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

David B Smith

Shadow Monetary Policy Committee

David B. Smith studied at Trinity College, Cambridge and the University of Essex. His subsequently career was mainly spent in the financial sector, commencing with the Bank of England, thereafter in clearing banks and securities houses. David B Smith is a Visiting Professor at the Derby Business School, has been a member of the SMPC since its inception in July 1997 and its Chairman since 2003. He maintains his own macroeconomic forecasting model at Beacon Economic Forecasting and has published numerous articles on monetary policy and the effects of public spending and taxes on economic performance, amongst other subjects. He has been a regular interviewee on radio and television since the early 1980s.

4 thoughts on “The British economy is on the wrong side of the Laffer curve”

  1. Posted 16/03/2011 at 14:43 | Permalink

    If “wrong side” means “past the revenue maximising point” then you may be right, we must be pretty near the revenue maximising point – certainly as far as welfare claimants and tax credit claimants are concerned who face marginal tax rates of 70% – 100% (in other words, making means less testing less savage would REDUCE the cost of welfare to the taxpayer without making claimants worse off).

    If “wrong side” means “at a level where overall GDP is depressed below its tax-free level” then you are certainly right, because even a flat tax of 10% depresses GDP by 5% or 10%.

    The only tax which doesn’t have these deadweights costs is of course Land Value Tax.

  2. Posted 17/03/2011 at 09:00 | Permalink

    Very sad that we have reached this point, and under a Conservative goverrnment.

    Not just a Conservative government but one that promised to cut the deficit through downsizing government.

    Now they look for growth, but growth from where? They wish to spend money, to revitalise the private sector whilst at the same time sustaining a growing public sector, which will have to be found somewhere. Perhaps there is a cunning plan……..

  3. Posted 19/03/2011 at 07:38 | Permalink

    The Cameroids plan is actually quite simple and is simply a cynical ploy to appear tough to both sides; guardians of public sector spending amongst the highest paid civil servants and axe-wielding warriors to the turnip Taliban and Colonel Blimps of the Tory Party faithful.

    I even have a clever acronym for this plan: Declining Rate Of State Sanctioned Theft Re-Appropriation Programme, or DROSSTRAP for short; borrowing more (i.e. Deferring taxation) but at a slower rate relative to percentage GDP with a view to ultimately reducing spending as a proportion of GDP.

    It’s Thatcherism by the backdoor, only the hope is to cut spending rather than just hold it back or grant concessions in other areas that the Civil Dis-service can abuse; problem is if we are on the long side of the Laffer curve then growth is already depressed and the cuts are not bloody enough to stop growth being overtaken by inflation or wage hikes in the public sector.

    Should’ve abandoned this strategy before it started, annexed the Bank of England and re-appropriated it’s interest raising powers and brought back up slowly to what markets wanted. Simultaneously reforming major civil bodies into funding bodies (education vouchers, healthcare etc.) and letting the markets do the rest, killing leviathan in the process.

    We are reduced to a gamble on long odds that the public sector is fighting all the way to a New NuLabour victory for want of an actual conservative party.

    God help us all.

  4. Posted 01/08/2011 at 21:21 | Permalink

Comments are closed.