Sunday, 28 December 2014

The Laffer Curve, again.

Interesting linguistic point first, to lighten the mood: no European language has a proper word for "tax", because the concept of having to hand over X per cent of your earnings or output or wealth to the government every year is a relatively new and unnatural one. So each language just uses a word at random.

For example:
English "tax" actually means estimate and "duty" means what it means,
German "Steuer" is not actually derived from their word for steer (as in steering wheel), it is derived from an old word for support or prop,
French "impĂ´t" and Italian "imposta" mean imposition,
Dutch "belasting" means burden,
Danish "skat" and Norwegian "skatt" mean treasure.
Right, down to business. The Scottish government can now, in theory, set its own income tax rates, i.e. abolish it by setting a rate of zero. Somebody who's campaigning for LVT in Scotland (to replace income tax) asked me whether I knew of any official or semi-official estimates of the deadweight cost of taxes.

He himself got a curt reply from HM Treasury years ago saying they thought is was about 30p for ever £1 (thirty per cent) of the amount raised in tax. To my mind, this is good start. The overall average marginal tax rate on income and output (taking income tax, National Insurance, VAT, corporation tax and working tax credit withdrawal into account) is around fifty per cent. Thirty per cent of fifty per cent is fifteen per cent, so that's the bare minimum amount by which the size of the economy is depressed (chances are it is much higher, especially if you factor in faster future growth). So if Scotland were to scrap income tax, that would reduce the overall average rate to about 35%.

The only official Treasury nod towards the existence of deadweight costs and the Laffer Curve was a couple of years ago, which I posted about at the time. The point being that the Laffer Curve looks specifically at tax revenues, but the fact there is a curve tells us that the economy is more depressed the higher tax rates are; obviously, with a 100% tax rate, revenues are nil and the size of the economy is zero.

We can turn their calculations into a chart and then work backwards. I shall assume that they are not completely stupid and that 50% is indeed the revenue maximising tax rate:

You can work out implied GDP by multiplying up tax rate by yield. Not all of the fall in implied GDP is down to the economy contracting, say HM Treasury, 60% of the apparent fall is down to evasion and tax planning and 40% is down to the economy contracting.

So at a tax rate of 50%, tax revenues are £31 and implied GDP is £62. At a tax rate of 35% (the lowest which Scotland can have), tax revenues are £28 and implied GDP is £80. The actual increase in GDP is not from £62 to £80 though, (a 30% increase) it is 'only' 40% of that i.e. 12%.

So there's your answer: if Scotland got rid of income tax, its economy would grow by twelve per cent. That's a significant amount. If it collects as much in (new) LVT as it would have done in (old) income tax, its citizens still end up 8% better off (35% of that 12% is lost in VAT and NIC).


Sackerson said...

Sorry to be so slow, but are you saying 30% of income tax raised is used up in collecting it?

Mark Wadsworth said...

S, no, that's "collection costs" which are considerably less than 1%.

"dead-weight costs" are all those transactions which don't take place, all the businesses which are not viable, all the jobs which don't exist… as a result of taxes on transactions, profits and employment.

Sackerson said...

Thanks for the clarification. But without the taxes presumably many other jobs - many of them useful - would not exist, or might re-enter as privatised "dead-weight costs" in the form of private healthcare, private education etc - which is where we seem to be headed anyway. Or am I being slow, again?

Mark Wadsworth said...

S, oops, I've checked HM Treasury's thing again, we have to scale down the 30% by 60%, so GDP would 'only' be 12% higher if average rate dropped from 50% to 35%.

And no, I'm not talking about 'crowding out', I am talking about dead weight costs as explained at Wiki.

Sackerson said...

So instead of dropping tax by 15% to get 12% GDP boost, better to spend the 15% on goods and services directly?

Shiney said...


Apologies in advance for the profanity!

Yes, yes but all this laffer curve 'revenue maximisation' bollocks really pisses me off.

Since when has it been the government's mission to take as much off me as they can. The b'stards should do the minimum necessary for the least cost and let me spend the rest how I see fit.

So what I'd really like to know is how much that is, and what the LVT would be if that was the case. You are an accountant and you even have a name for it.... its called Zero Based Budgeting.

Steven_L said...

obviously, with a 100% tax rate, revenues are nil and the size of the economy is zero

I'd always imagined that the 0% end represented anarchy and the 100% end slavery. One would be a power vacuum and possibly result in the other. But you can't have 0 economic activity unless there are 0 people surely?

Mark Wadsworth said...

S, no, what the government should or should be doing is a separate topic.

Sh, yes 'revenue maximisation' is of course bollocks, not least because it ignores the deadweight cost, which is the narrow focus of this post.

Clearly, whatever level of actual government spending you want in £'s, LVT is always better than taxes on income, because it has no dead-weight costs, so required LVT as % of total economy is smaller.

As to 'bare minimum of government spending', I've done that one, and you can make up your own mind, but clearly the true core functions of the state (defence, law and order, roads, refuse collection and fire brigade) costs less than ten per cent of GDP, probably nearer five per cent.

