My fellow equities blogger Sell on News recent excellent post gave an credible rationale on why property has become the No.1 investment option for Australians – purely by default. This post will go over a very “beta” version of an idea I had awhile back in how to arrest the problem of an insufficient base of investment opportunities, particularly for savers/retirees/superannuants. The idea is not designed to bolster the banks deposit base (far from it) but to encourage and support the only industry that I believe will sustain our economic future.
First, I will say at the outset that this idea is somewhat “socialist”. In a (long winded) post on my old blog, I contended that Australians are all at heart, socialist in nature.
The classic phrase “Why doesn’t the government do something about it?!” is testament to that fact. When you even have the Liberal Party (what a misnomer!) advocating a paid parental system, it surely points out this Big Mother bias in our collective wishes.
Second, I don’t have the answer to how this particular idea is implemented at the coal face, I’m not a scientist, nor an engineer: I’ll explain that first before going on to the mechanics of an idea I call “Research Bonds”.
There’s Research and then there’s “Research”
Associate Professor Steve Keen recently posted an excellent expose about the unproductive nature and lack of suitable investment funds in research, particularly the problems at the Australian Research Council (ARC).
In his words (with my emphasis added)
The irony is that this “be careful with our money” attitude ends up ensuring that the money will rarely if ever be used to achieve fundamental progress. If they want ARC funding, academics have to spend literally months each year drafting proposals which are then reviewed by other academics to decide which projects actually get funding. This is inherently a way of ensuring that only ideas that are extensions of currently accepted thought will get funded.
The fallacy in this process is that it flies in the face of how scientific progress occurs–the concept that there are “paradigms” in sciences, that progress involves both work within a paradigm that advances it (“normal science”), and infrequent “paradigm shifts” that constitute a scientific revolution, have literally become cliches of modern speech (they were first developed by Thomas Kuhn, though the scientific area itself has moved on somewhat). Yet the ARC’s funding methods are eminently suited to normal science, and biased against scientific revolutions which are the events that really advance human knowledge.
“The Princess” – my wife – is a former research scientist and can attest to Prof. Keen’s dilemmas. Most research projects are only funded for 3 or maybe 5 years at maximum, and the scientist must submit a full costing and account for everything. It seems prudent, but flies in the face of doing actual scientific work – whereby highly trained and all-to-rare researchers are turned into accountants and bureaucrats, wasting precious time (sometimes up to a third of their 3 year research grant) on this treadmill.
Sometimes grant proposals are gamed so that they are more likely to be approved, which leaves little room for esoteric research or “stochastic fiddling” or what really matters – a long period of time to get actual work done.
Putting these issues aside for now, let’s finally look at my idea.
Bond, Research Bond (version 2).
I propose that the Federal Government raise (i.e sell) “Research Bonds” that have the following features:
- initial capital supplied by Australian investors (targeted to superannuants (including SMSF and big retail/industry funds) and savers)
- two tranches – 10 year and 20 year maturities
- the annual coupon set at or 2% above (for 20 year bonds) the prevailing 10 year Federal government bond (currently approx. 5.5%)
- the annual coupon is guaranteed and paid by the Federal Government to the investor (i.e is not the fiscal responsibility of the recipient of the funds of the bond)
- the annual coupon is tax free with no means testing (which means the real rate of return usually exceeds that of a term deposit at a bank or a franked dividend from equity)
- a market is created for buyers (authorised institutions e.g. CSIRO, university/corporate R&D departments, private equity) to be matched to sellers (the investors), with a PDS style compliance system overseen by ASIC.
- any project that leads to a commercial venture for development converts the bond into equity (see below)
- bonds that are converted to equity are then later sold are not subject to capital gains tax
- at maturity, the bond converts into a standard 10 year Federal government bond (which can then be traded on the market for a capital return)
Debt to Equity
The debt-to-equity conversion is not that complex and is used in financial markets today. The idea is to create a nascent pool of development ideas for private equity/venture capital firms to step in and take a breakthrough research concept or idea and fund its development. The buy-out of that idea would then fund the conversion of the bond into equity.
Problems
The bond effectively becomes a contingent liability for the Federal Government and rightly so accounted that way. In effect the government is taking on a proxy debt – the considerably difference being they do not have to pay it back at the end, just fund the annual coupons.
Such funding could be easily matched by raising the GST to 12 or 15% and/or eliminating negative gearing (an annual $8 billion loss)- a long overdue taxation reform.
Older financial planners may note that the Research Bond closely resembles a short-term Term Allocated Pension (TAP) – which lost their popularity due to the government punishing savers again in the 2007 “Simpler Super” (sic) rules.
Another problem would be the unintended bias whereby underlying funds are allocated to research projects that have a possible commercial (i.e monetary) return, instead of other purely theoretical and esoteric projects that may provide better knowledge and insight – but nothing more.
Other potential problems include the tax-free nature of the bond – it may transpire that some people will use this to their advantage and have zero income from large amounts of capital. I would contend that the whole structure of how we tax investments (e.g term deposits, interest bearing bonds) and speculation (e.g investment property/shares and principal place of residence) is upside down and that this is not a problem. Why do we give capital gains tax concessions to the latter but fully tax (and thereby punish) the former?
Potential and Rationale
- Channels scarce capital away from unproductive uses (e.g property and share speculation)
- Allocates long term capital to researchers who can use their time more efficiently
- Encourages a larger savings pool and a liquid market in interest bearing investments
- Gives Government legitimacy to reform skewed sections of the tax code (e.g remove tax payable on interest)
- Expands the sustainable research sector for future commercialisation with possible less reliance on “houses and holes” to drive the economy
- Provides higher education facilities more flexibility in administration and revenue model (e.g less reliance on foreign students)
My strongest rationale is to provide a more sustainable economic base for the long term prosperity of the country. Sure, we are blessed with natural resources with very large reserves thereof. But at what cost? What has happened to our manufacturing sector? Why is the FIRE (financial, insurance and real estate) sector so large (and inefficient and reliant on external funds)? How can we sustain a tourism/education sector with a seemingly permanent high currency (as a result of the commodities boom)
Australia is a very small player in a big ocean – an increasingly Asian/Pacific ocean with growing, high-tech, highly educated and better structured economies. If we are to compete in the 21st century – even if we triple our immigration (good luck foreign finding professionals who can afford to live in the major capitals) – we will remain a small country. We need to act fast and build industries and technologies that can compete against better capitalised and bigger economies. Providing a strong system of encouraging research, higher education and commercialisation could be one way to achieve this.
Conclusion
As I said, this is just an idea, and I’m sure there’s plenty of flaws and unintended consequences I haven’t thought of (and I’m sure there are brigades of people out there ready to point them out!)
I just find it frustrating that the only type of financial innovation that our bloated FIRE sector can come up with are index futures over a residential property index or shared equity and reverse mortgages, or yep – residential property backed mortgage securities (which seem to be all the rage again. )
Perhaps we can start in a new direction based on engineering and constructing an economy, not selling it.