Ritchie actually gets some economics right!

As many know, I don’t buy all the arguments of the standard economics repertoire, especially as now interpreted by mainly mathematical economists. But some of the ideas they have abused are very obviously right. One is the diminishing marginal utility of income.

The idea of this is very simple. What it says is that the first £1 you earn is worth more than the second, and so on. Actually, the evidence may well be that there’s almost no tailing off for quite a long time – new research suggests until about £22,000 of income is reached – but thereafter there’s no doubt that each individual pound (or yen or dollar or euro) is relatively worth less than the one before.

Until you reach the point Nigella Lawson reached where you don’t check or notice that your staff have spent £600,000 of your money because there’s so much that simply passes unnoticed.

There is, however, an important point in this. The fact is that if each pound is worth less as your earnings increase then each pound of tax paid also imposes less strain. The declining marginal utility of income also means that the marginal cost of tax falls as income rises too – so hat a greater part of marginal income can be paid in tax without imposing a greater real burden on the taxpayer.

This is, I think, economic fact.

It’s why we need a progressive tax system in the UK.

Yup, that’s all absolutely correct. That’s also why we have a progressive income tax system in the UK. Which is where Ritchie goes wrong, of course.

We don’t have one right now.

We don’t have a progressive tax system, no, but we do have a progressive income tax system. And our progressive income tax system is exactly based upon that idea of the declining marginal utility of income. And, as we’ve seen with the 50p rate, we’ve got that tax system as progressive as we can make it. Or if you prefer the Saez and Diamond calculations, including employers’ NI, around the peak of the Laffer Curve at 53 to 54% of income with a 45 p purely income tax rate.

We do desire a progressive income tax system. And we have one. As progressive as we can have it without reducing revenues by making it even more progressive.

42 thoughts on “Ritchie actually gets some economics right!”

  1. Isn’t this a matter of taste? I think it breaks down to a certain extent once we can comfortably meet everyone’s absolute basic needs. Once we’ve done that, the next few pounds enable you to move on to some seriously pleasant consumption – I like travelling, indeed being a masochist I take pleasure in the process and trappings thereof as well as the going to cool places bit. So going from subsistence to being able to get a Ruinair flight and stay in an Etap was a massive increase in utility. Then getting a real job and being able to get a business class flight and stay in a Sofitel is a further big increase in utility.

    I’d tend to agree that going from that to a private jet flight to your own private island is a far more marginal increase in utility, but that’s just my tastes (or perhaps realistic expectation of life).

    So I wonder if the marginal utility curve actually goes up for a bit longer than we tend to think, before it goes down. And for how long it goes up depends on the individual.

  2. Also I don’t desire an income tax system so progressive that it maximises government revenue. Maximising government revenue might be the government’s objective but it definitely isn’t mine.

  3. Er no, Tim, we haven’t “seen that with the 50p rate”.

    There is zero evidence that the 50p rate is the wrong side of the Laffer peak, and there never will be any evidence. The entire period that the 50p rate was in operation was affected firstly by forestalling (income brought forward to avoid the higher rate) and subsequently by reverse forestalling (income delayed to avoid the higher rate). According to ONS, the increase in tax take arising from the introduction of the 45p rate was mainly due to delayed payment of financial sector bonuses to take advantage of the new rate (caused 4% increase in tax revenues), although economic recovery is also a factor.

    I am so sick of explaining this to people that I wrote about it. Actually I wrote about it when the 45p rate was first announced, but I updated it the other day because of Fraser Nelson’s gleeful crowing about the 45p rate.

    http://coppolacomment.blogspot.co.uk/2012/03/forestalling-tax-avoidance-and-politics.html

    The Laffer curve is like the Yeti. Everyone’s seen the footprints but no-one knows what it looks like.

  4. It occurs to me that the Laffer Curve has an externality to take into account.

    I might resent having more than 54% taken off me by the State, but surely how they spend the money is a factor?

    If I saw the State doing a good job (rather than the current mess), and I was publicly feted (rather than berated as a greedy scumbag) for having helped eradicate poverty (for example), I might be willing to pay more?

