Tag: Laffer curve

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From Reaganomics to Trussonomics

In her bid to become Conservative party leader, Liz Truss promised to make achieving faster economic growth her number-one policy objective. This would involve pursuing market-orientated supply-side policies.

These policies would include lower taxes on individuals to encourage people to work harder and more efficiently, and lower taxes on business to encourage investment. The policy would also involve deregulation, which would again encourage investment, both domestic and inward investment from overseas. These proposals echoed the policies pursued in the 1980s by President Ronald Reagan in the USA and Margaret Thatcher in the UK.

On September 23, the new Chancellor, Kwasi Kwarteng, presented a ‘mini-Budget’ – although the size of the changes made it far from ‘mini’. This, as anticipated, included policies intended to boost growth, including scrapping the 45% top rate of income tax, which is currently paid by people earning over £150 000 (a policy withdrawn on 3 October after massive objections), cutting the basic rate of income tax from 20% to 19%, scrapping the planned rise in corporation tax from 19% to 25%, scrapping the planned rise in national insurance by 1.25 percentage points, a cut in the stamp duty on house purchase and scrapping the limit placed on bankers’ bonuses. In addition, he announced the introduction of an unlimited number of ‘investment zones’ which would have lower business taxes, streamlined planning rules and lower regulation. The policies would be funded largely from extra government borrowing.

Theoretically, the argument is simple. If people do work harder and firms do invest more, then potential GDP will rise – a rise in aggregate supply. This can be shown on an aggregate demand and supply diagram. If the policy works, the aggregate supply curve will shift to the right. Real GDP will rise and there will be downward pressure on prices. In Figure 1, real GDP will rise from Y0 to Y1 and the price level will fall from P0 to P1. However, things are not as simple as this. Indeed, there are two major problems.

The first concerns whether tax cuts will incentivise people to work harder. The second concerns what happens to aggregate demand. I addition to this, the policies are likely to have a profound effect on income distribution.

Tax cuts and incentives

Cutting the top rate of income tax would have immediately given people at the top of the income scale a rise in post-tax income. This would have created a substitution effect and an income effect. Each extra pound that such people earn would be worth more in post-tax income – 60p rather than 55p. This would provide an incentive for people to substitute work for leisure as work is now more rewarding. This is the substitution effect. On the other hand, with the windfall of extra income, they now would have needed to work less in order to maintain their post-tax income at its previous level. They may well indeed, therefore, have decided to work less and enjoy more leisure. This is the income effect.

With the diminishing marginal utility of income, generally the richer people are, the bigger will be the income effect and the smaller the substitution effect. Thus, cutting the top rate of income tax may well have led to richer people working less. There is no evidence that the substitution effect would be bigger.

If top rates of income tax are already at a very high level, then cutting then may well encourage more work. After all, there is little incentive to work more if the current rate of tax is over 90%, say. Cutting them to 80% could have a big effect. This was the point made by Art Laffer, one of Ronald Reagan’s advisors. He presented his arguments in terms of the now famous ‘Laffer curve’, shown in Figure 2. This shows the total tax revenue raised at different tax rates.

If the average tax rate were zero, no revenue would be raised. As the tax rate is raised above zero, tax revenues will increase. The curve will be upward sloping. Eventually, however, the curve will peak (at tax rate t1). Thereafter, tax rates become so high that the resulting fall in output more than offsets the rise in tax rate. When the tax rate reaches 100 per cent, the revenue will once more fall to zero, since no one will bother to work.

If the economy were currently to the right of t1, then cutting taxes would increase revenue as there would be a major substitution effect. However, most commentators argue that the UK economy is to the left of t1 and that cutting the top rate would reduce tax revenues. Analysis by the Office for Budget Responsibility in 2012 suggested that t1 for the top rate of income tax was at around 48% and that cutting the rate below that would reduce tax revenue. Clearly according to this analysis, 40% is considerably below t1.

As far as corporation tax is concerned, the 19% rate is the lowest in the G20 and yet the UK suffers from low rates of both domestic investment and inward direct investment. There is no evidence that raising it somewhat, as previously planned, will cut investment. And as far as individual entrepreneurs are concerned, cutting taxes is likely to have little effect on the desire to invest and expand businesses. The motivation of entrepreneurs is only partly to do with the money. A major motivation is the sense of achievement in building a successful business.

