Monthly Archives: November 2011

Tim Morgan’s suggestion to stimulate aggregate demand through lowering the tax rates on labour at the low end of the scale is eminently agreeable, but the proposal is associated with some fallacies that deserve to be debunked. Supporting valid points with false arguments just reduces the credibility of the speaker, and by contagion that of other people making the same point.

First we have the usual small business fallacy:

Small and medium enterprises (SMEs) are the likeliest source of new jobs, but their growth is hampered by difficulties accessing finance. A partial solution to this would be to reduce taxation on SMEs, leaving more retained profits for investment in growth.

This is a popular one, after all big business is run by heartless Vulcans under contract from the devil themselves while small business is run by your, sometime irritating but otherwise entirely human and likeable, mother in law; or generally people you wouldn’t mind as in-laws. All very well, cats are cute, but that has no bearing on their economic performance.

Surely the optimal size of any given business is dependent on the equilibrium point between economies of scale afforded by size, and the diseconomies of scale like bureaucracy and inertia that are proportional to organisation size. It’s no accident that Tesco or Walmart are more efficient than the local grocery store or that a mass manufactured car offers more bang for the buck than one built by hand in a small workshop.

Left to its own devices most industries or activities should settle on the optimal size for what they’re doing, and we see there seems to be a sweet spot for say car manufacturers (big) or labour intensive construction firms (small). Why, then, should any specific industry size then have more potential for growth and “jobs”? Pending bizarre anomalies, company size just won’t be an salient factor on its own. Big companies as well as small take on new staff when they have more customers who want to buy their wares or services.

It follows that differential taxation based on company size is more than not likely to result in misallocation. People will be pushed by tax reason to manufacture expensive and poorly performing cars in small workshops and everybody will be worse off.

The point that they have difficulties obtaining finance is possibly more valid, but only on a short term horizon, while the banking system is not operating normally and has not yet been replaced by something better. Surely, if small business is such a source of economic performance, the market will rush to lend to it. If it doesn’t fund the workshop making poor  cars, it could be that it’s just a bad business proposition.

Then we have some ill-constructed argument on taxes:

Specific taxes could be reduced because they have adverse economic effects (for example, it has been argued that air passenger duty undermines tourism, that insurance duty is a tax on prudence, and that taxes on private pension funds have proved exceptionally damaging)

That taxes have “adverse” economic effect is self evident: the point of tax is to relocate resources from one point of the economic system to others, and whoever is on the giving side of the relocation is going to find it “adverse”. In that sense all taxes undermine whatever activity they are levied on, and it is all-right. People discouraged from flying by a tenner on their flight, will just go on a cycling holiday, which is good as they’ll probably have as much enjoyment, and consume as much at their destination, without the collateral damage (externalities) of flying that passenger duty contributes to make economically visible.

The taxes on private pension funds are a bit like Ricardian equivalence . Surely they’re so low visibility (the impact is a lower pension by an incalculable amount decades later) that the damage is likely to be very slow and on a relatively small scale. People just don’t make pension decisions by modelling minute tweaks to the tax regime. And if we want to boost consumption and jobs we don’t need everyone to start putting more money under the mattress in the short term.

And, finally, on a point order, the FT Alphaville editor says:

Morgan also thinks we should do away with the 50 per cent top rate of tax

then quoting a much more balanced paragraph where Morgan says no such thing, but basically that on balance the bad aspects (the deterrent effect) he dislikes are probably balanced by the political necessities of doing something about income inequality.

That said the deterrent effect is likely another fallacy. Star entrepreneurs and investors are rarely motivated by the difference a few extra pennies makes when they can practically afford anything they want. Most studies I have stumbled upon which try to quantify this effect seem to find a marginal tax rate in the vicinity of 60-70 percent, above which the disincentive effect becomes worth worrying about, and the UK is currently well below that.

If anything the main objection to high income tax rate is that the solvent wealthy can work around it by reducing their taxable income through simple and legal tax avoidance tricks. But it doesn’t hurt to try, and it’s even Pareto efficient: increasing the high income tax rates pleases those on lower incomes who believe the rich will pay more, without having the rich actually pay much more. However little it collects, it therefore seems a to be a no-brainer because is can make everybody feel good.