The TaxPayers' Alliance - Economics 101

Hong Kong's tax cuts

Hong Kong is to implement massive tax cuts:

"Hong Kong's financial chief said Wednesday he will cut salary and corporate taxes and abolish duty on beer and wine after a booming economy pushed the city's budget surplus to a record high.  In his maiden budget speech, Financial Secretary John Tsang said he would increase spending on health services and introduce measures to bridge the widening wealth gap and reduce air pollution.

Duty on beer and wine -- currently at 40 percent -- will be cut with immediate effect.

Tsang estimated the budget surplus would reach a record 115.6 billion dollars (14.8 billion US) in the fiscal year to March, four and a half times the government's forecast and nearly twice as much as last year's figure.  The territory's fiscal reserves will reach 484.9 billion dollars, he said.  Tsang attributed the surplus to higher-than-expected tax revenues from the city's booming stock and property markets as well as company profits and salaries."

This combination of swelling reserves and surpluses and hefty tax cuts is possible thanks to the dynamic returns to Hong Kong's already low taxes and the returns of broader economic liberalism.  Over many years the territory has had low taxes and rapid economic growth has left it with an income per person higher than that in Western Europe or Japan.  It places first, year after year, in the Index of Economic Freedom.  For more on Hong Kong's liberal economic order see the first 1980 episode of the late Milton Friedman's classic Free to Choose.  That commitment to low taxes and free-market economics creates growth which brings with it revenues that can fund future tax cuts in an incredible virtuous circle.

Britain, unfortunately, is going in the opposite direction with increased taxes hurting the economic growth that builds prosperity for the future.  That's quite a price to pay for little result in the public services.

More on the Laffer Curve from Dan Mitchell

Dan Mitchell, from the Centre for Freedom and Prosperity at the Cato Institute, provides evidence for the importance of dynamic effects on tax returns.

Cllr J P Floru: PUT FAT GOVERNMENT ON A DIET TO MAKE THE CAKE GROW

The British economic downturn did not start with the fallout of the credit crunch.  The foundation was laid in 1997, when Labour took power and started to carry out its ambitious programme.

The economic growth between 1992 and 1995 was very high. Since 1997 economic growth has never again reached the peaks of growth under Thatcher and Major and growth has declined steadily.

The size of government has risen to a staggering 44.7 % of GDP according to the latest economic figures. In 1997 it was 39 %. There is a direct link between the size of government and economic growth: the smaller the former, the larger the latter.

Gordon Brown’s public spending spree largely benefited the public-sector payroll, with poor productivity outcome.  NHS spending has almost tripled since 1997: from £32 to £92 billion.

To pay for it all, taxes continue to rise.  The tax take is the biggest in ten years.  Even that wasn’t enough, hence the steep rise in public borrowing,

Add to this a flood of new largely EU regulations (gold-plated by the Labour government), and we have a logical explanation of why the UK’s growth is slowing down.  Agreed, there is an international rise of prices for food, raw materials and fuel – but that is equal for all countries.  The reason why the UK is doing worse is its own government.  It is interesting to note that many non-doms who are fleeing the UK say that the new non-doms levy is “just the last straw”.

In this time of economic downturn we need tax cuts to make the pie grow again.  A substantial cut in corporation tax would do the trick.  This was, of course, what caused the steep rise in GDP growth in Ireland (wrongly described as The Irish “miracle” – there is nothing particularly miraculous about the link between tax cuts and economic growth).  There is no reason why the UK could not become the fastest growing economy in the world if it really wanted to.

Whereas in the medium term the Laffer effect would ensure a larger tax take as a result of GDP growth, in the short term the tax cuts could only be afforded by cuts in public spending.  The Conservative Party is far too timid on the subject.  A comment by Philip Hammond MP [against] a cut in public spending at a time of an economic downturn was profoundly unhelpful.  A pound spent in the public sector delivers a much smaller return than a pound spent in the private sector (kept in private hands as a result of tax cuts).  I cannot believe that 62 years after John Maynard Keynes’ death anyone still believes that public spending is needed to make the economy grow.

We like to blame Europe (I do),  but abandoning traditional Anglo-Saxon small government for continental big government was largely a choice made by Blair and Brown – not an imposition from Brussels.

