After Farrar: Laffer laughter

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?