Creating investment zones with lower taxes, no business rates and lower regulations may encourage firms to set up there. But much of this could simply be diverted investment from elsewhere in the country, leaving overall investment little changed.

To assess these questions, the government needs to model the outcomes and draw on evidence from elsewhere. So far this does not seem to have happened. They government did not even present a forecast of the effects of its policies on the public finances, something that the OBR normally presents at Budget time. This was one of the reasons for the collapse in confidence of sterling and gilts (government bonds) in the days following the mini-Budget.

Effects on aggregate demand

Cutting taxes and financing them from borrowing will expand aggregate demand. In Figure 1, the AD curve will also shift to the right and this will push up prices. Inflation is already a serious problem in the economy and unfunded tax cuts will make it worse. Higher inflation will result in the Bank of England raising interest rates further to curb aggregate demand. But higher interest rates, by raising borrowing costs, are likely to reduce investment, which will have a negative supply-side effect.

The problem here is one of timing. Market-orientated supply-side policies, if they work to increase potential GDP, will take time – measured in years rather than months. The rise in aggregate demand will be much quicker and will thus precede the rise in supply. This could therefore effectively kill off the rise in supply as interest rates rise, the exchange rate falls and the economy is pushed towards recession. Indeed, the mini-Budget immediately sparked a run on the pound and the exchange rate fell.

The rising government debt may force the government to make cuts in public expenditure. Rather than cutting current expenditure on things such as nurses, teachers and benefits, it is easier to cut capital expenditure on things such as roads and other infrastructure. But this will have adverse supply-side effects.

Effects on income distribution

Those advocating market-orientated supply-side policies argue that, by making GDP bigger, everyone can gain. They prefer to focus on the size of the national ‘pie’ rather than its distribution. If the rich initially gain, the benefits will trickle down to the poorest in society. This trickle-down theory was popular in the 1980s with politicians such as Margaret Thatcher and Ronald Reagan and, more recently, with Republican presidents, such as Goerge W Bush and Donald Trump. There are two problems with this, however.

The first, which we have already seen, is whether such policies actually do increase the size of the ‘pie’.

The second is how much does trickle down. During the Thatcher years, income inequality in the UK grew, as it did in the USA under Ronald Reagan. According to an IMF study in 2015 (see the link to the IMF analysis below), policies that increase the income share of the poor and the middle class do increase growth, while those that raise the income share of the top 20 per cent result in lower growth.

After the mini-Budget was presented, the IMF criticised it for giving large untargeted tax cuts that would heighten inequality. The poor would gain little from the tax cuts. The changes to income tax and national insurance mean that someone earning £20 000 per year will gain just £167 per year, while someone earning £200 000 will gain £5220. What is more, the higher interest rates and higher prices resulting from the lower exchange rate are likely to wipe out the modest gains to the poor.

Podcast

Articles

Analysis

Questions

  1. Distinguish between market-orientated supply-side policies and interventionist ones. Consider the advantages and disadvantages of each.
  2. Explain why bond prices fell after the mini-Budget. What was the Bank of England’s response and why did this run counter to its plan for quantitative tightening?
  3. How might a tax-cutting Budget be designed to help the poor rather than the rich? Would this have beneficial supply-side effects?
  4. Find out about the 1972 tax-cutting Budget of Anthony Barber, the Chancellor in Ted Heath’s government, that led to the ‘Barber boom’ and then rampant inflation. Are there any similarities between the 1972 Budget and the recent mini-Budget?
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Inequality and growth – a difficult game for governments

The latest edition of the IMF’s Fiscal Monitor, ‘Tackling Inequality’ challenges conventional wisdom that policies to reduce inequality will also reduce economic growth.

While some inequality is inevitable in a market-based economic system, excessive inequality can erode social cohesion, lead to political polarization, and ultimately lower economic growth.

The IMF looks at three possible policy alternatives to reduce inequality without damaging economic growth

The first is a rise in personal income tax rates for top earners. Since top rates have been cut in most countries, with the OECD average falling from 62% to 35% over the past 30 years, the IMF maintains that there is considerable scope of raising top rates, with the optimum being around 44%. Evidence suggests that income tax elasticity is low at most countries’ current top rates, meaning that a rise in top income tax rates would only have a small disincentive effect on earnings.

An increased progressiveness of income tax should be backed by sufficient taxes on capital to prevent income being reclassified as capital. Different types of wealth tax, such as inheritance tax, could also be considered. Countries should also reduce the opportunities for tax evasion.

