Big tax cuts can be beautiful

You learn a lot about a country by looking at what it considers to be news. The UK was this week enthralled by a report that the opposition Conservative party is actually seeking £20bn ($28bn) in tax cuts rather than the £8bn on which it has been campaigning in the general election.

This story is interesting and the FT had it first. Harder to understand is the media consensus that the shifting numbers reflect some kind of elephantine faux pas on the part of the Conservatives.

Look, the media seem to be saying, this mis-step proves the Tories are indeed the goofball spendthrifts everyone knows they are. They ought to know that the effects of tax cuts must be measured precisely and statically, preferably with a ruler. Besides, big cuts always devastate the fisc. The speed with which Tory leaders have raced to insist on the £8bn figure reveals they are afraid to contest the prevailing orthodoxy.

But maybe they ought to. After all, aren't there benefits to big tax cuts? And aren't they quantifiable? Yes and yes would be the answers, at least according to a report prepared by economist Chris Edwards for Congress's Joint Economic Committee.

Mr Edwards' survey focuses on the US with important ramifications for another party that has been acting defensively about its tax cuts lately, the Republicans. But the survey also contains material that might stiffen the spines of the indecisive Tories.

Start with the US and George W. Bush. The White House would like to install a 33-25-15-10 per cent rate structure for income taxes, replacing the 39.6-36-33-28-15 per cent regime. It would do this over a number of years. All in all, a modest plan. Still the survival of the programme is in doubt.

Lawmakers, including some of Mr Bush's fellow Republicans, are telling the White House it must forget about its 33 per cent dream and compromise on a top rate of 36 per cent. The reasoning here is similar to the British one: the Bush plan is "too expensive".

This static argument, points out Mr Edwards, ignores an important fact. High taxes distort economic behaviour. When rates rise, as they did in the US in the 1990s, people start to make economic decisions for tax reasons rather than efficiency reasons.

Most obviously, they cheat on taxes or spend dollars devising expensive tax avoidance schemes with their accountants. Every year Americans spend the equivalent of between 10 and 20 per cent of federal income tax revenues finding a way not to pay the piper. This is destructive since that energy and cash would otherwise have gone towards more productive work.

Then there are other distortions, less obvious but more powerful. Fleeing the tax man, people buy municipal bonds instead of commercial paper that might offer higher returns. They work less, because the rewards of work are eroded by taxes. Or, to put the matter in international terms, they do what Transgene - a company based in Strasbourg, France - did, and set up business in Massachusetts, rather than at home where they would have been more comfortable.

All these tax-driven behaviours slow economic growth and slow the flow of revenues to government coffers as well. The shortfalls to the economy are technically known as "deadweight losses". They can be significant. What is more, argues Mr Edwards, deadweight losses increase more than proportionally when tax schedules become more progressive.

Some studies have found that deadweight losses are equal to about a quarter for every dollar of additional income raised through higher rates. In other words, when rates are increased to collect revenue of $10bn, "taxpayers are $12.5bn worse off" for they lose both their tax payment and an additional Dollars 2.5bn. Government loses too.

The flip side of this is that tax cuts do more for society than they seem to on paper. A tax cut that officially amounts to $10bn will actually cost society much less because people will become more productive as a result of the cut. In the 1980s, for example, tax revenues increased after the Reagan tax cuts. The only problem was they did not increase sufficiently to cover new spending by Congress.

In Europe and the UK many talking heads dismiss such arguments as fairy tale economics. Not so all governments. A commitment to growth led G7 countries to drop their top income tax rate an average of 18 percentage points between 1980 and 1999.

In other words, William Hague, the Tory party leader, should stick to his guns, because he is not so isolated as he may feel. Nor has he necessarily been inconsistent. His much-maligned £20bn tax cut idea may actually "cost" the UK something closer to £8bn, the figure the party has been citing all along.

© Copyright 2001 Financial Times

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