Duncan’s Economic Blog

Dogs, Poker and Laffer Curves

Posted in Uncategorized by duncanseconomicblog on May 8, 2009

Hopi has an excellent post up in the 50p tax rate.

In the comments there has been a somewhat lively debate. Don Paskini, as ever, is making a lot of sense.

I commented:

Few random thoughts on the Laffer Curve.

The only empirical study I am aware of is the 2005 Congressional Budget Office report of 2005 – “Analyzing the Economic and Budgetary Effects of a 10 Percent Cut in Income Tax Rates” – requested by the GOP – which said it didn’t work.

Most economists argue that the curve doesn’t take effect until marginal tax rates are in the order of 80-90%. If it worked then the tories shouldn’t be arguing about rasing the rate from 40 to 50% – they should be arging to reduce it to 30%.

Also remember the curve was dreamed up in a meeting in the kid 1970’s between Laffer, Cheney and Rumsfeld and sketched on a knapkin.

A quick search of some economics databases gives the following.

Willingness to pay tax: The Laffer curve revisited for 12 OECD countries

According to Laffer, economic activities are a decreasing function of the taxation rate. As a consequence, total tax revenue increases with the taxation rate at its lower levels and decreases against it at its higher levels. The result is the Laffer curve. According to him, the reason for this decrease lies in decreasing economic activities. Although this may be true for activities in the official (white) sector, in the unofficial (black) sector they can increase under the influence of an increasing taxation rate. Part of the Laffer effect may be nothing more than an activity switch away from the white towards the (hidden) black sector. This paper takes both effects into account: decreasing activities in the white sector combined with increasing activities in the black sector. It examines the computation of the maximum tax revenue generating taxation rate for a number of OECD countries. It concludes that, with the exception of Sweden, the marginal taxation rate in these countries is below its optimum.

I can find a handful studies finding a Laffer Curve effect in emerging markets (especially Russia) which lack a strong state and suffer from high levels of corporation. The only ’empirical evidence’ I can find in the OECD comes from the right wing Cato Institute.

Can anyone point me to evidence suggesting there will be a Laffer effect at 50% in the UK?

27 Responses

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  1. Liam Murray said, on May 8, 2009 at 4:39 pm

    I certainly can’t point at conclusive proof that there’s a Laffer impact at 50% Duncan but I don’t think those who’ve opposed the 50% rate have done so based on that assumption.

    The Laffer curve is (as you pointed out over at Hopi’s) not some centuries-old truism but a theory sketched on a napkin 30 years ago by some neocons. Fraser & Eamonn weren’t using Laffer to argue that all tax rises are bad, they weren’t saying that taxes should be cut now, they weren’t even saying it was a dead-cert revenue loser – they were making a ‘direction of travel’ argument and citing some fairly incontrevertible numbers that show in the long term lower taxes can be progressive and raise more revenue. And that’s a fundamental belief of the party they both support.

    What I’m after is something from those who support the 50% tax rate that demonstrates it’s fiscal purpose, that explains why the Laffer argument definitely doesn’t have an impact at that rate. It probably doesn’t but that’s emphatically not the point here – it’s not incumbent on anyone to explain why a tax increase is bad, it’s incumbent on the government to demonstrate beyond reasonable doubt why it’s good. The burden of proof here lies massively with those advocating the increase.

    • duncanseconomicblog said, on May 8, 2009 at 6:16 pm

      Liam,

      Thanks for the response.

      I would argue, on your terms, that this tax rise is good as (as long as it raises revenue, which I think it will) then it will help balance a large budget deficit. Equally, and morally, I believe it right that those who earn the most should pay their fair share.

  2. newmania said, on May 9, 2009 at 9:56 am

    Well the IFS of course ( and not just on study but all work done over a period of years ) . More importantly the real life history of tax revenues in this country which have been , on every single occasion overestimated by New Labour , they also discovered that when they dropped the old top rate they increased revenue . Now I appreciate this could be coincidental but it was not presented as such by New Labour at the time as you are probably too young to recall. This was when New Labour wass being sold to Labour , now we seem to be watching Old Labour selling itself to the country with entirely predictable results . They cannot even sell to New Labour Duncan so what are you doing lining up with the Brownite class warriors , do you seriously think there is a future in it ?

    When I last looked I more had the impression that there were a n number of constraining factors interacting. It just seems that whatever you do you can only squeeze so much revenue out of the country and the real, amounts that turn up bear little if any relation to the hypothecations brandished by Politicians. I do not have the time but it does not take an economist to see that this discussion is largely in a fictional world from start to finish , have a look .

