Introducing the ‘austerity curve’ and how it affects the UK economy


5:10 pm - January 23rd 2012

by Duncan Weldon    


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The Laffer Curve is a concept close to the heart of many economists who advocate lower taxes.

Laffer drew the curve on the back of a napkin to illustrate how a rise in personal taxes proposed by Ford might lead
to lower tax revenues.

But I’ve thinking recently about the Laffer Curve in terms of how it might relate to austerity.

Laffer argued that if tax rates were set at zero then tax revenues would clearly also come in at zero, but if taxes were set at 100% then no one would bother working and so tax revenues would again be zero.

But the key question facing tax policymakers is where about on the curve are tax rates currently. For what it’s worth, the point at which tax rates move to the downward sloping, right-hand side of the curve, appears to be around the 70% mark, so in most cases Laffer analysis suggests that higher rates can indeed raise revenues, despite what the Curve’s usual proponents argue.

Last week international policy makers (including the IMF’s Christine Lagarde) urged a slowdown in fiscal consolidation – i.e. less austerity. They worry that austerity programmes across the developed world are leading to weaker growth, higher unemployment and ultimately higher deficits and bond yields.

Might it then be the case that something like a Laffer Curve exists for austerity? That is to say that cutting government spending up to a certain point leads to lower deficits but beyond a certain point, the impact of lower growth and higher unemployment means that deficits get worse as the government cuts more?

Like the Laffer Curve it suggests that there is a point at which cutting government spending becomes self-defeating, it simply lowers growth, depresses tax revenues and pushes up social security spending by more than the government is cutting.

The question for policy-makers then, is are they past the point and at which the curve becomes downwards sloping? Will more austerity simply lead to higher deficits?

Judging by the tone of S&P’s downgrade of several European sovereigns last week, it certainly seems to think that many countries have passed this point.


A longer version of this is on the ToUCstone blog, from where this is cross-posted.

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About the author
Duncan is a regular contributor. He has worked as an economist at the Bank of England, in fund management and at the Labour Party. He is a Senior Policy Officer at the TUC’s Economic and Social Affairs Department.
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Reader comments


I would say this is broadly consistent with the slowing of metabolism in weight management when you cut the amount of calories you consume. By slowing your metabolism your body becomes more efficient at burning energy. Metabolism slowing down to prevent starvation is the enemy of those who want to lose weight. The answer is to raise your metabolism, by increasing your calorie intake.

The balance of metabolic slow down for weight loss still eludes people. I would suggest that cutting the deficit is as difficult as losing weight. The problem is Labour left us with no excess money to lose so now we are probably anorexic.

Austerity is relative to a pre-cuts starting point in spending, so there’s no guarantee the curve will look like that – X axis should be government spending.

Duncan,

It quite probably does exist, with one important caveat – all else being equal. If the reduction in state spending means more money is spent by tax payers, then clearly the curve will not work (but that might just mean we are further down the left-hand slope than we might have been). If the state is the only one spending (for a hypothetical example, in a pure socialist economy say) then clearly the reduction in state spend may increase the defecit, although that is either a reductio ad absurdium on my part or something of a worry.

However, like the Laffer Curve, this proposed curve would be difficult to use for policy, simply because the fact that everything else is not equal will mean we cannot know which slope we are on (or will be on) with any accuracy. A useful, and valid, exercise in economic theory, but to accept it one has to accept alongside it the Laffer Curve as equally methodologically valid.

Try Mankiw et al on: Optimal Taxation in Theory and Practice
[economics.harvard.edu/files/faculty/40_Optimal%20Taxation%20in%20Theory.pdf]

and the IFS Mirrlees Review: Tax By Design – Conclusions and recommendations for reform:
http://www.ifs.org.uk/mirrleesreview/pamphlet.pdf

5. Luis Enrique

Duncan,

It’s an intriguing idea, but what it really boils down to is asserting a perticular shape of non-linearity in the multiplier.

When austerity is close to zero, an increase in austerity translates almost 100% into deficit reduction. For simplicity’s sake, suppose the impact on GDP hence tax revenues and unemployment benefits, is zero. So the multiplier dY/dG is zero. Then has dG (size of reduction in govt expenditure) rises, negative impact on GDP rises, tax revenues fall, jobs are lost and welfare payments rise, until at some point net impact on deficit is zero. And beyond that you end up actually increasing the deficit.

