Tim Worstall, the right wing blogger who likes to think he can answer all objections with reference to neo-liberal economics, challenged some of the assumptions in the Compass tax report, with reference to the Laffer curve.
Alex Cobham, a real economist, has rebuffed his claim to authority in a paper not freely available on the web, writing as follows:
Tim, I think this paper's assumptions are so strong that - at least in terms of the argument that you use it to make - the approach may in effect assume the answer that you are looking for.
Here is the abstract in full:
"We characterize the Laffer curves for labor taxation and capital income taxation quantitatively for the US, the EU-14 and individual European countries by comparing the balanced growth paths of a neoclassical growth model featuring ”constant Frisch elasticity” (CFE) preferences. We derive properties of CFE preferences. We provide new tax rate data. For benchmark parameters, we find that the US can increase tax revenues by 30% by raising labor taxes and 6% by raising capital income taxes. For the EU-14 we obtain 8% and 1%. Denmark and Sweden are on the wrong side of the Laffer curve for capital income taxation."
Although the paper can't be accessed freely via the NBER, you can find the University of Chicago version here:
http://mfi.uchicago.edu/wp/pdf/trabandt_uhlig_laffer_vers21_WP.pdfThe model has three key (sets of) assumptions on which any results must therefore rely:
i. the assumptions underpinning the neoclassical growth model; and
ii. the assumptions underlying constant Frisch elasticity preferences.
iii. a closed-economyLet's take these in turn...
(i) The neoclassical growth model has been largely superceded by endogenous growth models, although it is still taught in e.g. undergraduate development economics courses as a simple way of begining to think about the growth process. Steve Keen's debunking of the assumptions (e.g. showing the internal contradictions, never mind the lack of empirical support) is a little over the top but very clear; see his book but also e.g.
http://www.debunkingeconomics.com/Talks/KeenGrowthTheory.PPT A longer perspective, encompassing the theory's marginalisation of income distribution issues and highlighting some key flaws (e.g. the critical lack of evidence for fundamental underpinnings like the production function) is in e.g. Pasinetti: http://www.unicatt.it/docenti/pasinetti/pdf_files/Treccani.pdf Since the assumptions of the neoclassical model cannot be stood up, and have a direct bearing on the returns to capital and labour, we should be rather wary of putting much weight on the predictions of tax elasticity (of e.g. labour supply!) that the paper generates.(ii) The assumption of constant Frisch elasticity is, if anything, a more serious concern. The Frisch elasticity of labor supply is defined as the percentage change in labor supply resulting from a one percent increase in the expected wage rate, holding the marginal utility of wealth constant. Constant marginal utility of wealth means, for example, that an extra £1 is worth the same to someone with nothing or someone with £10m. You can think for yourself what that assumption might do to an assessment of responses to taxation.
In their 'Proposition 3', the authors demonstrate mathematically how the Laffer curve emerges from the CFE (and broader neoclassical) assumptions - the existence of the curve is thus entirely based on the mathematical extension of these assumptions.
(iii) The closed-economy assumption is an obvious concern for anyone who thinks that there may be anything to phenomena like international tax competition or tax-induced capital flows — e.g. profit-shifting , which is estimated to reduce Germany’s tax take by more than 10% - see Huizinga and Laeven: http://www.luclaeven.com/papers_files/huizinga_laeven2007.pdf When this model is used to calibrate real economies, in which we would expect to see both real capital flows and also artificial shifting of profit and income declaration locations, it seems inevitable that the calibration will give rise to upward bias in the estimates of capital tax elasticity. This would make the authors much more likely to find (erroneously) that any given real country is near the peak or even on the wrong side of the capital tax Laffer curve whose existence they have effectively assumed.
This is exactly what transpires: “we find that the US can increase tax revenues by 30% by raising labor taxes but only 6% by raising capital income taxes, while the same numbers for EU-14 are 8% and 1% respectively.”
[Open-economy assessment might favour, for example, better regulation of such international manipulations, rather than capital tax cuts.]
**
A final thought, Tim: even after all the assumptions are made, and the results thereby determined, the authors still find that tax cuts would not pay for themselves in either the US or the EU as a whole - indeed, tax increases would increase revenues. And all of this is without mentioning the likely inequality impact (ignored in the paper), or the fact that the authors focus on taxes being used to pay for transfers rather than e.g. public goods (which the authors, in fairness, point out as distorting the findings)... Imagine what the results of an assessment based on more realistic assumptions might look like.
That’s an argument Tim.
Note for future reference.