The second policy alternative is a universal basic income for all people. This could be achieved by various means, such as tax credits, child benefits and other cash benefits, or minimum wages plus benefits for the unemployed or non-employed.

The third is better access to health and education, both for their direct effect on reducing inequality and for improving productivity and hence people’s earning potential.

In all three cases, fiscal policy can help through a combination of taxes, benefits and public expenditure on social infrastructure and human capital.

But a major problem with using increased tax rates is international competition, especially with corporation tax rates. Countries are keen to attract international investment by having corporation tax rates lower than their rivals. But, of course, countries cannot all have a lower rate than each other. The attempt to do so simply leads to a general lowering of corporation tax rates (see chart in The Economist article) – to a race to the bottom. The Nash equilibrium rate of such a game is zero!

Videos

Raising Taxes on the Rich Won’t Necessarily Curb Growth, IMF Says Bloomberg, Ben Holland and Andrew Mayeda (11/10/17)
The Fiscal Monitor, Introduction IMF (October 2017)
Transcript of the Press Conference on the Release of the October 2017 Fiscal Monitor IMF (12/10/17)

Articles

Higher taxes can lower inequality without denting economic growth The Economist, Buttonwood (19/10/17)
Trump says the US has the highest corporate tax rate in the world. He’s wrong. Vox, Zeeshan Aleem (31/8/17)
Reducing inequality need not hurt growth Livemint, Ajit Ranade (18/10/17)
IMF: higher taxes for rich will cut inequality without hitting growth The Guardian, Larry Elliott and Heather Stewart (12/10/17)

IMF Fiscal Monitor

IMF Fiscal Monitor: Tackling Inequality – Landing Page IMF (October 2017)
Opening Remarks of Vitor Gaspar, Director of the Fiscal Affairs Department at a Press Conference Presenting the Fall 2017 Fiscal Monitor: Tackling Inequality IMF (11/10/17)
Fiscal Monitor, Tackling Inequality – Full Text IMF (October 2017)

Questions

  1. Referring to the October 2017 Fiscal Monitor, linked above, what arguments does the IMF use for suggesting that the optimal top rate of income tax is considerably higher than the current OECD average?
  2. What are the arguments for introducing a universal basic income? Should this depend on people’s circumstances, such as the number of their children, assets, such as savings or property, and housing costs?
  3. Find out the details of the UK government’s Universal Credit. Does this classify as a universal basic income?
  4. Why may governments reject the IMF’s policy recommendations to tackle inequality?
  5. In what sense can better access to health and education be seen as a means of reducing inequality? How is inequality being defined in this case?
  6. Find out what the UK Labour Party’s policy is on rates of income tax for top earners. Is this consistent with the IMF’s policy recommendations?
  7. What does the IMF report suggest about the shape of the Laffer curve?
  8. Explain what is meant by tax elasticity and how it relates to the Laffer curve?
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The North Sea

The Budget takes place on 17th March 2015 and as always there is much speculation as to what it will and won’t include. One industry that is eagerly awaiting Osborne’s Budget is the North Sea oil and gas industry. Tax cuts and rises may well play a key role in the Budget, but this is one sector where a possibly large tax cut is expected.

The tax paid by this industry is very high compared to others, potentially reaching 80%. The tax rate was increased some years ago and it is now thought that it may come back down. One key factor is oil prices: with such huge decreases in the price of oil relative to when the tax on the industry was increased, the industry is now asking for these tax rises to be reversed. The industry has suggested that a 10% tax cut is a possibility and this would make a big difference for the industry.

Danny Alexander, the chief secretary to the Treasury, said:

“We’ve been very clear that the direction of travel for tax in the North Sea needs to be downwards … And that needs to be even stronger given the low oil price we see at the moment. We want people to have the confidence to invest for the long term future of the North Sea … And so George Osborne and I have been listening very carefully to what the industry has been saying …People will have to wait and see what we say on Wednesday [Budget day], but I hope very much that it will give the North Sea that confidence that we all want to see for one of Britain’s most important industries.”

We may also see further changes for this industry, such as allowances to encourage further investment, as costs of investment are extremely high and this has led to many years of under-investment. These changes are hoped to regenerate this industry. Any change in tax allowances or tax rates will have an impact on tax revenue and it is not necessarily the case that an increase in tax will lead to a rise in revenue or a fall in revenue. The relationship between tax rates and tax revenues can be very complex. The following articles consider this particular issue and what the Budget will do for this industry.