    Their wastefulness, incompetence and general f*ckwittery are the reason we are stuck at 54%?

    We are unwilling to pay more if all it will do is fund the activities of malicious imbeciles, right?

  5. Ivor, there have been remarkably few governments in history not composed of malicious imbeciles. Even considering our current rulers, most rulers in other places and times are actually worse.

    So perhaps the lesson is that ~50% slavery is the highest amount of slavery a government composed merely of malicious imbeciles can impose without formenting revolution or widespread tax evasion.

  6. Frances seems to be arguing in her article that we simply don’t know which raises more revenue, a 45% rate or a 50% rate.
    Surely if, within measurement error, they raise the same revenue then we should have a 45% rate?
    If a lower rate raises the same revenue then there are 2 possible reasons; probably both apply. One is that the same people behave differently; they avoid tax less and/or work more. That’s good because doing less avoidance saves them, and HMRC, time and money, and if they work more it’s good for the economy.
    The second reason might be that more higher rate people move to the UK. That’s good because it increases revenue from other taxes, and any who are entrepreneurs are more likely to run their business in their home country, so we bring in economic activity and jobs.
    So if the income tax revenue is the same for a 45% rate and a 50% rate, we are still better off with a 45% rate. Or am I missing something?

  7. Alex

    The problem is that the introduction of the 50% rate led to early payments and then delays (in the hope it would be repealed). Then when the 45% came in the delayed stuff was paid. This means we cannot say with any certainty whether the 50p rate was to the left or right of the Laffer peak. If it had been in place for a while (thus making delays less worthwhile, but also leading to people leaving because they think it is permanent), we might have been able to say more about this. Note also that it isn’t just income tax that we need to take into account – the 50p if it drives people away reduces all taxes (VAT etc) as well.

  8. Frances

    First my fundamental objection to: being delightful, you oblige us to engage with you pleasantly, or at least politely. I for one would much rather be baiting Richard Murphy, so quite frankly you shouldn’t be coming onto this blog.

    Second: I note that, whilst you have quite rightly upbraided Fraser Nelson for his non-evidenced crowing, you do not attempt to deny the existence of the Laffer Curve. Indeed there is evidence for its existence as well as logic. It is undoubtedly a curve – let’s call the rate of change dT. We might not know at any given point dt=0 is and so policy makers might well be dealing with personal preference (or prejudice), it undoubtedly is there though.

  9. The idea of the Laffer curve is that people’s behaviour changes at different tax rates. Frances seems to have shown this to be the case. That’s hardly a disproof.

    The issue is, how would behaviour continue to change if the 50p rate were to continue? Would the tax take at that rate start to climb again after a while? That’s what needs to be argued about and there’s certainly evidence around the world of how behaviour changes under persistently high tax rates.

  10. Ironman,

    Firstly, may I apologise for breaking the rules of this blog by being nice. I shall endeavour to do better in future.

    Secondly. I don’t deny the existence of the Laffer curve (mind you I’m a firm believer in the Yeti too). I deny that we have any idea what shape it is, or even whether it is a normal distribution.

  11. Peter,

    There is indeed evidence from around the world, though of course what applies in other countries may not apply in the UK. There is also evidence from the UK’s own past: the top income tax rate in the 1970s was 90% IIRC, and for the whole of Thatcher’s reign the top income tax rate was 60%. Yet despite all this evidence, people are still arguing about the shape of the Laffer curve and where the peak is. I think it is simply not easy to prove a direct causal link between top tax rates and tax revenues.

    However, THIS time the cut in the top tax rate cannot ever be directly linked to increased tax revenues. To quote Aslan (from the Narnia stories), “no-one is ever told what would have happened”. We will never know what the 50p rate would have raised once forestalling effects had unwound.

  12. Diamond and Saez do not say that 54% is the peak of the Laffer curve in the UK. The say that in the USA, the peak is at least 54%, using a “conservative upper bound estimate” for elasticity of income with respect to one minus the tax rate, and may be as high as 80%. And the whole calculation depends on the real world matching the simple and mathematically convenient model D&S put together.

