The British economy is on the wrong side of the Laffer curve
With total non-oil taxes equivalent to more than 78% of residual private-sector GDP measured at factor cost once government spending has been subtracted, the British economy is probably now on the wrong side of the aggregate Laffer curve. This means any attempt by the Chancellor to tax his way out of the fiscal deficit is: 1) probably doomed to failure; and 2) likely to produce a downwards spiral in private activity and the tax base.
However, economies are complex, dynamic systems with many feedbacks. This means it is necessary to look at the evidence from macro-economic forecasting models. This takes one straight into the territory of the OBR. The 2006 IEA monograph, Living with Leviathan, included the following 1993 quotation from the University of Warwick macro-economic modelling bureau:
‘In order to analyse the impact of the various fiscal policy instruments it is essential to consider both direct and indirect effects. For example, the direct effects of tax changes on government finances can be quantified through an assessment of the size of the tax base to which the tax change is to be applied, andthese calculations may measure the short-run impact on government revenue quite well. However, over a period beyond the first few months following the tax change, the indirect effects through the operation of the economy as a whole come to dominate. Simulations of models of the macro-economy are the only method of quantifying the size and time profile of these indirect effects.’
This insight is crucial, given the fiscal adjustment that the nation now faces. The easiest course from a political-economy perspective may be to appease the spending lobbies while surreptitiously raising the tax burden on the rest of the community. The front-end loading of the VAT hike, and the rear-end loading of the spending cuts, suggests that the coalition government may have embarked on this course.
However, a simulation of the effects of the VAT hike on the Beacon Economic Forecasting model suggests that the 20% VAT rate will have destroyed output and jobs and exacerbated the budget deficit by some ¼ to ½ a percentage point of GDP. This implies that the VAT hike at the start of 2011 was a serious ‘own goal’. This mistake could have been averted if the government had: 1) paid attention to the existing macro-economic modelling evidence; or 2) had asked the OBR to do an equivalent run on the HM Treasury model. There is a danger that the OBR will always end up advocating higher taxes as the solution to the deficit problem because their methodology does not properly allow for the crucial second-round effects of tax- and deficit-financed government spending on private sector output and employment, not because of any conscious ideological bias.
The resulting undue complacency about the effects of big government contrasts sharply with the rule-of-thumb, which emerges from thirty-five years of international studies, that adding 1 percentage point to the government consumption ratio reduces the growth rate of real national output per head by 0.15 percentage points. The 8.4 percentage point rise in the British government spending ratio between 1996-2000 and 2006-2010, a comparison that smoothes out the recent recession, would correspondingly be expected to reduce growth by 1¼ percentage points. The implication is that the UK’s sustainable growth rate may now only be some 1½%. Against this background, the government’s main priority should be the nurturing of the private sector’s supply side, if for no other reason than the selfish one that this constitutes the tax base.
Indeed, there are clearly ‘free-lunch’ gains to be achieved by cutting high marginal rates wherever these are beyond the revenue maximising point. The policy aim should be to trigger off a virtuous self-reinforcing circle of increased output, higher tax receipts, further supply-side friendly tax cuts etc. which bootstrap the economy on to a new permanently higher growth path.
David B. Smith is author of the IEA’s latest Discussion Paper, Restructuring the UK Tax System: Some Dynamic Considerations, released today