The Laffer Curve

From today's City AM Forum (I can't find the article online yet, so I had to copy type. Please forgive any typos.)

By Harry Phibbs, a journalist at ConHome:

Hammond's virtue signalling on low wages is hypocritical

... There are alternatives the government could take that would help the low paid, and would also help reduce unemployment, rather than endangering jobs.

The first priority should be a sharp rise in the threshold for national insurance contributions.

Employees have to hand over 12 per cent of their earnings to the government on anything over £166 a week, so somebody on the national living wage working a 40 hour week has a significant tax bill [not to mention the 13.8% that the employer has to pay].

Raising the threshold would require the chancellor to find some savings in state spending. That's more challenging than just imposing a requirement on someone else and claiming the credit for it. But it would not be impossible to achieve.

Another priority to address is the Universal Credit earnings taper rate. Changing this would help make it more rewarding to be in work, rather than on welfare.

Before the Universal Credit reforms, people who accepted work really did end up with less money. This is no longer the case, but the taper rate means that for each £1 earned, 63p in benefits is [sic] lost. That is simply too steep a taper. After all, the Laffer Curve applies to the poor as well as the rich, so reducing the taper would reward work just as tax cuts do.

There is something awfully hypocritical about Philip Hammond and the government decrying "unacceptable" levels of low pay by employers, then grabbing a chunk of a salary so that it is even lower when it finally gets to the employee."

I've been saying all this for over a decade, but it's reassuring when others say it. The 67% overall marginal rate on wages over £100,000 a year* seems too high too me, but far less troubling than the 80% or 90% overall tax/taper/withdrawal rates faced by people on wages up to £20,000.

* Do the maths, this is mentioned even less often.

Laffer Curve of LVT Part 2

Prof Nicolaus Tideman kindly e-mailed me his thoughts on the matter.

"The answer is "it depends."

I assume that we are talking about a tax on the rental value of land, not on the selling price, so that a tax of 100% would collect all of the rent.

If the economy had no durable immobile improvements, and people were completely mobile, then as soon as the tax exceeded 100%, everyone would leave and the economy would disappear.

To the extent that there are durable, immobile improvements and people are mobile, the disappearance of the economy will be slowed.

If there are immobile improvements that last indefinitely, the excess tax will confiscate some or all of their value. If there is any vacant land in the community, no one will ever want to use it.

If there are no durable immobile improvements but people are unable to leave, there will be no equilibrium. Whatever the situation, people will find that they are better off using less land, and the rent of land will go up and up on whatever land is used, as people try to economize more and more on land.

One of the lessons of this analysis is that if a community wants to collect as much of the rent of land as possible, it will be important to have a mechanism by which the required payment is lowered to what someone is willing to pay whenever land is unused because no one is willing to pay the assigned taxes. It will also be important to give potential investors and residents assurance that the administrative procedures are intended to seek to ensure that they will never be expected to pay more than 100% of the rent."          


So as with other factors, there is a short and long term laffer curve. A landlord may decide to put his rent up by over market value. In the short term his tenants may pay it rather than being homeless. But in the long term, that property will become vacant and the landlord receive no rent. In the case of LVT the State is the Uber-Landlord. 

In which case the long term laffer curve for LVT drops off like a cliff after 100% of the rental value of land has been collected.

Point three is the effect of sending land values negative, which would happen in the short term.

Point four shows the effect on the margin of production. We know that a 100% LVT produces optimally dense cities. A 200% would lead under consumption of land.

Conclusion. From a public finance point of view, a hybrid Poll Tax/LVT seems optimum, insofar as it would stop migration to marginal locations that would harm the economy. It just so happens the Council Tax fits the bill nicely, and with a few modifications could be the perfect tax structure.

Edit: to clarify, by "Poll Tax" in this context I mean it as a flat lump sum tax attached to every freehold title/dwelling.

