Collecting *All* The Tax Would Make Us Poorer

So here\’s an interesting little idea.

Yes, we\’ve a new report out from our retired accountant from Wandsworth today. About the huge amounts of tax revenue that are lost to governments as a result of the grey economy….the legal activities but illegal because they\’re not paying tax, not the black economy which is illegal activities whether they pay tax or not….

And now we need to introduce Richard to the most important part of neo-classical economics: marginalism.

Forget all about the rest of neo-classical econ for a moment: rational agents, blah blah blah, and think on just this idea that things happen at the margin. The arrival of neo-classical economics was after all called the Marginalist Revolution.

Now while we\’re thinking about this we can see that it\’s obviously true. For example, we know absolutely that the first beer is worth more to the consumer than the 38 th of the day. We also know that it works the other way, with costs as well. Cleaning up the first 10% of pollution is simple (just tell people to shit in holes) while cleaning up the last 1% of pollution is impossible (things just will turn to dust, whatever you try and do about it).

Excellent, these same thoughts can be turned to taxation. Getting the first bit of tax revenue is simple. There really are law abiding people out there who just love to give money to the State. Last time I looked there were actually 5, four of whom were dead, who sent extra cheques to the Treasury. Getting the last bit of tax revenue is harder: there are always accountants out there who perform income splitting, dodge employers\’ NI by paying low salaries plus taking dividends, even those who blatantly refuse to pay business rates on the spurious grounds that they don\’t actually owe them.

And there is one more concept that we need to introduce: the deadweight costs of taxation (good paper here). Deadweight costs are that economic activity which does not occur because we\’ve imposed the tax.

The concept is obvious: we deliberately impose taxes on fags so as to reduce the number of fags smoked. The same is true of just about every other tax (except LVT!). Tax something and you get less of it.

Excellent, so, now let us put together our marginal idea, our marginal costs idea, with deadweight costs of taxation.

As tax rates get higher we would expect those deadweight costs to rise. (See paper already mentioned.) We would also expect those activities which currently dodge taxes to be more sensitive to such deadweight costs than those that do not so dodge. This again is obvious: people are taking risks in dodging so the economic activity they are undertaking must be more sensitive to deadweight costs than activities where people happily pay up.

So, we\’ve deadweight costs (read paper!) estimated at anything from 8% of revenue raised to 50% and more of it. Depends upon the tax, the activity, whether we\’re talking about average or marginal etc. And for the reasons that we\’ve already discussed we\’d expect our currently tax dodging activities to be at the higher end of this spectrum (which actually goes rather higher than 50%).

So, what does this mean? It means that, assuming the logical and empirical chain of reasoning above is correct, that there\’s a level of grey economy, of illegally untaxed activity which we should simply put up with. For to insist upon taxing it would make us all poorer.

For, from Ritchie\’s paper, we can see that the average tax as percentage of GDP in European countries is 38.9%. Let us imagine that the sensitivity of currently untaxed activities to taxation is 40%. So, we go off and collect, on the next £10 billion of economic activity, our 38.9%. We get £3.89 billion in tax revenue.

Well, actually, no we don\’t. For by taxing it we\’ve reduced that economic activity by 40%. So, when taxed, there\’s only £6 billion in activity. We actually get £2.33 billion in revenue. But economic activity has fallen by £4 billion.

We\’re poorer overall.

We\’d be better off just not worrying about what those criminal bastards, the tax dodgers, are doing over there in hte last 10-15% of the economy. We\’re made richer by ignoring it.

Which is where our retired accountant goes wrong: he just doesn\’t, ever, bother with the economics of things.

NB. I do not say that the sensitivity of the next £10 billion of the grey economy is 40%. But only that there will come a point when it is.

24 comments on “Collecting *All* The Tax Would Make Us Poorer

  1. Oh dear.

    Although you’re not excusing crime, you’re excusing excusing crime. So is allowing HRMC to decide what to do with only 76.7% of crime OK with you. Is that what you’re saying?

    It certainly seems to be.

    And it fairly nails your cuffs to the typist’s chair.

  2. you’re excusing excusing crime

    Yup, damn straight. I will excuse driving 71mph on the motorway, because I think it is morally inoffensive.

    I will excuse my cleaner wanting to be paid cash, because I think it is morally inoffensive to take income without paying tax.

    I will excuse myself for buying an MP3 player I can use with the MP3s I have illegally created from my CD collection.

    I will excuse anybody whose behaviour is driven by moral principles which I do not find offensive, rather than those whose behaviour happens not to contravene behaviour outlawed by the state.

