George Osborne may have just rediscovered the Laffer curve

THERE has long been a debilitating tension at the heart of this government’s thinking on the economy. It has embraced supply-side economics in a limited number of areas, slashing corporation tax and the top rate of income tax to boost incentives, effort and investment, in the knowledge that the faster economic growth generated would mean that the tax cuts will eventually at least partly pay for themselves. 

Yet the coalition has also explicitly rejected this supply-side view in other areas. It has refused to introduce tax cuts unmatched by equivalent spending cuts, arguing that to try and account for the dynamic, pro-growth impact of lower taxes was too dangerous. Some coalition insiders have even dismissed supply-siders as reckless purveyors of Reaganomics, and insisted instead on a simplistic bean-counterish version of tax policy.

In doing so, they have adopted the static, Brownite view of tax policy: that to hike taxes by £1bn ex ante will lead to an increase in revenues of £1bn – while in fact the amount raised can be lower or even negative. Even Keynes himself accepted this. Like many other economists throughout the ages, he understood and agreed with the principles that underpinned what eventually came to be known as the Laffer curve: that above a certain rate, hiking taxes further can actually lead to a fall in income, and cutting tax rates can actually lead to increased revenues.

Writing in 1933, Keynes said that under certain circumstances “taxation may be so high as to defeat its object… given sufficient time to gather the fruits, a reduction of taxation will run a better chance than an increase of balancing the budget. For to take the opposite view today is to resemble a manufacturer who, running at a loss, decides to raise his price, and when his declining sales increase the loss, wrapping himself in the rectitude of plain arithmetic, decides that prudence requires him to raise the price still more—and who, when at last his account is balanced with nought on both sides, is still found righteously declaring that it would have been the act of a gambler to reduce the price when you were already making a loss.”

The problem is that the static economic models used by the Treasury and other influential forecasters simply don’t incorporate such crucial insights. They don’t sufficiently account for the dynamic, supply-side effect of changes to tax rates on growth; for them, taxes primarily matter in as much as they reduce or increase demand. Unfortunately, these models make it much harder to cut taxes as the predicted fiscal downside is artificially magnified and the upside ignored – so politicians of all parties are locked into to an unrealistic world.

We need a new model – and astonishingly, after years of keeping us waiting, Osborne appears finally to have delivered the goods. Osborne will today announce that HMRC has started to run some dynamic simulations on what appears to be a new, state of the art Computable General Equilibrium (CGE) Model. The results of the dynamic scoring are striking: the new model finds that the coalition’s cuts to corporation tax will, over time, significantly boost growth and that over half of the static “cost” of the tax cut will be recouped.

In 20 years’ time, these tax reductions will increase the long run level of GDP by between 0.6 and 0.8 per cent and increase business investment by between 2.5 to 4.5 per cent of GDP. This seems on the low side but it is excellent news that the Treasury has finally delivered. The next step would be to score all of Osborne’s proposed and previous tax changes on the new model. The coalition is unlikely to have the guts to go that far – it won’t like all of the answers, especially those of a Reaganite flavour – but a central taboo of British tax policy has just been smashed, and that is reason enough to celebrate.

allister.heath@cityam.com
Follow me on Twitter: @allisterheath

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