Wednesday, May 18, 2005

Low Taxes

I was once described in The Observer as a "Total Taxcutter". Madsen Pirie of the excellent Adam Smith Institute has an interesting post on the ASI Blog (see link on the left hand panel) on the fact that cutting taxes can raise revenues. I'd like to see a real debate about taxation over the next few years. Too many people on the right have fallen for the 'big government works' agenda of the soft left. What they forget is that it has to be paid for. And paid for by us, the taxpayers. It is appalling that we as a Party seem to have accepted that the public expenditure should increase remorselessly. If we want smaller government we need to cut public expenditure. Much of it can be achieved by cutting waste and bureaucracy but let's not pretend that there are not whole areas of government which should simply be abolished. So, onto the piece from Madsen Pirie...

A minor statistic on tax revenue might pass unnoticed, but not by Neil Collins (Telegraph). There has been an unexpected jump in US tax revenues following President Bush’s action to cut the top rate from 39% to 35%. Laffer is having the last Laff. The Federal Government recorded a $57billion surplus in April and income tax revenues leapt 16pc compared with last year, as Americans worked harder and made less use of tax loopholes. The annual deficit remains but the boffins at Morgan Stanley are so impressed they have just cut their forecast for this year from 3.6pc of GDP to 2.8pc. The rise in tax revenues was not unexpected to all of us, in that it happens fairly regularly. Lower taxes give earners less reason to avoid and evade tax, and more reason to put in extra effort. The result is quite regularly more growth, more wealth, more jobs, higher tax yields, and a higher percentage of the tax bill paid by the top earners. No surprise there.


James said...

Surely the obvious explanation for the revenue boost is that the Bush tax cut was heralded in advance not that "Americans worked harder and made less use of tax loopholes"?

In other words, top rate tax payers simply deferred taking income until after the tax cut took effect thus artificially reducing the tax take in the quarter before the cut and artificially inflating it in the quarter after. This is very easy to do for top earners - particularly lawyers and accountants taking drawings from partnerships, but also for business people.

The evidence over a sustained period from the Reagan tax cut era is that America was absolutely nowhere near the "hump" on the Laffer curve. Pirie cherry picking a couple of quarters to draw dubious conclusions does not overturn the weight of historical evidence.

I think the supply siders were and are deluded about this point but I would be interested to hear if you seriously advocate the other view.

The debate on big vs small government is entirely separate of course. You are right to hint that the recent position of your party at the election ducked the issue. Even if the level of "fat cutting" savings had been at all realistic it does not address the question of what government ought (not) to be doing.

Iain Dale said...

I disagree with your assertion about the evidence from the Reagan era. Taxes were cut, revenues increased. Simple. It happened. It also happened when Lawson cut taxes here.

The big/small government is not a separate argument but very much related. If you have a smaller public sector it naturally follows that you need to collect less tax to pay for it. I am sure the Orange Book authors would agree.

I would have hoped that the LibDems would now develop their thinking into a more traditional liberal position of less government and less tax.

Very interesting to see Ed Davey moved. Consensus seems to be that the Local Income Tax will be dumped. I have to admit I found that the most difficult thing in the LibDem policy armoury to argue against, as on the face of it it seemed so fair. It wasn't, but I never felt I had ever really won the argument on that. I remember the public debate in Sheringham where I was trounced on it. Not my brightest moment!

What do you think government ought not to be doing (beyond abolishing the DTI and therefore Norman's job!)?

Andy Cooke said...

To illustrate the argument that tax xuts at the higher rate lead to "a higher percentage of the tax bill paid by the top earners":

Percentages of national income tax bill paid by the super-rich (top 1% of earners), rich (top 10%) and average and below (up to 50%):

Super-rich: 11%
Rich: 33%
Average and below: 18%

Super-rich: 20%
Rich: 48%
Average and below: 12%


James said...

Seeing as it is my lunch hour and things are quiet...

