Not the Laffer Curve again!

I’m a little embarrassed that my previous, rather nasty post was at the top of the home page for so long. I haven’t posted since August! The human has changed jobs and only recently acquired a new netbook that I’m now appropriating. Anyhow, I’m going to make my right-wing bashing a bit more measured going forward. And what better place to start than the Laffer Curve, that piece of economic fantasy from the 1980’s that every now and again gets dragged out and dusted off. Given the supply-side tendencies of the current US vice-presidential hopeful Paul Ryan, such theories are very much in vogue right now.

The theory behind the Laffer curve (originally, so legend would have it, drawn on a napkin during a 1974 meeting) is essentially sound, and intuitive. If you accept that a government cannot raise any revenue at a tax rate of zero percent, or at a rate of 100 percent, there must be a rate somewhere in between at which revenue is maximised. Where the fantasy comes in is with any attempt to show where this point is. Indeed, any attempts to actually plot data for any given country shows a series of disconnected dots not even resembling a curve. The problem with data of this nature is that it is very difficult to establish what effect the tax changes alone have on the economy. Any study that could actually show that the Laffer curve is more than just a warm feeling in the conservative bosom would be big news indeed, especially with the current ideological war raging in the US.

So when I saw this video, I was intrigued:

Firstly I had a bit of a chuckle over what Tim Groseclose had to say about his economics textbook from 1984. My economics textbook from the same era has this to say about it: “Again, things did not turn out as supply-siders hoped. The tax cuts of 1981 did not generate additional tax revenues. Government deficits ballooned.” Oops!

But Groseclose claims we were all misled. And the really interesting bit is that he cites the Romer and Romer study from 2007 as evidence that the curve peaks at a 33% tax rate. He makes a big deal out of the fact that Christina Romer was an economic adviser to President Barack Obama, and the Romers are liberals. Of course, the king of all arguments from authority is one delivered by your ideological foe but supporting your position. Unfortunately for Groseclose, the Romer study does no such thing.

Here’s the study. I’ve spent a few days getting to grips with it, econometrics not being my thing much at all. The Romers isolated the effects of tax changes implemented for mainly ideological reasons, and conclude that such a tax increase has a significant negative effect on GDP (the study did not cover effects on government revenues). It doesn’t show anything we didn’t already know (although it’s great to have the data), that specific, targeted tax changes can be very effective in changing economic behaviour. This is what I’ve been saying for a long time, and it’s why I support the Irish government’s low corporation tax rate; something I’ve been criticised for by some of my more left-leaning friends.

But Groseclose must have some brilliant insight that he’s not sharing with the rest of us when he claims if you “do the math” you come to 33% as a revenue-maximising tax rate. I can’t figure it out and I’m not the only one. Even his fans are scratching their heads over that one. Come on Tim Groseclose, you owe it to conservatives everywhere to show us the math and prove us supply-side sceptics wrong.

 

 

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On taxes and government spending

Economics is intertwined with politics, indeed in Adam Smith’s time no distinction was made between the two disciplines. One of the great questions right at the heart of this intersection-from-hell is that of how involved the government should be with regard to the economy. Everybody has an opinion, ranging from the extreme left’s Soviet-style planned economies to the extreme right’s libertarianism and laissez-faire approach. Neither approach can be shown to be empirically unworkable, yet planned economies were tried, and failed, and a completely “free market” is an elusive fantasy – fairytale economics.

So it would seem that the sensible approach would be a mixture of the two, but how to mix them is crucial, and economic success doesn’t always mean political success, especially in the short term. That is because you humans are very short-sighted when it comes to your comforts. Most of you would choose a lifetime of poverty if it meant you could be rich for just one day, as long as that day is today. But I digress….

Taxes – Spending = Surplus (or Deficit). Even politicians can understand the mathematics of this (you’d think). Raise taxes or cut spending (or do both), you get a surplus. Lower taxes or increased spending puts you in deficit. Countries are not corporations; a budget deficit is not necessarily a bad thing and, as David McWilliams points out in this piece: if everyone and everything is balancing their budget at the same time, that’s a recipe for disaster. Because my spending is your income, and vice versa. A targeted mix of policies is necessary to balance a myriad of potentially conflicting forces.

In general, I like taxes. But taxation is a powerful tool and should be used responsibly. It’s a bit like chemotherapy, it might kill the cancer but could also kill the patient. Tax policy needs to be simple. The simpler the tax, the harder it is to avoid. I love VAT, I could wax lyrical about VAT for hours (don’t worry, I won’t). VAT is a beautiful tax because it’s simple, impossible to avoid, and all the work in its collection is borne by VAT vendors, not the government. It’s also about the most fair tax you could imagine; because it’s a tax on consumption, everybody pays, and what’s more everybody pays the same percentage. Whoever invented VAT should be knighted and sainted.