    Your suggestion that most blind man’s buff players …oops I mean economists , think that the laffer effect will apply at this or that rate is of course fantasy. Think of what you are claiming to know . You are suggesting that in differing cultures people `s perceptions and motivation as regard tax and action will conform to a graph that does not even merit a napkin. I think it looks unlikely that any serious amount will be collected and it risks a long term diminution , in this country at this time , but its largely instinct.

    The serious amounts will be collected from people who employ other people to move their money around and it will immediately be lost . The marginal people will be stickier but if they take action it will not easily be reversed when the damage starts to become apparent . I see this sort of pattern in my little world and it’s not a static thing .

    On the activity at ordinary levels and tax the relationship has broken due to the enormous gearing applying to personal finance , working less is not an option . You might say that New labour have had the middling by the jugular and they have continued to slave despite diminishing reward from fear instead of hope. If you look back at the polls as react to tax I think that a wall has been reached over the last year and prior to the slump. I think there is no more to be got from that well and it is in any case a morally bankrupt act of exploitation to pillage the aspirational so as to buy election victory.

    This was only a bit of theatre Duncan to be honest I am pretty surprised to find you still Brown nosing . Authority forgets a dying king and his fawning courtiers tend to get a buit of shoeing as well.

    • duncanseconomicblog said, on May 9, 2009 at 11:38 am

      Newmania,

      The keyfor me is that I believe, rightlyor wrongly, that this will raise rebenue. More importantly I believe it to be a fairer way of raising revenue than others.

      That said I also believe other taxes are going to have to rise too. And I think we need to be honest about that.

      Public opinion does support higher taxes on higher earners.

      On a final note, and those who know will agree. I am not a Blairite or a Brownite.

  3. tory boys never grow up said, on May 9, 2009 at 10:11 am

    Liam

    It is difficult to find incontrovertible evidence that the 50% tax rate will raise revenue in the UK – given that we haven’t had such a tax rise in the UK economy for such a long time. However, if you look at Western Europe where most countries (of all political complexions) have much higher marginal rates than our current 41% it really does stretch credibility to think that all the goverments concerned have raised their tax rates to such levels in order to reduce their tax take. There has also been quite a lot of studies at a micro level which show that income effects tend to outweigh price effects – and it is probably these which have been built into the various models which work on the basis that high marginal tax rates work.

    One point that has been missed in respect of the income tax rises is that because of the way the personal allowance is being withdrawn there is now a marginal tax rate of 61% between £100K and £113k of tax income – which then goes doewn to 41% before rising back to 51% at £150k. This justs seems plain irrational from any economic viewpoint and really shoudl be looked at – keep the personal allowance and introduce a 45% at c£130k would be a more sensible answer.

    Of course on the other hand there is plenty of empirical evidence that the burden of indirect taxes falls more on the less well of – and if the Tories are not going to increase direct taxes on the well off – it is pretty clear who will pay instead. Unfortunately, when it comes to economics and fiscal policy I do tend to find most Tories believe in acts of faith rather than empiricism.

    • duncanseconomicblog said, on May 9, 2009 at 11:33 am

      TBNGP,

      I agree that the changes in marginal tax rates are irrational.

      I agree on the indirect issue – Thatcher cut income tax and raised VAT.

      • Paul said, on May 9, 2009 at 10:24 pm

        Remember she had to fight the EU to keep VAT of childrens clothes in the UK. Thankfully she won that fight.

  4. Tim Worstall said, on May 9, 2009 at 10:29 am

    “Can anyone point me to evidence suggesting there will be a Laffer effect at 50% in the UK?”

    There will certainly be Laffer Effects. Some people, somwhere, will try to doge said taxes. Or think the marginal effort not worth it. Those are Laffer Effects.

    Whether those are outweighed by the revenue raised by the higher rate from those not so dissuaded is what we’re actually interested in, no?

    • duncanseconomicblog said, on May 9, 2009 at 11:34 am

      Sorry Tim, I was imprecise. You are correct.

      Do you think the new rate will lower or raise revenue?

  5. Tim Worstall said, on May 9, 2009 at 11:40 am

    “Do you think the new rate will lower or raise revenue?”

    Agnostic at the moment. It’s one of those empirical questions where we’ll simply have to wait and see.

