant position in the industry. Because of this, it had access to large amounts of documents and files that detailed the activity that went on within the offshore dealings of many individuals. In 2016, a whistle-blower, whose identity is still unknown, leaked many of Mossack Fonseca’s documents to the International Consortium of Investigative Journalists.

While offshore activities are not, by themselves, illegal, they can be used to disguise and hide criminal activities. As a result, with the help of the information detailed in the Panama Papers, crime authorities in many different jurisdictions were able to uncover criminal activity and arrest and prosecute many suspects: In the U.S., the Panama Papers allowed the IRS to uncover several cases of tax evasion through offshore dealings, ultimately leading to the arrest of several people; U.S. authorities also found several cases of fraud. The Canada Revenue Agency also claims to have discovered 35 different cases of tax evasion. In late 2020, Germany issued two international arrest warrants for Juergen Mossack and Ramon Fonseca (the founders of Mossack Fonseca) for their involvements in the criminal activities of Mossack Fonseca, although they are unlikely to be extradited.

However, these types of investigations and legal procedures often take years to culminate in an arrest or a conviction and, so, we can expect that the Panama Papers will continue to aid authorities in investigations for many years to come. That will likely also be the case for the more recent Pandora Papers.

A possible solution – The Global Minimum Tax

A possible solution to tax heavens might be through a global minimum tax. A global deal to ensure big companies pay a minimum tax rate of 15% and make it harder for them to avoid taxation has already been agreed by 136 countries. The global minimum tax rate would apply to overseas profits of multinational firms with 750 million euros ($868 million) in sales globally. Governments could still set whatever local corporate tax rate they want, but if companies pay lower rates in a particular country, their home governments could “top up” their taxes to the 15% minimum, eliminating the advantage of shifting profits. A second track of the overhaul would allow countries where revenues are earned to tax 25% of the largest multinationals’ so-called excess profit – defined as profit in excess of 10% of revenue. Applying a similar version to individuals might just do the trick to combat tax avoidance by wealthy individuals.

 Conclusion

Offshoring allows companies and individuals to take advantage of low or no corporate taxes and limit public disclosure about companies and their owners. These practices are legal, but they pose a fundamental morality question. Offshoring practices provide benefits for the countries being used as the offshoring destination while negatively impacting the ones from which the money is being taken out off. This might create social unrest on these practices as taxpayers feel like not all citizens/companies are paying their fair share.

Sources: DW, Forbes, ICIJ, The Guardian.

Diogo Almeida

João Baptista

Jonathan Magzal

Inês Lindoso

João Correia