And when poodles armed with noodles in a fiscal muddle scuffle, they call this a fiscal-feudal muddled poodle Laffer laughter ever after addled prattle battle

This morning David Farrar tries to resurrect an old chestnut: “If you want the rich to pay more tax, you should tax them less.” Apparently, not content with bringing New Zealand the lowest overall top tax rate in the high income OECD, now some in National intend to complain that it is still too high.

His argument is dangerously simplistic, and shamefully wrong.

The basic logic goes like this: if you lower someone’s marginal tax rate, they will increase their effort, because the after tax rewards for that effort are higher. Sometimes there is so much added effort that all this new effort and productivity increases economic growth to the extent that it generates more new tax revenue than was lost through the tax cut. In that way, lower taxes bring in more tax.

If marginal taxes are extremely high, then this argument is appealing. For example, if you have a marginal tax rate of 90% and decrease it to 80%, then you have doubled people’s after tax return. Doubled! In order to get the tax revenue back, they only need to increase their effort by somewhere around 12% (depending on your assumptions). Will effort increase by 12% in response to a 100% increase in after tax marginal reward? Seems like a good bet.

But taxes are not that high in New Zealand. And this changes the calculation massively:

In New Zealand the top marginal income tax rate is 33%. If you reduced that to, say, 28% to get rate alignment between corporate and personal rates, then people’s after tax return on marginal effort would go up 7%. But in order to make up for lower tax rates, those same people’s combined effort would have to go up by 18%, even under assumptions very generous to David’s argument.

Will people expend 18% more effort on the promise of 7% increase in marginal return? That is a very different proposition, and much less likely to happen. Why not just use the extra money to enjoy a Hawaiian vacation or a better car instead?

The silly part is that David Farrar thinks those two situations are basically the same bet, not fundamentally different. In his post, he uses examples of tax cuts from very high rates, followed by purportedly consequent revenue increases, to suggest the same thing will happen if New Zealand cuts taxes from their already low rates. This is a cardinal sin.

The British examples he cites, for example, focus on a cut in the marginal tax rate from 83% to 40%, and a large increase in tax receipts from high-income folk between 1980 and 1997. Two points here: (1) cutting 83% to 40% is a very different beast than cutting from 33% to 28% (see above); (2) David’s conclusion only holds if the **only** thing to affect tax receipts that happened in the UK over those 17 years was the tax cut. And that claim is very, very wrong.

The initial rate of tax has no role in David’s argument, even as it is crucial to Arthur Laffer’s famous formulation of the same claim. Laffer’s more sophisticated version, by the way, has been subsequently renamed the “laughter curve” by The Economist because it is ridiculed so much.

This Kiwiblog economics is pure junk. With analysts like these, who needs jesters?

Comments (14)

by Justin Maloney on August 09, 2011
Justin Maloney

Rob, I think you miss the point.

Increasing the top marginal tax rate increases the incentive for those people to avoid paying tax. I am not sure DPF is suggesting decreasing from the present level will increase output.

This is a significant problem if you also provide them with a perfectly legal means by which to avoid paying the tax, say having a >10% difference between income and company tax.

by Frank Macskasy on August 09, 2011
Frank Macskasy

Excellent article, Rob.

I believe this chart shows us where NZ is positioned in terms of taxation.

http://en.wikipedia.org/wiki/Tax_rates_around_the_world

Note: these tax rates are applicable prior to National's April 2009 and October 2010 tax cuts. So we are paying even less (which indicates why National is borrowing $30 million a week to pay the bills).

 

by Rob Salmond on August 09, 2011
Rob Salmond

@Justin: I do not think aligning the corporate and top personal rates provides any extra tax revenue through preventing legal avoidance behavior. Currently, with PIT 33% and CIT 28%, the argument goes that some folk are avoiding paying 33% by declaring their income as CIT and paying only 28% (or running it through trusts and also paying a lower rate). Under rate alignment, those same folk are free to declare it as PIT or CIT, because the tax rate in either case is 28%. In both the current and the rate aligned scenario, the tax rate on the income-that-can-be-declared-either-way is 28%, meaning there is no extra revenue from making the change, only a loss of income to tax accountants. The only way to generate extra revenue out of tax cuts is through extra productivity, an argument I address above.

by alexb on August 09, 2011
alexb

Clamping down on tax aviodance by the top 1% couldn't hurt either. As the old chestnut goes, if you want the rich to pay more tax, jail them when they illegally underpay.

by Tim Watkin on August 09, 2011
Tim Watkin

Alex, I can't find it online but I saw in the NBR's Rich List coverage this year that the authorities have confirmed they use it to target the richest of the rich. Googling around it seems they've been doing something similar since 2004 at least.

