Overcoming the public choice dilemma
With the death of James Buchanan, it is interesting to reflect on some implications of public choice theory. Public choice theory presents a powerful explanation of why democracies tend towards government expansions that are difficult to reverse. As Dr Butler succinctly puts it: 'small groups with sharply focused interests have more influence in decision-making than much larger groups with more diffused concerns, such as taxpayers.'
Buchanan and the public choice school stress the importance of constitutional restraints on the size of government. Indeed, many Americans revere their Constitution’s ability to check the growth of government. Some of the Founding Fathers understood the public choice-style implications of large government and the tendency towards it, even if they did not express these fears in the same language.
But American constitutionalism has not been entirely successful in restraining the growth of government. For all its merits in guaranteeing enunciated political liberties, over time the US has seen such significant erosion of many of the economic liberties of the US that in many respects it is not greatly different from European 'social democracies' in terms of government spending or economic regulation.
Fortunately, it is not inevitable that large government will favour special interests. Public choice assumptions account for only part of the rationale for collective action. There are significant variations between and within different polities in relation to particular levels of government activity. There have been points when large group interests have coalesced to prevent further exploitation by special interests. Without siding with critics of Public Choice, it is important to recognise that its explanatory power is not total.
I would argue, following Robert Higgs (his fascinating lecture series is well worth a listen), that ideology also presents a major explanatory factor that runs counter to 'instrumental' interests. In the US, this would suggest that the growth of government and the 'failure' of the Constitution has been caused as much by the development of new ideologies such as Socialism, Progressivism, Keynesianism and so on as by pure instrumental interests (particularly because the results of such ideologies often run counter to the instrumental interests of many of those who support them). By the same token, the American Revolution itself emanated from a Whiggish culture and ideology which was imbued with a scepticism of powerful government and a desire for liberty. Ideology, as much as interest, also explains say, the abolition of the slave trade or Thatcherism.
Those advocating a smaller state should, therefore, take some heart that public choice theory does not provide a remorseless logic of concentrated special interests overpowering the general interest.
Public choice presents a powerful ideological reason to oppose big government and rent-seeking, and ideas about how to do so. But, alongside public choice critiques of government, we must also promulgate an ideology of a free society and limited government. As Higgs points out, prevailing ideologies can be shifted, sometimes rapidly.
Welfare cuts might save money, but where's the growth?
Following the benefits cap debate today, I can’t help but think that, yet again, the government has missed the point. Yes, the cap will save some money. Virtually everything the government spends money on needs to be cut. But where are the pro-growth policies? Where are the jobs that people on welfare are supposed to take? And where is the wholesale reform of the state that would allow the really big cuts to be made?
The country is broke. Government debt has topped £1 trillion. This year, we will have borrowed another £108.5 billion, only down £13 billion from the year before. The deficit reduction plan has only just begun, and we'll keep borrowing until 2018 at the earliest.
At a little under £3bn/year, the savings from capping the rise in benefits at 1% in cash terms (a real-terms cut, in other words) are better than nothing. But let’s not kid ourselves – they will be painful, especially since the fastest-rising prices are for things like food and home heating. Because we tax low-income workers and then give it back to them in the form of ‘tax credits’ (which are really just a cash transfer payment), many people who are in work will be affected.
On the other hand, public sector pay has been capped at the same rate, and it would be perverse for benefits to rise faster than Whitehall cleaners' pay. And this is no ordinary recession – the deficit is staggeringly big, and the global economy is moribund. Cuts really do need to be made, and I haven't heard any alternatives from the people opposing these ones.
As I wrote last week, the government has singularly failed to make the big reforms that would make public spending cuts work by promoting growth. There has been essentially no deregulation of enterprise; no simplification of the tax code to produce a revenue-neutral tax cut (for everyone who can’t afford a Westminster lobbyist, at least); no real, pro-construction reforms to the planning system; and no sense on immigration.
