Thursday, 2 February 2012

Having a Laffer

Earlier this week Mehdi Hasan wrote a Guardian column entitled 'Why are deficit-cutters so afraid to talk about tax?' - a well-argued piece that said taxation should form a bigger part of deficit reduction than it presently does relative to the massive cuts.

It also quoted US judge Wendell Holmes "I like paying taxes, with them I buy civilisation" to make the pertinent point that taxes are what fund everything around us - the pavements we walk on, the schools our children use, the hospitals, the roads, the street lights, etc. A similar point has been made by Tony Benn who argued that suffrage (i.e. democracy) transfers power from the wallet to the ballot - what people couldn't afford themselves they could now vote for at the ballot box. Likewise Richard Murphy makes the case for tax very strongly in his new book 'The Courageous State' (which will be reviewed on this blog shortly).

Like Murphy, Mehdi Hasan wants courageous politicians - ones who will make the case for taxation - and more of it if necessary. As he righty says, "'deficit reduction' has become a convenient euphemism for cutting public expenditure" and "senior politicians of all stripes daren't refer to the T-word in public" as they are decried by the vocal right.

As if to prove that, when Mehdi tweeted* a link to his article it got a near instant response from the right. Toby Young replied "Two words Medhi [sic]: Laffer Curve". This is the argument that increasing taxation rates doesn't necessarily raise revenues, since it might provoke avoidance or damage the economy.

However, the Laffer Curve is not a tool solely of the right. Toby Young - a man whose knowledge and arrogance seem to have an inverse relationship - obviously hasn't read much about the Laffer Curve. If he had he might not be advocating a 70% taxation rate. That according to Mathias Trabandt & Harald Uhlig in 'How far are we from the slippery slope: The Laffer Curve revisited' is the income tax rate after which revenues start declining.

So the left should embrace the Laffer Curve and argue that income tax rates for the richest should rise from 50% - why not make that rate 60%, throw a 50% rate in at £100,000 and let's hit £200,000+ earners with 65%?

If Trabandt & Uhlig are right and revenues do slip off above 70%, then is that a reason not to have them? That might sound like a silly question, but that judgement is based on the assumption that the sole purpose of taxation is to raise revenue. It's not.

The London congestion charge does raise revenue, but its main function is to deter some traffic from central London and achieve what transport planners call 'modal shift' - getting people to use the bus to you and me. And using the bus becomes more attractive when there are bus lanes and clear roads: post-congestion charge and bus lane investment, journey times reduced. Taxation achieved that. Better for the environment, for the economy, and for you and I sitting on the 159.

Likewise the Tobin Tax (aka financial transaction tax or re-branded Robin Hood Tax) was designed to shift behaviour: to deter financiers from speculating on markets (which can have highly volatile and disruptive effects on the real economy) and to instead invest in something productive, like businesses or infrastructure.

So is there a deterrent effect (with a potentially beneficial outcome) reason to go over the peak of the Laffer Curve? Possibly. Let's consider an 80% tax rate on all incomes over £300,000 (about double what the Prime Minister receives or about 1/15th of the average FTSE 100 CEO's salary). Would a company set a salary at £4.5m knowing their employee was receiving less than £1m of it and the rest was going straight to the Treasury?

So, if we could effectively cap salaries at £300,000 (and therefore also reduce the ridiculous pension pots to the super-rich) that money could then be spent more productively - on research and development, or improving the wages or working conditions of general employees. Then the right would cry that British business could not compete. But the German Commerzbank caps its top pay at 500,000 euros or £416,000 - about one-third of what Stephen Hester will receive as his basic salary, even without his now defunct bonus.

*LEAP tweets @LEAPeconomics - follow us on twitter

1 comment:

  1. You are missing some important information from that paper you reference:

    "According to the model the US and the EU-14 area are located on the left side of their
    Laffer curves. However the EU-14 countries are much closer to the slippery slopes than the
    US. More precisely, we find that the US can increase tax revenues by 30% by raising labor
    taxes but only 6% by raising capital income taxes, while the same numbers for EU-14 are
    8% and 1% respectively. An overview of the sensitivity of these results to alternative values
    for the Frisch elasticity of labor supply and the intertemporal elasticity of substitition has
    been provided in table 12.
    In addition, our results indicate that tax cuts in the EU-14 area are self-financing to
    a much higher degree compared to the US. We find that for the US model 32% of a labor
    tax cut and 51% of a capital tax cut are self-financing in the steady state. In the EU-14
    economy 54% of a labor tax cut and 79% of a capital tax cut are self-financing.
    We therefore conclude that there rarely is a free lunch due to tax cuts. However, a
    substantial fraction of the lunch will be paid for by the efficiency gains in the economy
    due to tax cuts."

    What this is saying, is that essentially it isn't known where the economies tested are on the laffer curve. Tax hikes *could* generate more revenue, but tax cuts *could* also be self-financing.

    You are also deliberately conflating revenue raising with the deterrent effect.