Thursday, September 30, 2010

Open letter to Roger Helmer: Laffer is bunk; tax competition is harmful

Recently a British Conservative politician wrote an open letter to TJN's director John Christensen, arguing that tax competition between states is a good thing, and that he seems to have ignored the so-called Laffer Curve (see picture). Christensen's reply is below.

30th September 2010

To Roger Helmer
From John Christensen

Dear Roger

Thanks for your letter extolling tax competition: do you think that cutting VAT rates would stimulate growth, or is it only taxes on capital that concern you? I have noticed a tendency for politicians to push for tax cuts for some (those rich enough to provide party funding) while being all too happy to increase taxes on poor people (who foolishly don't fund politicians and their parties). Why are some tax cuts competitive but others not? I only ask because raising VAT - a regressive tax which will only make British society even more unequal - was among the first measures your party took on assuming government.

I would hope that any university lecturer promoting the Laffer Curve to first year undergraduates would be quickly called to task. Embarrassingly for it proponents, empirical evidence for its existence remains elusive, and most accept that it is shifty, which limits its policy application. You might like to consult Martin Wolf:

"the theory that cuts would pay for themselves has proved altogether wrong.:

or Greg Mankiw, chairman of the Council of Economic Advisers under George W. Bush no less, who described supporters of the idea to be "charlatans and cranks."

For a more entertaining and thorough read, you might like to try this.

"The Laffer Curve became the supply-siders' Sermon on the Mount, the core of their faith. For Cheney, it was "a revelation, for it presented in a simple, easily digestible form the messianic power of tax cuts", Chait notes. "In that sloping parabola was the magical promise of that elusive politician's nirvana, a cost-free path to prosperity: lower taxes, higher revenues."

No wonder it is so popular among Conservatives who want to be tax-cutters and deficit-cutters! The trick, as one of its leading early proponents (also a big fan of extra-sensory perception, or ESP) liked to say, is that "you've got to have faith." Empirical evidence is everywhere. Just take one example. From 1947 to 1973, the US economy grew by 4 per cent a year - while the richest Americans paid a 91 per cent top rate of tax. Tax revenues soared.

Now on the subject of tax competition, I am sure that you will appreciate we receive many enquiries about it -- so we have prepared a web page primer to which I refer you. You might also take a look at this briefing paper and this newsletter on the theme of tax competition, both published in 2006.

Many people fall into the trap of lazily conflating tax "competition" between jurisdictions, on the one hand, with real competition between firms in a market. The notion that these two kinds of competition are comparable is simply nonsense. Although they (unfortunately) share the same word, the processes involved are wholly, entirely different.

I would draw your attention to two matters in particular: first, using subsidies such as tax holidays, special exemptions, accelerated depreciation rates, etc, to attract inwards investment creates economic distortions that undermine the entire intellectual basis of comparative advantage. Instead of investing where productivity is highest, investors head towards wherever they can wrangle the best fiscal incentives. Tax Justice Network is not alone in questioning the value of such subsidies: the IMF and OECD have also called them into question. I would particularly draw your attention to this IMF report on the impact of tax competition on Sub-Saharan African countries, which raises a number of important questions.

Second, the beggar-my-neighbour tax policies of places like Switzerland and Jersey does not attract investment in the normal sense of that term. Locating a headquarter offshore is entirely artificial and does not contribute one iota to economic efficiency: quite the opposite. Multinational companies use tax havens for profits-shifting and tax avoidance. Small and medium sized companies which are not multinational in their operations can not. The outcome is a massive economic distortion which reduces competition, allows free-riding on public goods and leads to misallocation of capital. I am surprised that you do not address this issue, which was outlined in the OECD’s 1998 Report on Harmful Tax Competition.

As an aside, I would note that economists are generally weak on the free-riding issue. Perhaps this is because it presents us with modelling issues (no data and all that). But we know it happens. We know it leads to inefficient resource allocation. And we know that corporate tax avoidance is a massive exercise in free-riding on public goods. Why do you politicians tolerate it? When the UK tax gap is running at such astronomical levels, the failure to crack down on corporate tax avoidance (which is just another form of evading taxes) strikes me as unacceptable.

Which leads to a final comment. Way, way back, it might have been arguable that high marginal tax rates spurred tax evasion. But not now. Marginal rates have tumbled on all forms of income, but tax evasion and avoidance has risen in scale. Just take a look at the volume of personal assets held in secrecy jurisdictions for tax evasion purposes. Your arguments just don't stack up: tax evasion is endemic in Britain not because of high rates but because too many greedy and self-absorbed people don't give a damn about Big Society.

Economic theory has moved on a bit since Laffer scribbled out his notions on a hotel napkin in the 1980s. I hope you find this more recent reading illuminating.

Best wishes

John

2 Comments:

Blogger Kenneth said...

Sir,

This letter fails on two popular, yet incorrect, conceptions of the Laffer curve:

1) The Laffer curve is not concerned with tax competition, and
2) The Laffer curve is not an instrument by which tax cuts "pay for themselves".

The Laffer curve is an inherently real thing. The Laffer curve is a tool by which the amount of taxation paid to the government can be maximised.

A simple analogy please. If a firm manufactures paper clips it must then determine the price at which it will sell the most amount in order to maximize revenue. If the sales price per paper clip is £0, revenue will be zero. If the sales price per paper clip is £100, revenue will also be zero.

If the Laffer curve was applied in our little, imperfect example, it would assist in determining the optimal price by which the most paper clips could be sold and thus maximise revenues for the firm.

Same idea as it relates to taxation. At 0% rates the amount of taxes raised by government would be zero. At 100% rates the amount of taxes raised would be zero. The point at which most individuals will pay tax lay somewhere in between, if one agrees, one acknowledges the existence of the Laffer curve.

Do note, the Laffer curve is not related to the spending side of things.

5:33 am  
Anonymous TJN said...

Kenneth,

Thankyou for those points. We disagree with you, of course. The paperclip example you give is very similar to what was described by Arthur Laffer to Dick Cheney on a hotel napkin in the 1980s as he explained the simplicity of the Laffer curve. Indeed, the theory is a beautifully elegant one. but it remains just that - a theory, that requires a lot of faith to sustain.

You say that there is a popular misconception: "The Laffer curve is not an instrument by which tax cuts "pay for themselves"

Indeed, that is a popular misconception (they don't pay for themselves, even in the long run), but that is precisely what Mr. Helmer said:

"In dozens of countries, over many decades, it's been demonstrated that lower tax rates will (counter-intuitively) actually raise total revenues."
http://conservativehome.blogs.com/centreright/2010/09/tax-competition-between-states-is-good.html

Moreover, it has been comprehensively demonstrated that -- while a 10% rise in tax rates, say, won't necessarily lead to a 10% rise in revenues -- the notion that the Laffer curve is a basis for serious policy-making is simply wrong. Please scroll back up to our blog, and the associated links, to see some examples of why.

And as regards the Laffer curve not being concerned with tax competition - well, the theory is very much tied up with tax competition. The theory. But if the theory itself doesn't hold water, then we haven't got very far.

2:32 am  

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