Taking Andy's point first, because it is easiest to dispose of. In 1978-9 in the UK (the figures you refer to) effective tax rates on the "super rich" were up to 98% (sometimes lower but still very high). At that sort of level, most economists would accept that you are over the "hump" on the Laffer curve and a tax cut will yield higher revenues. Very, very few economists - even those well to the "right" - would say we are still on that side of the hump at 40% or indeed anywhere near it. The figures will also be strongly affected by increased income inequality - the top 1% earn very much more as a proportion of GDP than they did in 1978-9.

I am less well placed to comment on Iain's figures as he did not offer a link. However, it should be noted that the total tax burden was not cut heavily in the US or here in the early 1980s - a lot of it was a shift to indirect taxes and highly targeted tax cuts for high earners. There were also (entirely laudable) moves to remove tax loopholes which were quite effective at the time. Mainstream economic thinking (including majority opinion on the right) is that beyond the positive effect of eliminating manifest "98%-style" absurdities the targeted tax cuts reduced revenue. That is not to say they cannot be justified on their own merit of course - but the view that you can cut taxes and boost revenues from where we are at present is very much a minority (and borderline quack) economic view. You are welcome as Tories to try and argue it, but you will forgive me if I side with the large majority of professional economists on this one.

On LIT, in the spirit of post-election non-partisan discussion, I will make an admission on it. Income is a very good way to measure ability to pay but it is not the only way. Better off pensioners may have a lower income than the hypothetical "nurse and fireman" couple, but they will have paid off their mortgage and their children will likely be self-sufficient. It is not entirely unfair to base some of a person's tax liability on wealth rather than income even though council tax has grown to a level where it takes up too much of the strain. Of course, as a Tory you could not argue this point as you were after the same "grey vote" as the Lib Dems, so the debate turned into a phoney one about the "average taxpayer" (of which there is no such thing). Nobody looks pretty having a phoney debate. I suspect LIT will be kept as a policy but modified to tackle the "nurse and fireman" issue. The proper way to proceed on taxing wealth is a heavily modified inheritence tax (which plainly does not work at present - it clobbers middle income types but the super-rich can pay lawyers and accountants to dodge it very easily).

On the proper role for the state, this is a subject that any of us could easily write a very dull and ill-informed book on. I will confine myself to a few salient points (you will be glad to hear).

First, we have to accept that two major costs will continue to increase as a proportion of all our incomes for some time to come (whether these are provided by the state or privately). Pension costs will increase because are expectations of how long we want to be retired for as a percentage of our working lives have changed radically - retirement is no longer seen as a person's "declining years" but as an exciting new phase. Health costs will increase more than prices generally because the range of things healthcare can do has risen dramatically. "Healthcare" in 1950 meant basic operations and emergency care and allowing people to die with some dignity - what can be done now is much more and will continue to grow. These are both positive but costly developments. My personal view is that the cost of healthcare should continue to come from general taxation to ensure equality of access but I am relaxed about greater private provision. Pension funds should be privately managed but there may have to be an element of compulsion (i.e. you must put at least 5% of your income into a private pension). Whatever happens on these major expenditures, though, people will see more of their salary devoted to them through one or other mechanism.

Secondly, in my own view, the main area where the government needs to do less (and spend less) is military spending. It is true that not going to war in Iraq would have saved a lot, but it is a glib point to make in response to an unpopular war. The truth is that cutting spending in a sustained way means reducing our world role and that is not easy or popular. But, purely personally, I think it should happen. I also personally think that there should be less public (and more private) patronage of arts and competitive sports (not school sports and so on but Olympic bids etc). This is not, however, a major current area of spending and would not bite into public spending much.

I am on the "Orange Book" wing and have never really seen the difference in terms of "ethos" between somebody with a pay cheque signed by the state and one with a pay cheque signed by a private employer. Often, the state paying for something (e.g. health or eduction) to be done privately will be more efficient than having the state doing it itself. However, I do join in the "big government" consensus to some degree. I do not think that chopping the total tax take down from 40% to 30% (say) is realistic if you want to improve equality of access to key, expensive services like health and education. I do think efficiency rather than further expansion is an achievable and sensible way forward.