I’d have thought the primary determinant of the size of the multiplier is the state of the economy at time of cuts, rather than the size of the cut. But okay for any given initial economic conditions, the multiplier might be nonlinear as you suggest. But why?

One may imagine that small cuts may make some workers redundant who can be quickly reemployed, leaving GDP and unemployment largely unchanged. But once you are cutting loose workers who are going to stay unemployed for a while, why would the impact of the second 100k job losses be so different from the impact of the first 100k? At least, in the sort run, long run, it would take longer for employment to recover the more you fire, but your austerity laffer curve does not distinguish between the long run and short run and I guess you had the short run in mind.

Incidentally if you google “government multiplier nonlinear evidence” you will find lots of relevant research.

Isn’t it implicit even in Osborne’s approach that some such ‘curve’ exists? If he thought cutting even further, even faster would eliminate the deficit even sooner, he’d just do that, wouldn’t he? The fact that he doesn’t suggests he thinks doing so would be counter-productive – i.e. he thinks deeper, faster cuts would push him on to the right-hand side of that curve.

In 2007 the IFS ,calculated that the government would maximise revenues from those earning over £100,000 by imposing a marginal rate of 55.6% .This was close to the then current marginal rate of 53%including Income tax NI and indirect tax. It concluded that there was “No powerful case for increasing income tax on the very highest earners even on redistribute grounds”. Sure enough it is common knowledge that ther higher rate has lost revenue for the exchequer as everyone predicted and was clearly likely in that Gordon Brown could have imposed it at any time but chose to only to trap the coalition into a “Sharing the pain” corner
Let us be clear then , this excruciating tax level Duncan thinks would be such a boon would only reap dividends at middle and low levels of income( and this is pure conjecture )
There is no curve for “austerity”. It is truer to say that a structural deficit contains multiples of itself which will be revealed by the only measures that can remove it.
This is just another way of thinking about the extent to which New Labour mortgaged up the future,far more than might appear.

Your graph ignores the effects of deficit + total debt over time.

You could keep on borrowing but the debt interest becomes higher and higher. That in turn raises borrowing or forces further cuts.

Our national debt is 80%. We have about 20%-40% of GDP before the markets will worry about total government debt. If it goes beyond this then debt interest will grow faster than you can cut spending and we are bankrupt. To make matters worse the markets will impose high interest rates on us making the problem many times worse.

The trick is to bring down the deficit fast enough so that we don’t breach that limit because if we do we will get forced austerity + extremely high unemployment and we will be back to the 30s.

This is only government debt. If you want the really scary graph look at total debt – that is closer to 500% of GDP and is probably already beyond the point of no return.

Is there a point where cutting public spending to close a deficit becomes self-defeating and the deficit actually increases? Yes. Is that happening? No. We are a long way away from that type of scenario because the austerity is just not severe enough to provoke that reaction. The last quarter G contributed to GDP growth. Government austerity is not what is depressing the economy. Some sections of government spending may be suffering more severely than others but the macro picture is what you are speaking about. The lack of private sector business investment in the economy is the problem. See the latest McKinsey report and it is obvious where the problems lie.

http://www.mckinsey.com/Insights/MGI/Research/Financial_Markets/Uneven_progress_on_the_path_to_growth

The coalition must be quite disappointed that private sector investment has not picked up. During the summer of 2010 it was obvious that their advisors were telling them it would. Unfortunately, there will be no sustained UK recovery until business investment increases. We will just continue to bump along the bottom with anaemic growth.

Total debt is not that meaningful when it includes financial sector debt. Banks owing money to each other can result in a big figure if you have a large financial sector. However, households and the non-bank private sector are still over-leveraged as the McKinsey charts clearly show.

Sure enough it is common knowledge that ther higher rate has lost revenue for the exchequer as everyone predicted

If “assertions for which there is not yet any conclusive evidence at all, one way or the other” == “common knowledge”, then yes.

Mouse: we’re paying absolutely naff all interest on UK government bonds (2% or thereabouts). Every country which issues bonds in its own currency is paying absolutely naff all interest on government bonds. Japan, where government debt is 200% of GDP, is paying 1%. If the UK were in the eurozone, or if its debt were primarily denominated in EUR or USD, then you’d have a point. It isn’t, so you don’t.

Just to add to Richard W’s point, the 500% figure is completely meaningless, since it’s a gross figure rather than a net. Most of it consists of UK banks’ international borrowings, which are offset by UK banks’ international assets, and therefore not worth worrying about.