    I’m convinced that the Treasury hasn’t calculated it all the way through but I’m also aware that the IFS showing a loss is only one of a range of outcomes they provide, and an outcome that depends upon certain heroic assumptions.

    If we were starting to talk about 65% or 70% then I’d definitely predict a loss.

    Or if we were talking about 50% on capital taxation (capital we know is more sensitive to tax rates, it being that much more mobile) then I’d be predicting a loss.

    I’m also absolutely certain that whether or not this raises money has nothing at all to do with why it was done. It was a Labour Government in trouble cheering up the grass roots by socking it to the rich bastards.

    • Liam Murray said, on May 9, 2009 at 12:42 pm

      …and Tim gets to the nub of this whole debate – the politics vs economics agnle. This thread and the related one at Hopi’s demonstrate a few things beyond any doubt and, I suspect, agreed by all.

      (1) There’s no way of knowing for sure if this tax rise will raise any revenue – a cautious yes is the fair assessment while acknowledging that it’s a drop in the ocean in terms of need.
      (2) It’s unlikely that a 50% top rate will provoke any significant ‘Laffer’ behaviour but again that’s hard to confirm one way or another. When marginal rates hit 65/70 it’s more straigfroward.
      (3) the facts of (1) & (2) mean that the measure clearly isn’t an entirely economic one. It’s not scheduled to take effect for a year and is clearly aimed at creating a (largely false) dividing line between the parties.

  6. newmania said, on May 9, 2009 at 8:57 pm

    Liam
    1 Wrong
    2 Wrong
    3 Right

    It is difficult to find incontrovertible evidence that the 50% tax rate will raise revenue in the UK – given that we haven’t had such a tax rise in the UK economy for such a long time.

    What cock ( and bull) the amount by which public spending has increased since 97 is about the same as the total amount obtained from income tax while the size of the state during what we now know was a fake boom overtook Germany ( previously the poster country of the left who now sing of the ‘Nordics’). This was done by stealth and fiscal lag , but we also ran deficits every year after the three years New Labour were committed to Conservative spending plans.
    The IFS allow for a range of outcomes but the central conclusion as often repeated by Robert Chote is that this will lose money. As the removal of the old, top rate gained revenue I am not sure how much proof you need . In this context its about as done a deal as it could possibly be . Duncan is mis representing the nature of the work by announcing as if shocked , look they are not quite sure . Of course not .
    This expansion of the Public sector , the misjudged debt and the creation of explosive “Stabilisers” in a recession is now revealed as horribly misjudged unsustainable and quite literally based on the lunatic theory that we had “Cured boom and bust”. Inflation was in fact rampant if you include housing and the value of earnings after housing and tax actually reduced for many people ( Chalk the omission of housing as one more daft idea justified on the grounds of falling onto line with Europe) . These are the people who will ,be asked to cut into their children’s clothing budget to finance Public Sector jobs for life pensions and waste .

    I think it is broadly accepted that the heavy lifting will have to come from cuts , I expect to see Trident go but the usual format is for the projects to stay in situ but the money to have a prior engagement . All this is New Labour’s fault and there is another interesting outcome of the ten years of drunken squander . In recent Polls ( well two I have noticed ) the long term consensus that taxes were worth paying ,for better services, has broken down, and there is now a quite new and violent swing to cynicism about the state . The Cameron project was born out of a reconciliation with the old consensus and is actually a fair way to the left of its optimum electoral position in raw numbers .
    Note you are a Tone clone Dunc its like post war France everyone was in the resistance.

  7. Alex said, on May 10, 2009 at 12:20 am

    There will certainly be Laffer Effects. Some people, somwhere, will try to doge said taxes. Or think the marginal effort not worth it. Those are Laffer Effects.

    There will certainly be income and substitution effects. Maybe the demand curve will after all slope up!

    Not terribly good.

  8. VinoS said, on May 10, 2009 at 9:14 am

    Indeed, Alex – the thing that has always struck me about claims of disincentive effects of tax rates has been that there may be a corresponding substitution effect. If people’s net pay falls [because of a tax rise] they may be willing to work overtime in order to return net pay to its former level.

    Personally, i don’t think disincentive effects of a 50% tax rate on incomes over £150k are that great. If anyone on more than £150k thinks they are, then i’d be happy to swap jobs [and salaries!] with them for a year😉

    There is an issue of people avoiding/evading tax. This may be what could cause tax revenue to fall [as well as the general economic situation] on top earners when the new rate comes in. However, that – to my mind – is an issue of enforcement. We shouldn’t allow our tax policy to be dictated by fear that certain greedy and devious individuals won’t obey it. We wouldn’t allow policy in other areas to be dictated by criminals.

