ECONOMIC PERSPECTIVES – 105

Conventional wisdom maybe – but it’s never the truth

Whether it’s the belief that commitment to more infrastructure spending by the state will create more jobs; or that import tariffs are needed to protect domestic industries; or that currency manipulation can boost exports; or that a statistical figment called GDP can be used by the state to guide economic policies; or that QE got us out of the last recession and it’s necessary to repeat it to prevent another depression – these, and scores of other economic platitudes are simply accepted. No further scrutiny is sought because they are seen to be self-evident, and taken for granted.

But no matter how obvious they may seem, nor how widely accepted, what they have in common is that they’re wrong – indeed, in many cases the reverse is closer to the truth.

For example, central to the current furore about NHS and healthcare funding is the belief that higher taxes are needed to pay for the government’s accumulating Covid-related debt. The idea that government can raise more revenue by lowering tax rates is counterintuitive, but it’s true. In extremis, a tax rate of zero per cent will of course yield nothing. But a tax rate of 100 percent, being confiscatory, will also yield no revenue because no one will have any incentive to work.

Tax rates & tax yields

This concept was explained by Arthur Laffer, economics professor at Chicago University. Its simplicity resonates powerfully with common sense and to this day it is referred to as the “Laffer Curve” – a bell-shaped graph showing the tax rate on the X-axis and the tax yield on the Y-axis. It entered economic folklore when Laffer sketched it on a napkin while dining with his friends Donald Rumsfeld and Dick Cheney at the Two Continents Restaurant in Hotel Washington in 1974.

The Laffer Curve

Implicitly, there must be a rate of tax (X-axis) that yields an optimum amount of tax (Y-axis) represented by the summit of the inverted bell. This amount is invariably a lower rate than Treasury officials are prepared to accept – mainly because the curve doesn’t factor in what happens to the tax revenue once it has been raised. We can think of this as the “squander” factor that lies in the realm of “big projects” – or, more likely, just waste, necessitating the need to raise more revenue! The tax-yield shown by the graph may therefore be notional rather than actual.

Laffer did not claim ownership of his eponymous curve. He himself attributed the idea to Ibn Khaldun, a 14th century Tunisian political scientist who observed: “at the beginning of the dynasty, taxation yields a large revenue from small assessments. At the end of the dynasty, taxation yields a small revenue from large assessments.”

The principle applies to any tax

The beauty of the Laffer Curve is that it’s principle is applicable to any tax – whether based on income or consumption. A zero percent tax on alcohol sales, for example, will raise no revenue – although it would help the hospitality sector to become more productive over time and thereby increase its own “taxable capacity”; while a 100 percent tax on alcohol sales would effectively confiscate their entire proceeds – equivalent to classifying alcoholic products as contraband and re-establishing the esteemed profession of Capone-style “bootlegging”. The miniscule tax “haul” would be far outweighed by the cost of collection!

The Hong Kong Experience

Tax is usually thought of as a necessary burden – but which may be avoided if you are clever enough or in receipt of expensive “advice”. But this view is negative and misconceived. It is based on the notion that owners of wealth earned by honest toil are understandably reluctant to see it pillaged by state profligacy. The Hong Kong experience demonstrates a positive model – that free markets, unhampered by regulatory excess, generate tax revenue so naturally that it is scarcely noticed, still less thought of as burdensome.

The alternative Hong Kong model

As its Financial Secretary from 1961 to 1971, Sir John James Cowperthwaite, guided Hong Kong to develop from one of the poorest places on earth to one of the wealthiest and most prosperous. What he called “positive non-interventionism” was the focus of his economic policy, which promoted free trade, low taxation, budget surpluses, limited state intervention and sound money – an approach that drew more from Adam Smith than Keynes.

He was a pragmatist rather than a theoretician, and he steadfastly refused to compile GDP statistics, arguing that such data was useless for guiding economic policy; and that it would simply encourage officials to meddle in the economy. Indeed, when asked to identify the key thing that poor countries could do to improve their growth, he replied: “They should abolish the office of national statistics!” He summed up his own economic philosophy in this down-to-earth reformulation of “Say’s Law”: “In this hard world we have to earn before we spend” – a truth than runs counter to everything we see being enacted now.

Low tax rates on land values

Cowperthwaite’s pragmatic approach is still abundantly evident. He observed that every infrastructural development that enhances community life, notably transport, causes the value of proximate sites to rise. Putting two-and-two together it was obvious that the surplus wealth created by those improvements effectively provides the natural fund for meeting their cost. Both Singapore and Hong Kong use low tax rates on land values, not state subsidies, to fund new highways and metro systems. It is possible for a tax system to create, rather than destroy, wealth!

Like Laffer’s insight, this is both simple and easily understood. Compare it with the intricate web of convoluted tax legislation in the UK which latest proposals can only make worse. No one has a clue on the optimum rate for maximising revenue when there are other taxes that reduce public finances because they disincentivise economic activity in other areas. This week’s round of tax rises will raise an estimated £12 billion a year. Yet this figure could be achieved with lower taxes instead.

Look at the record

Fanciful? Just note: in 2016 George Osborne cut the capital gains tax rate from 28 to 20 per cent. Yet its current yield is £11 billion compared with £3.8 billion in 2015. As noted by the indefatigable Matthew Lynne, when the penalty is lower people are prepared to cash in more gains, and the total amount raised goes up. Corporation tax was cut in 2011 from 28 per cent to 19 per cent – one of the lowest rates in the developed world. Yet over the last decade the tax haul has doubled from £31 billion to £62 billion.

What about VAT? Care homes are exempt from charging VAT, but they are not zero-rated. Therefore they cannot reclaim the VAT they have suffered on their inputs. The government is therefore raising hundreds of millions from the care sector at the very time it is struggling to find ways of paying for it! The insanity loop that “taxes” the income of public sector employees who are paid out of taxes is alive and well! As Lynne puts it: “Even by the surreal standards of the British tax system, this beyond bonkers.”

But from a “Conservative” government it is simply beneath contempt.