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What is interesting about this. 1) You are using an economic model although you constantly state that you give no weight to economic models. 2) the paper you cite does not seem entirely conclusive, but if anything it suggests your assumptions about the tax take of a large increase in taxes is not supported – it depends much more on the effacacy of the tax avoidance assumptions you make. 3) there are variations in impact between the different members of the EU, but it seems to be somewhat dependent on the assumptions made on marginal utility of a £1 of income over all these separate locations.
Alastair
It says tax could be raised despite its weaknesses
How the heck doesn’t it support my arguments in that case?
Can’t you accept a glaringly obvious argument when you see one?
Richard
Why do all neoliberal ecomonists who quote the “voodoo economics” of the Laffer Curve always make the a priori assumption that the current marginal tax rate is on the right-hand side of the curve? I’ve seen the Laffer Curve quoted time and time again with no evidence ever supplied that the tax rate is greater than T0 (the top of the curve). Presumably because it’s not meant as a genuine policy aid, so much as a retrospective justification for the tax cuts that these people want for ideological reasons.
@Adam Smith was to the left of the current government
don’t know what voodoo economics is, but think I want to – it sounds like a promising area of study 😆
I don’t know if your assertion about economists, neo liberal or otherwise, is true. The fundamental proposition of Laffer is that tax rates of 0% and 100% will raise no revenue – and between the two there is a curve that goes up and then comes down. It would be a challenge to construct the curve against the UK tax “system” as it a complex set of rules – although the study Richard refers to does indeed have a go at this.
Actually I think that the furthest most economists actually go is to suggest that there is no linear relationship between raising overall tax rates and the amount of tax £notes raised, that there will come a point at which raising the rate will lower the take, and that in the UK we are close to that rate.
I guess if you are in the business of trying to raise the tax take then that is not the argument you want to hear.
Alastair
“here will come a point at which raising the rate will lower the take, and that in the UK we are close to that rate.”
An assertion made with no evidence to support it whatsoever
Mere puff from an anti-tax campaigner – like all Laffer guff
Richard
I’ve already addressed this argument here in comments at this blog.
To repeat: I do not claim that we are at the peak of the Laffer Curve. I do not claim that the tax rises Richard suggests will not raise more revenue.
I make a much narrower claim (one which is not addressed above) which is that there are dynamic effects to tax changes. Dynamic effects which as far as I can see (and what I’m asking to see, if they have been looked at, is that process of having looked at them) have not been considered in working out how much these tax changes will raise.
From what Richard has actually written on hte matter here he seems to be assuming that there will be no income or substitution effects at all from raising the average tax rate on hte top decile of households from 34% to 55%. And similarly, no such effects from raising marginal tax rates to 75% (and in places, to 100%).
That’s one of those very strong claims which requires strong evidence. Evidence which we haven’t been offered which is why the raised eyebrow at the assumption being made.
This isn’t, please note, about people avoiding or evading the new taxes. It’s about people changing their behaviour in the face of the new tax rates: by, for example, trading leisure for income.
@Richard Murphy
what sort or evidence do you think would be appropriate? I guess that over the next 4 years or so we are going to get some – bet its not conclusive 😉
Tim
Good to note you agree the tax could be raised
Your only query seems to be how much tax is raised
Your way of expressing this is to question our assumption on elasticity
For reasons we have given – and which iI have explained here – we think there will be behavioural changes – which may result in more, not less effort
I think there may be a greater demand for work – for example from the second partner in a high earning household that will – in accordance with all observed social behaviour – including the wish to ‘keep up with the Jones’ or to simply pay the mortgage – which is widely ignored in the blackboard economics you favour developed, rather oddly, by economists who have never worked in a market in their lives
That pressure to earn more to cover fixed obligations will, I (we) think counterbalance any tendency to reduce work
Leaving the outcome we predict
And of course we may be wrong
But that’s our prediction
And I stand by it
Richard
“For reasons we have given – and which iI have explained here – we think there will be behavioural changes – which may result in more, not less effort”
Finally, you’re actually answering the question that was asked.
In formal terms, you think that the income effect will be greater than the substitution effect. At least I now know what you’re assuming: however wrong I think you are.
@Richard Murphy
on the other hand, for example, look at the number of private schools that are struggling to collect fees, and the difficulties prestige dealerships are having in selling expensive motor vehicles, not to mention the levels of reposessions and the increasing numbers of empty units in the high street. And even keeping the rates the same is seeing tax incomes falling. I’m not sure your maths add up.