The Laffer Curve of Land Value Tax

The principle that deadweight losses act as gravity on government revenue is uncontroversial. The top graph below is familiar and shows the effect of taxes on factors that are produced by human effort. Like income or added value. 

However, this doesn't apply to taxes on the scarcity value of natural resources. In the bottom graph, straight line A shows the effect of a land value tax where markets are perfect. That is a market where we all rent our property from a landlord.

Curve B shows the effect of the alleviation and elimination of deadweight losses, area C, due to the fact owner occupiers can impute their rent (thus over consume immovable property).

But what would happen to revenues after more than a 100% tax was applied to the rental value of land? How would you extend that line? Please share your thoughts.

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Mark W adds: It's a straight line up to 100% with no Laffer Effects. At rates above 100%, first it would discourage new development, which might reduce the total tax base in the long run. Once the rate was so high that it exceeded the total rental value of land and buildings then people would abandon them, so total revenues would decline. It's not difficult to know where the 100% limit is, as long as land and buildings are being sold for rebuild cost/value or more, you haven't exceeded 100%. We can argue and bicker over what the rebuild cost/value is, but if similar buildings are being sold for similar amounts wherever they are - ignoring buildings in areas with zero land value - we know that we haven't exceeded 100%.

Laffer Curve of Planning

From Wiki

"The tragedy of the commons is an economic theory of a situation within a shared-resource system where individual users acting independently according to their own self-interest behave contrary to the common good of all users by depleting that resource through their collective action." 

We all understand the concept of the Tragedy of the Commons. Today, most of us know that over fishing and deforestation are symptomatic of this.  

In the case of fish stocks, we have recognised that they are a common resource which needs to be regulated in order to achieve a sustainable level of “catch maximisation”. 

So, like all things there is a Laffer Curve, by which to the left of the curve there aren't enough fish being caught to maximize yields, and to the right too many for the stocks to be sustainable.

These is why we have quotas. Quota systems are not the most efficient way of allocating the rights to catch fish, but that's a separate issue (an auction system would be better, but for some reason, Governments love grandfathering property rights to natural resources).  Point is, we no longer allow a fishing free-for-all around our coasts.

Our shared environment, is also a common resource. And without the right framework of property rights and regulations, will lead to an over consumption of horizontal and vertical location, lowering our stock of wealth and welfare. 

As land values are derived from the efficient exploitation of agglomeration effects on one hand(development) and a preference for spending on locational amenity over alternative goods and services on the other (preservation/enhancement), there is a sweet spot for the maximisation of our stock of wealth and welfare, which can be measured as the aggregate rental value of land (location). In other words there will also be a Laffer Curve of planning. 

At zero, there are no restrictions. That is no rules, restrictions or property rights over land.
At 100, there is no development allowed. That is there cannot be any changes to the environment caused by human actions. 

The trouble is that while high aggregate land values are a good thing, they go bad when capitalised into private rental incomes and selling prices because they are not spread evenly throughout society.  This not only transfers incomes from the young and the poor to the elderly and the rich, lowering the discretionary incomes of typical working households, but causes excessive vacancy, under occupation, land banking and urban sprawl.


The solution to this are just property rights, whereby we equally share the value agglomeration effects and good planning gives to locations, via a 100% tax on it’s rental value.

As the State would be collector of rents on our behalf, it must therefore align itself with our interests in order for it to maximise revenues in order to pay for public services. In other words, it would have to get very interested in the subject in finding that planning sweet spot, as it would be competing for our spending (LVT is about choice, not coercion) against privately provided goods and services. 

It’s not that an LVT causes more or less development, but the right kind of development where it is most needed.

Efficient markets are not the same as "free-for-all" markets.

The dynamic 'cost' of getting rid of VAT would be a lot less than current VAT receipts

Here's a simple diagram showing how VAT reduces economic activity (assuming a certain fixed level of costs) and sketching in the receipts from VAT (about £100 bn) and PAYE/corporation tax. This assumes that the overall average rate paid by employees (income tax and NIC), company and business owners averages out at 40%. So mathematically, PAYE and corporation tax receipts etc are about £200 bn and total tax paid by the VAT-able sector is £300 bn:


Now, what happens if we got rid of VAT but left other tax rates the same?