The principle of universal benefits is, thankfully, being chipped away, but as long as the health and pensions systems remain as they are there will not be any way to avoid people on £24,000/year paying for the healthcare and retirement of people who have earned three times that.
So long as the tax threshold is so low, the government’s claims to be ‘making work pay’ are a joke. Full-time minimum wage workers pay nearly £1,600/year in tax, which is then topped up by more welfare money (the mis-named ‘tax credits’, which will now be capped!). How different would today’s debate be if we weren’t taking low-income workers’ money away with one hand and giving it back as welfare with the other?
But these things are difficult. It’s easy not to touch business regulation, to keep immigrants out and leave reform of the welfare state to some other sods. Welfare cuts are very popular with voters, and it’s easy to see why. So, another frustrating day – some cuts, yes, but none of the reforms needed to grow the economy and make them work.
Pensions tax relief is no stealth subsidy
The UK Labour Party’s plan to reduce the tax relief that higher-rate taxpayers can take when making private pension contributions (in order to fund job-creation programmes) is an intriguing one.
Labour finance spokesman Ed Balls argues that “When times are tough it cannot be right that we subsidise the pension contributions of the top two per cent of earners at more than double the rate of people on average earnings paying the basic rate of tax.” Under his plan, those earning £150,000 would be able to claim only 20% tax relief on their pension contributions – the same rate as a person on average earnings – rather than the 50% that top earners can claim now (which will fall to 45% in April as the top rate of tax is reduced).
What Mr Balls forgets, however, is that the tax relief available on contributions to private pension plans is not, in fact, a straight subsidy. It is, rather, deferred taxation. And that makes a big difference, since if taxation is being deferred, it should be deferred at the rate it is paid.
Confused? You should be. Pensions are absurdly complicated. But here is how the tax relief actually works. Decades ago, governments wanted to encourage people to make private pension contributions. This, they reasoned, would help keep them off the welfare rolls when they retired and no longer had a wage coming in. And it would encourage thrift and self-help. So they decided to defer the tax on pension contributions. In other words, if you took all your salary now, you would pay tax on it. If, however, you chose to defer taking part of your salary and instead invested it in a pension, then part of your tax would be deferred too. That is, people would be taxed only when they actually consumed their pay: postpone the consumption, and the tax is also postponed. They would not pay tax on income that they were not actually enjoying right now.
Thus a 20% income tax payer would not pay the 20% tax on contributions to a pension, until they actually started drawing that income. Likewise a 45% income tax payer would not pay the 45% tax until they did the same. It is not a differential subsidy for high earners, just a postponement of their tax on income that they have decided to put off enjoying.
Under this logic, reducing the tax relief on higher-rate earners amounts to confiscation. They defer consumption, but still get landed with 25% tax on income they have not yet drawn.
However much governments might like to tax people on income they do not draw, it doesn’t make it right.
Cut spending? If only it were that simple
In between the turkey, spiced beef and mugs of hot port, I spent some of Christmas thinking about the state. Specifically, how to make it smaller.
Milton Friedman used to say that cutting taxes would force governments to cut spending to make ends meet. The last ten years has basically proved him wrong. Why cut spending when you can spend more, tax less and let the next lot pay the bill?
The old ‘tax cuts first’ strategy is dead. For a smaller state, we need to cut spending as we cut taxes, and avoid government borrowing as much as possible.
But it’s not quite that simple. The problem is that there aren’t many places you can cut without also changing quite a few other things as well. “Cut spending” sounds good, but, without much more fundamental reforms, almost any big spending cut would leave a lot of people high and dry.
The five biggest areas of government spending are health, welfare, pensions, education, and defence. To really shrink state spending, we need to cut all of these things. But without a complete overhaul of policy in general, no real cuts can be made.
The NHS is a socialist bureaucracy, but until we liberalize the healthcare market and make health insurance a viable alternative for NHS users, cutting the NHS might very well make patients’ lives a lot worse. A simple cut to the NHS would be bad because, thanks to the state, a lot of people depend on it for their healthcare.
