UK Evidence for the Laffer Curve

I wrote this piece in 2022 when Liz Truss was Prime Minister. I am reposting it now in light of the recent piece by David Aikman, Director of NIESR who is advocating for tax increases in the UK in the Autumn budget. If the government follows that advice, and if marginal rates are increased on high earners, there is likely to be a further exodus of high net worth individuals and a possible drop in revenue to the UK Treasury. I present some evidence from the Osbourne tax experiment from 2010 to 2012 to support my argument.

Charlottesville VA, October 2022.

The change of leadership in the United Kingdom has generated a fair bit of comment in the UK press and in the international community more generally. Of all the policy changes that the Truss government has announced, the one that has generated the most opprobrium from the domestic and international commentariat is the proposal to reduce the marginal tax rate on incomes higher than £150,000 from 45% to 40%.   I realize that this is not a popular opinion: but there is a case to be made that this particular tweak may well be revenue enhancing.

First, let me remind you of the liberal/establishment consensus. Here is the Sunday Times in their October 2nd, 2022, leader

“… the prime minister and chancellor have made economic conditions more challenging and snookered themselves politically. Undoing even part of their £45 billion in tax cuts — particularly the eye-catching scrapping of the 45p top income tax rate – could fatally damage Truss in the eyes of her MPs …. Giving a £2 billion windfall to 600,000 top-rate taxpayers while shrinking benefits for the most vulnerable looks awful.”  [Sunday Times, October 2nd, 2022, my emphasis]

It's not just the UK establishment that is unsettled by the Truss-Kwarteng proposal to cut the top marginal tax rate. In a remarkable intervention in domestic politics that goes well beyond their remit, the International Monetary Fund issued the following comment:

“We are closely monitoring recent economic developments in the UK …  the nature of the UK measures will likely increase inequality. The November 23 budget will present an early opportunity for the UK government to consider ways to provide support that is more targeted and re-evaluate the tax measures, especially those that benefit high income earners.” [IMF Statement on the UK (September 27, 2022), my emphasis][1]

In my opinion, restoring the top tax rate on earned income from 45% to 40%, – the rate that applied under the two previous Labour Chancellors – will not result in economic Armageddon although there is certainly a case to be made that it is politically unwise.

During the period from 1999 to 2009, the top marginal tax rate was 40%, the same rate that Kwarteng is proposing to reintroduce in the September ‘not-a-budget’.[2] For three years from 2010 to 2012, the top marginal rate was raised by George Osborne to 50% for those earning more than £150,000. In 2013 it dropped back to 45% for those in the top tax bracket where it remained until this month.  So, what was the effect on UK tax revenues?

Roughly 25% of UK tax revenue, 10% of GDP, is raised by taxes on labour income. These taxes can be broken down into two groups. Basic-rate and high-rate. In 2018, basic-rate taxpayers were those earning less than a threshold – about £42,000 in 2018 – and high-rate taxpayers were those earning more than the threshold.  In 2018 there were 26 million basic-rate taxpayers, each of whom paid 20% of their income in taxes and 4 million high-rate taxpayers, each of whom paid 40% on every pound they earned above the £42,000 threshold.

In 2011, George Osborne split high-rate taxpayers into two groups. Those earning below £150,000 continued to pay a top rate of 40%. Those earning above £150,000, of whom there were less than 300,000 people in 2010, paid 50% on income above £150,000. The result of these changes in marginal tax-rates provides an experiment that we can learn from today.

              Chart 1 shows the impact of the Osborne tax experiment on the UK Treasury. The vertical bars measure the top marginal tax rate. The red dots measure revenue raised from high-end taxpayers (everyone above the £42,000 threshold) as a percentage of GDP. Although there are ten times more basic-rate taxpayers than high-rate taxpayers, the revenue raised from high-rate taxpayers – £121 billion in 2018 – is twice as much as the revenue raised from basic-rate taxpayers which was £61 billion in 2018.  