Finally, on Norman Lamb's "abolish himself" job, I am aware you are being tongue in cheek. The DTI is a department with no core function now that the government no longer seeks to sit around the management table of major UK companies. However, it has many disparate but important functions (e.g. R&D, international negotiations, consumers, employees) which would be better delivered by other departments on non-government bodies. A "shadow" is not just a "minister in waiting" - you have to have somebody actively to hold the government to account on such matters - and it is a more challenging job for being more disparate and wide ranging. I look forward to Norman Lamb challenging the government on these matters - I think he will do a very good job!

Anonymous said...

is it not also that more people are being employed in the U.S. again, as it gradually comes out of a downturn?

Andy Cooke's figures prove that absurdly high marginal rates (say 95%) is silly, but does it demonstrate that if we cut the top-rate from 40% to 35% that we would get a much bigger take?

Andy Cooke said...

Me again - back home and the kids are in bed, so I can post again ...

responding to James:
The 98% rate was an amalgam of the 83% top rate and the 15% surcharge on "unearned income" (shares, pensions etc.)
The top rate on which most of the tax was applied was 83%, which was demonstrably way over the top of the Laffer curve. The "rich" would not often have been paying the surcharge.

Bearing in mind that tax cuts take a couple of years (at least) to show dividends (changing habits, reverse "brain drain" activity, etc.) the activity seems to me to have gone:

78-79 - figures as above. Howe cuts the top rate to 60%.
By 86-87, the "super-rich", "rich" and "average and below" percentages of contribution were 14%, 39% and 16% respectively.
Lawson cut the top rate to 40% in 88-89.

A few years later, figures were as shown above (20%, 48% and 12%).

So 83% is on the far side of the Laffer hump. There is reason to believe that 60% is further down the curve than 40%.
Empirically, trying 35% (or 50%) for a few years would produce useful data.

As to the income inequality - if there are a lot of very rich people over here, paying large amounts of tax and consuming very little of the public services - fine by me :-)

If Bill Gates, Paul Allen and that chap who owns IKEA were to move here and pay taxes here, income inequality would increase, but the tax take would go up without me paying more.

Gotta go - the wife's complaining ...

Iain Dale said...

One of the more interesting debates in this blog for sometime. Very interesting James. Isn't it nice with the election we can have some meaningful political dialogue. At least, I'd happily reply in details but it's late and I've got to get some sleep - and think about my hopefully soon to be confirmed new job...

Andy Cooke said...

Back again, and this debate has triggered off a few thoughts overnight ...

Firstly on LIT. I believe that LIT is unfair. So is Council Tax. So was the poll tax. So was rates.

Basically, every option is unfair, and this is exacerbated by the fact that "fair" is a variable word - it means what the speaker wants it to mean. A combination of all of the options may be the least unfair system, but it could well be prohibitively complex*:

-An element based on property wealth, for local infrastructure (on the order of a quarter of current Council Tax).

-An element based on personal income (on the order of 0.5%-1.0%; as the nibbling increase in National Insurance seems to have been swallowed without problem, this order of LIT would seem platable to everyone).

-An element of local sales tax (low enough to (hopefully) not cause too much comparative shopping between local authority areas)

-An element of direct charge (for rubbish collection, for example) on the order of £100 per head. This could be subsidised for pensioners, students and those on low incomes or income support, citing the precedent of things like charges for using the municipal swimming baths - a fixed charge per head, subsidised for certain groups.

-A direct government grant (many things should be paid nationally anyway).

Each household should receive a one page annual statement, showing amounts funded by each source (for accountability). We may even see people taking a real interest in how the council contracts its rubbish collection, for example.

Each single element would be unfair to a segment of the populace, but hopefully a different segment each time. It would, of course, be political suicide to implement it.

Back to Income Tax and the Laffer Curve**

As well as the frequently cited incentive to earn and "brain drain" reversal effects, tax cuts have another direct benefit - they give people more money to spend (or save, but a glance at current debt levels in this country indicates that spending - even when we don't have the money anyway - is far more likely).

