As a follow up to yesterday’s blog I wanted to say a tiny bit more about Laffer curves and whether or not they work in the real world. I feel that I dismissed a huge idea in modern economics without giving it time of day, but I didn’t want the whole blog to be about the myth of self funding tax cuts.
The basic problem with applying Laffer curves in real life is that the financial relationship between the state and the citizens is incredibly complicated. The state takes money from the citizen in many ways, direct and indirect taxation, fines, student loan repayments, licenses, child maintenance charges, excise duty, with a range of deductions and exceptions depending on whether you are employed or self employed, married or single.
The state also gives people lots of money too. Benefits, rebates, subsidies.
Because of this each individual’s marginal tax rate – the amount the state will take of the next £1 you earn over your current income varies hugely. Someone who is self employed with no student loan can pay a much lower marginal tax rate than someone on the same income who is employed and has student loan repayments or a child maintenance liability, or both. I can be sat in the pub with someone who earns an almost identical income to myself, but who pays a marginal tax rate 5 or 6 times higher.
That’s why applying the simple notion of the Laffer curve doesn’t work with income tax.
I also think that the elasticity of income in response to changes in the tax rate is more complex than the Laffer curve allows for.
If you are rich and you are faced with a short term increase in tax you can manipulate your income, moving funds around, to avoid the higher tax rate. George Osborne announced in advance that he was cutting the higher rate of tax, which meant that lots of people deferred their income until after the tax cut came in. This gave the appearance of a increased tax take, but was really just the same income moving from one time period to another. Once that one off increase was over the tax take was lower because the tax rate was lower. This is why he discovered that his extra cash evaporated quickly leaving him with a whole in his budget. This is a familiar story – Reagan championed self funding tax cuts throughout his period in office, but doubled the US budget deficit in the process despite big cuts to welfare programmes. This means that the short term elasticity of income in response to changes in the tax rate is greater than the long term elasticity.
Only the super rich who can move their money around using the kinds of tactics reveals in the Panama Papers have truly elastic income, and can shop around for tax havens. The rest of us don’t have that option.
That doesn’t mean that the Laffer curve doesn’t work at all. There are other ways in which the state takes money from individuals – student loans for example – where the higher the level of repayment the higher the default rate and the higher the cost of collection (as the rates get higher complaints, challenges and enforcement costs go up). Eventually you reach the point where further increases in repayments don’t bring in any more money.
This isn’t unique. The Child Maintenance system has lots of debt where the cost of collection is greater than the value of the money to be collected. The state doesn’t want to publicly write off this debt for moral and political reasons, but fiscally it is a dead loss.
It looks to me that the student loans book is in a similar state. A sensible Government could reduce the repayment rates on student loans with little or no impact on the total sums collected. This isn’t quite the same as proving that the Laffer curve is right – after all anyone who has worked with debt books knows that this phenomena isn’t unique to Government income, it is simply a function of the relationship between cost of collection and amount collected, and not a specific function of tax.
In the main blog I was a bit underwhelmed by Corbyn’s plans on Government spending. The size of the increases in spending were well below those implemented by Wilson, Callaghan, Blair and Brown, and the plans to expand the state were limited. The last Labour manifesto talked a lot about ending austerity, but actually the difference between the Labour plan to eliminate the deficit and the Tories was pretty slim:
This graph from the Resolution Foundation shows the Labour Manifesto as the red line with the different Tory plans as the blue lines. Fiscal Objective was Osborne’s original plan, the dark blue line his revised plan after the tax cuts, and the purple line is Tory Manifesto. Not a lot to choose between the 2 parties.
This minimal relaxation in austerity isn’t anything like enough to cover the commitments to more funds for the NHS and ending tuition fees. There were tax increases planned, but this doesn’t explain how big increases in spending could be achieved without an equally big increase in public spending as a % of GDP.
There are 2 answers to this.
Firstly that Labour was quietly banking £7.5bn of Conservative party benefit cuts, which would have hit poor families hard, as this graph from the IFS shows:
Labour’s tax hit on the rich was matched by a Tory style reduction in the incomes of the poorest.
But secondly because Labour is planning a big increase in the role of the state in running the Railways and key utilities, but claims that this can be done “off balance sheet”. John McDonnell was questioned about this on the Marr show and the Robert Peston show over the last few months:
(the nationalisation stuff is from 5minutes in)
The proposals which Labour has are to issue bonds to the private sector to fund the nationalisation of utilities, which will then pay out to the bondholders. The purchase prices will be set by the Government, presumably at a discount.
This effectively means that it is a leveraged buyout, with the discount taking the place of a cash investment from the Government. It also looks spookily similar to the kind of off balance sheet PFI transactions that got Ken Clarke, Gordon Brown and George Osborne into so much trouble.
I’m not as hostile to PFI as some people, but they only work when the Treasury Cost of Capital rate is high. At the moment the Government can borrow at close to 0% interest, which makes any kind of PFI pointless. Labour are planning to borrow more expensively than they need because they don’t want to show the true impact of the plans.
The privatised utilities, as McDonnell points out, also have substantial debts of their own, in addition to the debt which will be loaded onto them by the nationalisation process.
These debts have to go onto someones books somewhere, and if they have been nationalised this can only be on the Governments books, including any pension liabilities. Which means that they can’t be off balance sheet. I honestly can’t work out how this impacts on Labours plans for deficit reduction, and I suspect that is because they haven’t worked it out either. Nor am I convinced that the National Audit Office will allow the nationalisation costs to be treated as off balance sheet, given that they wouldn’t allow Network Rail’s liabilities to be treated as off balance sheet either.
If the accounting of the liabilities is opaque then how the revenue activities of the newly nationalised utilities and railways will show in the National Accounts as even vaguer. If they are counted as public sector spending then Labour will be increasing public spending as % of GDP by a much greater amount than their last manifesto indicated, in fact it would make public spending a great proportion of GDP than any previous Government Labour or Tory.
All of which means that Labour under Corbyn might actually have a more radical plan than I gave them credit for. They just haven’t worked out how to account for it, nor have they learnt any lessons from the last 3 waves of PFI deals.