I cannot understand how, in general, the same people who favour cutting taxes also want spending cuts. Lower taxes and increased spending are two sides of the same coin, they bring you to the same point, and can even complement each other. Of course you can’t always substitute one for the other; roads won’t be built and maintained if we cut taxes. And governments can be wasteful spenders. A low corporation tax, as we have in Ireland, is another way for the government to invest money (that would otherwise be raised by a higher tax) in job creation. This is an example of a sensible, targeted policy. It involves one tax type, and achieves a very specific outcome. Now think of the govt spending equivalent: Family Income Supplement (FIS). This is a social welfare payment made to working people  with families, to supplement their income (the clue is sort-of in the name). This effectively allows employers to get away with paying lower wages; it’s not only the employee who is being subsidised here. Now why would you be in favour of a low corporation tax, but averse to a government income subsidy? The answer is that some humans hold economic ideas the same way they do religious ones, and they don’t think about the implications of those ideas; this applies to left and right equally.

Which brings me to a final musing; there’s a growing fascination in right-wing economics with an unsubstantiated fantasy called “Supply-side theory”. One of the central dogmas of this religion is that lowering taxes leads to increased government revenues. Even if the Laffer Curve was an actual curve, and not just a series of disjointed dots (with very different results for different countries) which is what the actual data gives us, it’s still the Laffer Curve not the Laffer Vertical Line and you might just still be on the left hand side of it. It’s amusing that this is presented as a serious economic study……….sure, and Alice in Wonderland is a great work of non-fiction. To be fair to supply-siders, other economic factors, especially shifts in demand, are always getting in the way of them ever proving their theory. Which kinda just goes to show that those factors are much more important.

Unions – the supply-siders of the labour market

Supply side economics is the unproven belief that as long as you ensure favourable conditions for producers, demand will somehow follow. By cutting taxes, supply-siders hope to encourage production, and shift the aggregate supply curve to the right as shown below.

In theory, output (NP) increases when aggregate supply shifts from AS1 to AS2, without an increase in prices (inflation); prices will actually fall, employment is up, and we all live happily ever after. Look carefully at this and you will realise it’s a load of bollocks. Firstly, “cutting taxes” is like saying “water the garden” and expecting everything to grow. What if it’s a cactus you’re trying to grow? You’ll drown it. It depends on what is being taxed. If you raise or lower the VAT rate, for example, it matters not one jot to the producer – his output remains exactly the same. But demand will vary, because VAT is a consumption tax.. If you cut corporation tax, it encourages investment in that area where the tax is low, but only if the demand for the product exists in the first place. And there is no causal relationship between such a tax cut and prices. Prices are always demand led. I can’t remember that there has ever been a situation where a booming economy went hand in hand with low prices – can you? If prices are low, it means you’re in recession.

And things are no different in the labour market. Why should they be? Unions forget that wages (the price of labour) are led by demand, not by supply. Unions are forever seeking to steepen the demand curve for labour, as shown here.

If they can successfully make demand for labour inelastic, they get to push up wages without a drop in employment levels. They do this by, among other things, coercion and thuggish tactics.

Econocat believes there is a season for all things. I share some left wing ideology with labour unions, and acknowledge that they were vital in establishing acceptable working conditions in the early days of capitalism. But their season has passed. Labour legislation in civilised society has relegated them to the role of market policeman or vigilante, depending on where your sympathies lie. There may come a time when they once again have relevance. Things are changing all the time, and my views may change too.But I will never withhold criticism just because I share beliefs or values with someone.

I work for a large American multinational firm, and we have recently been awarded a large contract with a de facto semi-state company. In the industry in which we operate, in such a situation where one company takes over an existing contract from another, staff are usually transferred under TUPE (Transfer of Undertakings – Protected Employment), unless the customer says they don’t want this – something a semi-state body will never do. So we have taken on 100 new staff under the exact terms and conditions as they had with their former employer. Because the former contractor, quite understandably, couldn’t be bothered to send out the files of all these people (would you if you’d just lost a €3m contract?), we had to ask each new employee for the relevant personal information required in order to set them up on our system. We sent out a standard application form, as well as an information form that had as its header the words “New Contract – Employee Information”. The “New Contract” bit referred to a new contract for the company, not the employee. This form is clearly not a contract – there are no stated terms and conditions, and nowhere where anyone has to sign anything. The union saw this and peed themselves; the upshot was that we had to phone every one of these people for basic information such as uniform sizes and their bank details so we could pay them, because the union had told them not to send in any forms (bizarrely, the “Application Form” was somehow acceptable, not that we actually got any of these back). These people are merely obstructionist, desperately trying to justify fleecing their own members of €4.70 per week. They stuck a spanner in the works that did nothing but cause me extra work (for which I received no extra compensation), so that they could go back to their members and claim they had done something.

Having said that, there are some union people I respect. Jim Stanford, an economist with the Canadian Autoworkers Union, is one. His book, Economics for Everyone, is a must-read primer. Kieran Allen, a sociologist at UCD and very active in the union movement, is one of the most coherent voices in the campaign against centralisation of EU power in Brussels. I expect him to be at the forefront of the NO campaign leading up to the referendum of the EU fiscal compact treaty.