Saturday, February 2, 2019

Rates of tax tell us nothing about economic success

When Leigh Sales of 7.30 asked Scott Morrison what evidence he had to support his claim that the economy would be weaker under Labor because it would impose higher taxes, he replied “I think it’s just fundamental economics 101”. Sorry, don’t think so.

The belief that an increase in taxes must, of necessity, discourage work effort, saving and investing is regarded as a self-evident truth by the well-paid. Similarly with the converse: a decrease in taxes must, of necessity, encourage work effort, saving and investing.

But since no one particularly enjoys paying taxes – and some people really hate it – they would think that, wouldn’t they.

It’s a simple, all-purpose, no-need-to-explain argument against me being asked to pay more tax and in favour of me paying less. What’s not to like?

Just that it misrepresents what economics teaches.

It’s true that some economists emphasise the “deadweight loss” involved in imposing taxes. In principle, a tax distorts an individual’s choices, causing them to do things they otherwise wouldn’t.

This distortion of choices is said to be “economically inefficient”, in that it fails to produce the allocation of economic resources – land, labour and capital – that maximises the “utility” (satisfaction) the community derives.

The degree of allocative inefficiency differs for different taxes, with some said to involve greater deadweight loss than others.

By this logic, one of the worst taxes is conveyancing duty (which discourages people from moving house) and the best is a poll tax (everyone pays the same dollar amount each year which, being impossible to avoid, doesn’t change behaviour).

One thing often not mentioned in economics 101 is that tax on the unimproved value of land (such as council rates) and inheritance taxes score well.

But these calculations are based on theory and assumptions. The first of their limitations is that they ignore the benefits that flow when the taxes are spent. When they’re spent on government provision of “public goods” (goods or services that would be undersupplied if their provision was left to the private sector) they increase allocative efficiency.

You shouldn’t have to go beyond first year economics to learn that changes in the price of something have two effects: an “income effect” and a “substitution effect”.

People who believe an increase in income tax (which is a price) discourages work, and a cut in income tax encourages it, are focusing on the substitution effect and ignoring the income effect.

It’s true that a higher rate of income tax should discourage work by reducing the monetary benefit you get from it, relative to the benefit you get from not working. That is, from enjoying more “leisure”. It thus should encourage you to substitute leisure for work – that is, work less.

 By contrast, lowering the tax on work should encourage people to substitute work for leisure – work more.

Trouble is, the income effect works the opposite way. Increasing income tax reduces your after-tax income. If you don’t want your income to fall, you have to do more work, not less. Similarly, cutting income tax increases your after-tax income, encouraging you to work less.

The fact that the income effect and the substitution effect pull in opposite directions means economic theory can’t tell us whether or not tax increases discourage work. To answer that question you have seek out empirical evidence from the real world.

In doing so you’ll make up for theory’s implicit assumption that money is the only factor motivating people to work. If that’s what you think, you’ve got a lot to learn about human nature.

The empirical evidence says changes in the rate of income tax for “primary earners” – the main person a family relies on for income, who’s usually working full-time – aren’t great.

It’s only “secondary earners” - often women working part-time – whose hours of work are much influenced by increases or decreases in income tax.

This is pretty obvious when you think about it. The number of hours worked by full-time employees is set by their boss, whereas part-timers have some degree of control over the hours they work. Certainly, they decide whether they want to move from part-time to full-time.

Let me tell you: politicians’ motive for tax cuts is almost always more political than economic. If Morrison was really on about encouraging more work, his tax cuts would be aimed at working mothers, not the highly paid full-timers they are aimed at.

But there’s another empirical test of his confident assertion that high rates of tax discourage economic growth and low rates encourage it.

If that were true it should also be true that countries with high tax rates have low living standards, whereas countries with low tax rates have high living standards.

Try as they might, however, economists have never been able to find an inverse correlation between the level of taxes and a country’s rate of growth.

For a start, the poor countries have much lower rates of total taxation than the rich ones. Rich countries have high tax rates so they can enjoy the many benefits of being rich: the welfare state, good public infrastructure, good health care, good education and much else.

The Organisation for Economic Co-operation and Development regularly publishes figures for their 35 member-countries’ rates of total taxation (federal and state) as a percentage of gross domestic product.

Its latest figures, for 2017, show its rich-country members ranging from 46 per cent for France and Denmark to 23 per cent for Ireland. Sweden is on 44 per cent, Germany on 37.5 per cent.

The average for the whole OECD is 34 per cent, with us on about 28 per cent and the United States on 27 per cent (but with a much bigger budget deficit).

If they don’t tell you all that in economics 101, ask for your money back.