Fair Tax Mark fails by its own standards

Here’s a great little excerpt from the Fair Tax Mark Methodology document:

 “To appraise this current effective tax rate we use an averaging method, considering six years of accounts in the process (using as our sample three sets of accounts and their comparative data) but weighting each year on the sum of the digits method so that greater attribution is given to more recent data than older data, which we think appropriate if changes in behaviour is to be given the credit it deserves in a reasonable time frame.

The use of this averaging method to calculate the current effective tax rate lets us, in our opinion, ignore the vagaries of deferred tax since the timing differences that it should record should, on average, we think reverse over such a time scale. Please see our discussion of deferred tax on the Fair Tax Mark website for more discussion of this issue.

This does, in our opinion, increase the objectivity of the information”

This is my highlighting. In the space of two sentences the FTMRNG essentially states that:

  1. more recent events are weighted more heavily than older events, and
  2. the method is dependent on recent events being of equal weight to older events

I’ve illustrated this elsewhere. The time weighting means that it is a practical certainty that timing differences will not even out because of the annual weighting.

The Fair Tax Mark calculation fails completely under its own internal contradictions.

If this is primarily about judgement, you have to question the judgement of a campaign who sees this calculation as being more objective than simply using the actual effective rate of tax.

About Ben Saunders

I'm a Chartered Tax Adviser and a freelance writer. This is my personal blog about, well, mainly taxation. I might put other stuff in. Who knows.
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13 Responses to Fair Tax Mark fails by its own standards

  1. Alex Cobham says:

    Ben, I think you’re overstating this.

    As we’ve discussed, any index construction is a subjective exercise in choosing and excluding different elements, and in their relative weighting. The FTM index construction, as I understand it at least, reflects a concern about both the points set out in the quote you provide above: a desire to consider a longer time period in order to allow for cyclical variation, and a desire to allow some time discounting so that more recent good behaviour is ‘rewarded’ with a better score more quickly.

    If you accept these two concerns (you don’t have to share them, just recognise that the creators have these concerns), what you’re pointing out is the inevitability that the index will reflect a trade-off between the two. At one extreme there would be no time discount, so no (greater) reward for more recent behaviour; at the other extreme the index would only look at the most recent year, and ignore the time pattern.

    Any point in the middle, that is any construction which puts more than zero weighting on both concerns, inevitably loses the ‘purity’ of the extreme positions. To point out that there is a trade-off between partially competing concerns doesn’t seem, to me at least, to constitute a particularly grave criticism – but more importantly, it leaves unclear what exactly it is that you would change.

    One of two things follows from your position above: you could either propose alternative ways to make the trade-off, if your point is really that the one currently used is suboptimal; or you might want to argue for one (or both!) of the concerns to be dropped, so that no trade-off is required. I wonder which is your view?

    • Alex, thanks for your comments.

      I know it’s a bit of a technicality in some respects, but it does highlight the bigger issues, namely the assumptions that the FTM method adopt and then contradict. My reasoning is that more people understand basic maths than deferred tax.

      Just a quick recap, one of the things we were talking about was the FTM method neglecting to weight according to profit. So the rate of tax on £5k profit is given as much significance as the rate of tax on £5m profit. If you paid 1000% on the former and 0% on the latter, I think people would be rightly concerned that the average is 500%.

      The annual weighting exacerbates this factor as the £5k profit in 2013 would be given six times the weight of the £5m in 2008. The weighted average between those two would be 857%. The actual rate is obviously a fraction of a percentage.

      That’s not such an extreme example, but it is what the index would calculate. No reasonable person would consider that a fair reflection.

      That’s the chief mathematical error. It allows too much distortion from small variations.

      But, in terms of the two decisions you discuss, I’d definitely throw out the decision to ignore deferred tax. The logic behind the decision is ridiculous: Some deferred tax charges may possibly be misleading, so we’ll ignore all of them.

      The current tax charge may possibly be misleading too. Yet it’s the sole focus of the FTM method.

      In terms of analysing the tax charge for a year, they’d be much better looking at both the current tax charge and the deferred tax charge and eliminating explanations from the tax reconciliation that they do not think are fair.

      • If weighting is to be applied, would it be better to apply the weighting to the PBT and the actual/expected tax figures, then get weighted totals and thus a weighted tax rate? That way small numbers couldn’t swamp larger ones.

    • Andrew, that’s my biggest concern with the maths. It is just basic common sense: http://www.bbc.co.uk/schools/gcsebitesize/maths/statistics/measuresofaveragerev6.shtml

      Initially I thought that the annual weighting might be alright if they sorted that error out, but I changed my mind when I realised that without including deferred tax, the weighting was a cause of major distortions that produce unfair results.