The same goes for all the other big areas of spending. Want to cut education spending? Fine, but without something like school vouchers or private education tax credits, things will probably get worse. Some bits of welfare can and should be cut, but without planning reform to reduce the cost of rents and employment deregulation to increase the number of jobs going, people who genuinely cannot find work will suffer. And a tax system that takes £1,500 from a minimum wage worker is utterly morally bankrupt.
Try explaining to granny why her pension is being cut after spending her life paying National Insurance (under the impression that it was something other than a tax in disguise). And defence cuts – great, but not until we’re out of Afghanistan and servicemen’s lives won’t be threatened by a shortage of bullet-proof vests.
Of course deep spending cuts are needed. But, unless you’re happy to mess over people who rely on state services through no fault of their own, they can only work in conjunction with big changes in how we do things.
Spending cuts are a little bit like Brussels sprouts: quite good for you, but not very appealing on their own. But as part of a bigger meal, they can be wonderful. Deeper cuts are only possible with fundamental libertarian reforms of the state. That will be a bigger task than many would like.
The true lesson of A Christmas Carol
As I've mentioned, this is the time of year to be talking about taxation. It was Caesar Augustus who started this whole Bethlehem thing after all. And here we have Steve Landsburg telling us that the real lesson of A Christmas Carol is, well, it's this:
Great artists are sometimes unaware of the deepest meanings in their own creations. Though Dickens might not have recognized it, the primary moral of A Christmas Carol is that there should be no limit on IRA contributions.
Well quite. And this is the lesson of the Mirrlees Review as well.
As Landsburg points out. if you save then you're doing someone else a favour. If you save what you've earned and stick it in the bank then that lowers interest rates (however infinitesimally) for someone who wants to borrow, allowing them to consume. And if you save just under the bed then you have produced something in order to earn but you're not consuming. Thus leaving more goods and services to be consumed by others.
The lesson of which actually extends long beyond IRA (or pension) contributions. All savings and all earnings from savings should be tax free. It is consumption, not income or capital, that should be taxed. As indeed the Mirrlees Review goes on to point out.
What we'd really like to have is a proper consumption tax. At the end of the year your income is measured. What you have added to savings is deducted from that. What you have withdrawn from savings and spent is added to it. It is this net sum, income plus or minus changes in savings, which then pays tax. Earnings on savings which are reinvested are not taxed.
Essentially, all savings are inside a giant ISA in our system. At which point Tiny Tim would indeed be able to say, "God Bless us all. Everyone."
Eric Pickles shows us what's really wrong with local government
It is the season to be talking about taxes isn't it? After all, yesterday's historical events took place where they did as a result of the coralling of the population to work out how many could be taxed. Which gives an opportunity to highlight how Eric Pickles illuminates exactly what is wrong with local government finances.
This is a super little paper with 50 ways that councils can save the taxpayers' denarii. Hire out the town hall for weddings, don't order mineral water at meetings, use tap. Make sure meetings aren't over lunch so that no lunch need be provided. Stick a coffee shop in the library (well, why not, bookshops have cafes now!). A couple in more detail:
Share back office services: from planning to press, from HR to legal. Does the country really need 350 different business rate collection departments?
Yes, fine with that: very similar in the business world. Not every company has a payroll department for example, there are plenty of subcontracting companies to do that for you.
Close council cash offices: Instead allow residents to pay bills in local post offices.
Sure, why not? In the same way that you can pay your other bills at the post office. Who really needs a network of cash offices when someone else will do it for a small fee?
Scrap trade union posts: Get rid of unnecessary non-jobs such as taxpayer-funded, full-time trade union ‘pilgrim’ posts.
That'll please Guido no end.
Cease funding ‘sock puppets’ and ‘fake charities’: Many pressure groups - which do not deliver services or help the vulnerable - are now funded by state bodies. In turn, these nominally ‘independent’ groups lobby and call for more state regulation and more state funding.61 A 2009 survey found that £37 million a year was spent on taxpayer-funded lobbying and political campaigning across the public sector.
