The Rahn Curve

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An interesting little idea that I'd not come across before: the Rahn Curve. It's analogous to the Laffer Curve, in that it says there's a level of public spending up to which more increases growth rates, over which it reduces growth rates.

It shows that growth is maximized by small governments that focus on core “public goods” like rule of law and protection of property rights. But when governments expand beyond a certain growth-maximizing level (the research says about 20 percent of GDP,....), the result is slower growth and less prosperity.

It's intuitively appealing to people like us of course and as with the Laffer Curve at extremes it's clearly and obviously true. Zero tax means zero government and without at the very least some form of defense, police and a criminal justice system there's not going to be much economic growth. When the government takes and spends all of the economy there's not likely to be much either. The argument will be, as with Laffer, what is that sweet spot? One interesting note is that Keynes himself thought that 25% of GDP passing through the government's hands was probably as high a portion as we would want.

However, it's also true that growth purely as growth isn't the only thing we want:

There is also another issue which can get lost – the fact that maximizing growth rates is not necessarily the government’s highest priority. Issues of equity, fairness and concern for the environment are arguably more important than maximizing rates of economic growth.

As indeed it is also arguable that they are not. But I'm entirely happy to accept that stricture, that economic growth isn't the only thing we want out of an economy. What this Rahn Curve does allow us to do though is keep insisting that, as ever in economics, there's a trade off here.

How much equity and fairness now are you going to insist upon at the cost of making our children poorer than they could be? Given that we can't have both, a decision has to be made. And that's very useful in itself: a counter to those who say that greater equity now will make our children richer. It won't.

The real bonus scandal

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There was much irony and turning of tables at Whitehall this week. Yesterday, the Telegraph reported that more than 1,000 senior civil servants would receive bonuses of up to £20,000 this summer. According to Dame Helen Ghosh, Permanent Secretary of the Home Office, the sums are “not exactly big bucks”. The total cost to the taxpayer is estimated at £10 million. Well, a mandarin’s stay in Santorini is better value for money than, say, the fire brigade, right?

At issue are the hypocrisy and merits of awarding the bonuses. One of the most useful verses I’ve retained from Sunday school is Matthew 7:5, “Thou hypocrite, first cast out the beam out of thine own eye; and then shalt thou see clearly to cast out the mote out of thy brother's eye.” Ministers had called on officials not to take their bonuses but were dismissed. Big bonuses. Bad timing. Shamelessness. Sound familiar? The government should not impose a super-tax against banker bonuses while it keeps its own bureaucrats on the gravy train. There is less call to meddle in the private sector than to get their own house in order.

It is also unclear how effective the bonuses are as performance incentives. The Ministry of Defence has experienced its fair share of scandal this year, with £6.3 billion in assets unaccounted for, and yet its officials will still receive bonuses. If bonus grants are unresponsive to serious controversies like that, then there appears to be little link between performance and reward.

A Cabinet Office spokesman said on Wednesday that the Coalition government plans to “restrict bonuses for senior civil servants to only the top 25 percent of performers.” This is a move in the right direction. Performance-based incentives, when they actually tie performance to reward, increase productivity. They might well be used to make departments more cost-effective. To achieve this, though, the Coalition must be prepared to reduce salaries and marry bonuses to measureable success.

Why Britain's stuffed

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Scott Sumner sums it up:

British voters have no stomach for the savage inequalities of Swedish-style laissez-faire.

And he's right, the body politic simply will not put up with some of the major features of the Swedish State. No inheritance tax, low capital and corporate taxation, for profit voucher financed schools, well, read more of his list of what Sweden does and we do not, cannot.

And it's this paper that shows us why this means we're stuffed:

An increase in government size by 10 percentage points is associated with a 0.5 to 1 percent lower annual growth rate.

Yes, it is possible to have all those lovely accoutrements of an icy social democracy. But there is a price to be paid for it, reduced economic growth. The other name for which is making our children poorer than they could be.

However, there is a way out of this, a get out of jail free card:

countries with large governments compensate for high taxes and spending by implementing market-friendly policies in other areas.

Which brings us back to the way in which Britain simply will not put up with the sorts of market friendly policies that Sweden does routinely.

This is backing up a long held (and often said) contention of mine. Yes, it is possible to have a high tax, high government and high redistribution society. But in order to avoid stagnation while doing so you've got to have a classically liberal, almost laissez faire, economy humming along underneath.

You cannot have what the British left seem to call for, both a highly regulated economy and a highly redistributive one. You can, of course, have the low redistribution, lightly regulated one and that's of course what I would prefer (and I assume no one at all would like the heavily regulated and low redistribution version). Which means that yes, we need to deregulate the economy, whichever of the two, high or low redistribution, versions of classical liberalism you would prefer.

For the children, of course.

Real problems, nominal solutions?

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Two of my favourite macroeconomists online are Scott Sumner and Arnold Kling. Both have blogged about the OECD's chief economist's statement that the UK should slow the rate of government cuts if growth doesn't pick up soon. Sumner, who wrote a report for us earlier this year on The Case for NGDP Targeting (PDF), says this idea is:

Pain without purpose. Let’s make the UK budget deficit even larger, imposing crushing future tax obligations on an already over-taxed economy, and do so in a way that is assured of having absolutely no positive impact on growth. That’s conventional macroeconomics circa 2011. . . .

