Posts Tagged ‘Policy Exchange’

25 Mar

While I do hate the Argument from Authority …

Posted by freethinkingeconomist in Economics. Tagged: , , , , .

… I wish to use it on the VAT argument.     Remember that what Policy Exchange put out on VAT was not something like this:

“Did you know that if income taxes were flat and the world was like the following thought experiment then VAT would not be any different from Income tax?”

Instead, from the FT story, which influences the world’s policy makers, we have:

Policy Exchange …  said modelling and academic research showed the idea established in the 1970s and 1980s that VAT was less damaging than income tax was no longer valid.  “We found that, contrary to what is widely assumed amongst journalists and politicians, increasing VAT would be more damaging to economic growth than increases in the basic rate of income tax,” the report concluded. … Politicians should consider restructuring taxes by raising the basic rate of income tax and cutting VAT, it said.

It is a claim that their paper proves this particular point, and as such needs to be taken seriously.  More seriously, I dare say, than a straightforward thought-experiment that clearly misses out essential features of how the tax system works.   The people behind this report are very bright and honourable; they know that they need to treat the world as it is.   Empirical data on how consumption taxes affect growth may help ….

I don’t like arguments from Authority, as you may be able to tell.  People with 20 years  in academia are capable of reaching very different conclusions. Such authority is no vaccine against having badly thought-out views, but merely a great anaesthetic against the stings of criticism that are their best antidote.

But in this case, I find that referring to what the OECD has found in cross-country regressions on tax rates is rather useful.  It is not just “politicians and journalists”, as the PX press release misleadingly implies, but serious economists too.   And the paper is a recent one, not from the 1970s or 1980s.

Here is the table that justifies their view that:

The results of the analysis suggest that income taxes are generally associated with lower economic growth than taxes on consumption and property … These findings suggest that a revenue-neutral growth-oriented tax reform would be to shift part of the revenue base towards recurrent property and consumption taxes and away from income taxes, especially corporate taxes. There is also evidence of a negative relationship between the progressivity of personal income taxes and growth.

The OECD’s findings are about how things work in practise.  Economics as a profession earns its lowest reputation when it is accused of taking a “that’s all very well in practise, but how does it work in theory?” approach.  If your theory produces results that are blatantly at odds to the findings, and go against a lot of conventional wisdom, perhaps the right thing to do is question the rather-too-neat theory.

On the question of a more theoretical approach, here is my second argument from Authority: Greg Mankiw, arguably one of the most influential economists around because of his widely read textbooks, and ex-advisor in Bush’s first term.  A supply sider – someone who cares for growth more than social justice, I should think:

From a strictly economic standpoint, a VAT is great. It is essentially a flat consumption tax, like the so-called FairTax, but implemented in a way to reduce compliance problems. Because it is collected in stages along the chain of production, rather than all at the retail level, tax evasion is more difficult. If you look at the economic effects, a VAT is similar to the Hall-Rabushka Flat Tax, which many economists love. … My bottom line: If I could replace our current tax system (including the personal income tax, corporate income tax, payroll tax, and estate tax) with a VAT, I would gladly do it.

That is from an anti-tax Republican.

Let me be clear: I am not blindly pro-VAT. I recognise the social injustice, and would and will argue for these to be mitigated should it rise again.   But defending it with oversimplified analogies, a blackbox model and mischaracterisations that go against the evidence has not, in my humble view, advanced the argument.

Now back to the Budget ….

24 Mar

VAT is not the same as income taxes

Posted by freethinkingeconomist in Economics. Tagged: , , .

One of the many thought provoking ideas put out in Policy Exchange’s latest report is that VAT is really no better than income tax; both simply reduce the value of your income, either by raising the prices of the things you want to buy (VAT), or taking income directly.

To quote directly:

“Suppose a worker earns £100 and pays £20 tax on it, and there is no VAT or other taxes. Then she has £80 to spend, and her £80 goes on goods with a real vale of £80 … Suppose now that income tax is abolished and instead a flat VAT of 25% is imposed.  Then she earns £100 and she uses it to buy goods with a real value of £80 on which a 25% tax is imposed, raising the price from £80 to £100.  So the real value of her consumption is again £80″.

I think this thinking is flawed, because it ignores how income tax is not flat, and has thresholds.  I have structured the problem around how much of an incentive a person has to do some extra work under two regimes: income tax only, or VAT only.   And the tax gained is meant to be the same – no cheating by not making it fiscally neutral.

The thinking is really simple.  I have arranged the thresholds so they roughly resemble ours in the UK. There is single product (“fun”) which is going to either cost $1 or some higher number if the tax chosen is VAT.  All consumption is spent, thereby avoiding the complexities that PX admirably look at in terms of savings/deferred consumption/etc.

