According to the Director of Demos “the most important question about the state is not how big it is, but what you do with it”. (1) In support he cites John Stuart Mill, but he would have done far better to cite Adam Smith, who argued in The Wealth of Nations that the opposite was true. The lower are overall taxes, the smaller is government and the higher are living standards (as well as liberties).

Most market sympathisers know this, but for support they concentrate on statistical evidence such as the adverse relationship between economic growth and the level of overall taxes. (2) This evidence is very strong, but an underlying theory showing WHY this is the case would make it far stronger. Naturally such a theory exists, but it is little known nowadays outside Adam Smith aficionados and the Austrian School of Economics to which both Ludwig von Mises and F. A. Hayek belonged. Even then, I have yet to see a simple and arresting explanation. In The Constitution of Liberty, Hayek refers to the effects of taxation, including “the frequent restriction or reduction of the division of labour”. (3) The Institute of Directors’ Graeme Leach refers to the “deadweight loss” as the loss of output that would have occurred in the absence of the tax – a loss of economic welfare above and beyond the tax revenues collected. (4)

These observations are absolutely correct, but it is probably fair to say that they do not describe in layman’s terms the simple mechanism at work. We must remember what we are up against in the shape of government and the public sector in general (including many schoolteachers and lecturers); the last thing they want is to have their cover blown. It is nothing short of a scandal that generally respected commentators can still promote government spending as a major plank in getting out of the current recession when (in addition to the fact that such spending was a major plank in creating the recession) it will inevitably reduce output even further. Such a level of ignorance could not possibly exist were it not for the state’s iron grip on the education system via a nationalised school system including a national curriculum. And you certainly won’t find a mention of the topic on the website of the “National School of Government”, the Civil Service training college.

All taxes are based on the exchange of goods and services

How, then, can the fact that every rise in overall tax levels means a net reduction in aggregate living standards (a net reduction which in my estimation for the UK at present is about three-quarters of the tax rise) be brought to the attention of the wider public? (5) It is not as if the theory is complicated. Consider, for example, tax in the form of tariffs or import duties. A tariff is a simple tax on cross-border trade and even its advocates must appreciate that it reduces such trade – that is the intention! Now consider tariffs on trade within a country’s borders – in other words, taxes. Again, such tariffs reduce trade, this time internal trade. Borders make no difference to the outcome; the price of trading is increased, and those participants whose preferences for the exchange are not strong enough to accept the additional cost will cease to participate.

Naturally, the higher the tariff, the greater the loss. A 50 per cent tariff would remove very large numbers from the relevant trades and exchange. Let’s face it; a 50% tariff is halfway to a 100% tariff, which would entirely eliminate all trade and exchange if effective, and take us back to the Stone Age – or worse. (As Adam Smith himself said, “nobody ever saw a dog make a fair and deliberate exchange of one bone for another with another dog”. Man is the only animal that carries out voluntary exchange and he owes his prosperity to this.)

The only difficult point to grasp is that all taxes are effectively tariffs, i.e. taxes on exchange or trade (which means that a 50% tariff is a reality in the UK). When you think about it, there’s nothing else to tax. Excise Duties, VAT, Corporation Tax, Income Tax, Council Tax, Rates, and so on are all derived from trade. If you provide me with food and I provide you with clothing, it matters not whether Government takes its cut on the trade itself, or from you and me as providers and recipients of the goods. The only activity that eludes tax is providing for oneself, and oneself only, in the form of DIY (do-it-yourself).

Households are tax havens

The above reasoning leads to an example so simple that it could be easily taught in primary schools. Trade and exchange within a household is not taxed at all. So a married couple (say) can enjoy the fruits of Ricardo’s law of comparative advantage without any government rip-off. If the female is a great cook, and the male a great gardener (or vice versa), each can concentrate on what they do best. But a similar pair of people who are friends but don’t share a home cannot, strictly speaking, do the same without being taxed. This means immediately that under a 50% tax on exchanges, each of them needs to be at least twice as productive at his/her own speciality if these specialities are to be put to full use. If this (quite high) productivity hurdle is not reached, each partner will carry out both activities, entirely for himself/herself, so as to avoid the tax, which has thus entirely removed the division of labour but has yielded nothing. Since each is working inefficiently for half of the time, there is a loss of total output. This is the deadweight effect. (6)

Child’s Play

At this point the basic argument has been made. The introduction of a 50% tax on the exchange of goods and services within a household would remove large swathes of division of labour in the household, which accordingly suffers a very significant loss of productivity. Any normal child of primary school age would be able to see the results daily (“why are you doing that, Dad, and making a hash of it to boot?”) and would understand that something similar happens outside households if the same taxes operate. There is no reason why this cannot be taught in primary schools; it certainly seems more useful than learning Mandarin! (7)7. While a modicum of teaching in the private sector remains outside government control, a campaign aimed at private schools to teach this simple fact may just work. (Naturally a successful campaign at state schools would be even better!)