And maybe I hang with the wrong crowd, but I've never once heard someone say, 'ooh a tax cut, I'm going to work harder now as a result'. Not once.

by Rab McDowell on August 10, 2011
Rab McDowell

There is an increasing  view, particularly amongst those of a more left leaning political sway, that given the state of the world, we should do the honourable thing and pay more tax and that those who have more money than us should be even more honoutable and pay considerably more.

We need to be cautious about this. If some of us think that extra taxes are such a good way of fixing our problems then we should allow those who believe it is socially reponsible to help the economy in this way to voluntarily pay more taxes than they are obliged to. It could be handled quite simply by putting another box on the tax return to be ticked by those who wish to along with a place to indicate just how many extra dollars they are providing.

Tim Watkin may have never once heard someone say, 'ooh a tax cut, I'm going to work harder now as a result'.  Can he tell us if he has ever heard of anyone so concerned about the lack of revenue that he wishes to make such a contribution?

On the other hand, I can recall, in times when marginal tax rates were higher than they are now, workers turning down overtime because, once the high marginal rate of tax was deducted, they felt the extra work was not worth the reward. I have not heard of this happening with the lower marginal rates in place now. Does that mean that workers have in effect said 'ooh a tax cut, I'm going to work harder now as a result'


One of the best reasons for caution is that tax is an inefficient way of funding things. About fifteen years ago the Inland Revenue Department commissioned research into the efficiency of taxes. They must have been somewhat embarrassed when they found that every dollar spent of the taxes they collected had a net cost to the economy, as I recall, of around $2.54. This cost was not just in paying bureaucrats but in a whole host of factors such as the opportunity cost to the taxpayer of funding more productive investment.

by Rob Salmond on August 11, 2011
Rob Salmond

@Robert:

1. I agree with you that tax cuts can cause extra effort. That should be clear from the main post. For me, the big question is *how much* extra effort do you obtain from any particular tax cut.

2. There are many problems with voluntary taxes, one of which is that that systems inevitably leads to the undersupply of socially desirable goods. That is, whatever society collectively decides it wants will be undersupplied if you have voluntary taxes. The basis of this argument is nicely stated in Mancur Olson's "The Logic of Collective Action." Taxes may be costly to collect as you note, but they are still a relatively efficient means of giving a community what it wants, which is not always "productive investment" (for example, humane hospice care).

by r0b on August 12, 2011
r0b

Hi Rob - The Economist dissing the Laffer curve - do you have a reference / link?  Ta...

by Draco T Bastard on August 12, 2011
Draco T Bastard

And maybe I hang with the wrong crowd, but I've never once heard someone say, 'ooh a tax cut, I'm going to work harder now as a result'. Not once.

That's because the majority of people physically can't work any harder and they're the people who are actually productive. The people who keep demanding more tax cuts won't work any harder either as they just don't need to - they already have more than they can spend.

by on August 14, 2011
Anonymous

On the other hand, I can recall, in times when marginal tax rates were higher than they are now, workers turning down overtime because, once the high marginal rate of tax was deducted, they felt the extra work was not worth the reward. I have not heard of this happening with the lower marginal rates in place now. Does that mean that workers have in effect said 'ooh a tax cut, I'm going to work harder now as a result'

Actually I think it can only mean that you've pulled a Rip Van Winkle since mid/late 2008, when we weren't in the middle of a recession and workers weren't grabbing every bit of scarce overtime available just to stay financially afloat.

Welcome to 2011 and Pundit.co.nz, and if you're a Michael Jackson fan I'm so very sorry.

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