Posts Tagged Tax Rates

Why Tax Increases Can Be Expansionary

In my quest to rationalise my desire for the state to control every aspect of people’s lives, I have formulated and collected together a few reasons that tax increases may actually be expansionary. This is an ex post justification, in light of apparent empirical evidence that they don’t have the negative effects so often attributed to them.

To understand why tax increases might be expansionary, we don’t have to abandon the logic of ‘econ101’ entirely – that is, if you reduce the reward somebody gets for doing something, or increase its cost, they will do it less. However, a couple of real world mechanics – which are omitted from economic thinking – can use this logic to conclude that tax increases could potentially be expansionary:

(1) Many productive activities are tax-deductible. Profits that are reinvested are not taxed; similarly, corporation tax is deducted from the cost of employing someone. So the higher these taxes, the greater the incentive to engage in these activities. There is potentially a point where the negative impact of the tax outweighs these positive effects, but we don’t appear to be anywhere near it.

(2) Economic rents are highly pervasive, particularly at the top. Taxing this activity discourages it and hence encourages productive activity. According to Michael Hudson, this was the intent of the original income tax. A clear example of this effect is the Land Value Tax – if landlords are charged for sitting on their land doing nothing, it encourages them to make some money, or sell the land to someone who does.

There are also some other mechanisms that suggest tax increases might be expansionary, some of which I have explored in earlier posts:

(3) The fact that the income effect is stronger than the substitution effect can mean that higher income tax makes people produce more; that is, when faced with higher taxes, people will have to work longer hours to recoup their post-tax income. This adds to gross national product.

(4) Cutting taxes at the top can simply inflate the price of positional luxury goods and hence do nothing to help real production; if that money were redistributed, it would be spent on ‘normal’ goods and hence have more impact on growth.

(5) Governments can spend your money better than you, so higher taxes and spending will increase the productive potential of the economy.

(6) Another interesting proposition from James Kroeger: tax and spend means more money is spent.

The crux of the argument is that it is reasonable to say the population as a whole has a Marginal Propensity to Consume (MPC) of less than one – they save some of their income. The government, on the other hand, has an MPC of at least one. Hence, should money be taxed and spent, there is a high possibility that this increases national income.

Kroeger also notes that people often confuse the expansionary effects of borrowing with those of tax cuts. To fund tax cuts, the government often has to borrow to sustain current levels of spending. However, in this case it is the borrowing that is expansionary, rather than the tax cuts. To truly see the effects of reducing taxes, we’d have to reduce taxes and spending by the same amount.

Another point worth noting is that, whilst taxes might have a deadweight loss in the area to which they are applied, the money that would have been spent does not disappear – it can go into other areas. In other words: if you tax cars then people might spend less on cars, but they’ll also have more to spend elsewhere. So taxes are more likely to change the composition of national income than the total.

Some of these effects are stronger than others; maybe some are negligible or based on faulty reasoning. But the overall combination of conflicting effects makes the story far less clear cut than the basic ‘econ101’ approach to taxes would have you believe.

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The Poverty of Mainstream Debate, Part IV: Laffer, Taxes and Trickle-Down

Continuing the series on just how poor debate in the political arena has become, it’s time to look at the discussion of marginal tax rates, and by extension, the Laffer Curve and ‘trickle down‘ economics. These two represent the main (technocratic) arguments against higher marginal tax rates, so I will deal with them in turn.

The Laffer Curve

So goes the argument: don’t raise taxes on the rich, they will work fewer hours, move abroad, create less wealth, and so forth. It’s usually accompanied by logical ‘gotchas’ like this:

It’s intuitively appealing to people like us of course and as with the Laffer Curve at extremes it’s clearly and obviously true. Zero tax means zero government and without at the very least some form of defense, police and a criminal justice system there’s not going to be much economic growth. When the government takes and spends all of the economy there’s not likely to be much either.

Of course, even this isn’t true. The USSR effectively had 100% tax rates, give or take a few incentive schemes, and managed to achieve positive growth rates throughout its existence. At the other end, whilst I’m not much of an anarchist, no government doesn’t  necessarily lead to no growth whatsoever, as demonstrated by various stateless and taxless communities across the ages.