11. Leon Wolfeson

Using the Laughter curve for anything is ridiculous.

It’s a standard bell curve, ffs.

12. Mydogsgotnonose

You clearly haven’t a clue. The Laffer curve applies to a normal economy in which most people provide added value by their work. Our economy is biased towards Statist economics which borrow from the future to subsidise employment. And we are connected to a whole lot of other economies for which the same applies.

If you tax a Statist economy more, you still further reduce its efficiency thus accelerating the crash. This is encapsulated in the recent shenanigans concerning the UEA’s CRU which has just lost a major appeal concerning its tactic of refusing to release information. In essence, it was falsifying scientific results to provide an excuse for the State to tax the population to a greater extent than before.

Thus we were already at the limit of the Laffer curve. Taking away the legitimacy of carbon taxes means the Revolution is much nearer. What this means in practice is that the population is adopting a much more critical attitude. This is seen in the popular support for the government’s attempt to limit benefits’ payments, particularly to immigrants.

Cleggeron rule, in effect that of the carbon traders and insurance companies, is ending to be replaced by something else. The people have had enough.

13. So Much For Subtlety

This sentence:

For what it’s worth, the point at which tax rates move to the downward sloping, right-hand side of the curve, appears to be around the 70% mark

cites Wikipedia. What does Wikipedia say?

Economist Paul Pecorino presented a model in 1995 that predicted the peak of the Laffer curve occurred at tax rates around 65%.[12] A 1996 study by Y. Hsing of the United States economy between 1959 and 1991 placed the revenue-maximizing tax rate (the point at which another marginal tax rate increase would decrease tax revenue) between 32.67% and 35.21%.[13] A 1981 paper published in the Journal of Political Economy presented a model integrating empirical data that indicated that the point of maximum tax revenue in Sweden in the 1970s would have been 70%.[14] A recent paper by Trabandt and Uhlig of the NBER presented a model that predicted that the US and most European economies are on the left of the Laffer curve (in other words, that raising taxes would raise further revenue).[2] The New Palgrave Dictionary of Economics reports that for academic studies, the mid-range for the revenue maximizing rate is around 70%.[3]
However, a study by Teather and Young of the conservative Adam Smith Institute using evidence from the Republic of Ireland has suggested that the optimal rate for capital gains tax, as opposed to income tax, may be around 20%, but this is at least partly due to savvy taxpayers holding onto assets in anticipation of tax rates being lowered in the future.[15] A 2007 study by the conservative think tank, the American Enterprise Institute, found that the revenue maximizing rate for corporate taxes in OECD countries was about 26%, down from about 34% in the 1980s.[16]

To claim that this supports the idea that the turning point is at about 70% is utterly laughable.

1. We have a 1995 model that estimates the rate at about 65%. This is worthless as models tell you whatever you like.

2. We have an empirical study up to 1991 that gives a rate between 32.67% and 35.21% – one based on actual evidence. Hard to ignore.

3. We have a model using actual real data (apparently this is not the norm in economics) but restricted to Sweden and looking only at the 1970s, which says it is about 70%. OK, so it is a model, but Sweden is not the rest of the world. What is more the 1970s were an odd time. The question you have to ask is if you did not want to keep your money in Sweden, where would you put it? The UK? Iran? The choice was limited. Globalisation means that capital is more mobile and so you would expect the turning point to have moved.

4. Another useless model that guesses rates are not high enough in most of the West – but implying they are too high in some Western countries.

5. An utterly unbelievable claim about the Palgrave book – 70% is a mid-range figure? What the hell was a high one? 99%? This should be easy to check because it must be wrong.

6. An undated study that suggests for capital gains tax the rate is about 20%

7. A 2007 study that says, as I predicted, the rate is dropping and it is about 26%. That is low.

So we have a range of estimates of which the 70% figure is mostly based on worthless models, has no real world evidence to support it, it based on the past when capital was much less mobile and really had nowhere else to go anyway – and it is the highest figure given. The figures based on actual evidence suggest a much lower figure in the range 20-35%.

14. Leon Wolfeson

So you’re depending on America and the AEI, who provide tailored “studies” for conservatives.

Never mind in reality there HASN’T been a flight of significant capital from the Nordic nations, with a real 50% tax rate. No, ideology > reality!

The laffer curve is a fine picture of a curve, and very little else.

Every country which issues bonds in its own currency is paying absolutely naff all interest on government bonds.

Tell the Hungarians.