Revenue from high earners in the five years from 2005-2009, before the Osborne experiment, was on average equal to 5.7% of GDP.  In the three years from 2010 to 2012, when the top tax rate was 50%, revenues from high-rate taxpayers fell to 5.4% and when the tax rate fell back to 45% in 2013, revenues picked up again to 5.8%, roughly the same as in the earlier period.

The Osbourne experiment of raising the marginal tax rate from 40% to 50% suggests that a marginal tax rate of 50% is too high and that lowering the rate back to 45% was revenue enhancing. The UK under Osborne was on the wrong side of the Laffer curve.  Will a further cut from 45% to 40% raise or lower revenue? The Osborne experiment suggests that the effect may be a wash and that the peak of the Laffer curve (the marginal tax rate that maximizes revenue) is somewhere in the range of 40% to 45%.

Is the proposed Truss-Kwarteng cut in the top tax-rate to 40% politically wise? Probably not, given the current state of UK politics. Will it lower revenue by £2 billion as claimed in the Sunday Times Leader? Almost certainly not and that particular aspect of the not-a-budget may even be revenue enhancing.

Roger E. A. Farmer.
Professor of Economics, University of Warwick.
Distinguished Emeritus Professor of Economics, UCLA

[1] https://www.imf.org/en/Countries/GBR Retrieved October 2nd 2022

[12 The following analysis draws mainly on data published by the Office of National Statistics, Table 2.5a, which presents data on tax rates and tax revenues by income. These data begin in 1999, when Gordon Brown was Chancellor of the Exchequer under the Blair government and run through the 2018-2019 tax year when Philip Hammond was Chancellor under Teresa May. 

Tariffs and the Trade Deficit

In an X post here John Carney argues that the U.S. trade deficit is large and historically unprecedented. James Surowiecki disagrees. The issue is not: is the trade deficit large? It is. The right question is: will tariffs reverse the trend? Probably not. But more on that issue below. First: Here are the data.

The US Trade Deficit as a Percentage of GDP

A deficit of 3% of GDP means that we are accumulating a debt to the rest of the world, largely China, at a rate of 3% a year. This is cumulative. But as long as we are financing government budget deficits at a rate of 5% of GDP, and as long as US households are unwilling to save 5% more than they invest domestically, the excess will inevitably appear as a trade deficit.

That is not to say that tariffs are a mistake. They will help bring manufacturing back to the US and that will benefit blue collar workers as US intellectual and physical capital is increasingly forced to combine with US unskilled labor instead of a billion Chinese unskilled workers.

Tariffs will change relative prices and they will raise the real wages of American blue collar workers. Not just the US workers who are employed by the manufacturing sector. But also all those working in services and non tradeable goods who compete with manufacturing workers. Manufacturing does not have to be large as a fraction of the economy for the manufacturing wage to influence wages throughout the rest of the economy.

As Stolper-Samuelson taught us more then 75 years ago, trade makes the average resident of two trading blocks better off. It does not benefit the owners of labor and capital equally. Workers in a country that is relatively well endowed with capital, like the US, are unambiguously harmed when they are forced to compete, indirectly through trade, with a large pool of foreign unskilled workers.

Trumps pronouncements aside, the trade deficit and tariffs are two disconnected policy concerns. One can favor tariffs without believing they will reverse the trade deficit which is primarily a consequence of the fact that the rest of the world chooses to use the US dollar as a store of wealth and as a means of payment.

How to Fix the Banks

This post first appeared in the Financial Times Economists Forum on February 9th 2009. I am reposting it here because it is as relevant today as it was then. My argument provides a way to provide a backstop to the banking system as a whole, without generating the incentive for any individual bank to engage in risky behavior and without putting taxpayer funds on the line.