The evidence for the Laffer Curve is pretty underwhelming, with Mike Kimel’s work suggesting that, empirically, it appears to be upside down:*

Why? I can think of a few reasons:

– Economic rents are pervasive – as Schumpeter said, they are the ultimate aim of any capitalist firm. Taxing this unproductive activity discourages it and therefore encourages productive activity, meaning higher taxes can increase income. Michael Hudson’s video on this is recommended.

– As Kimel notes, if you reinvest your income it is tax deducted, which means that higher marginal rates will encourage investment.

– If a rich person can avoid/evade tax, they will – doesn’t matter how high the rate is.

– Corporations and rich people aren’t as mobile as they’d have us believe, as there are legal and personal barriers to simply upping and moving abroad. As Ha-Joon Chang says, ‘Capital has a nationality’.

– Cutting taxes on a small group of people at the top simply inflates prices up to what they can afford, and so doesn’t encourage production.

Whatever the reasons, the evidence is fairly conclusive: the Laffer Curve is a useless idea; there are so many conflicting factors that it probably resembles a rollercoaster at any one time, and something like a chaos pendulum over time.

 Trickle Down

‘Rich people create jobs’ is a mantra that is often repeated – sometimes, for obvious reasons, by rich people themselves, but even more sadly by useful idiots. Perhaps they revere the rich; possibly they expect to join them one day (of course, probability suggests that they won’t).

The basic fact is that jobs are created by demand. Ask any employer – a firm hires people if there is enough demand for its products to warrant said hiring. To the extent that taxes and regulations have a negative effect, it tends to be higher prices. What’s more, this obviously occurs more in firms who can afford to increase prices; that is, those with market power – the richest ones. In other words, higher taxes have the least impact on the hiring practices of the rich.

What’s more, when there is demand, it is small businesses who create the majority of jobs – a study by the University of Nottingham estimates their share at 65%. So the argument holds no water by any metric.

In summary, the Laffer Curve simply doesn’t exist in its napkin form, and trickle down economics is completely  incoherent and at odds with all the evidence. No wonder they’re all that Republicans can talk about.

*Yes, Kimel is only a blogger, but his conclusions corroborate well with peer reviewed work by others.

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Cutting Taxes on the Rich Causes Inflation, Again

In my previous post on cutting taxes on the rich and inflation, I explored Jame’s Kroeger’s thesis that, past a certain point, tax cuts for the rich just inflate the price of positional luxury goods and hence do not benefit the rich people. I found some supporting evidence, such as the CLEWI rise and the evidence that marginal tax cuts aren’t good for growth (i.e. don’t increase production).

Apparently we aren’t the only ones to note this type of argument, as I stumbled across something similar in Moshe Adler’s Economics for the Rest of Us. Adler argues that inequality may create price inflation, by giving firms with market power an incentive to provide fewer goods at higher prices. The logic is simple: if the distribution of income is more unequal, the rich will be willing to pay significantly more than the poor and so, in absence of ability to discriminate, the profit maximising price for a firm will be higher.

Adler has a variety of supportive evidence. Firstly, he cites the 14% decline in musicians performing at concerts, instead choosing to perform at private parties for larger sums, and netting a 20% increase in revenue to boot. Secondly, he notes that in New York, high square footage apartments bought by the rich have been on the up, in conjunction with a more than doubling of price per square foot. Thirdly, he mentions that doctors have begun to charge large sums for face time, and as a result are seeing fewer patients. To top it off, he presents survey evidence that rich people often only do these things because other rich people do them, rather than because they need the extra space/goods/time. This is in line with Kroeger’s ideas about positional luxury goods.

But the problem here isn’t just about price rises. As Adler notes, inequality actually reduces the size of the economic pie as well as altering the distribution of it, because fewer goods are provided at a higher price.

The net result of these effects is that fewer goods are produced, and the rich do not get anything that they wanted before other rich people had it, whilst the middle and poor get less. This is pretty substantital evidence against low marginal tax rates.

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Can Governments Spend Your Money Better Than You?

A standard objection to tax and spend policies is ‘how can the government know what to spend better than millions of individuals?’ Allow me to try and provide an answer to this question.