    In the UK, both the elasticity and the shape of the upper-income curve are different, so the revenue-maximizing tax rate will be different. (I went through this in some detail here, and tentatively suggested a higher number).

  13. Slightly off topic. Ritchie puts the fact that Saatchi didn’t notice the large credit card payments down to diminishing utility. Indirectly maybe. But the direct cause was that he was relying on his accountant, who didn’t want “to bother him with trivial matters” (his words) till the sums got really silly.

    Where Richie sees economic theory in action, I see a possible professional negligence case. I never was one for the big picture.

  14. PaulB – given that American citizens pay tax to Uncle Sam wherever they go, isn’t the Laffer Peak likely to be higher there than places where no such rule exists?

    In essence, we are Billy Bibbett and they are R. P. McMurphy?

    Medication time.

  15. Luke,

    no, it is *directly*. The fact that he was relying on his accountant, and the accountant didn’t want to bother him about something so trivial, suggests that the money wasn’t important to him. Believe me, if he needed that money to pay his mortgage he would have been paying more attention – and he wouldn’t have relied on a beancounter to tell him.

  16. Frances

    And the fact that the UK had high rates of taxation in the 1970s and into the 1980s isn’t evidence that there isn’t a Laffer curve or where it is. We can be fairly certain that the 90% of the 1970s reduced the tax take – look at the number of tax exiles in this period. Also we need to take the effective tax rate – which is frequently less thanks to tax avoidance which means that measuring Laffer is a pain.

    I’m on the fence on the 50% rate – I’ve not done the numbers properly, but back of the envelope suggested that it was marginal either side. (So I tend to think the peak is in this range*, PaulB thinks its higher).

    *50% + all the other taxes that fall on income including employer paid taxes falls to roughly 58%

  17. so how many people wake up in the morning and think “I don’t need any more income so I will go out and earn some for the government”? It would be a very strange theory that made that kind of assumption!

  18. “new research suggests until about £22,000 of income is reached”

    Is Ritchie now supporting a significant increase of tax free allowance, wouldn’t this put him more in line with libertarians?!

  19. It is a basic human right that people be treated equally by their governments. Progressive taxes are a violation of this basic human right.

  20. Frances, far be it from me to argue with you about the difference between the words “directly” and “ultimately.”

    But I have some experience of defending accountants accused of allowing their wealthy clients to be defrauded. Arguing that “the direct cause of Mr X being defrauded was his wealth, not my client’s incompetence” has, to date, not been a successful defence.

    (No comment on this case, where the a/c did blow the whistle – and no lawyers chipping with contributory negligence.)

  21. Gamecock,
    “It is a basic human right that people be treated equally by their governments. Progressive taxes are a violation of this basic human right.”

    Would you take that as far as objecting to any percentage based tax? That seems the logical conclusion. I don’t remember the poll tax being a great success. (FWIW I’m not knocking your logic, just not sure that a tax system can be created on abstract notions of fairness – I go for the least hissing/deadweight loss.)

  22. Tim, I had you down as a flat taxer above a minimum wage linked allowance. Are you a proggie after all?

    Tim adds: Ah, but a flat tax with an allowance is indeed a progressive income tax. The average rate asymptotically rises to the headline rate….

  23. Although there is undoubtedly a Laffer Curve, mightn’t it only become apparent until after the fact & not be predictable? The utility of further earnings depends on so many different & conflicting pressures.
    Take someone who has the opportunity to earn more money. But also has the opportunity to attend the world cup final. But has creditors chasing him for debts. Yet has a wife he’d prefer to be away from for a week..And then there’s the tax…
    And every earnings opportunity is like that. Marginal utility. Call it what you will. But there’s no,way of predicting what all those conflicting influences will sum to, for all occasions for all players, because so many of them are not the slightest bit ‘economic’.

  24. Tim – thanks, and indeed. This post is as close as I’ve seen you come to making the case for progressive marginal, not just average, rates though.