So of the money given back, when it is spent, 17.5% heads straight back to the Treasury in VAT (on the majority of purchases). Of the remaining 82.5%, some goes on profits, some on costs, some on salaries. As profits and salaries are taxed, say 25% of that 82.5% is claimed by the taxman again. This would mean that nearly 40% of the returned money heads straight back to the Treasury on the first transaction alone.

As further transactions are taken, more money spirals into the gravitational well that is the Treasury (before being spat out in the white hole of public spending, to extend the astronomical analogy). Most of the money ends up in the inescapable grasp of the taxman anyway, but does more work en route. This should boost GDP growth (shouldn't it?).

The incentive effect would vary as to the level of tax - it would be a stronger driver at higher levels (i.e. it isn't a constant distorting factor, but a variable).
I think that the 50% point is an important psychological trigger point. Below 50%, people think "I keep most of what I earn".***
At 50%, people think "The taxman gets half of what I earn"
Above 50% "The taxman gets most of what I earn".
As you get closer to 50% (from the lower side), the "half of what I earn" meme grows.

The "brain drain" effect is also variable, dependant upon mobility of money and rich people, and on differences in tax rates in other attractive countries. For example, we know that the current 40% rate suffices to exile Sean Connery and the Rolling Stones, but not Paul McCartney or J K Rowling. The shape of the Laffer curve due to this will vary dependant on other countries - if the "flat tax" regime becomes widely adopted, there will be a distorting effect on the Laffer Curve. Conversely, if a high tax-and-spend regime becomes widely globally adopted (for example, in a widespread war), the Laffer Curve would be distorted in the other direction.

I'd be interested on your comments (and/or demolition?) :-)


*Disclaimer 1 - I am not involved in local government, so these suggestions are those of an averagely informed interested member of the public.

**Disclaimer 2 - I am not an economist, so apologies if I am rehashing old arguments.

***Disclaimer 3 - I know that this is only on marginal income.

James said...


LIT - I have a lot of sympathy with your points although (as you say yourself) a mixed system may be costly. A clearer statement (at national level too) would be a good idea.

On tax incentives you may be losing sight of the wood for the trees. You appear to be refering essentially to the velocity of money. Government itself spends money - whether wisely or not is a separate question. When it does so, that money goes into the hands of private individuals (transfer payment recipients like pensioners, public sector employees like teachers, and private firms like builders building a hospital). They then spend it and the merry-go-round continues. So money never "ends up" with the taxman.

Keynsians believe that cutting taxes while keeping public spending the same (or even higher) can stimulate the economy in the face of a recession - but of course it creates a budget deficit so it can only be short term. Supply siders believe cutting taxes increases saving and investment which can increase GDP but as a much more long-run effect (evidence is very patchy for this though). But these are very different points from a view that money does more work "en route" to the Treasury.

It is important not to lose sight of fundamentals when looking at GDP. It is a measure of how much we produce (including services as well as goods) in a year - a measure of how we employ resources (people, land and capital). The tax regime in place distorts those incentives in important ways. Higher taxes do indeed discourage people from employing their labour (although the loss properly measured is in any event much less than any resulting reduction in GDP), but there does not appear to be a wider point to be made along the lines you have in mind.

On the international perspective point, you are quite right that a major tax cut in France (say) would increase incentives for rich people to go there in the face of a tax rise here. That would mean the "hump" of the Laffer curve moving over time with international trends, flat taxes and so forth. At the moment, the scope to do it is a bit limited and to the extent it happens it is pretty marginal. People working overseas as part of the "brain drain" largely do so because pay is higher there in their line of work and/or they like the other country for more personal reasons. Tax is a factor, but it is not huge in my view. My guess is that Sean Connery's decision to live abroad is driven partly by lifestyle and meterology - would a 10% top rate tax cut tempt him back? Probably not. I am not saying it is irrelevant, but my view is that the effect is small as long as you are not wildly out of line with comparator countries (you have to accept some loss to the Caymen Islands almost whatever you do - you cannot get close to competing with small tax havens and just have to live with it - by comparator countries I mean continental Europe and North America). It will be interesting to see how things like the flat tax develop though, I agree.

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