The Guardian discovers the Laffer Curve

Interesting piece here which manages to miss an important point.

Here\’s the Nerdonomics answer: if your hourly wages are raised from £5 to £6, say neoclassical economists, you face two effects: the substitution effect and the income effect.

In the first case, a good angel on your shoulder, steeped in Phillips\’s work ethic, says: \”You\’re being paid more per hour, so it\’s worth doing an extra couple of hours\’ work since that work will be better rewarded than under your old contract.\” That\’s the substitution effect based on the idea that the opportunity cost of leisure has increased by a pound per hour: you\’re losing £6 by not working, instead of £5, so you substitute into work.

But the little devil on your other shoulder says: \”Yes, maybe, but you\’ve always been happy enough with your old wage. Why not ease off the accelerator, cut your hours back to give yourself the same wage but with less work?\” That\’s the income effect. You gain leisure and lose no money. You\’re feckless and idle and probably spend the extra couple of hours a week down the pub.

Absolutely true but missing the larger point I fear. For what we\’ve done here is just rediscover the Laffer Curve from first principles. The Laffer Curve describing the interplay of the substitution and income effects. So that we can have a tax rate (a low one) where the substitution effect will predominate and a tax rate (a high one) where the income effect will predominate.

Amazing how often people rediscover the things they\’d be horrified to admit they believe, isn\’t it?

2 comments on “The Guardian discovers the Laffer Curve

  1. Doesn’t the substition effect alone do it? Even if tax rises always led to reduced work, the tax take would rise as taxes increased from low levels, then fall as they continue to increase.

    You get a Laffer curve even with a constant elasticity of substitution – and no income effect.

    The Laffer Curve arises (I always thought) from the interplay between pre-tax income falling in a non-linear fashion with higher taxes, but the percentage taken rising linearly.

    Or to put it most simply:
    – at a tax rate of 0% the tax take is obviously zero
    – at a tax rate of 100% the tax take is obviously zero
    – at at least one point in between, the tax take is obviously positive

    So the tax take must rise then fall, as tax rates rise.
    Q.E.D.

  2. Ah yes, paying people more and finding they do even less, I can understand that.

    Surely the answer to it is pay a low living wage and top it up with bonuses.

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