Saturday, June 26, 2010

Model way of conning us all

A new prime minister but the same old problem: the mining industry claims the resource super-profits tax would damage it and the economy, whereas the government claims it would be great for the industry and the economy.

And both sides have "independent modelling" to support their claims.

If that doesn't make you sceptical about the use of modelling in the political debate, it should. But if you need more, try this: the two seemingly diametrically opposed modelling exercises were undertaken by the same commercial firm, KPMG.

It's taking people - even those close to the political action - a long time to wake up to the truth that the use of modelling in political arguments is just a way of conning the electorate. The less you know about economic models and how they work, the more impressed you are by their seemingly authoritative results.

The economy is a highly complex mechanism, which economists don't understand all that well. When you construct a mathematical model of the economy, you end up with a hugely oversimplified version of the real thing.

Often you can't test what you'd like to test - and what the punters assume you tested - because the model isn't sophisticated enough or because the data series you'd need don't exist. You end up with a model full of "proxies" (the best substitutes you can find). You can't model shades of grey, so you make do with black and white.

In other words, you have to make lots of assumptions. Economists don't know how the economy works; they just have rival theories about how it works. So their models are based on one theory or another.

The results thrown up by models are based heavily on the assumptions used. Use this set of assumptions, get that result. Use a different set, get a different result. Tell them what results you'd like and competent modellers can find the assumptions that produce what you want.

Economists don't accept the results of someone else's modelling until they know what assumptions were used and decide whether they consider them realistic or consistent with their own prior beliefs. Ideally, they want to determine which particular assumptions are driving the results.

Honest use of modelling results highlights the key assumptions used. But that is never the way modelling results are used in the political debate. Rather, the people who paid for the modelling quote a version of the results as impressive as possible and quite unqualified. The assumptions on which the results are based are never mentioned. They're trying to con the uninitiated.

The government paid KPMG Econtech to model the long-run effects on the economy of the resource super-profits tax and the cut in the rate of company tax. The government says the results were a "reform dividend" of a 0.7 per cent increase in long-run gross domestic product and a long-run increase in real average after-tax wages of 1.1 per cent.

If the long run is 15 or 20 or 30 years (we're not told), that's a pretty modest dividend. And the key assumption? Apparently, that the changes would make the tax system more economically efficient (because economic theory says they would).

Get it? If you thought the modelling was testing whether the changes would be good for the economy, you were conned. All the modelling tells us is by how much the changes would benefit the economy if they're economically efficient as assumed ... given all the other assumptions.

The modelling KPMG prepared for the industry lobby group, the Minerals Council of Australia, was begun in September last year - so much for the claim the industry was "ambushed" by the government.

It found that the impact of a higher effective tax rate and funding costs above the long-term government bond rate would be to reduce the net present value of new mining projects under evaluation. "This is likely to result in mining companies deferring or cancelling Australian mining projects in the short to medium term."

But what were the key assumptions used to achieve this result? I can tell you thanks to an evaluation of the study by Professor Paul Frijters, of the University of Queensland, found on the blog site.

He says that, rather than looking at what the new tax would do to all possible future projects, the report looks at the "second quartile" of all projects. That is, not the 25 per cent of most profitable projects but the 25 per cent after those.

"This is, of course, because the first quartile will go ahead anyway and the third quartile will probably see increases in net present value due to the cost-sharing in the resource super-profits tax. It loads the dice towards the negative to focus on only 25 per cent of all considered future projects," Frijters says.

Even so, Frijters says the study relies on two tricks to get its low net present values. In four out of six cases it assumes new projects have to obtain their equity capital at a cost of 15 per cent a year. And it assumes all projects last 30 years, even those that soon fail.

The 15 per cent required return is based on actual returns to equity over the past 30 years (including capital gains) which are unlikely to be repeated in the coming 30 years (you can't go on growing by 15 per cent a year forever), rather than the cost of obtaining capital.

Frijters says huge mining companies should be able to use corporate bonds to borrow capital for about 8 per cent. Clearly, inflating the assumed cost of capital makes projects appear less profitable.

Given this inflated cost of capital, the assumption that even failed projects last 30 years hugely reduces the value of the new tax's guarantee of a 40 per cent rebate on all losses, because firms have to wait up to 30 years to receive their rebate, with the value of that rebate indexed by only the long-term government bond rate.

I noted, too, the assumption that the guaranteed 40 per cent rebate on losses doesn't affect the cost of equity capital, the cost of borrowed capital or the proportions of each that are used.

So a key attraction of the proposed tax is effectively ignored as, remarkably, these economists assume businesses don't respond to incentives.

Frijters concludes that, in his mind, the report carries a big sticker saying "some poor competent modeller was told to make up a set of assumptions that would help the cause of a rich client".