North sea oil groups set for tax breaks in budget Financial Times, Christopher Adams and George Parker (16/3/15)
What does the Budget 2015 mean for the North sea oil industry? The Telegraph, Andrew Critchlow (16/3/15)
Britain needs oil tax cuts to attract North Sea Investment Reuters, Karolin Schaps and Claire Milhench (16/3/15)
Treasury paves way for major tax cut for North sea BBC News, Kamal Ahmed (16/3/15)
Home of Brent Oil benchmark seeks help as investment slumps Bloomberg, Firat Kayakiran (17/3/15)

Questions

  1. If a tax is imposed on an industry, what type of effect might this have on costs of production? Use a diagram to support your answer.
  2. In the BBC News article, North Sea Oil is referred to as a cash cow. What does this mean?
  3. If taxes are cut for the North Sea Oil industry, how will this affect its costs and what might it doe for investment?
  4. What will happen to tax revenues if taxes are cut? Use the Laffer curve to help your answer.
  5. How has the North Sea Oil industry been affected by falling oil prices? Does this offer a justification for a tax cut?
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A 50p top tax rate: more or less money for the government?

The UK Shadow Chancellor, Ed Balls, has announced that, if Labour is returned to power in the next election, it will bring back the 50% top rate of income tax (see also). This will apply to incomes over £150,000.

But will this raise more tax revenue? The question here concerns incentive effects. Will the higher rate of income tax discourage work by those earning £150,000 or encourage tax avoidance or tax evasion, so that the total tax take is reduced? The Conservatives say the answer is yes. The Labour party says no, claiming that there will still be an increase in tax revenue.

The possible effects are summed up in the Laffer curve (see The 50p income tax rate and the Laffer curve). As the previous post stated:

These arguments were put forward in the 1980s by Art Laffer, an adviser to President Reagan. His famous ‘Laffer curve’ (see Economics (8th edition) Box 10.3) illustrated that tax revenues are maximised at a particular tax rate. The idea behind the Laffer curve is very simple. At a tax rate of 0%, tax revenue will be zero – but so too at a rate of 100%, since no-one would work if they had to pay all their income in taxes. As the tax rate rises from 0%, so tax revenue would rise. And so too, as the tax rate falls from 100%, the tax rate would rise. It follows that there will be some tax rate between 0% and 100% that maximises tax revenue.

As Labour is claiming that re-introducing the 50% top rate of income tax will increase tax revenue, the implication is that the economy is to the left of the top of the Laffer curve: that, at current level of income, the curve is still rising.

Work by HMRC, and published in the document The Exchequer effect of the 50 per cent additional rate of income tax, suggested that the previous cut in the top rate from 50% to 45% would cut revenue by around £3.5 billion if there were no incentive effect, but with the extra work that would be generated, the cut would be a mere £100 million. This implies, other things being equal, that a rise in the rate from 45% to 50% would raise only a tiny bit of extra taxes.

However, the HMRC analysis has been criticised and especially its assumptions about the incentive effects on work. Then there is the question of whether a rise in the rate from 45% to 50% would have exactly the reverse effect of a cut from 50% to 45%. And then there is the question of how much HMRC could reduce tax evasion and avoidance.

The following article from the Institute for Fiscal Studies examines the effects. However, the authors conclude that:

… at the moment, the best evidence we have still suggests that raising the top rate of tax would raise little revenue and make, at best, a marginal contribution to reducing the budget deficit an incoming government would face after the next election.

But there is also the question of equity. Putting aside the question of how much revenue would be raised, is it fair to raise the top rate of tax for those on high incomes? Would it make an important contribution to reducing inequality? This normative question lies at the heart of the different views of the world between left and right and is not a question that can be answered by economic analysis.