If we now move from an untaxed household to a hypothetical (similarly untaxed) community, the standard of living will be much higher (due to the vastly greater division of labour and the similarly greater number of tasks which can be undertaken). But since each worker is now concentrating on his/her speciality nearly all the time rather than only half of it, any reversion to DIY is doubly damaging.

Thus the UK’s 50% tax (all taxes combined) knocks out all divisions of labour which don’t carry an extra 100% productivity compared to DIY. You have to be more than twice as good at your speciality to carry it out, pay the tax, and still be ahead of the game. This is a big hurdle, and here I’m ignoring the regulatory costs involved (“health and safety” for example). Note also that the behavioural changes come into being before the tax is (or would be) paid, so it is impossible to collect as if the trades and exchanges were still operating.

The larger the community, and the greater the diversity of natural resources within it, the greater are the opportunities for the division of labour and higher living standards. On a world scale, low taxes and genuine free trade (as opposed to trade “managed” by governments) would maximize the division of labour i.e. the use (and promotion) of comparative advantage around the world. (8) The scope here is huge, bearing in mind that global, cross border trade as a percentage of total trade has only just reached its pre-1914 level.

We now need to verify (or otherwise) whether the conditions of a small community still hold on both the national and international stage.

The tax effect operates at the margin

First of all, we must look at the effect of overall rates which differ from my 50% illustration. One of the problems with most of the literature on this topic is that the debilitating yet often silent effects of tax is that the statistics used to estimate the adverse relationship between economic growth and tax do not properly cater for the different levels of overall taxation. This is crucial; the effects of a tax hike of one percentage point are far greater if tax is already high as opposed to very low. My estimate that a move in the UK of total taxes from 30% to 50% has meant a loss of one sixth of national output would be far less marked in a move from 10% to 30%. (9) Or more simply put, a move from nil tax to 50% would not remove all output except strict DIY, whilst a move from 50% to 100% does just that!

Is an “all taxes combined” rate still realistic on a world stage?

It may be argued that because each of the myriad of businesses and other economic agents act only with regard to their own tax situations, the use of an aggregate tax rate is no longer applicable. “Thus,” the argument goes, “while we can accept that income tax might be responsible for the lack of old-fashioned nannies or the similar lack of chauffeurs for sales reps (as opposed to for big company executives), it doesn’t follow that the disincentive is on average 50%”. But the fact that every market participant faces a smaller array of taxes is irrelevant. If all taxes were levied only on the consumer as expenditure taxes or tariffs the true rate of 50% would be exposed. (A single tax is still favoured by many serious economists, one of the most popular being an expenditure tax.) (10)

Hayek's triangles: A necessary digression

Before proceeding further, a digression on the structure of economies will help us to understand the bones of the Austrian School Theory of the business cycle, and introduce the triangles of F. A. Hayek. In essence the argument is as follows. (Please also note the charts which follow.)

(i) In developed economies, a crucial element is the presence on a large scale of capital goods, provided via previous saving which in turn requires partial abstinence from consumption. For example, take Robinson Crusoe stranded on a desert island, who needs to eat fish to live. At first he uses a fishing net hastily cobbled together, but sees the enormous possibilities of working from a boat. To find the time to build one, for a while he must survive on some combination of fewer fish, less sleep, less exploring, and so on. Building the boat is a huge drag for him but when it is finished his fishing will be far more productive. He has saved time and resources to build capital equipment and multiply his output beyond recognition.

(ii) A developed economy has made very large savings, over many years, in order to build capital equipment – factories, machinery and so on. This lengthens the overall time-period to produce goods and services but the wait is worth it as the goods eventually come on stream – of high quality and in huge quantities. Anybody can fashion a very simple wooden pencil in a few weeks, for example, but their mass production involves thousands of processes from all over the world and takes a decade or more to reach the shops from the original logging of cedar trees (more still if the growth of the necessary trees is taken into account, which it should be). (11)

So the hallmark of a developed economy is a long period of production, with a massive pay-off in both quality and quantity.