  9. Tim Worstall said, on May 10, 2009 at 9:39 am

    “We shouldn’t allow our tax policy to be dictated by fear that certain greedy and devious individuals won’t obey it. We wouldn’t allow policy in other areas to be dictated by criminals.”

    Actually, I think we make those sorts of arguments about the law all the time. I certainly do. I argue that drugs should be legal precisely because whether they’re legal or not poeple will distribute and take them and the effects of their doing so while they are illegal is worse than would be the case if they are legal.

    Alex, about income and substitution effects. Sure, here will be both. The Laffer argument is simply one about at what point one outweighs the other really.

    • VinoS said, on May 11, 2009 at 7:28 am

      Tim, I can see that may be a consideration for drugs policy – i.e. keeping them illegal causes more problems than legalising them. But, with income tax, I don’t believe that those who evade it should be (effectively) given a veto on any increases in the rate.

  10. tory boys never grow up said, on May 10, 2009 at 9:51 am

    Newmania

    “As the removal of the old, top rate gained revenue” – I think you will find that there were a few other things going on as well during the same period – ceteris paribus certainly didn’t apply.

    All the Treasury models in Western Europe have econometric assumptions that raises in tax rates at the 40% level lead to an increase in tax rates – please challenge the underlying economic assumptions if you want but at least do it properly.

    If you read the IFS study properly you will find that they express some degree of uncertainty re their assumption that 43% is the maximum marginal tax rate – probably on the same grounds as myself that it is untested.

    Of course if economics is a matter of faith rather than rationality it is necessary to be worried by such niceties.

  11. tory boys never grow up said, on May 10, 2009 at 10:12 am

    While considering fairness in the tax system perhaps one area that attracts too little attention is growing level of abuse of the system by many (but not all) who are self employed. Ever wondered why when you are making normal purchases you are increasingly asked whether you want a receipt – the reason why this is happening that there a growing number of self employed people who put all their household expenses through their businesses so that they can get relief on them from income tax and claim back VAT. To say nothing of attributing income to partners who do not work.

    It is quite interesting how many MPs are attracting criticism for similar abuses.

    • VinoS said, on May 11, 2009 at 7:25 am

      True, Tory Boys Never Grow Up. I suspect that there is a lot of tax evasion by some self-employed individuals. However, I bet that doesn’t stop the same people getting outraged at MPs doing similar things [like claiming personal expenses as business/work-related ones]. As Macauly is quoted as saying “There is nothing so ridiculous as the British public in one of its periodic fits of morality”.

  12. Tim Worstall said, on May 11, 2009 at 7:39 am

    “But, with income tax, I don’t believe that those who evade it should be (effectively) given a veto on any increases in the rate.”

    That’s not quite the point. Rather, that as some people will change their behaviour (ie, avoid, not evade) at certain tax rates, sufficient to lower the amount collected, there’s some rate at which you don’t want to raise it further.

    This does rest on an assumption though, that what you’re interested in from a tax is the revenue raised. If you’re more interested in, say, equalising outcomes even at the expense of the total productive capacity (ie, kicking the rich where it hurts) then this constraint upon rational policy doesn’t hold.

    • VinoS said, on May 11, 2009 at 4:05 pm

      True, there must be some level that which revenue is maximised. But it may well be far above 50%. Also, yes, to some degree high levels of taxation are about redistribution as well as revenue-raising. The two go together – by raising revenue from top earners, the aim is to raise funds for benefits/pensions/public spending and to ensure that the post-tax distribution of income is more equal than the pre-tax one.

  13. newmania said, on May 11, 2009 at 11:16 am

    “As the removal of the old, top rate gained revenue” – I think you will find that there were a few other things going on as well during the same period – ceteris paribus certainly didn’t apply.

    The same thing could be said about any evidence of anything and the conclusion was certainly one that Gordon brown and alluded to on several occasions , thats when he was not praising the bonus culture and predicting a perpetual boom . As to Western European models they would be constructed by people who have got nothing right whatsoever and like our own collection of grovvelers told the government what they wanted to hear. The reality is that the money does not turn up …models oh great .Pah!
    Our models have failed utterly every single year . Got it ?
    You have not read the last IFS study you gave read Duncan`s spin on it .Yes it allows for a range of conclusions ( mostly much worse than its overall guess ) but. Robert Chote the head of the IFS made the overall inference quite clear over the last year to my certain knowledge.( and I have the cuttings )

    I agree there are so many ways to look at it that you might as well go for what your gut tells you and mine tells me the revenue will be minimal in the short term but gradually less and then into negative with damage to the supply side economy.

