Economic Theory

There are few things in positive economics that are settled – except that there are few things that are settled

Mariana Mazzucato is a well-known Professor of the Economics of Innovation at the University of Sussex. She advises the Labour Party and can be seen here, close to Dilma Rousseff, after having been commissioned to advise the Brazilian government. Unfortunately, Dilma Rousseff is going the way of many other South American government leaders. She is not only facing impeachment proceedings, but has appointed a former president to a cabinet position purely to give him criminal immunity. But, that is no reason for well-known economists not giving them advice. Even bad presidents need good advice and let’s hope that advice from the UK helps rather than hinders her. Mother Theresa and Milton Friedman were famously happy to talk to anybody who would listen, however evil, in the optimistic hope that their mind could be changed.

But, after hearing Mazzucato on Newsnight on Budget night, I would have to question the advice she might give on empirical matters. This is what she said: “There is no evidence – no empirical evidence – that cutting capital gains tax or cutting corporate income tax will increase business investment”. This was not a slip of the tongue because she then tried to reinforce her point by immediately talking over and interrupting the following speaker though exactly what she said at that point is inaudible.

On the face of it, this is a very strong claim. The idea that there could be no evidence that a tax cut would lead to greater investment is quite implausible. Unsurprisingly, it is not true. For example, Djankov et al (2008) found quite a different result:

We present cross-country evidence that effective corporate tax rates have a large and significant adverse effect on corporate investment and entrepreneurship. This effect is robust if we control for other tax rates, including personal income taxes and the VAT and sales tax, for measures of administrative burdens, tax compliance, property rights protection, regulations, economic development, openness to foreign trade, seignorage, and inflation. Higher effective corporate income taxes are also associated with lower investment in manufacturing but not in services, a larger unofficial economy, and greater reliance on debt as opposed to equity finance. In these new data, corporate taxes matter a lot, and in ways consistent with basic economic theory.”

This is strong stuff.

Ah, you might say, only a small proportion of UK activity is in manufacturing and they did not find evidence for increased investment in services. However, there is a reason for that result. An increase in corporate taxes leads to a shift into the informal (shadow) economy and most of that activity is services. This paper has been published by the NBER and a different version in a peer-reviewed academic journal.

Another study, this time relating to innovation rather than investment, finds:

“We exploit staggered changes in state-level corporate tax rates to show that an increase in taxes reduces future innovation…The effect we document is consistent across the innovation spectrum: taxes affect not only patenting and R&D investment but also new product introductions, which we measure using textual analysis. In the cross-section, we document that the tax effect is stronger among firms that face higher marginal tax rates…”

Of course, investment is not everything. The productivity of investment is perhaps more important. Tax systems that encourage wasteful investment reduce consumption today without increasing it (sufficiently) tomorrow. The UK’s total factor productivity record is around average. It was much better in the years after the Lawson corporation tax reforms which reduced incentives for wasteful investment and reduced headline rates. Total factor productivity growth has been especially high in low corporation tax Ireland and has slumped in the high corporation tax US (a model that Mazzucato suggested on Newsnight that we copy).

This debate (and it is a debate – the science is not “settled”, still less in the direction Mazzucato claims) raises interesting issues about ethics in professional life. The statement Mazzucato made was definitive and very precise. But, in positive economics, nearly everything is arguable except for the fact that nearly everything is arguable. Mazzucato left the impression that her claim was simply not disputable, still less that there is a huge amount of evidence that points in the other direction.

Let us imagine that a doctor was on Newsnight who said: “there is no empirical evidence that sugar consumption causes diabetes”. Quite rightly, he would have been pilloried. Yet the effects of claiming definitely the absence of a causal relationship in economics when such a relationship is present can have just as serious effect on policy and ultimately on society. Economists and academics do not have a professional body to which they must answer and to which they swear oaths and make promises. However, perhaps they should be more careful when making their claims. Certainly, my own professional body, the Institute of Actuaries, would expect that when I make public statements about issues that are in doubt.

It is true that it is easy to not quite say the right thing when on TV. If Professor Mazzucato really meant that she believed that the empirical evidence did not show, on balance, that lower taxes lead to higher investment and that she thought the mass of evidence that does suggest a relationship was, in some way, not persuasive, that is a proposition with which I can respectfully disagree. However, I struggle to see how anybody can argue that there is no empirical evidence for the link.

Those on the left would do well to copy Hayek’s professional humility when he said: “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design”. We should also have the humility (and courage) to admit when we think that the empirical evidence runs against our prior views or, at least, admit to the enormous areas of economics where the evidence cannot settle debates definitively.

Prof Philip Booth is the IEA’s Academic and Research Director, and Professor of Finance, Public Policy and Ethics at St. Mary’s University, Twickenham.

Academic and Research Director, IEA

Philip Booth is Senior Academic Fellow at the Institute of Economic Affairs. He is also Director of the Vinson Centre and Professor of Economics at the University of Buckingham and Professor of Finance, Public Policy and Ethics at St. Mary’s University, Twickenham. He also holds the position of (interim) Director of Catholic Mission at St. Mary’s having previously been Director of Research and Public Engagement and Dean of the Faculty of Education, Humanities and Social Sciences. From 2002-2016, Philip was Academic and Research Director (previously, Editorial and Programme Director) at the IEA. From 2002-2015 he was Professor of Insurance and Risk Management at Cass Business School. He is a Senior Research Fellow in the Centre for Federal Studies at the University of Kent and Adjunct Professor in the School of Law, University of Notre Dame, Australia. Previously, Philip Booth worked for the Bank of England as an adviser on financial stability issues and he was also Associate Dean of Cass Business School and held various other academic positions at City University. He has written widely, including a number of books, on investment, finance, social insurance and pensions as well as on the relationship between Catholic social teaching and economics. He is Deputy Editor of Economic Affairs. Philip is a Fellow of the Royal Statistical Society, a Fellow of the Institute of Actuaries and an honorary member of the Society of Actuaries of Poland. He has previously worked in the investment department of Axa Equity and Law and was been involved in a number of projects to help develop actuarial professions and actuarial, finance and investment professional teaching programmes in Central and Eastern Europe. Philip has a BA in Economics from the University of Durham and a PhD from City University.

2 thoughts on “There are few things in positive economics that are settled – except that there are few things that are settled”

  1. Posted 22/03/2016 at 21:30 | Permalink

    Excellent analysis. I wish there was more of this reported on by mainstream business journalists

  2. Posted 23/03/2016 at 13:23 | Permalink

    Part of the problem is that the media both select those guests who are willing to take the most extreme position, and push it most strongly, and that individuals (responding to this) are inclined to over-state their case so as to get the publicity.

    It is also true that, in a five minute debate in front of a generalist audience, nuance is not conducive to winning the audience over.

    Nonetheless, professional integrity demands that one at least acknowledge the existence of contradictory evidence.

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