. . . it is still quite revealing that a prominent macroeconomist thought the solution to a growth slowdown is more government spending, rather than slowing the expected pace of monetary tightening.

Arnold Kling says that most British economics commentators are practicing "folk economics":

In textbook macroeconomics, aggregate demand is aggregate demand. It does not matter whether nominal GDP goes up because of monetary expansion or fiscal expansion.

Sumner points out that in the UK they are experiencing inflation without real GDP growth. According to textbook macroeconomics, that means that there is a problem with aggregate supply, not with aggregate demand. Instead, commentators are willing to blame the inflation on loose money while blaming the low real GDP growth on fiscal austerity. My guess is that very few textbook authors will bother to correct the commentators, because the textbook authors are hostile to the conservative government in the UK. . . .

Folk macroeconomics consists of spending and an aggregate production function. When the government spends more, output goes up, and employment goes up. End of story. Money is just voodoo. Oh, the central bank can jigger interest rates, but that does not really do anything. [Emphasis mine.]

Most economic critiques of government cuts (see Ed Balls' "too far, too fast" claim) argue that the cuts will hurt aggregate demand. But, as Sumner points out, these criticisms miss the other part of aggregate demand – money supply. If cutting government expenditure hurts demand, then increase the money supply to maintain nominal GDP.

As both Sumner and Kling argue, criticising the government cuts is silly from the textbook macro view. Any loss in demand from government cuts can be offset by a monetary expansion. Textbook macro isn't a perspective that I subscribe to, but it's fairly standard and surely what Balls and other critics of the cuts are basing their arguments on.

Debunking Keynesians

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Chris Edwards has a great piece on Cato-at-Liberty attacking former White House adviser Christina Romer’s Keynesian economics. Her assertion that “government spending on things like basic scientific research, education and infrastructure . . . helps increase future productivity” gets the full treatment:

• "Most federal spending is on transfers and consumption, not investment. The debt crisis we face is driven mainly by entitlements, which is consumption spending. Romer’s talk of investment spending is a rhetorical bait-and-switch.
• "Romer doesn’t distinguish between average and marginal spending. If some federal investment spending has created positive net returns, that doesn’t mean that additional spending would. Governments already spend massive amounts on education, for example, so the marginal return from added spending is probably very low.
• "If the government investments that Romer touts are so valuable, then why hasn’t the government done them already? After all, federal, state, and local governments in this country already spend 41 percent of GDP.
• "If science, education, and infrastructure investments have the high returns that Romer seems to think they do, then why does the government need to be involved? Private firms seeking higher profits would be all over such investments.
• "Romer mentions that the “social returns” on some investments might be higher than purely private returns. However, that doesn’t mean that the government should automatically intervene. For one thing, the government suffers from all kinds of management failures and other pathologies.
• "Romer also ignores that the government imposes substantial deadweight losses on the economy when it commandeers the resources it needs for its 'investments.'"

The university fantasy

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The idea – which I have to say has affected large numbers of politicians – that you can just give people at university a certificate and, hey presto, they’ll earn this amount more and the country will be x-amount richer has always seemed so bizarre to me that I have to pinch myself that so many apparently rational people believe exactly that. . . .

We know that pouring out skills is not one of the key ways in which you generate growth. Look at past experiments. Did the Soviet Union become the greatest economy in the world through a combination of planned allocation of resources and making everyone do engineering and science? No, it didn’t. Take a look at some of the successful economies. Look at Switzerland. It has one of the lowest higher-education enrolment rates in the world, yet it has a fantastic economy. If the economy demands skills and you’ve got a decently responsive higher-education system you’ll end up with an equilibrium situation… You don’t generate growth through number of graduates.

Alison Wolf

People really do move because of tax rates

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We keep trying to tell the lefties this, that people really will move out of a tax area to escape high tax rates. The usual response rarely rises above "Yah, Boo, Sucks, so what?". And of course it's quite difficult to prove, absolutely, that the 180,000 odd Brits a year who are leaving the country are doing so over the taxes alone. There will obviously be some, like myself, who simply could not stand the weather any more.

However, a nice little natural experiment has been spotted. In the NBA (the American basketball league) there's a salary cap: not just how much the team can spend as a whole, but on how high individual salaries can be. Thus the long term, experienced, players end up on pretty much the same money whichever team they play for. Local and state income taxes are thus the biggest variable determinants of their take home pay.

There is a clear pattern of talented players migrating to, or staying with, teams in states with little or no personal income tax. Since they can more easily attract and keep better players, teams in states with lower taxes have consistently performed better on the court than teams in highly taxed states in recent seasons.

The effect carries through to team performances as well: teams from low tax states reach the playoffs more often than teams from high tax states. The win/loss ratio is also much better for the teams from low tax states.

It's also worth noting that basketball is a team sport: yet that migration of the star players due to tax rates does lower the performance of teams in high tax states and raise it of those in low tax ones. The analogy to people working in the general economy, also a collaborative, team, activity should be obvious.