“I think there may be a greater demand for work – for example from the second partner in a high earning household that will – in accordance with all observed social behaviour – including the wish to ‘keep up with the Jones’ or to simply pay the mortgage – which is widely ignored in the blackboard economics you favour developed, rather oddly, by economists who have never worked in a market in their lives”
By the way, this is not ignored in the economics I favour. It’s a well known point and thoroughly discussed in the literature. The effect of a tax change upon revenue will depend upon the interplay of the income effect (which is what you are talking about) and the substitution effect. Most economists would claim that, at the sort of tax rates you are contemplating, the substitution effect will predominate.
But you are of course entirely free to ignore them…..but not to make the allegation that they’ve not considered the issue.
This is interesting.
“Supply of labour in the short-run: choice for the individual between income and leisure,
including the backward-sloping supply curve.”
From the A Level economics syllabus.
http://www.ocr.org.uk/download/kd/ocr_10069_kd_l_gce_spec.pdf
Guess that old “blackboard economics” really does ignore such things…..
N.B. Alex might be a “real economist” – I see he describes himself as once having lectured at Oxford – but I think he’s made an elementary mistake.
“The Frisch elasticity of labor supply is defined as the percentage change in labor supply resulting from a one percent increase in the expected wage rate, holding the marginal utility of wealth constant. Constant marginal utility of wealth means, for example, that an extra £1 is worth the same to someone with nothing or someone with £10m. You can think for yourself what that assumption might do to an assessment of responses to taxation.”
When you “hold something constant”, that just means you keep it at whatever it is at the point of calculation. So if you are thinking about how somebody earning £10m will respond to an extra £, you take the marginal utility at £10m when making the calc, and if you are thinking about how somebody earning nothing will respond, you take the marginal utility at zero £. This isn’t my area, so I write with some trepidation, but I’m pretty sure that the concept of Frisch elasticity cannot rest on assuming “an extra £1 is worth the same to someone with nothing or someone with £10m” because that’d be absurd and inconsistent with basic neoclassical theory. In general, calculating X holding Y constant absolutely does not mean that Y is a constant. If I’ve got this right, that’s a pretty big mistake for a real economist to be making.
I think he also completely misunderstand the role of assumptions in economic modeling. Showing how the Laffer Curve emerges from the assumptions does not mean “the existence of the curve is thus entirely based on the mathematical extension of these assumptions” it merely show that such simple assumptions give rise of a Laffer Curve. Consider the simplest neoclassical growth model, the Solow model. This shows us that with a few simple assumptions (constant returns, diminishing marginal products etc.) that you cannot account for the observed differences in income across countries by appealing to differences in savings rates. It would be a mistake to say this insight can be discounted because you don’t like the simple assumptions used to generate it.
My initial response is also that he’s also wrong about the bias caused by assuming a closed economy – doesn’t the existence of tax competition and mobility make it more likely that raising taxes will reduce revenues? He seems to be saying the authors are finding Laffer effects because of the closed econ assumption. But I haven’t read the paper so may have muddled his argument.
Given the section in question was written by a professor of economics I think you can safely assume that as on other issues we carefully considered all dimensions in reaching our conclusions
And that the statement made was a fair summary of them
All you have done is nit-pick Tim
Have we got one stage further forward as a result of your pedantry – bar you agreeing that the tax can indeed be raised?
No, we have not: all you have shown is that you can only deal with the detail, the big questions are beyond you and pedantry is your stock in trade
It’s not a good CV, is it?
And at that point this debate is closed
Richard
Luis
I think you have seriously middled his arguments e.g. he is agreeing with you that the assumptions made on elasticity are absurd
I think you should stand back and read again
Richard
Richard,
I think you should slow down and read again! I’m saying that holding marginal utility constant does not entail making the absurd assumption he describes, I am not agreeing with him; I’m saying I think he doesn’t know what holding something constant means.
Holding marginal utility constant is absolutely the right thing to do when considering the response to small marginal changes. If you were trying to calculate how somebody earning £10,000 will respond to being given £10m, then holding the marginal utility constant at whatever it is at £10,000 would not be appropriate. It’s point elasticity as opposed to arc elasticity; the rate of change at a point, as opposed to the change over a span. This is basic stuff.
Luis
You may have posted this before I gave notice that the thread was closed
I am amused by your comments
You genuinely believe that pedantry of your sort carries weight?
If so you sadly miss the basic point that the entire methodology you use is discredited
Perhaps you have not noticed that it just caused the collapse of the world financial system
Try looking at the world outside your ivory tower sometime: it helps if you want to be a real economist
Debate over
Richard