  25. @ Frances Coppola
    No, we don’t have much evidence of the impact of a 50% tax rate in the UK but YES we do have evidence of the effect of a tax rate higher than that. Everyone started believing in the Laffter curve after Geoffrey Howe increased tax revenues by reducing the top rate rate from, 83%/98% to 60%, but we have modern evidence on the effects on poor people from (expletive deleted’s) Tax Credit System with its 38-100+% effective tax rate and the simultaneous rise of 2 million-odd in the number unemployed (including those on sickness benefit only paid to the unemployed) and 3.7 million (of more than 2 million were adults) people born overseas coming here to fill jobs that native-born people did not want to or could not afford to take.
    “According to ONS, the increase in tax take arising from the introduction of the 45p rate was mainly due” – mainly! Some of the tax avoidance undertaken when the rise to 50% was installed was never reversed – I can think of one company where the CEO and his No 2 were quite happy with fairly modest salaries* and dividends in good times but not bad and paid tax, until the rate went up to 50% whereupon the company introduced a tax-efficient substitute for dividends, saving them something in six figures (£2m for all shareholders); this has continued.
    I personally should prefer a 60% top rate but anything over 50% has psychological disadvantages (and 50% income tax plus 1% NI or 5.4% NI if one is self-employed). Interestingly or coincidentally every single person who told me that he** would move offshore (physically or just legally) if top rate went up to 50% was a Labour Pary member and/or declared supporter.
    “The Laffer curve is like the Yeti. Everyone’s seen the footprints but no-one knows what it looks like.” I’ve never seen a Yeti but I can see that an unemployed guy in my town under 65 is worse off getting a job in London unless it pays more than the average wage. I don’t like Bob Diamond or Fred Goodwin but I don’t really care whether they tax at 2% or 200% – it is the struggling guys facing 70-80-120% tax rates that I care about.
    *when they hired a youngish outsider as an executive he got paid over 25% more than the CEO
    **you doubtless know more about female reactions to taxes

  26. @bis,

    I think few enough people, albeit among the highest taxpayers there are (if stupid enough to reside somewhere with high or indeed any taxes) decide on a minute-by-minute basis to earn more money this week rather than attend the world cup final that we can neglect them. Especially as they have plenty of other potential excuses to excuse themselves of their spouse.

    But otherwise an elegantly made and accurate point.

  27. @Tim’s comments on MyBurningEars,

    Yes, this effect is known in Germany as the “mittelstandsbauch” (middle-class [beer] belly) because of the effect on the tax curve. Which is accentuated by the progressive tax system. Of course what people don’t realise is that it is inevitable (unless you use a flat tax with no allowance or, heaven forfend, negative progression) and essential (if you want to run an advanced eglitarianist communist society like Germany), because there aren’t enough rich people who would carry on paying 100% tax in order to flatten the curve for the middle classes.

  28. “because there aren’t enough rich people”

    Therein lies the fallacy of the progressive tax system, because the rotten statists like Richie simply redefine “rich”. They use anecdotes like Nigella to sweeten the pill for a “tax the rich” solution and then suddenly everyone is “rich” and taxed like Nigella. Rinse and repeat.

  29. @Runcie,

    Everyone’s definition of “the rich”, especially “the rich who should be paying lots more tax”, is “anyone earning a euro more than I do”.

  30. What about the diminishing marginal utility of government? In fact it hits zero very quickly and then heads steeply into disutility.

  31. That extra pound is still mine, regardless of whether I value it fractionally less than the previous one. It does not justify the State stealing it and giving it to India to fund their away day to Mars.

  32. @jamesV
    I’d accept the sort of people who are well into the higher tax bracket wouldn’t think like my simple example. But it doesn’t mean the same principal doesn’t apply. Money is not always the driving force.
    A lot of people in that tax bracket will be in creative fields. It’s entirely possible money isn’t the driving force & the primary reward they seek is the acknowledged value of their work. Earnings are more a way of keeping score than anything else. Conversely, others may resent high taxes on principle & be happy to forgo other benefits to avoid them irrespective of whether they need to.
    It’s not as if claims aren’t made for other non-economic factors influencing behavior. The widely trumpeted “Olympic feel good factor”, (if it ever existed). A particularly cold winter or two could the marginal financial attraction of a warm climate country look less marginal..
    Looked at this way, a Laffer Curve behaves much more like the reflection of a chaotic system. There’s feedbacks. High earners are also high spenders. The beneficiaries of that spending maybe high earners as well. Lose one you lose the other. it’s rather like looking at the weather. You can say March will be cold & wet but how cold & wet only March will show. Last year’s. temperature isn’t much good at predicting whether you need an extra jumper. It just advises you’re unlikely to be wanting shorts.