  3. yes all right, the optimal level of informal activity is not zero.

    Say there is £100m of informal activity in the economy, and you are thinking about the effect of taxing £10m of that. What happens to the revenues? Are you supposing that there is an additional £10m of public expenditure – if so, what effects does that have? Or are you assuming that public expenditure is held constant so there are £10m of tax cuts elsewhere in the economy – if so, what effect does that have.

    I don’t think you are doing a terribly good job of bothering about the economics of things.

  4. Mr S. Evil – please accept my sincere apologies. I have tarred you with the wrong brush, and for this, I find my own behaviour morally offensive. (In my defense, I read an article in the Guardian this morning, so my blood pressure is higher than usual, hindering rational thought). Please carry on as usual.

  5. duh, sorry not £10m of public expenditure / tax cuts, I mean whatever the sum of revenue raised from bringing that £10m into the formal sector, after accounting for however much that £10m shrinks.

  6. Nice to see a favourable reference to LVT for a change .Not the enemy of the grasping entrepreneur as commonly proclaimed,rather his salvation.> See Adam Smith (real Adam Smith not the much reduced version sans land tax offered to the downcast entrepreneur whose grasping ambitions have been frustrated by the high cost of land/property which keeps him and his potential customers tinless.)

  7. Luis Enrique, Tim already assumed that the effect if the revenue was used to fund tax cuts would be a net negative when he said ‘we can assume that informal activity is more sensitive to deadweight losses than other forms of activity’; ie. raising taxes here and cutting them there will increase overall deadweight loss. As for increasing spending, well, so much of current spending is pure wastage that I would assume that increasing gov’t spending further would cause welfare to go down, not up (even if that money were raised “for free”.

  8. Richard,

    thanks for pointing that out – yes, if true that would make a difference. Not sure why it would be true though.

    In some countries you could argue increased public spending would be a bad idea – much harder to argue that in countries where informal sectors are large and the state woefully inadequate.

  9. “In some countries you could argue increased public spending would be a bad idea – much harder to argue that in countries where informal sectors are large and the state woefully inadequate.”

    I think there are lots of occassions where they both have spend too much public money and have large informal sectors. Greece and Italy seem to be just 2 examples of such countries…

  10. I still think you have it the wrong way around. The quality of the state needs to improve before they are given more money.

  11. Oh gawd Luis, do you live in a bubble?
    Poor country’s states need to prove they can run things before they get any larger. Otherwise you just end up with an even poorer country with a lot of bureaucrats.
    There’s nothing intrinsicly benign about government. It’s just despots in suits.

  12. oh gawd “bloke” in spain, are you a mug?

    FFS it’s the private sector’s responsibility to be responsible else your whole stupid ideology means nothing.

    The state is only as responsible as the strength of its democracy. That means a buy-in from the population. That means co-operation between private corp and public body.

    You idiots demonise the efforts to reintroduce public interest into how their country is run, whilst perpetuating the myth that all democracy leads to “socialism”. What a dirty word!

    It seems to me that Luis has a very rational take on matters, far more so than most of the bitter and envious [see: devoid of ideas] on here.

  13. I don’t know if anyone has asked this before, but who the hell employs Ritchie as an accountant?

    If mine sat me down and said: “My main purpose is not to save you money but to ensure the Govt gets as much of your income as possible”, he would not be my accountant for long.

  14. Arnald, I can only bow to your obviously superior personal knowledge of the politics of developing countries.

  15. @20
    Maybe if Ritchie had been your accountant when he was practising you mightn’t have been so critical.
    Dab hand with the tax fiddle our Murph in the day:

    http://timworstall.com/2010/08/24/in-which-we-are-challenged-by-richard-murphy/

    This is the great man himself from his Graun column:

    ” But, if the company is run with strong discipline, and keeps good accounts, then dividends can be substituted for most of the salary paid in the previous example. Just enough salary is still paid to make sure that the director is credited with paying national insurance – currently £4,615 – although no national insurance (or tax) is actually paid on this. That leaves a profit of £25,385 in the company on which corporation tax of £3,654 is paid. This is low because the first £10,000 of profit generated by a small limited company is tax-free.

    That means a dividend of £21,731 can then be paid. Because that level of dividend does not take the recipient into the higher rate bracket, he or she does not have to pay any additional income tax on the dividend. The only tax paid will be the company’s corporation tax bill of £3,654, which is £3,581 less than the self-employed person pays.”

  16. I’ve made this point before too. Ritchie commits a fallacy by using GDP *including the ill-gotten fruits of tax evasion* and then assuming we can just eliminate tax evasion without any further impact.

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