In each scenario, a person has a choice whether to work for an extra $5000 or not.   For the Income Tax payer, it is easy to work out the value of working more.  Just take the marginal rate at their current rate of income. For the VAT-only guy, he is considering whether to take $5000, but with a higher price for a unit of FUN*.

As you might expect, the VAT system being flat beats the income tax system, particularly when the incomes are close to thresholds.  If you make incomes very very high, then the two approximate, because the VAT required to raise the same as an income tax tends towards the 40% rate.   If you programme all thresholds to zero, you get the PX thought experiment:

I have graphed how this advantage varies with the income:

but realise that this is a slightly unrealistic way of showing things.  In the real world, there are a range of incomes and work-leisure decisions, but only one VAT rate.   So if you assume you need an average VAT rate of 20%, and then look at individual work incentives, you get a chart like this:

This is more realistic, because the upper-rate earner faces a choice between his 40% tax rate, and the VAT rate required for the whole of society to pay the income tax. So for him the incentive advantage of changing the overall tax rate towards VAT is undoubtedly good (that flat line is around 38% when the VAT presumed to be needed is 20%).  Think it through: if you earned 40k, and the VAT rate for society was 20%, pushing prices up by 20%, you would be able to get $4166 of real goods for your extra $5k of work.  In zero-vat world, you would get $3000 after paying 40% on your marginal income.

If I were really clever, or had the time, I would try to model the entire work/leisure payoff, including benefits and tax credits.  Then you might be modelling an increase in VAT that could be used to fund a lower tapering of benefits/credits.  Since the people at the bottom of the earnings face such high withdrawal rates, I would again argue that the change would greatly improve work incentives.

Now I appreciate that I have been perhaps over-influenced by an OECD finding (June 2009 Economic Outlook) that the worst taxes for growth are corporate taxes, followed by personal income taxes, then consumption taxes, then taxes on immovable property.  I often criticize others for extending results gained during non-deflationary periods into today’s crisis; I agree with Robert Reich today that with corporate profits increasing and labour income stagnant, and big companies not knowing what to do with their cash, it is ‘absurd’ to call for a tax cut for big corporates to boost recovery. So I don’t intend to use this OECD result as ‘proof’ that a rise in VAT is better for the economy – no-one should be citing piles of pre-crisis results as proof of anything right now.

But I am unconvinced that this simple thought experiment proves how VAT is really just a disguised income tax**.  Sometimes the conventional wisdom is correct.

UPDATE:  I have put the scrappy little Excel sheet here, if you want to play with the numbers.

*Note: if total income is 20k, and VAT is 15%, the VAT raised is not 15% of 20k  = 3k.   If it raises the price by 15%, 100/115 fewer units are bought.   To raise £3k from the £20k you need to choose X so that X/(1+X)*20 = 3 ….)

**interestingly, Mark Wadsworth has elsewhere complained that it is a gross margins tax.  I have a radical idea.  Maybe it is a consumption tax.

10 Feb

The myth of the spending splurge

Posted by freethinkingeconomist in Economics. Tagged: , , .

This post is aimed very specifically at a particular characterisation of how government spending has ‘splurged’ since 2007.   It is sufficiently influential that it must have a profound effect upon the fiscal debate going forward – and it is superficially very appealing.  It goes like this:

“Before the recession, in 2005/6, government spending was already 41% of GDP.  Then, the crisis hit.  The Labour government lost all common sense and resurrected Keynesianism.  This meant a spending splurge – as their own figures show (tables B13 and B14), spending leapt from 43% to 48 or 49% over the crisis.   Cash spending went up from £627bn to £706bn in two years.  If that ain’t a splurge, what is? So, the government used the cover of a crisis to relaunch defunct economic policies and takeover the economy, to the detriment of our long term prosperity. “

If you attended as many events with right-leaning speakers as I do, you would have to listen to this sort of narrative a lot.  And it is difficult to refute.  Cash spending has risen.  The government spend is a higher ratio of GDP.  It is true.