Cllr JP Floru
Director of Freedom Alliance

Sources

2008 Index of Economic Freedom
The size and Functions of Government and Economic Growth, by James Gwartney, Robert Lawson and Randall Holcombe, Joint Economic Committee Study, April 1998.
Tories’ economic legacy has been squandered, by ruth Lea, The Daily Telegraph, 17 September 2007.
Tory row over tax and spending grows, by Jean Eaglesham, Financial Times, 5 February 2008
Barmy arguments from Philip Hammond on spending, by Corin Taylor, Taxpayers’ Alliance Website, 5 February 2008.
Tax ‘n’ spend: No way to run an economy, by  Ruth Lea, CPS,  2004.

A thousand little Laffer Curves

Peter Franklin argues against the dynamic case for tax cuts, suggesting that if there is a Laffer Curve we are on the wrong side of it to get increased revenue when we cut taxes.

What needs to be remembered about the Laffer Curve is that it is an abstraction of a much more complex relationship between taxes and revenues.  It captures an essential truth that tax rises will not always increase revenue, and tax cuts will not always lead to a decrease.  However, it necessarily omits two crucial factors: time and the specific tax that is to be cut or raised.

Economic gains from tax cuts will often be felt over the medium to long term.  The European Central Bank studied the effects of growth in the state and found that a growth of 1 per cent in the size of the state led to a 0.13 per cent fall in economic growth.  Other studies have found effects at a similar order of magnitude.  That fall in economic growth won't mean a lot in the first year but over time becomes very significant.  Brown's spending splurge since 2000 may have left Britain's GDP almost £14 billion lower.

Different taxes will have different effects on the economy.  There is an ongoing debate over the kind of tax cuts most conducive to higher growth.  However, the conventional view is that the effects on growth will be at their largest when they affect incentives to work and invest in the United Kingdom.  Alistair Darling is retreating from taxing non-domiciles because it was expected that tax rise wouldn't increase revenue - even immediately.  A dynamic model (PDF) produced for the TaxPayers' Alliance by the Centre for Economics and Business Research suggested that pre-announced, phased cuts in corporation tax to the Irish level over 14 years would boost investment by 60 per cent and GDP by 9 per cent - and pay for itself within eight years.

The evidence that tax cuts and controlling spending will have a very positive effect on growth is quite well established.  Gains from increased growth quite quickly weaken and then overwhelm the effects on revenue of a tax cut.  Combine that with an easing of the burden on hard pressed taxpayers and the case for restraining growth in spending in order to cut taxes and unleash the dynamic potential of a low tax economy is incredibly strong.

European Central Bank provides new evidence that shrinking the state can make us richer

The European Central Bank has, today, released a new study "Government size, composition, volatility and economic growth" (PDF) which examines the effect of big government on the rate of economic growth.  It finds a substantial effect:

"In particular, a percentage point increase in the share of total revenue (total expenditure) would decrease output by 0.12 and 0.13 percentage points respectively for the OECD and for the EU countries."

This is big.  The numbers might sound small but blogger Chris Dillow explains how, if correct, the study implies that the growth of Government here in the UK in recent years is set to put a big dent in our national wealth:

"This implies that the rise in government spending we've had in the UK since 2000 (from 37.2% of GDP to 42%) would, if sustained take half a point off GDP growth, making us more than 5% worse off in 10 years' time than we would have been had spending stayed at 2000's levels."

One surprising result is that indirect taxation, such as VAT, does the most to undermine growth.  Other work, such as the dynamic model (PDF) commissioned by the TaxPayers' Alliance from the Centre for Economic and Business Research has suggested that cutting corporation tax would be particularly effective.

This is a powerful contribution to the debate over the size of Government and shows the medium to long-term price we pay for the expansion of Government spending over time.  It makes the case for tax cuts more pressing.

US deficit to fall yet again

The Financial Times today reports that the US budget deficit will shrink to $158 billion in fiscal year 2007, according to the non-partisan Congressional Budget Office. This latest forecast is down from its March estimate of a $177 billion deficit and significantly lower than a $205 billion estimate issued by the Bush administration on 11 July.

Despite huge spending increases, the US deficit has been falling progressively from a high of $413 billion in 2004. But this is not surprising. The cuts to dividend, capital gains and income tax enacted in 2003 have seen tax revenues exceed forecasts ever since, which shows what bold tax reductions can achieve.

Dynamic modelling conducted by the Centre for Economics and Business Research earlier this year, commissioned by the TPA, shows that a phased reduction in Britain's main corporation tax rate to the Irish rate of 12.5 per cent would deliver enormous growth, employment and tax revenue boosts. It's time for politicians to learn the tax lessons, if not the spending lessons, from across the Atlantic.

Total Lifetime Tax

How much will the average person pay in tax during their lifetime?  Find out in this TaxPayers' Alliance Research Note.

Download Total Lifetime Tax (PDF)