  33. Just thinking about Tim’s triumphal Forbes post & there’s a fine example of the marginal utility of the last quid. I’ll bet each & every one of those last quids is as sweet as its predecessor if it’s one more than Richie’s getting.

  34. There isn’t a Laffer Curve, as originally described, and it can be debunked with simple arithmetic. It’s certainly the case that tax policy will have different outcomes, including higher or lower revenues, all dependent on particular circumstances of time, place and psychology but that ain’t “The Laffer Curve”.

    It’s a classic bit of macroeconomic gobledegook, in which you start off with a specific claim- that A is some particular function of B, and then when it’s pointed out that A is not this function of B, you lapse into this, “well A must be related to B in some way or other” which is trivially true and also conveniently unfalsifiable, but not the original claim.

    See also:- “Keynesian Stimulus” etc etc

  35. John77

    Crikey, where do I start??

    Tim’s post is not about high marginal tax rates due to benefits withdrawal. And neither is mine. The 50p rate did not apply to those people, and it is the 50p rate that we were talking about. Tim implied that the increase in tax revenues since the 45p rate was introduced indicated that the 50p rate was on the right-hand side of the Laffer peak. And I disputed that on the grounds that forestalling effects made the evidence unreliable.

    I don’t dispute the fact that very high taxes can be a serious disincentive to work (or to remain in the country, if your income is unearned). In that respect I do not deny the existence of a Laffer effect. There must be some point at which the returns from work and/or investment just aren’t worthwhile. That point may be different for different people, of course – we know, for example, that mothers and people close to retirement are more sensitive to marginal tax rises. But the Laffer peak is the point at which the revenue from higher tax rates starts to drop because so many people are opting out one way or another. Lots of people have opinions on this, but we don’t actually know where that point is.

  36. Luke
    November 29, 2013 at 3:47 pm

    Gamecock,
    “It is a basic human right that people be treated equally by their governments. Progressive taxes are a violation of this basic human right.”

    Would you take that as far as objecting to any percentage based tax? That seems the logical conclusion. I don’t remember the poll tax being a great success. (FWIW I’m not knocking your logic, just not sure that a tax system can be created on abstract notions of fairness – I go for the least hissing/deadweight loss.)

    ==================================

    I have no problem with a percentage based tax. Be it 10% or whatever. It should be applied to EVERYONE.

    I believe taxes should be general and levied in equal amounts or equal rates.

    Additionally, I think it is grossly inappropriate for the government in an egalitarian society to use words like “rich” and “poor.” Citizens are citizens. Treating people differently under the law because of what group they are in is wrong.

  37. @ Frances Coppola
    I do realise that you were addressing the 51% or 55.4% tax rate but Murphy was arguing for a progressive tax system. It is *very* progressive for those paying 80% or so on their marginal £ of earnings.
    I do not know the shape of the Laffer curve nor how many peaks it has, merely that it must exist because tax take at a 0% rate is zero and, even if Murphy claims that the take at 100% is non-zero which I do not believe, we have evidence that a cut in the rate to 60% increased revenue.
    My point was that the effect of 51% taxes on the top 1% of the income spectrum is not as important as the effect of very high effective tax rates on 6.3 million households, nearly one-quarter of the total and nearly one-third of non-retired households. Murphy wants us to believe that it is all about a tiny number of stinking rich people when the worst burden is on 30-odd% of working age households who are struggling.

  38. Art Laffer himself doesn’t pretend to have come up with the concept of the ‘Laffer Curve’, attributing the idea to a number of theorists going all the way back to the 14th-century Arab scholar Ibn Khaldun. Perhaps we should call it the Khaldun Curve, which has the merit of being alliterative.

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