But at the same time it uses a methodology that is incredibly misleading, in terms of the stimulative effect presumed, and the extent to which fresh government spending happened.  Bear in mind several facts:

  • Businesses and households plan forwards. And they do so in terms of nominal cash. When a large business makes investment decisions, it shoves out many spreadsheets, all of which try to anticipate how much cash spending there will be for its products and savings.  Similarly, you and I, when planning whether to, say, buy a car or house or holiday, make estimations of our future cash income, and what it can buy.   We may compare it to our assets and our debts – so if our house price is falling, and our mortgage debt steady, we may pull in our horns.  So too for businesses.
  • But what we do not do is make our plans based on what proportion of GDP our spending is.  If GDP expectations fall massively from £1.5trn to £1.2trn, , so that my £1500 holiday has leapt from being 1 billionth of GDP to 1.25 billionths, I do not think I am spending more.
  • More to the point, if a business is expecting to get paid £150 million for a piece of work, and GDP expectations fall as above, the business does not go around thinking “Great! I was going to be paid one ten-thousandth of GDP for this, now I will get 1.25 ten-thousandths of GDP!  Party ON!
  • More to the point again: if one set of people – say, 10,000 teachers – were expecting to be paid £300m, and were basing their consumption decisions around that, the fall in GDP would not make them think they were getting more money, just because it represented a bigger chunk of GDP.
  • People’s current expectations of what their future incomes will be – the sum total being the economy’s expectations of forward Nominal GDP – play a dominating role in determining CURRENT spending. About a million hat-tips: Scott Sumner.  It is funny how easily the Right recognises this fact when trying to use Ricardian equivalence to disprove the ability of government to achieve anything with changes in its stance.
  • In 2007, the government was forecasting spending in 2010-11 of £678bn. Table B11.  So the latest forecast spend is £30bn higher.  About £12bn is in higher debt interest; about £15bn in tax credits and social security.   There has been no remarkable increase in actual public works. The ‘stimulus’ for what it is worth was on the revenue side: failing to tax spending as much as before, for 13 months.

So putting these all together, what do we get?

  • The boost in spending/GDP almost entirely reflects future GDP falling.  This does not stimulate ANYONE!   In particular, none of the sudden increase in that ratio would have fed into some businesses and people revising upwards their previous expectations of income derived from the government – or indirectly from it.
  • The cash increase that DID happen was hardly stimulatory.   Out of work people got more benefits than expected, and our creditors got paid interest.
  • Attempting NOT to do these spending increases would have immediately lowered expectations of future GDP, which as they had stood would have anticipated the increase from 2007-8 of £589bn to £678bn in 2010-11 in their CURRENT plans.  (This ~4.8% p.a increase was originally expected to match the rise in NGDP, incidentally)
  • Since the financial sector was ****ed, the lower expectations of government-derived income would not have been substituted with expectations of other incomes derived from private sources
  • As a result, businesses and households that were expecting incomes of a certain size (whether directly or indirectly from the government) would have had to drastically lowered their expectations of future NGDP, which would have lowered their current nominal spending plans, which would have lowered current GDP.

This is blindingly obvious: if the government had (madly) targeted the level of spending as a proportion of GDP during a nominal GDP slump, then all it would have done is made GDP slump even more.  Even if it had done this at the same time as cutting taxes, because tax cuts would have gone towards groups with a lower marginal propensity to consume, particularly given the collapsing asset markets, than the recipients of government benefits and incomes.

Don’t be fooled by ratios.  Yes, we need to get spending down as a ratio of GDP.  yes, Brown spent too much, relying on mirage revenues.  But what happened over 2007-10 is not the splurge, and using spending as a ratio of GDP is, for such situations, a lousy metric for understanding macroeconomic relationships.

UPDATE: if you want robust confirmation of this view point, read Martin Wolf today. Read him anyway.

What would happen if governments also slashed their spending? In an economy without monetary or exchange-rate offsets to austerity, any reduction in spending is likely to lead to at least an equivalent short-run reduction in output (a “multiplier” of one). An attempt to cut a fiscal deficit by 10 per cent of GDP, via cuts in spending, would require an actual reduction of 15 per cent of GDP, once one allows for falling fiscal revenue. GDP would also shrink 15 per cent. As Desmond Lachman of the American Enterprise Institute pointed out in FT.com’s Economists’ Forum, the decline could be even larger.

Some of you wiseguys may retort that we DO have monetary and exchange rate offsets.  But where is the evidence that (a) they work for the real economy at this point and (b) that even if the ER did fall, exporters would increase volumes?  As Conway points out, and I did in Slash and Grow, they may just increase margins.

25 Nov

Not sure what Policy Exchange are adding here . . .

Posted by freethinkingeconomist in Economics. Tagged: , , , , , .

. . . though that will not stop the Telegraph following it, slavishly.

I’m afraid I’ve only skimmed Policy Exchange’s latest attempt to convince us that government spending really doesn’t have any useful economic effects. The theory section on page 25-27 seems to imply that:

  • insufficient demand is never a problem unless financial markets are broken
  • Ricardian equivalence is a proven fact that stops public spending working, ever, in normal conditions
  • very little needs to be said of the zero bound constraint on monetary policy.