    I would recommend TNGU that when you invent your just so stories you ijagune trying to seel something to soenmone which they had to buy with their own money and ask yourself how many punters you would get.

    Answer – None .

    This is how the public sector rots the brain

  14. tory boys never grow up said, on May 11, 2009 at 12:42 pm

    Newmania

    Unlike yourself I have read the IFS study rather than the cuttings – as I have already said the IFS is nothing like as definitive in its conclusions as you are. They do use different behavioural assumptions to the HMT model – but they do have the good grace to say that there is uncertainty about both sets of assumptions.

    If you knew a little about economic modelling you might understand why models employing a very large number of assumptions will not hit the right overall answer for the entire economy. But that does not invalidate every component of those models – some of which are supported by large amounts of empirical evidence (and some which are not such as increases in marginal tax rates in the UK). It would of course be easier to operate in a parallel universe where every economic decision could be made on the basis of faith in ones own political prejudices but………..

    You perhaps also ought to note that one of the reasons why the IFS think that that increasing the income tax rate will not be effective is because of the impact of the well off converting their income into capital gains taxed at 18% – well that problem could be addressed pretty easily.

    And as for the public sector rotting my brain – I have spent nearly all my working life in the private sector, so it must be something else.

  15. tory boys never grow up said, on May 11, 2009 at 12:58 pm

    For Newmania’s benefit the actual IFS study is here – not sure that he would like the conclusion in the final para i.e another way of raising £3bn is to raise the tax rate to 43% for all incomes above £100k

    http://www.ifs.org.uk/bns/bn84.pdf

  16. Tim Worstall said, on May 11, 2009 at 11:34 pm

    “But it may well be far above 50%.”

    Indeed it might but I seriously doubt it with income taxes. And I’m absolutely certain upon capital taxes. I’m equally convinced that the revenue maximising rate is higher than 50% on certain indirect taxes (fags, petrol etc). It’s always which tax, in which society.

    “Also, yes, to some degree high levels of taxation are about redistribution as well as revenue-raising. The two go together – by raising revenue from top earners, the aim is to raise funds for benefits/pensions/public spending and to ensure that the post-tax distribution of income is more equal than the pre-tax one.”

    Ah, well, I’m one of those bastard classical liberals. I’m entirely happy with the idea that those with more should pay more for the exigencies of the State. As Sunny has gleefully pointed out, Adam Smith said that it seems reasonable that those with more should pay in greater proportion to their income for the money that is needed to run the State.

    And I agree. I’ve no problem with the idea that someone running hot and cold Aston Martins pays more for the defense of the country, more to keep the roads going, more to succour the poor, (in both cash terms and as a portion of their total income which is what Smith said) than those who are struggling to raise the price of a bicycle.

    In my wilder moments I dream of the situation we had only a few decades ago, that only those on or above average incomes get caught in the income tax net at all.

    However: “to ensure that the post-tax distribution of income is more equal than the pre-tax one” I don’t actually give a toss about this at all.

    Tax is a necessary evil, something that has to be paid so that the necessary functions of the State can be financed. That the rich pay proportionately more than the poor? Fine. I might even, in lax moments, be convinced that tax should be used to equalise prior endowments.

    But I do not accept that tax should be used to make incomes more equal just because there is some moral value to incomes being more equal. I’ve never seen a good argument in favour of that thought, only assertions along the lines of “but of course more equal is better”.

  17. […] is Laffer Curve theory at its daftest. Once again, a slam dunk for our favourite blogging leftie economist – empirical evidence strongly suggests that, among OECD countries, all but Sweden have […]

  18. […] I mention this because as I read the economic ideas and analysis coming from the right, I occasionally have to stop and ask – are we living in a Mirror Universe? They are using words and ideas that I’m familiar with but somehow they seem to think the normal chain of causation, of action and reaction has broken down. Of course, Mirror World logic has existed on the right for a long-time. Most (in)famously there is the Laffer Curve, the idea that cutting tax rates raises tax revenues by making work more attractive. Now whilst there may be cases where taxes have been set too high and lowering them will therefore raise revenue, in the real world such cases are comparatively rare. […]


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