From PJ O’Rourke’s excellent Eat the Rich, something which will resonate with economics students everywhere
Recently I wrote about the curiously stable 35% share of GDP which the British government takes in tax. I want to add something about that.
In March 1974, Labour Chancellor Denis Healy raised the top rate of income tax from 75% to 83%. The effect of that on the share of GDP taken in tax (the government’s allowance) over the next five years is shown below
Source: The Guardian
In 1979, Conservative Chancellor Geoffrey Howe lowered this to 60%. Again, the effect of that on the government’s allowance over the next five years is shown below
Source: The Guardian
Finally, in 1988 Howe’s successor, Nigel Lawson, reduced the top rate of income tax to 40%. As before, the effect of that on the government’s allowance over the next five years is shown below
Source: The Guardian
What I think this does is to isolate from the previous chart the effects of quite large changes in the top rate of income tax on the government allowance. Quite simply, there isn’t one, as the chart below illustrates
Why not? If these changes in income tax rates are not producing commensurate changes in total tax revenues that must be because top rate taxpayers are reducing their tax exposure elsewhere. The lesson is one of the oldest in economics; people respond to incentives. If they are taxed differently they will act differently. There are three things to take away from this.
First, is that estimates you see which say ‘an increase in the x tax rate of x% will bring in £x more revenue’ need to be clear that they mean revenue from that tax, not total revenue. The evidence is that that will be largely unaffected.
Second, ideas, prevalent on the political left, that Britain can increase the top rate of income tax to close the deficit are fantasy.
And, third, the idea, prominent on the political right, that slashing tax rates will ‘shrink the state’, reduce the share of GDP accounted for by government activity, are equally misguided. As well as showing the minimal effects of tax rate rises on that 35% figure, the chart above also shows the minimal effect of tax cuts.
Once again, the British people seem to have decided, collectively but individually, that 35% of their income is what the government is going to get. The sooner fiscal policymakers reconcile themselves to that fact, the better.
Governments have three ways of getting money to spend
1) They can tax it
2) They can borrow it
3) They can print it
If you can think of anymore, let me know.
I wrote a little while ago about how the government of an independent Scotland would finance itself. I argued that if Scotland adopted a currency board with England its government wouldn’t be able to pursue 3 and if their fiscal situation was poor they’d struggle do 2, at least at a rate they could afford. This would leave them entirely reliant on 1 and I doubted that that avenue would provide the revenue necessary to sustain Scotland’s present levels of government spending.
The case of Greece is interesting. In the euro its government cannot pursue 3. It’s citizens have a famously low tolerance for 1. It has just about exhausted its capacity for 2. That is the Greek crisis in a nutshell.
If Greece left the euro I believe avenues 1 and 2 would still be closed to the Greek government. I don’t think Greeks are going to suddenly start paying lots more tax and I doubt lenders will reassess the country as a sound credit risk. But the Athens government would reopen avenue 3 – it would have control of a new drachma and could print it to finance its spending.
The obvious drawback is that this would be inflationary. All those euros that Greeks are unable to shift out of Greece would be swapped at some rate for x drachma and that rate would, almost certainly, fall and fall quite rapidly as the government printed more drachmas to continue funding pensions which currently amount to 16.2% of Greek GDP. The spending power of Greek citizens will fall just as surely as if their wage had fallen in nominal terms from €1,000 to €800 a month.
But even this has limits. If they could find a counter party (a big if) holders of drachma could switch their currencies, even at heavy discounts, for other currencies in an effort to preserve something of their purchasing power. This is capital flight. Alternatively, they could swap money for goods and services in Greece while their money can still purchase them. The falling demand for money relative to the demand for goods and services would increase the money price of those goods and services – inflation. Less generally, it could push up only a few prices and create asset bubbles. The point to make is that all money is convertible, even fiat paper money. That, after all, is its point.
Governments always and everywhere have to live within the three means listed at the top. 1 is limited by the public’s willingness to pay. 2 is limited by people’s willingness to lend. 3 is limited by people’s ability to swap their money for something else. Hopefully this will be heeded by whoever is in charge in Greece a month or so from now.
EDIT – This post was picked up by the people at the Foundation of Economic Education