Article

50p tax – strolling across the summit of the Laffer curve? Institute for Fiscal Studies, Paul Johnson and David Phillips (Jan 2014)

Questions

  1. Distinguish between tax evasion and tax avoidance.
  2. How would it be possible for a rise in tax rates to generated less tax revenue?
  3. Could policies shift the Laffer curve as opposed to merely resulting in a move along the curve?
  4. What is meant by ‘taxable income elasticity (TIE)’? What are its determinants?
  5. Is the taxable income elasticity at the top of the Laffer curve equal to, above or below zero? Explain.
  6. Why did the Office for Budget Responsibility chairman, Robert Chote, conclude that, whatever the precise answer, we were ‘strolling across the summit of the Laffer curve’?
  7. Explain why ‘there is little additional evidence to suggest that a 50p rate would raise more than was estimated by HMRC back in 2012’.
  8. What contribution can economists make to the debate on the desirability of reducing inequality?
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The 50p income tax rate and the Laffer curve (update)

Recently there have been calls from business leaders and Conservative politicians to scrap the UK’s 50% income tax rate, which is paid on taxable incomes over £150,000. The 50% income tax rate is thus paid by top earners, who comprise around just 1% of taxpayers.

And yet the government receives about 30% of income tax revenue from this 1% – and this was before the introduction of the 50% rate in April 2010. (In fact, with the marginal national insurance rate of 2%, top earners are paying an effective marginal rate of 52%.)

One argument used by those who favour reducing the 50% rate is that the rich would pay more income tax, not less. There are four reasons given for this. The first is that people would be encouraged to work harder and/or seek promotion if they knew they would keep more of any rise in income. The second is that fewer rich people would be encouraged to leave the country or to relocate their businesses abroad. The third is that more people would be encouraged to work in or set up businesses in the UK. The fourth is that there would be less temptation to evade taxes by not declaring all income earned or to find clever ways of avoiding tax.

These arguments were put forward in the 1980s by Art Laffer, an adviser to President Reagan. His famous ‘Laffer curve’ (see Economics (8th edition) Box 10.3 or Economics (7th edition) Box 10.4) illustrated that tax revenues are maximised at a particular tax rate. The idea behind the Laffer curve is very simple. At a tax rate of 0%, tax revenue will be zero – but so too at a rate of 100%, since no-one would work if they had to pay all their income in taxes. As the tax rate rises from 0%, so tax revenue would rise. And so too, as the tax rate falls from 100%, the tax rate would rise. It follows that there will be some tax rate between 0% and 100% that maximises tax revenue.

Those arguing that a cut in the top rate of income tax would increase tax revenue are arguing that the 50% rate is beyond the peak of the Laffer curve. But this is an empirical issue. In other words, to assess the argument you would need to look at the evidence as, theoretically, the peak of the Laffer curve could be below or above 50%. Indeed, some argue that the peak is more likely to be at around 75%.

The following podcasts and articles consider the arguments. As you will see, the authors are not all agreed! Consider carefully their arguments and try to identify any flaws in their analysis.

Update
On 27 June 2012, Arthur Laffer appeared on the BBC Today Programme to discuss the Laffer curve and its implications for UK income tax policy. You can hear it from the link below

Podcasts
Should the 50p tax rate be ditched? BBC Today Programme, John Redwood and Paul Johnson (3/3/12)
Arthur Laffer: Tax rate should ‘provide for growth’ BBC Today Programme (27/6/12)

Articles
Where’s the High Point on the Laffer Curve? And Where Are We? Business Insider, Angry bear Blog (3/3/12)
Tax cuts: we can have our cake and eat it The Telegraph, Ruth Porter (22/2/12)
‘Scrap the 50p tax rate’ say 500 UK entrepreneurs Management Today, Rebecca Burn-Callander (1/3/12)
The Laffer Curve Appears in the UK Forbes, Tim Worstall (22/2/12)
Memo to 50p tax trashers: Laffer Curve peaks at over 75 per cent Left Foot Forward, Alex Hern (1/3/12)

Questions

  1. Explain how a cut in income tax could lead to an increase in tax revenue.
  2. Distinguish between the income effect and the substitution effect of a tax cut. Which would have to be bigger if a tax cut were to increase tax revenue?
  3. If, in a given year, the top rate of tax were raised and tax revenue fell, would this prove that the economy was now past the peak of the Laffer curve?
  4. What would cause the Laffer curve to shift/change shape? To what extent could the government affect the shape of the Laffer curve?
  5. If the government retains the 50% top tax rate, what can it do to increase the revenue earned from people paying the top rate?
  6. What other objectives might the government have for having a high marginal income tax rate on top earners?
  7. Investigate the marginal income tax and national insurance (social protection) rates in other countries. How progressive are UK income taxes compared with those in other countries?