By Roger E. A. Farmer Feb 9, 2009 @ 12:11

We don't need to nationalise the banks. We don't need to guarantee bad assets. We don't need government to own voting shares in private banks. We don't need to create a bad bank full of toxic assets. We just need a little faith in free markets and a little creative intervention. I propose that the central bank should support the price of an indexed fund of bank stocks.

The financial crisis that began in the US subprime mortgage market has spread far and wide. Between January 2007 and January 2009 the top 10 US banks lost two-thirds of their value as market capitalisation fell from $961bn to $333bn. The problem that began when investors were unsure of the value of mortgage backed securities has spread to corporate paper, credit card debt and student loans. These events are not confined to the US. The world financial system is hemorrhaging.

Before trying to solve a problem, it is a good idea to understand its nature. Investors in banks are not irrational. They are placing extremely low values on bank assets because they correctly assess that the economic situation can get much worse. The US economy is shedding 0.5m jobs a month and Europe, Asia and Latin America are not far behind. The loss in value of bank stocks is in danger of becoming a self-fulfilling prophecy as low wealth generates low demand and low demand adds to the unemployment rolls.

Free market economies need help sometimes. In every post-war recession the Fed has lowered the interest rate to restore private demand. That option is now unavailable because the interest rate cannot fall below zero. Policy makers are rightly considering a broader range of options. One option should be price support for bank stock. In a piece published on January 12 in the FT online, I argued for central bank support of a stock market index. A more limited version of this same idea provides a way for a central bank to inject new equity into its national banking sector without owning the banks or nationalizing them. How would this work?

First: Define an indexed fund that would include all publicly-traded bank stocks with weights based on initial market capitalisation. These weights could be revised periodically according to preannounced rules. Second: Allow private financial corporations to create and trade this fund by purchasing bank shares as assets and selling the indexed fund as a liability. Third: Direct the central bank to purchase an initial block of indexed funds - $300bn might be a good starting number for the US - and pay for it by issuing newly created short-term interest-bearing debt backed by the treasury but issued by the central bank. Fourth: At each meeting of the monetary policy committee, announce a price, and a rate of growth for this price, at which the central bank would be willing to buy and sell the indexed fund over the next few weeks.

How much would this cost? Let's take the US case and suppose that the Fed buys the fund at $10 a share under current bank capitalization. Now let the Fed announce that, one week from now, it will stand ready to buy or sell the indexed fund at $15 a share. The announcement will provide private investment companies with an incentive to buy the bank stocks that make up the index in order to profit from the Fed intervention. As these companies buy bank stock, the price of the stock of each bank in the fund will rise until their collective value is equal to the announced value of the index. This scheme recapitalizes the US banking system and could be implemented with little or no cost to the US taxpayer.

Banks are undervalued because there is no market for the ‘toxic assets' that they hold. How will the Fed decide on the correct value of these assets? It doesn't have to. The market will decide what they're worth. The relative price of each bank stock will be determined by marketplace trades and not by the Fed. As new information comes in about the underlying values of a bank's assets, the bank's value will rise or fall. If a single bank is found to have an unusually high proportion of toxic assets, market capital will shift to better managed banks. If a new bank is created, and is found to be efficiently managed, market capital will shift to the new bank and the old ones will fall in value or fail.

What are the advantages of this approach to alternative recapitalisation schemes under consideration? First: It need not cost the taxpayer a penny. Second: It allows the market to determine asset values. Third: It does not reward bad management but allows bad banks to fail without destroying the entire financial system. Fourth: It provides an incentive for the creation of new financial institutions to replace the old.

The world financial system is not illiquid: It is potentially insolvent. This is not a problem of bad fundamentals: It is a problem of market psychology. In the global crisis there is such a thing as a free lunch. By preventing meltdown of the world financial system we can get the global economy back on track. But to get there world government leaders and central bankers need to start thinking outside of the box.