(iii) In free markets, all this is held together by the infrastructure of businesses, whose total spending dwarfs all government and consumer spending (broadly GDP) by a factor of around four. In particular, market interest rates are unknowingly determined by consumers and savers in their relative propensities to consume or save. This is what determines the length of the production periods. Low time-preferences for goods “now versus later” mean that consumers are prepared to wait for something bigger and better for relatively little reward in terms of interest in the meantime, whilst high-time preferences mean “I want it now (or soon)”. If market interest rates are sabotaged by government (as they are) the incredibly delicate structure of the economy is torn apart. Artificially low interest rates result in an artificially long and unsustainable production structure and the following recession is a purge to a more sustainable structure in tune with what are undoubtedly significantly higher consumer time-preferences – although at some point these “I want it now” preferences will moderate as the need for greater saving kicks in.

 

 

Back to taxes, the division of labour, and business expenditure

As mentioned above, in developed economies, business expenditure is far higher than GDP, which is little more than government and consumer spending. Business expenditure is a good measure of the length of the productive period shown in the above charts. In turn, that length illustrates the depth of the division of labour. The biggest sufferers from high tax are savers, whose savings enable a long production period by providing money for investment. We are now seeing in the UK and the USA a contraction in the division of labour, which means a contraction in average living standards in future. Already in the USA business expenditure last year slumped by 10% – a far greater fall than that of government or consumers. (12) The UK picture is likely to be similar.

In other words, both government spending – i.e. tax and future tax to pay back borrowing – and consumer spending have careered out of control and point to an even greater reduction of the division of labour in future. Indeed there is evidence that this has been going on for two decades or more. (13)

The vast majority of politicians haven’t the foggiest idea of such changes or their import. But the fact remains that in all private sector business activity, the demand for the division of labour has its own structure fashioned under the silent influences of taxation, and the supply of expertise and skill operates in unison. Thus, just as under lower taxes domestic issues such as cleaning, house-maintenance, decorating, and many other DIY tasks around the home would be contracted out to specialists, so a typical business today combining a PA/secretary/typist, a finance director/pension scheme manager, a book-keeper/accountant, and various factotums, would (under lower taxes) would similarly split them up into deeper specialities – either within the firm or, more likely, contracted out. (Under higher taxes the reverse will apply). Without the tax wedge, the greater division of labour would allow more contracting out to take place, the average size of firm would be smaller, and the number of businesses would be larger. (14)

Perhaps anti-capitalism protesters against giant global companies, having first learned that global cross-border trade has only recently returned to its pre-1914 position, should focus on campaigning for lower taxes as a means to promote smaller firms. Knowledge of the underlying principles behind economic activity would be a good counterbalance to the hopelessly misguided economic thought that currently dominates.

Notes & References

1. Reeves, R. (2009) Daily Telegraph, 13th November.

2. See for example, ‘The driving forces of economic growth’ OECD Economic studies 2, 33 (http://www.oecd.org/dataoecd/26/2/18450995.pdf) , the IOD’s recent publication ‘How to save £50 billion’.
and www.heritage.org/index, www.fraserinstitute.org

3. Hayek, F. A. (1960) ‘The Constitution of Liberty’.

4. Leach, G. (2009) ‘The negative impact of taxation on economic growth’ Institute Of Directors.

5. Arthur, Terry, ‘Economic Affairs’, March 2003.

6. This assumes for illustrative purposes that the relative advantage is the same for both parties and that both activities are required to the same extent.

7. Suggested in January 2009 by Ed Balls, current Schools Secretary.

8. Here we should note that, as Ricardo showed, there are still efficiencies to be gained even if A is more productive than B in all activities.

9. This estimate is perhaps more a guesstimate. The effect depends on the statistical distributions of the additional productivity under specialisation. My estimate assumes that the additions between 0% and 100% add up to a similar total to the additions of more than 100%. This seems plausible and I believe it is futile to try and nail this down any further; this is especially so given that my estimate fits in very well with all the statistical data.

10. In fact the actual burden of nearly all taxes, including sales or expenditure taxes, is shifted back to income taxes, from those who physically pay them. See Rothbard, M, ‘Man, Economy, and State, with Power and Market (Chapter 12), Mises Institute. (2004)

11. Read, L. (1998) ‘I….. Pencil’, The Foundation for Economic Education, Revised Edition. (fee.org/doc/i-pencil-3/ )

12. Corrigan, Sean. (2009) ‘Tangible Ideas’, Diapason Commodities Management.

13. The Capital Letter, Capital Insight, May 2002.

14. Coase (1988) ‘The Firm, the Market, and the Law’, Chicago, University of Chicago Press. Ronald Coase argued that business firms exist to avoid some of the transaction costs which would otherwise be necessary.