Firstly, the truth of modern capitalist economies is that large amounts of the process of production go towards creating demand that wouldn’t formerly be there – advertising, marketing and so forth. Standard rebuttals to this point tend to rest on the idea that people behave like perfectly logical robots, but the fact is that people are influenced by advertising to buy things they didn’t previously know they wanted – if they weren’t, it wouldn’t exist. So a decent proportion of private spending is ‘artificially’ created, and hence people wouldn’t miss it if it were gone.

Secondly, consumption tends not to increase happiness past a certain point, as humans fall victim to two cognitive biases that, as Jonathan Aldred says, put them on the ‘happiness treadmill’:

  • Adaptation. This is when people become accustomed to new things they have, and their happiness level adjusts back to where it was previously. This is pretty extensively documented – there are many examples of lottery winners who do not feel any happier than previously, and there is the well known phenomenon of ‘buyer’s remorse‘.
  • Rivalry. This is the fact that a large part of our desires for consumption rest on what we see around us and what our neighbours have – ‘keeping up with the Joneses‘.

So people buy things because others have them, and quickly adapt, resulting in no net gain of happiness or utility. This continues, fuelled by advertising, and growing consumption fails to deliver the goods, so to speak. Hence, reducing people’s private purchasing power does not necessarily make them less happy, though of course it depends on the stage of development and on the type of good.

Even if you accept this, you might ask ‘well how can the government improve on this once it has the money?’ The answer is actually very simple, neoclassical (!) economic theory: the government provides public or quasi public goods, which would be under provided or not provided at all in the private sector. Private individuals do not have the incentive to provide these goods, so the government is required to step in. After all, it’s better than spending money on things for which demand has been artificially created, and which do not appear to increase people’s happiness.

The idea that governments can spend money better than the private sector has been suggested as as a reason for high tax rates appearing to be a net positive for economic growth, though there are numerous other possible explanations. It also may help to explain the relative success of the Scandinavian economies, where consumption (and other) taxes are high and advertising is strictly regulated. As a result, consumerism is lower and public services are, broadly speaking, the best and most well-funded in the world.

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Cutting Taxes on the Rich Causes Inflation

James Kroeger has an interesting website that puts forth some unique arguments, particularly in favour of progressive taxation. The thrust of Kroeger’s argument is as follows:

When individual lottery winners collect their millions, they enjoy a dramatic increase in their purchasing power.  Suddenly, they are able to make a claim on the scarcest goods & services that the economy makes available.  But what if our politicians in Washington were to decide one day to simply hand out a million dollars to every household in America?  We’d all be able to share the same great experience of luxury living then, wouldn’t we?  Well…no.

By re-framing marginal tax cuts as simply ‘giving’ rich people a certain amount of money, he exposes somewhat of a right wing contradiction: though RWers are often keen to scream inflation when money is doled out, they do not seem to hold the same opinion when the money is doled out to the rich. Now, you might say that taxed money doesn’t disappear; it is spent on other things, and this is true. However, if we consider the ‘Cantillion‘ effects of the distribution of spending, we might expect there to be more of a problem as the goods and services purchased by rich people become more esoteric.

I’d also like to add something to Kroeger’s thesis. As marginal tax rates decrease, people will be more inclined to ask for pay rises, as they have more to gain. If, for example, marginal tax rates were actually lower than the ones that preceded them, we’d be highly likely to experience higher wage inflation (and therefore higher general inflation).

Ultimately, of course, it is an empirical question whether cutting marginal tax rates simply inflates the price of luxury goods, thus benefiting noone but damaging the public purse. So what has happened to the price of luxury goods over the last 30 or so years, when marginal tax rates have done this:

For comparison, Forbes have an incredibly useful ‘Cost of Living Extremely Well Index’, which is shown along with the CPI here:

Clearly, the relative price of luxury goods has taken off as marginal tax rates have plummeted. Now, I don’t want to infer correlation-causation, but this seems like evidence for Kroeger-Unlearningecon effects (!), and I am having a hard time coming up with other explanations for the CLEWI rise.

But perhaps I just have a bias in favour of my new hypothesis.

Addendum: If anybody has any further evidence that is relevant to this argument, I’d be grateful.

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