Yes, people do move beause of tax rates and this does affect not just those individuals who move, but those they stop working with and also those they go to work with. Which is why we'd really rather have tax rates that don't encourage people to leave.

Tax Freedom Day, Part 2

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As of June 2024, this is out of date. Please refer to Tax Freedom Day 2024 for the updated statistics.

Tax Freedom Day 2011 came on May 30, three days later than in 2010. That means that for the first 149 days of the year, Britons were earning for the taxman. Only on May 30 did they start earning for themselves.

But even this alarming figure understates the heavy financial burden imposed by the British state. If the government had to finance all its spending through taxes, rather than relying on borrowing, Tax Freedom Day would not have come until today, July 1.

To put it another way, the government would have to take every penny earned in the United Kingdom from January 1 to June 30 – a full six months – in order to balance the books for the year at current levels of spending.

What’s our money being spent on? If Britons were funding all public spending through taxes, they would have to work 50 days to cover the cost of benefits, tax credits and pensions, and a further 8 days to cover personal social services. Paying for healthcare would take them 32 days. Education would take 23.

Shockingly, Britons would have to work a full 11 days to finance debt interest payments – that’s longer than they’d have to work to pay for defence (10 days) or law and order (9 days).

How big is the funding gap? The gap between Tax Freedom Day based on tax revenues – the traditional figure – and Tax Freedom Day based on government spending now stands at 32 days. That is a smaller gap than in 2009 (37 days) and in 2010 (40 days) thanks to the government’s efforts to reduce the budget deficit. But as recently as 2001, there was no gap at all – then, the government could fund all its spending commitments through taxes, without having to borrow money.

What’s going to happen over the next five years? Assuming that the coalition governments delivers on its promise to reduce spending, then Tax Freedom Day based on government spending will continue to come earlier in the year, and the gap between it and Tax Freedom Day based on tax revenues will continue to get smaller. Based on Office of Budget Responsibility forecasts:

• In 2012, Tax Freedom Day will be May 30 based on tax revenue and June 23 based on government spending – a gap of 24 days.

• In 2013, it will be May 31 based on tax revenue and June 16 based on government spending – a gap of 16 days.

• In 2014, it will be June 1 based on tax revenue and June 11 based on government spending – a gap of 10 days.

• In 2015, it will be May 31 based on tax revenue and June 6 based on government spending – a gap of 6 days.

No doubt the actual figures will turn out different from that – government forecasts are rarely correct a year in advance, let alone five. But I do think these figures provide an interesting indication of what is to come. The tax burden will get worse, but only marginally, and government borrowing will be reduced, but not eliminated. 

Bankers aren't evil

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Today's FT also contains an interview with Stephen Green, the former chairman of HSBC, who is now a government trade minister. It is for the most part fairly unexceptional stuff – the headline is that Green thinks the banks need to honour their Project Merlin commitments to SME lending – but one paragraph did catch my eye:

But one populist refrain – that bankers are “evil and greedy” – is enough of a red rag to prompt even the discreet Lord Green to speak up. “I have known many, many bankers in my time. To say there have been episodes and evidence of greed, of course, [but] evil is a very strong word to use on other people and I don’t do it, and nor would I think it’s helpful.”

Later, Green continues:

“I’ve got many banking friends, and I know what high-calibre people [they are], not just in a commercial sense, but also in the sense of wanting to do the right thing. The notion of demonising an entire industry for the undoubted failures that did occur in the banking industry is neither helpful nor fair.”

This is a point I've often tried to make to left-wingers, usually without success. Too many people are so blinded by hatred of the financial industry, that they simply assume that all its problems are caused by bad people with bad motivations. It leads them to completely overlook the very real structual and systemic problems in banking, and produces little more than shallow, populist rhetoric.

It's why so much public debate has focused on marginal issues like executive pay and bonuses, and so little attention has been given to the all-important skewed incentives created by bailouts, central banks, and government regulations. Political discourse seems inevitably to focus on the personal, which hardly matters at all, and ignores structures and systems, which matter a great deal.

Perhaps it was ever thus. But regardless, it's not a sensible way to discuss, let alone make, policy. 

The Bank of International Settlements gets it

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The BBC reports that the Bank of International Settlements, one of the few major economic institutions to forsee the financial crisis, has warned that monetary policy around the world needs to be normalized and that persistent low interest rates may prove counter-productive. It quotes them as saying:

The prolonged period of very low interest rates entails the risk of creating serious financial distortions, misallocations of resources and delay in the necessary deleveraging in those advanced countries most affected by the crisis.

Meanwhile, the FT's Norma Cohen and Chris Giles write:

The BIS report, however, warned policymakers not to expect a normal recovery because much of the pre-crisis growth had been unsustainable and capacity will have been destroyed for ever, particularly in finance and construction.

Jaime Caruana, general manager of the BIS, said on Sunday that the imbalances caused by unsustainable growth before the crisis “now need to be rectified, and as they are, growth is bound to be slow. Policymakers should not hinder this inevitable adjustment.

The emphasis there is mine. Now is it just me, or does the Bank of International Settlements actually seem to get it?