Chris Snowdon is already celebrating that one over on his own blog.
Across the country there are hundreds of council-run MOT test centres which are used to check council vehicles like taxis and buses for their safety and roadworthiness; these centres can also open their doors to the public to provide MOTs to the wider public: this is a far better way of making money from motorists than the lazy way of hiking parking charges.
Yes, absolutely, sweat your assets.
Now you might think that this is just wonderful, central government telling people how to save money. But that's actually what I would complain about. No, not that they're saying it, but that having it said is necessary. For what this is actually showing us is that local government doesn't currently contain the incentives for those running it to reduce costs. As opposed to what happens in for profit businesses. Half that list above is the sort of thing that every business is always monitoring. What do we have that can bring in additional revenue? Have we spare capacity somewhere? Are we wasting money on this or that?
That local government needs to be told to do these things shows that the correct incentives just aren't in place in local government. Which is, I hope we would agree, something of a problem.
Pickles signs off with this Hayeckian point:
And finally… ask your staff for more sensible savings ideas: Your staff will be the most informed and actually the most enthusiastic about cutting waste. Give a prize for best staff ideas for efficiencies. Allow staff to submit anonymous ideas too.
Yes, knowledge really is local. The people actually doing things will be the people who know how to do them best. Provided those incentives are in place of course. The thing that really provides incentives being a market structure of course.....
The Laffer Curve doesn't depend upon what you think is a fair tax rate
While scribbling elsewhere on Gerard Depardieu and his fleeing of the extortionate tax rates in France it occured to me that there's something rarely mentioned in this whole thing about where the peak of the Laffer Curve is. It's that that peak isn't determined by what you think is a fair rate of tax that they should pay is. Nor what the community in general, or democracy, politicians, think is a fair rate. It's determined by what those who have to pay the tax rate think is a fair rate.
And there's a lot of very interesting economics been done on what people do think is fair: take the ultimatum game for example. Two people, $100. One of them gets to decide how the two will split it. The other one can accept the split or reject it: on rejection neither of them get anything.
The logical policy is to accept any split at all from 1:99 on up. Hey, at least you'll get a whole dollar! But as it turns out people just don't react that way. As soon as the split starts getting worse than $40:$60 the rejection rate goes way up. The conclusion is that we're so tied up, we weird humans, about fairness that we will even punish ourselves in order to punish someone else we think is acting unfairly. There have also been experiments with both monkeys and apes (although with lovely pieces of fruit rather than useless pieces of paper) that lead to the same conclusion. All of us higher primates seem to be wired pretty much the same way: you try and rip me off and I'll take you down with me fella.
I've not seen this point explicitly made anywhere: although I assume that's to do with my lack of reading more than anything else. But if that sense of fairness is hard wired, then obviously it's also going to apply to those we're trying to tax. Which will mean that that peak of the Laffer Curve, that rate at which people bunk off, leave the country, reduce their work loads, lie or cheat the taxman, isn't determined by what we think is a fair rate to tax them. It's a result of what they think is a fair rate to tax them. Which, of course, could be a very different rate indeed from what we think is a fair rate.
Indeed, when we look at the family fortunes and incomes of those who advocate much higher tax rates we do indeed see all sorts of shenanigans going on to avoid those higher rates. The list of wills altered, trusts to hide from inheritance tax, personal service companies, dividend splitting and all the rest: even those who propose those higher taxes rates wriggle as if they think they are unfair when applied to themselves. That revealed preferences thing again: those who face those rates don't think they're fair.
And as I say, adding that unltimatum game into the mix does tell us something very interesting. It's not what we, or the left, think is a fair tax rate that matters. It's what the people paying the tax think is a fair rate that does. And as that game tells us, people start getting very unhappy with anything less than a 40:60 split. To the point where they will indeed give up income themselves in order to punish those offering such a measly share.
