The deadweight of the money-go-round

Jamie Whyte
WHAT will the government do to promote economic growth? I wish everyone would stop asking this question. It encourages politicians to “do something”; it encourages them to “deliver”.

Yet the best way the chancellor George Osborne could promote growth is to stop delivering. Nothing that can be supplied privately should be supplied by the government – be it education, healthcare or the loans to small businesses that Osborne promised on Tuesday. To see why, you need only understand the deadweight cost of taxation.

Suppose you are willing to pay up to £10 an hour to have some work done, and the cheapest qualified labourers are willing to work for anything over £9 an hour. Then you should find someone to do the job. But if incomes are taxed at 20 per cent, the most the labourers can earn from you is £8 an hour and they will be unwilling to take on your job.

Sales taxes have the same effect. If I can produce a widget for £10 and you are willing to pay £11, then a widget will be produced. Unless, of course, a sales tax drives the price of my widget up to £12. The greater the tax, the greater the wedge driven between the prices sellers are willing to accept and buyers are willing to pay, and the greater the lost opportunities for productive activity.

Measuring the deadweight cost of a tax system is difficult. You cannot observe all the valuable things that are not made or done but would have been if not for taxes. But economists are ingenious, and estimates have been made. Most put the deadweight cost of raising another £1 of tax revenue at between 20 and 50 pence.

This means that anything funded by taxation costs 20 to 50 per cent more than it would if provided privately. Consider my daughter’s “free” state education. The government taxes me and spends £8,000 per pupil on her school. Add on the deadweight cost of tax, however, and the real cost is more like £11,000. If the government cut my taxes by £8,000 and left me to buy my daughter’s education privately, she could get the same education and GDP would be £3,000 greater.

Our coalition government is devoted to fairness, by which they mean severing the connection between what people earn and what they consume. But this mistake need not stop them from slashing taxes. They need only stop the money-go-round whereby people pay tax and then get it back in the form of government supplied services. That would allow taxes to be roughly halved and GDP to grow by about 20 per cent.

President Obama’s former chief of staff, Rahm Emmanuel, famously said that a reformer should never let a crisis go to waste. Osborne should take his advice. These hard times provide a perfect opportunity to end the lunacy of middle-class welfare.

Jamie Whyte is a management consultant and author of Crimes Against Logic (McGraw Hill, 2004).