Output, in units, increases by one-fifth and the 40% average rate, now applied to a much larger tax base, would raise about £281.25 bn (if my geometry is correct). So although VAT taken in isolation is £100 bn a year, getting rid of it would only mean total revenues falling (a 'cost' from the government's point of view) by £20 bn.


For sure, I have made a lot of assumptions here, the higher the fixed cost line, the more dramatic the effect and vice versa. But even if the fixed cost line is set to zero, total receipts would only fall from £300 bn to £240 bn, a dynamic 'cost' of only £60 bn.

And the 40% is just an overall average rate, the average rate for low earners will be lower, but all those extra jobs means millions off the dole queue into low paid jobs at least, and the welfare savings is well in excess of 40% of the extra money they earn.

Perhaps we can split the difference between £20 bn and £60 bn and call it £40 bn?

The Laffer Curve in action

From City AM:

Corporation tax rates have been falling globally for decades. In 1981, the average rate across the OECD was 48 per cent. It has now plummeted to 24 per cent. In the UK, the decline has been even more stark, with the rate dropping from highs of 52 per cent to just 20 per cent today...

Despite the reduction in the UK’s main rate of corporation tax since 2010 from 28 per cent to 20 per cent, revenues have remained remarkably resilient. In 2013-14, onshore corporation tax receipts (excluding the volatile North Sea oil and gas sector) were £35.7bn compared to £35.3bn in 2010-11.

In the year so far, onshore corporation tax receipts have been 10 per cent higher than over the same period last year – despite a further two percentage point reduction in the rate. The simple truth is that higher taxes do not always lead to higher revenue.

Also from City AM:

Changes to stamp duty in December’s Autumn Statement mean that homes worth below £1m received a tax cut, but those at the very top end of the price scale have to pay a far bigger levy. Under the tax changes, the average London home selling for £510,000 saw its tax bill cut by £4,900. But a property worth £2.1m saw its tax bill rocket by £18,750.

In the first quarter of 2015, there were 638 prime London transactions, down from 949 in the same period a year earlier – a fall of 33.1 per cent. And the stamp duty haul raised from those sales fell from £125m to £93m, down 25.6 per cent.

Of course, this is City AM, so they pretend that corporation tax and SDLT are the worst taxes; they are bad taxes but far from the worst.

So they seldom mention the Laffer Curve as it applies to the worst taxes VAT or National Insurance; the trick here is to look at total tax receipts from all taxes on economic activity. So while a cut in VAT or NIC rates would no doubt mean a reduction in VAT or NIC receipts in isolation, you have to balance that with increased revenues from income tax or corporation tax (the rather less bad taxes).

(With good taxes there is no Laffer effect whatsoever, of course.)

Probably true.

Ryan Bourne is a bit of an apologist for the corporatists and rent seekers and is incapable of distinguishing between earned and unearned income, but you can't argue with facts.

From City AM:

In fact, it may well be that significant hikes in taxes are not even feasible – even if they were considered necessary or desirable.

The UK already has a high tax burden. According to the Treasury’s measure, it currently stands at 37 per cent of GDP with a forecast increase to 38 per cent in the next Parliament. But 38 per cent of GDP represents the absolute maximum that governments of any political persuasion have been able to raise in revenue – irrespective of the tax rates they have set.

So it looks like we are already at the upper limits of our taxable capacity. With increasing labour and capital mobility among those paying the lion’s share of taxes, we might expect this maximum taxable capacity to fall further in the future.

This is a slightly different way of thinking about the Laffer Curve, I suppose.

His figure of 38 per cent seems about right (let's not bicker over a per cent or two either way), no UK government has ever raised more than that, not even the supposed high tax governments of yesteryear. So let's face facts and try and keep spending down to 38 per cent max.
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What is not clear is how much of that 38 per cent is really tax (and how much of government spending is really spending).