Why we don't want to equalise capital gains and income tax rates
This will sound a little odd, for we nromally say around here that we want to remove distortions in the tax system. One obvious such distortion being that capital gains and income are taxed at different rates, leading to everyone who can manage it shifting income over into capital gains. However, we don't want to rush off and try to equalise those rates. The reason being the following:
What we mean by "integrated" here is the combination of the corporation tax and the capital gains tax. A share goes up in value as the company makes more profits. But it's post tax profits that do this, not pre tax. So the higher the corporation tax the less the share price will rise: thus the lower the capital gain that the shareholder will receive.
We should thus look at the interplay of both taxes on the amount that the shareholder receives for putting their money at risk. Which is exactly what this "integrated" rate is. And that's with CGT at the current rate of 28%, not the income tax rate of 45% (the tippy top rate that is). So, if we moved CGT up to the marginal income tax rate then capital gains would be more heavily taxed than income because of that bite already taken by corporation tax. And that's absolutely not what we want to happen at all: for we know that capital taxation has higher deadweight costs than income tax anyway.
There is one way to do it though. If we abolish corporation tax altogether and simply tax dividends and capital gains as the income they are then we will indeed have equal rates for all types of income. Plus, what joys, all the spivs trying to dodge taxes through manipulation of the corporate tax system go out of business. And tens of thousands of our most highly paid lawyers and accountants have to do something productive with their lives.
What's not to like? Abolish corporation tax and then tax all income as income?
But, but, people invest in order to get their profits back in their own pockets!
The US has a high corporation tax rate. The US also doesn't charge that tax to profits made outside the US and kept outside the US. Therefore, obviously, US corporations keep the profits they make outside the US outside the US. You know, that first great secret of economics, incentives matter?
Back a few years a temporary solution was suggestedL bring back the profits and we'll charge you only a teensie rate: many did. Again, incentives matter. Now there's vast mountains of money sitting offshore and perhaps that low tax trick might be tried again. Mebbe: but a common argument against it is the following:
ABSTRACT: This paper analyzes the impact of the Homeland Investment Act of 2004, which provided a one-time tax holiday for the repatriation of foreign earnings and thereby reduced the cost to U.S. multinationals of accessing a source of internal capital. Lawmakers and lobbyists justified its passage by arguing that it would alleviate financial constraints. This paper’s results indicate that repatriations did not lead to an increase in domestic investment, domestic employment or R&D—even for the firms that appeared to be financially constrained or lobbied for the holiday. Instead, estimates indicate that a $1 increase in repatriations was associated with a $0.60-$0.92 increase in payouts to shareholders—despite regulations stating that such expenditures were not a permitted use of repatriations qualifying for the tax holiday. The results indicate that U.S. multinationals were not financially constrained and were reasonably well-governed. The fungibility of money appears to have undermined the effectiveness of the regulations.
Note that this is used as an argument against the tax holiday, not in favour of it. when obviously it's an argument in favour of it.
The basic error is to think that investment is something only done by companies with the money that they have internally: thus the shock at the idea that shareholders might get some of their own money back. When in fact, all the really important investment in hte economy is actually done by individuals in new businesses: not by old ones ploughing back in their profits.
No, obviously, the amount of new investment is very much smaller than the amount of reinvestment. But that's not what I mean. The things that really change economies, that bring in the new disruptive technologies, are the entry and exit from the marketplace of firms. Which by definition means the creation of new firms able to do the entering (and exit of those going bust of course). And who are the people most likely to invest in a business from the outside? Clearly, those who have already shown that they will do so by virtue of the fact that they hold equity in a business or two.
At present there's some vast amount of money offshore in those corporations. $1.2 trillion, $1.7, estimates vary. Assuming that it is a good idea that this money leaves the Bahamas or wherever and gets injected into the US economy (which I think it probably is) then this argument about dividends is piffle. The very fact that it is likely to be paid out in dividends is the very reason why it's a good idea. For putting it into the hands of investors increases the chances that it will be invested in new businesses: the long run lifeblood of economic growth.