Given all these, and the evident bias, it is difficult to expect much from the voluminous history-description that follows, in terms of the endless macroeconomic debate about the efficacy of fiscal stimulus.   Since they start with bad theory, there is likely to be some bad history. Moreover, the point about macroeconomic analysis, surely, is that it is fairly context-specific.  Asking what happens on average is pointless if there is a crucial difference to this situation. The rule “Don’t throw buckets of water over people’s heads” is a pretty good one, on average.  But not “if their hair is on fire”.  Ditto “cutting back on public spending boosts growth on average” and “but not if we are threatened with deflation and the banking channel is f***ed”.

So in how many of the situations they examined were the interest rates needed minus 6%? Oh, none?  Thought so.

This is really 101, and over the Atlantic, where the debate is really raging, pretty standard stuff. So I am not tempted to use a couple of hours reading it.  To snark at just one bit of the theory section:

households will understand that if the government borrows extra today, it will have to raise taxes tomorrow to pay off that borrowing. In anticipation of those extra taxes tomorrow, households will save extra today

NO. (a) Households do not anticipate like this. If so, why did they spend so much when Brown was borrowing too much earlier? They would be magic-balancing-creatures, forever calibrating their consumption for long run fiscal equilibrium (b) when the economy is far below capacity, government spending can provide INCOMES that enable people to spend and save.  As has been endlessly pointed out, since the beginning of time.  Imagine an economy where 30% are unemployed.  The government comes along and promises to do some spending – build some homes, say.  Do the people with their incomes from this get all worried and not spend it, because of the taxes that might arise in 10 years’ time? No.

And this is a terrible explanation for why Keynesians think as they do:

it is precisely the denial that Ricardian equivalence applies in such cases that motivates the belief in Keynesian stimulus can work

No.  A belief is not motivated by a denial.  Keynesian stimulus is motivated by a combination of commonsense and inspiration about how economies operate in deflationary, sub-capacity situations.  This sentence is the logical equivalent of “my belief in gravity is motivated by a denial of the existence of levitating elves”.

It is deeply tedious to keep bringing this up, so once more I refer to the far more vicious blogs of American geniuses similarly frustrated.  In his musings on an intellectual train wreck, Brad De Long writes:

There is nothing illogical or inconsistent about the economy being in a state in which aggregate planned expenditure is greater or less than income. Today’s Chicago school would know this, had it not forgotten all of monetary economics from David Hume on.

Policy Exchange seem keen to join the Chicago School. What I can’t understand is the determination to have the SAME economic policy regardless of circumstances.  Facts. Change.  In 1-2 years’ time, I too will clamour for fiscal restraint.  LIke Martin Wolf, I want a plan, but just not to have it implemented until it is safe.  Now let’s move on*.

If there is a redeeming feature to this dip into pre-Keynesianism, it is that they seem to have done some work on the political problems of spending cuts.  But in many ways, what is far more interesting than “Policy Exchange don’t like fiscal stimulus” is “Mervyn King won’t ALLOW fiscal stimulus” – which is what he effectively said yesterday.  Who is in charge of fiscal policy?  The Bank.  We need an Independence of the Government bill soon.

Other news: Vince has fleshed out the National Infrastructure Bank idea.

I thought Charles Dumas’ letter to the FT was excellent:

the idea that the UK (and presumably the US) should have run fiscal surpluses in 2004-07, “saving up for the next crisis”, neglects the fact that a balanced overall policy to promote full employment and low inflation would have then entailed lower interest rates (and probably exchange rates) than we had. An even more extravagant housing boom would have resulted, with greater upward distortions in house prices and consumer debt than the “fools’ paradise” (Dr Weale’s words) that actually occurred.

The FT has a useful breakdown and scoring of the Government’s many small financial interventions.

Finally, for light relief, Don Paskini STILL thinks that asking people questions about how to fix the financial crisis is in any way relevant. The Don still thinks that democracy fixes problems.  Quite apart from some of the ideas being really bad (CAP interest rates = Welcome Loan Sharks), and others really tired (“Educate in Financial literacy” is up there with “Spend more efficiently” and “no more wars”), and everything optimistic-statist (yes, a ‘charter for responsible lending’ should fix the mess), you have to ask: why are we asking citizens, as if this is all a political matter?  Why does putting “citizens” in front of something make it suddenly wise and efficient?

I want the centre-left to do well.  This sort of platitudinous talk-to-ourselves is going to go precisely nowhere – but make the participants feel important for a few minutes.

*(not moving on) If you want further, confusing but brilliant reasoning for how investment now can determine saving later, this blog of Andy Harless is wonderful. It proceeds with this assumption: all income is instantly saved.  You then have a decision how much to dissave – the residual is saving.  The dissaving is what gives someone else an income to save.

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