Professor Roger E. A. Farmer is vice-chair for graduate studies in the department of economics at the University of California Los Angeles. He is the author of two forthcoming books on economics with direct relevance to the current crisis: Expectations, Employment and Prices and How the Economy Works

Axel Leijonhufvud Remembered

I learned today that my friend, colleague and mentor, Axel Leijonhufvud passed away on Monday May 2nd. Axel was one of the most creative macroeconomists of his generation and a towering presence in UCLA macro from 1964 until his departure in 1995 when he took up an appointment at the University of Trento.

In 2006 I was privileged to organize a conference in Axel’s honor at UCLA that was later published as a Festschrift, Macroeconomics in the Small and the Large, with contributions from his friends and admirers, one of whom, Ned Phelps, was a Nobel Laureate and two more, Tom Sargent and Lars Hansen, went on to win the Nobel Memorial Prize subsequently.

UCLA Faculty at the 2006 conference in honor of Axel Leijonhufvud

This photo was taken at the conference dinner on the evening of August 30th 2006. It features, from left to right, Joe Ostroy, Gary Hansen, Roger Farmer, Axel Leijonhufvud, Ken Sokoloff, John Riley and Mike Intriligator.

I first came across Axel’s writing as an undergraduate student at Manchester University where we were taught from his doctoral dissertation, Keynes and the Keynesians; a book that shot Axel to intellectual rock stardom. He argued in that book that Keynes’ General Theory had nothing to do with sticky wages and prices but was instead about inter-temporal coordination failure. Here is a link to a 2004 interview with Brian Snowdon that provides an excellent introduction to Axel’s thought.

Axel was part of a long UCLA tradition of independent thinking and he was responsible for recruiting me to UCLA in 1987. He never accepted mainstream interpretations of macroeconomics and was wary of consensus. And although Axel’s work was non-technical in nature, he recognized the importance of mathematics and was attracted to the formalism of theories in mathematical models. His view of the rational expectations revolution was one of amused bemusement. I recall a conversation with him in which, to paraphrase,

‘My view of modern macroeconomics is much like my view of modern Hollywood movies. The pyrotechnics are spectacular but the plots are sadly lacking.

Although Axel recognized the importance of mathematical methods, he also recognized the limitations of formalism and he insisted that a good economist must be aware of the past. To this end he was a strong supporter of the teaching of economic history and the history of thought as part of the core curriculum.

Economic history disappeared as a core subject from many economics departments in the 1980s. UCLA was an exception largely due to Axel’s insistence that a good macro economist needs to understand the past before she can understand the present or the future. He was instrumental in bringing Ken Sokoloff to UCLA and in supporting Ken’s successful efforts to attract Naomi Lamoreaux and Jean-Laurent Rosenthal to UCLA

Axel’s support of the history of thought was deemed anachronistic by many of his contemporaries who viewed economics through the lens of a linear progression of knowledge. In contrast, Axel viewed science — and particularly economics as a non experimental science — as a tree in which herd behavior led often to persistent treks down roads to nowhere. Here is an excerpt from his 2004 interview with Brian Snowdon,

… the history of economics [is like] a decision tree. … That's exactly why those who are working at the frontier of the subject should know some history of economic thought. This is a different reason than just wanting to know the history of the subject for antiquarian interest. This view also suggests that economics itself exhibits very strong path dependence. So if you take the wrong path, the errors can be with you for a long time.

Axel was a follower of Imre Lakatos and his view of the progression of economics was heavily influenced by Lakatos’ methodology and the concept of progressive and degenerative scientific research programs. In his view, modern macroeconomics is a degenerative research program that took a wrong turn in the 1950s. Axel was right about this and it is a theme that has influenced my own research agenda. Time will tell if the profession will eventually agree.

Yours Truly with my friend and teacher David Laidler, Axel Leijonhufvud and Axel’s wife Earlene Craver

Axel Leijonhufvud: September 6 1933 — May 2nd 2022

An Interview with Roger Farmer by Phil Armstrong: Part 4 of 4: On Modern Monetary Theory

An excerpt from Chapter 5 of  Can Heterodox Economics Make a Difference, published by Edward Elgar in 2020. Here is a link to the Table Of Contents, and a link to the biographies of all those interviewed for the project.  