For example: until last year, my wife and I received Child Benefit, so a primitive mind would count the £2,000-odd a year we received both as tax (which we'd paid in the first place) and as spending. It's a philosophical point whether it's both or neither.

Some higher earners chose to waive their Child Benefit entitlement without receiving a tax cut; does that mean the government is spending less? Sort of. Does it mean the government is taxing less? Nope.

I, being pig headed, decided to continue claiming the Child Benefit but the price I pay is that they add the equal and opposite amount to my tax bill. Would I be paying less tax if I waived the Child Benefit? Nope, clearly not.

We've got the same dilemma with e.g. public sector employees. As Lola has pointed out often enough, public sector employees cost less than their headline salaries because the government only pays out part of it, it keeps the rest under the heading "PAYE".

Ditto with Housing Benefit "paid" by DWP to local councils. You can count payments from the private sector to the government as "tax" and you can count payments by the government to the private sector as "spending" but book keeping transfers between government departments are neither.

Remember that local councils have to pool most of their income from social housing and hand it over to Whitehall (or they did until recently). That's neither tax nor spending. Housing Benefit payments from DWP to local councils are the same nothing, but in the other direction.

Capital Gains Tax and the Laffer Curve

The Lib Dem conference this year was a big disappointment. Instead of proposing that we all ride round on bicycles powered by moonbeams or women-only shortlists for offshore windmills, it was all rather realistic and sensible.

The only really stupid idea was Clegg's suggestion that the rate of capital gains tax be increased in order to be able to reduce the tax burden on the lower paid. People get all heated about CGT, but it is a very minor source of revenue, it covers less than 1% of total government spending, a point which everybody, from Clegg to Booth missed.

Philip Booth in City AM yesterday:

Indeed, when the top rate was increased to 28 per cent under pressure from the Lib Dems, it was felt by the Treasury that this was the rate that maximised the revenue from the tax.

As it happens, CGT revenue has roughly halved since the rate was increased, although this may have been for other reasons. Nevertheless, it is quite possible that we are already on the wrong side of the Laffer curve – in other words, beyond the revenue-maximising rate (a notion popularised by the economist Arthur Laffer via his famous curve) – as far as CGT is concerned. Certainly, we are not far away from the top of the Laffer curve.

From this morning's City AM Reader's Letters:

The biggest yield from capital gains tax (some £7.4 bn) came under Alistair Darling's giveaway when liability could be crystallised at just 10 per cent for those who had held assets for a while.

People talk a lot of rot about the Laffer Curve, the lefties deny it exists and the right wingers often claim that every cut in rates leads to an increase in revenue.

The sensibles merely point out that if rates are too high, you can increase revenues by reducing the rate. This is the mathematically correct view, but ignores the fact that the revenue-maximising point still depresses the size or efficiency of the economy.

As it happens, I know from personal experience that ten per cent is the rate which clients were happy to pay, they weren't fussed about claiming deferment or hold over reliefs, or simply not triggering the gain or anything. They just sold what they wanted to sell and sent one-tenth of the gain to HMRC. A while ago I read that the Americans had noticed the same. So in all probability ten per cent is the revenue maximising rate.

It's still a bad tax of course. The irony is that the real point of CGT is not to raise revenue by taxing capital gains (hence and why the largest source of capital gains, owner-occupied housing, is exempt), the real point is to prevent people turning taxable income into otherwise tax free gains. So the system is quite different in different countries, and changes regularly in the UK, they are always struggling to reconcile these two quite different aims, but there you go.

Spreadsheet Sex

There's been a lot in the news this week regarding the use of accountancy techniques in order to document sexual activity and the excuses for lack of. Which you can read here for more details.

I think the response to the frustrated spouse should have been based on an economic model. Rather than an internet outing. Something like this perhaps.