      When I say “unfair” that is obviously my opinion, which I think is shared by others. But it doesn’t look like FTM have consulted with anybody else.

      Perhaps FTM should use my examples on their website to illustrate what is, and is not, fair.

    • Alex

      I don’t really agree with your analysis. The problem with FTM’s tax rate fairness methodology is that it tries to do two things using the same, simplistic method.It’s trying to combine an assessment of the overall closeness of accounting and taxable profits with an assessment of the direction of travel of the difference. The second is the gradient of the first.

      Murphy’s grave error is to try to combine the two into a single calculation. For his approach to have any chance of working, he should have first assessed how closely taxable profits and accounting profits align. Then, and only then, he should have calculated the gradient of the difference between taxable and accounting profits in each year. Mathematically, that would at least have delivered what he was claiming to deliver in his written methodology.

      Personally, I think the direction of travel requires too much interpretation to be useful in FTM. A company that invests heavily in capital items would have a divergent gradient. But only the most frothy-mouthed left-winger would claim that this is evidence of tax avoidance.

      Also, it’s clear that the level of consultation – Murphy’s claims of ‘peer review’ notwithstanding – was either of very poor quality or was virtually non-existent. And probably both.

  2. My problem with the weighting is that in most of what it does Fair Tax seems to be trying to be very simple and objective, and to remove any element of subjectivity from the results it gives.

    So Murphy is refusing to include deferred tax, as it’s an accounting concept and therefore subjective. He won’t look at the tax rec and adjust for tax exemptions like SSE, as deciding what should be adjusted for is subjective. He won’t even allow for the intentions of Parliament when deciding what is “fair”.

    And yet he then goes and whacks in a completely arbitrary weighting system, because he thinks that improvements in the results should be rewarded, and declines should be punished, regardless of the underlying causes. That is completely subjective, and doesn’t even have the merit of being justifiable by reference to the UK tax system.

    Yes, it’s fair enough for Murphy to decide that this weighting should be applied, just as he can decide that “fair tax” and ” tax intended by Parliament” should not be equated and he can assume that deferred tax which doesn’t reverse within six years is in some way illicit. But it’s not a sensible decision, in my opinion, and it’s not at all consistent with the rest of his methodology.

    I think it brings in the potential for very large distortions, and its objective could be better achieved by simply noting whether the difference between actual tax rate and expected tax rate is now better or worse than the average over time. Given the number of factors used in giving each 0-5 rating, it wouldn’t be hard to include this. It would still be too simplistic for my taste, but would fit neatly within the methodology.

  3. Alex Cobham says:

    Interesting discussion, thanks all. Overall, I don’t give arguments about simplicity or subjectivity a great deal of weight – we’re talking about an index, which is necessarily a subjective simplification!

    The question is whether an index is sufficiently intelligible and accurate to be relevant on its own terms, to its own stated aims. (There’s a separate question about whether you agree with the latter, of course!) It’s great to see engagement on how such a measure could perhaps be improved. A couple of thoughts…

    1. Weighting. Is there a problem with something like this?
    (w_1.t_1 + w_2.t_2 + w_3.t_3 + w_4.t_4 + w_5.t_5 + w_6.t_6) / (w_1.p_1 + w_2.p_2 + w_3.p_3 + w_4.p_4 + w_5.p_5 + w_6.p_6)
    where the t_i are tax paid in each of years i = 1,…,6; the p_i are PBT in each year; and the w_i are weights for each year. This would provide an overall tax rate for the six years, so remove any systematic bias for size of profit in a given year. Time discounting is rejected by setting the w_i constant, but can be reflected by w_i > w_j where i>j, i,j = 1,…,6.

    2. Deferred tax: I’m sure you all know better than me just how much distortion is introduced if this is equated with tax paid; and the nature of its growth over time in many listed companies; so it’s difficult to see what to do other than exclude it. That said, this is of course distorting also (though perhaps less than inclusion for the companies in the mark?).

    What’s fascinating (in a bad way), highlighted by the mark and this discussion, is that it seems that even such a basic concept as tax paid is not available (in an undisputed way at least) in international standard accounts. I suppose an optimistic view of that would be that it hasn’t been an important consideration for many users of accounts until the last decade or so, and that change is bound to come now. Alternatively, I’m sure some would imagine in accounting practice a deliberate desire to obscure, rather than clarify, this basic element of corporate performance. (As an economist with data frustrations, I’m torn…)

    • Tax paid, like many basic concepts, is a more complex area than it seems at first glance. UK quarterly instalments, for example: you pay half the tax in the year it relates to, and half the year after. And then a bit more or less when you amend the computations to reflect changes in loss relief, and a bit more a few years later after the enquiry finishes.