The point is that the "bare minimum of taxation" is an irreducible figure equivalent to land rents. If the government doesn't collect it (and dish it out again per person) then it will be collected privately, and allowing that to happen in itself has dead-weight costs.

SL, OK, with a 100% tax rate there would still be economic activity but it would all be black market, so what it means is "with 100% tax and totally honest but economically rational citizens…"

Bayard said...

"Since when has it been the government's mission to take as much off me as they can."

Since, oh, the time of Hammurabi, I suspect. That's how it's always been, since the idea of " the state" was invented: the state takes from its citizens the maximum they will put up with, then spends the minimum it can on things that it know the citizens will not tolerate not being provided with and wastes the rest, or in the old days, spent the rest on fighting their neighbours.

Mark Wadsworth said...

B, yes, fair summary. But we are in a democracy and some governments are clearly far more kleptocratic than others. If the ruling classes only nick a few per cent of GDP for themselves, that is tolerable, but the current UK government/ruling class nicks more like ten or fifteen per cent.

Lola said...

MW. Very nice piece of logic and analysis. Thanks.

Sackerson said...

If cutting 15% only raises GDP by 12% then wouldn't it be better for the government to spend 15% directly on goods & services? Isn't this about getting value for money - educating the "government shopper" as Burning Your Money called it?

Mark Wadsworth said...

S, no, because that lost 12% of GDP is lost completely.

For the purposes of this discussion, let's put to one side how efficiently the government spends or redistributes what it collects.

The point is, collect the same £££ amount in LVT to replace that 15% of GDP collected in taxes on income and output and GDP grows by 12% and tax revenues remain constant.

Sackerson said...

Mark, I must really be thick. Why would it make a difference paying tax as LVT rather than income tax? It's still tax.

Mark Wadsworth said...

S, the point is that LVT has no dead-weight costs (and possibly even stimulates economic activity).

So if we start with hypothetical tax-free GDP of £100 and impose taxes on income and output of total £40, we end up with GDP of £90 and revenues of £36.

If, instead, we try to collect £40 in LVT, we end up with GDP of £100 (and growing) and revenues of £40. People on the whole are 10% better off.

Bayard said...

"But we are in a democracy"

I would call it an elective oligarchy. Democracy is what they have in Switzerland. I expect the government would be a lot less kleptocratic if we had a Swiss-style democracy, but perhaps not.

Sackerson said...

Educate me, mate. If you can make me get it, anyone can get it.

(1) Taxes £40, revenue £36. I thought you said costs of collection were much less than 1%.

(2) LVT may be levied on property but will be paid nevertheless, presumably from income in most cases, whether the taxpayer is a director or employee. It's still money not available to spend on ice cream and DVDs.

Sackerson said...

... though I can understand that taxing land/property would make people think about using it more efficiently.

Mark Wadsworth said...

S, first you have to look up excess burden of taxes/dead weight costs, as per link above. That is the key to all this.

Apologies for my lazy explanation. I meant "GDP is £100 and you attempt to collect £40 in tax by imposing income tax at 40%…". So GDP shrinks to £90 and revenues are only £36, so you have to increase the tax rate a bit and GDP shrinks a bit more etc.

(Collection costs are surprisingly low (it's the welfare system which has ridiculously high admin costs), let's ignore these for now.)

Of course LVT will be paid out of income, that's a red herring. Everything is paid out of income. But it is no longer a tax on income and so has no deadweight costs.

You say: "It's still money not available to spend on ice cream and DVDs."

No, it's money which would otherwise be collected in rent by one group at the expense of another group.

Total spending on ice cream and DVDs unchanged. Workers can afford more ice cream and DVDs, landlords, unemployed, retired and bankers can afford less ice cream and DVDs.

Unless they start working, in which case there is more ice cream and DVD's being created and more being consumed.

And whether the ruling class nicks the money or dishes it out as welfare payments or public sector salaries, it is still available for spending on ice cream and DVDs.

Ben Jamin' said...


If you tax income and capital, you get less income and capital.

Think petrol,booze and fags. The reason the Government puts high taxes on them is to stop you consuming so much of them.

Same with work and enterprise. Taxes distort incentives, so we end up with less output because of taxes. ie a deadweight loss.

But, you can't get any less land by "taxing" it.

Or rather, because under LVT, it's based on a fixed charge attached to a freehold title, not a % of income or capital. So, like paying for any other good or service, it doesn't affect work incentives.

In fact, because land values are currently a free lunch enjoyed by free holders, they are misallocated and over consumed (deadweight losses of monopoly/subsidy). So, a LVT makes people pay for the value they benefit from, so the land/property market can function on a level playing field. Ending another set of deadweight losses.

Professor Nic Tideman calculated the combined deadweight losses (shrunk GDP) from taxes and capitalised land rent come to 48% GDP for the UK economy.

An enormous sum of economic activity lost every year.

Lola said...

Apologies for being late to this, but only just had a chance to really study it.
To extend the discussions onward a bit, and outside the deadweight costs meme, this analysis, or any analysis like this, should make any free citizens blood boil. Just how far we have been taken - possibly willingly - down the road of dependency by self serving governments is quite appalling.