A2 Economics – The Laffer Curve

New to the A2 syllabus last year was the Laffer Curve. PBS Economics correspondent Paul Solman explores the question of just how high U.S. tax rates should or shouldn’t be and examines the relationship between economic activity and tax rates. There is a good explanation of the Laffer Curve which is the relationship between economic activity and tax rates.

In between, a smooth curve representing Laffer’s pretty simple idea: Somewhere above zero percent and below 100 percent, there is a tax rate where government will collect the most revenue in any given year. Now, the Laffer Curve applies to everyone, but the top so-called marginal rate is only relevant to the rich. It’s now 35 percent on all taxable income in excess of about $380,000 a year. Does that 35 percent rate maximize total tax revenue for the government?

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America has preferred debt to taxes

With the US debt currently standing at 16 billion dollars and the prospect of a fiscal cliff – slashed spending and higher taxes – is it sustainable to keep on borrowing money? Historically Americans have preferred debt to taxes – you could say that it all started with the Boston Tea Party where they disposed of tea in the harbour because of the tax policy of the British government and the East India Company that controlled all the tea imported into the colonies. The video clip below from PBS News has MIT economist Simon Johnson talking about his recent book “White House Burning” which discusses the history of US debt – 225 years of it. He states that if we want to keep Social Security and Medicare we need to think how you are going to pay for it. The answer is NOT selling more debt to the Chinese but to pay the taxes to support social insurance programmes. He also mentions that if you go over the fiscal cliff in a disorganised way, with significant political confrontation, it will be a disaster. Quite simply the US government needs to acquire more tax revenue and bring its spending under control.

Lower taxes don’t necessarily help those on higher incomes

Robert Frank, author of the Economic Naturalist and The Darwin Economy, wrote a piece in the New York Times on the influence money has on determining the outcome of political decisions. Wealthy donors to political causes will want to make sure that policies implemented by the authorities will mean lower taxes for them and less regulation for their businesses. As their income goes up this will only increase the monetary contribution they can give to demand greater favours.

This invariably leads to greater inequality and eventually may become so acute that even those politicians who have large funding from the corporate sector won’t succeed against opponents who seek major reforms. However, lower tax rates can have both positive and negative impacts on wealthy donors:

Positive – lower taxes mean greater disposable income and more consumption in the private sector.
Negative – budget deficits and the reduced quality and quantity of public services e.g. roads, schools, hospitals etc.

Those on higher incomes have been insulated from the declining quality of public sector goods and services by being able to pay for the equivalent in the private sector – schools, hospitals etc. But with a declining middle class it might be harder to recruit productive workers in addition to a reduction in demand for goods and services. Furthermore there are consequences of poor public goods/services that cut across the inequality of income and affect everyone:

* poor roads, bridges and general infrastructure
* electricity shortages/ blackouts (remember ENRON in California)
* effects of reduced investment in nuclear power that could be detrimental to safety

Scenario – 2 Societies with differing degrees of government and private spending

Frank asks which country would be happier? As improvements to cars are quite costly above a certain value and can be viewed as only minor, most people think that the BMW drivers are better off, not to mention safer. Furthermore the BMW drivers are less likely to feel deprived as societies don’t often mingle.

Frank concludes by saying:

So if regulation promotes a safer, cleaner environment whose benefits exceed those broadly shared costs, everyone – even the business owner – is ahead in the long run.

The Swedish Model of how to run your finances.

From reading the October 2012 IMF Fiscal Monitor I came across a page on the Swedish model of managing its public finances. Obviously the IMF see this as a good example for other economies to follow. At the bottom of the recession in 2009 the fiscal deficit in Sweden was only 1% of GDP and by 2011 it was at pre-crisis levels. The IMF publication identified four main points that other countries could learn from.

1. The building up of fiscal buffers during good times, together with credible fiscal institutions, provides room to maneuver during bad times.

Before the GFC Sweden enjoyed a fiscal surplus of 3.5 percent of GDP, compared with an average deficit of 1.1 percent of GDP among advanced economies. When the recession hit the government had enough fiscal space to allow automatic stabilizers to operate fully and to implement stimulus measures without jeopardizing fiscal sustainability. The fiscal balance went from a surplus of 3.5 percent of GDP in 2007 to a relatively small deficit of 1 percent of GDP in 2009. The authorities’ expansionary policy was not called into question by markets because of the low level of the deficit and the credibility of Sweden’s comprehensive fiscal policy framework—including a top-down budget process, a fiscal surplus target of 1 percent of GDP over the output cycle, a ceiling for central government expenditure set three years in advance, a balanced-budget requirement for local governments, and an independent fiscal council.

2. Central bank credibility allows monetary policy to be used aggressively.

During the crisis, the Riksbank lowered its target short-term interest rate nearly to zero and implemented sweeping liquidity measures, including long-term repurchase agreement operations and the provision of dollar liquidity.

3. A flexible exchange rate can help absorb the shock.

During the crisis, the krona fell in value against both the dollar and the euro as investors flocked to reserve currencies. It depreciated by 15 percent in real effective terms from mid-2008 to early 2009, supporting net exports and helping prop up economic activity.

4. Decisive action to ensure financial sector soundness is crucial.

Swedish banks were badly hurt by the financial crisis, despite their negligible exposure to U.S. sub- prime assets. Bank profitability fell sharply in 2008– 09, and two of the largest banks — both increasingly funded on wholesale markets and exposed to the Baltics — saw their loan losses spike and their share prices and ratings decline accordingly. The authorities took fast action to calm depositors and inter- bank markets, including a doubling and extension of the deposit guarantee and introduction of new bank recapitalization and debt guarantee schemes.