And I think that the model that was used to derive a figure of ~70% for peak Laffer rates was based on assuming a closed economy without freedom of migration for top earners. Which is rather an assumption.

Leon,

Never mind in reality there HASN’T been a flight of significant capital from the Nordic nations, with a real 50% tax rate. No, ideology > reality!

As a genuine question, do you have evidence for that assertion? It would be interesting to see. I worry thought that you are looking for something dramatic when the effect of raising tax would anyway be incremental.

18. Luis Enrique

here you go Duncan:

” Cut the deficit too aggressively, and the negative impact on growth and the rise in the cost of debt service from higher spreads could result in a higher, not lower, debt-to-GDP ratio.”

that’s the Economist paraphrasing the IMF

http://www.economist.com/blogs/freeexchange/2012/01/imfs-latest-forecast-3?fsrc=gn_ep

“As a genuine question, do you have evidence for that assertion?”

Luis Enrique has posted something several times regarding entreprenuership in Norway being the highest in the world.

20. So Much For Subtlety

15. Cylux

The laffer curve is a fine picture of a curve, and very little else.

So you think if the average income tax rate was raised to 100% tomorrow it would have no impact on the amount of revenue the State brought in?

We must all work together to sustainably rebuild our economy so that everyone who wants to work can work and pay taxes. The current focus on short term savings and austerity for the poor is not working. Putting David Cameron and millionaires first and women with children last is not only morally wrong but is also a colossal economic failure. The ConDemEd regime are all the same, voting GREEN is the way to serve our Queen. For Queen and country, vote Green.

22. Leon Wolfeson

@19 – Precisely *because* failing isn’t a disaster which will leave you on the streets…

I think what it shows is rich people CAN pay more and working people SHOULD have tax cuts ASAP. Tax cuts need to be targeted for the middle and working classes and avoided for the rich at all cost now.

Of course these days rich is not someone who owns their own house etc just to be clear that means your actually tax cutting for almost everyone but a few. Votes are safe.

When you do this you draw more revenue into the cycle as the tax people don’t pay guess what they spend it! Tax revenues rocket up so gov can then supercharge the economy. And guess what rich people ironically are no worse off in fact they may be better off as people trade “more” with them.

There is a reason some very rich people are offering to pay more tax you know…they know this way is better than money printing and devaluation. They fear what will happen to their businesses and capital as money printing goes wild and people stop buying and working. There is no need for that to happen. We need to spin up the money not slow it down with austerity and fear so people save and horde money.

Of course a host of other fixes are needed but this would be a good start. The USA has all the tools just know one to start using them again to make this happen.


Reactions: Twitter, blogs
  1. Linda Burnip

    Introducing the 'austerity curve' and how it affects the UK economy http://t.co/UIF0rERT

  2. Paul Hood

    RT @sunny_hundal Important > @DuncanWeldon introduced the 'Austerity Curve' and shows how cuts lead to a downturn http://t.co/sw4KZJuW

  3. 1nvisibleman

    Important > @DuncanWeldon introduced the 'Austerity Curve' and shows how cuts lead to a downturn http://t.co/02ccI434

  4. Nick Bentley

    Loving the old 'austerity curve' http://t.co/RRZjT92l #toofartoofast

  5. The Austerity Curve...

    [...] Austerity Curve… January 23, 2012By Rob WallerEven for the Left this is moronic… Might it then be the case that something like a Laffer Curve exists for austerity? That is [...]

  6. Joseph Burnett

    Important > @DuncanWeldon introduced the 'Austerity Curve' and shows how cuts lead to a downturn http://t.co/02ccI434

  7. Janet Graham

    Introducing the 'austerity curve' and how it affects the UK economy http://t.co/UIF0rERT

  8. Robert CP

    Introducing the 'austerity curve' and how it affects the UK economy http://t.co/UIF0rERT

  9. Owen Blacker

    Important > @DuncanWeldon introduced the 'Austerity Curve' and shows how cuts lead to a downturn http://t.co/02ccI434

  10. Rob Shepherd

    Important > @DuncanWeldon introduced the 'Austerity Curve' and shows how cuts lead to a downturn http://t.co/02ccI434

  11. wendy griffiths

    Important > @DuncanWeldon introduced the 'Austerity Curve' and shows how cuts lead to a downturn http://t.co/02ccI434

  12. David Davies

    Introducing the ‘austerity curve’ and how it affects the UK economy ~ http://t.co/HQg1PZE7





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