      Or to put it another way: the tax paid in a year is partly this year’s tax, partly last year’s, partly the year before’s, partly a credit for four years ago when you prudently overpaid in respect of an enquiry which ended in your favour, partly a charge from the enquiry into the year before that which didn’t…

      I suppose you could break down the tax note into great detail and note down the year to which every adjustment relates and give the cumulative tax paid for each of them, but it seems an awful lot of effort for very little gain – especially as you could be looking back ten years or more.

      After all, the main stakeholder outside the company’s tax department who needs to know how much tax you’ve paid in relation to any given year is the tax authority – and they should know already.

      • Alex Cobham says:

        Would it be fair then to say that from an accounting perspective (if I’m not casting an aspersion there), you’d say that reporting tax paid is too complex to do, because it’s not sufficiently (additionally) valuable to the tax authority to whom companies should be accountable in this regard?.

        From a development perspective (which I don’t limit to lower-income countries, btw), I’d say that (tax) accountability of companies to citizens also matters; as does accountability of tax authorities to citizens. On which basis, it would seem surprising if pressure to agree a single number didn’t eventually lead to changes in reporting standards. This, it seems to me, is what the FTM is fundamentally a response to: pressure for a mechanism for citizens to be able to compare the tax performance of companies. (Hence my view that this conversation is potentially productive, if it helps to improve the mark; continuing to say that this is too difficult an area doesn’t seem like a great option.)

      • No, not quite. I’d say that the cost-benefit analysis comes down on the side of it not being worth it, as it’s a complex set of disclosures to come up with and to set out: the cost is that this is a lot of effort for the company; the benefit to tax authorities is marginal, as they have the information already; the benefit to citizens is also marginal as I think the interesting stuff is *why* taxes are low, and a simple statement of *what* they are doesn’t really help with that.

        A more useful disclosure, in my opinion, would be to publish an updated detailed tax reconciliation for every year for which there’s been a tax charge or credit. That would be an even more onerous job, and would be open to massive misunderstandings (or misrepresentations). It’s bad enough for a large company’s tax department to keep things straight internally without trying to get the information in a form that any layman coming fresh to the case would understand.

        Of course, as Ben says, Murphy’s aim with the Fair Tax Mark seems to be to ignore the whys and look only at the whats: low tax is defined as unfair even if it’s the express wish of Parliament. I do struggle with that definition of “fair”.

    • Alex, thanks for the reply. On first look, I think your first suggestion is roughly the sort of thing I had in mind in my original post ie using the raw data correctly and applying an annual weighting mechanism in it, or after it.

      I accept what you’re saying about that being a subjective element for creating an index, with regards to the weighting but I think there’s another desire which probably offsets the desire to introduce it in the first place.

      The FTM website talks about companies “wriggling out of their tax liabilities by deferring payment” or something similar. Therefore, it doesn’t seem right that a company improves its score with recent fair tax payments outweighing the deferral in a previous year. Given the corporation tax rate is dropping, there is more than just a timing advantage.

      If weighting is considered necessary, there really needs to be a discussion as to whether it should be something so simple as a linear progression. For starters, it looks like no real thought has gone into the weighting system, which is what my first impression was of the method.

      But, the second point about deferred tax is probably the biggest issue out of the two points. The deferred tax charge provides a balance to the effect of timing differences on the current tax charge.Without that balance being recognised, legitimate timing differences are deemed to be “unfair” when they reduce the current tax charge.

      That is a subjective assumption of the method, but it’s one I don’t think people would agree with that assumption. And it is not readily apparent that FTM makes no assessment of whether a company is complying with the law as intended.

      The real issue is that FTM doesn’t even bother to attempt to identify what adjustments are legitimate and which are not.

      If you’re going to treat all legitimate reliefs and adjustments as being unfair, which the FTM does, then I can actually understand the logic of eliminating deferred tax. It relates to legitimate reliefs and adjustments. But then the overall rationale of the method seems totally at odds with what people want

      Most people would understand that these are fair in the sense of being intended by law and what is expected by society as determined by our democratically established laws.

      I genuinely don’t think that people are bothered whether companies are conforming to some mystical ideal rate of tax in a Utopian world where all statutory accounts are reliable enough for governments to base their tax liabilities on without adjustment.

  4. graeme says:

    Ben…you have demonstrated quite clearly what a load of bullsh1t this whole exercise is…no more than another moralistic grand-standing exercise without any reference to reality

  5. Pingback: Thanks to Economia! | Ben's white space entries

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