“If the question is ‘what determines the price level?’, which I do take to be a useful question, I’m probably in bed with modern monetary theorists. My view is that beliefs determine the price level. But the reason that I’m able to make that statement and live in two worlds at the same time, is because the equilibrium models I build contain lots of interacting agents of different types.”
“There are many pluralistic views. I’m not sure why anyone would put a label on themselves, I refuse to be labelled as anything. I don’t know why anyone would want to be labelled as an ‘MMT person’ as opposed to someone who seriously considers the ideas in Modern Monetary Theory and tries to integrate them with other things that they found useful. ”
— Roger E. A. Farmer

PA: You remind me of Charles Goodhart, who also has sympathies and criticisms of various schools. I’d like to turn next to Modern Monetary Theory. You’re a very experienced economist, I’m interested to know what you’ve picked up about MMT?  If you’ve not come across MMT, that tells me a lot about its outreach.

RF: It has very little outreach in terms of mainstream economics and my initial reaction to the definition is that it’s confused. [1] My work is heavily influenced by conventional neoclassical economics – that makes me mainstream. And with my mainstream hat on; I insist on constructing coherent models that are based on individual maximising behaviour. 

When you start thinking about monetary theory and monetary economics in that context, what you might say immediately is, “Yes, but general equilibrium theory has no role for money”, which is partly true. But to the extent that it forces you to construct logical chains of reasoning, the arguments about endogeneity of money – that’s where I’ve met MMT – I find critiques of mainstream monetary theory to be misplaced. Of course, money is endogenous! But what does that mean? 

If the question is ‘what determines the price level?’, which I do take to be a useful question, I’m probably in bed with modern monetary theorists. My view is that beliefs determine the price level. But the reason that I’m able to make that statement and live in two worlds at the same time, is because the equilibrium models I build contain lots of interacting agents of different types.As a consequence, I end up with situations where the model is not determining prices, I need something else. So there’s clearly room for a marriage of that idea with notions of endogenous money from modern monetary theorists, and I suspect that if I actually sat down with Stephanie Kelton, or you, or some other modern monetary theorist, and had a debate about that, we’d find that we had a lot in common. I’m simply more willing to use the apparatus of traditional microeconomic theory to explain those ideas.

PA: Yeah, I get the feeling, having heard you speak before, that you are open to dialogue with what I would call heterodox views. More so than most.

RF: I think that’s essential! 

PA: One of the things about MMT- which leads me onto my next point – is its ‘unique selling point’ in the non-academic world: this idea that taxes drive money, the idea that the government must spend money before it can tax. For modern monetary theorists, taxes have two functions: one, to give value to state debt, because without taxes underlying the value of the currency people wouldn’t accept state money in payment for delivering services to the state. And secondly, by adjusting spending and taxes, the government can adjust aggregate demand. The government, in order to fund spending, must acquire money from the private sector and/or borrow it.

RF: I believe that this is related to the debate, in the standard theory, on the Fiscal Theory of the Price Level. Government spending, taxation and borrowing are connected by an accounting identity.  In any period of time, the difference between the amount the government spends and the amount it takes in in taxes has to be funded by issuing some kind of debt. It could be money, it could be short bonds, or it could be long bonds. Treasuries spend and create liabilities. Central banks decide on the composition of those liabilities between the different categories. 

There is currently a lot of angst in modern macro circles about what determines the price level. And the government accounting identity can be viewed in two ways. In one way it’s a budget constraint, which the government has, just like you and I have budget constraints.  We spend, we borrow, we get income, we die, and as a consequence of eventually dying, over our lifetime we can’t spend more than we earn. That places a constraint on how much we can borrow.

Now you and I can shift resources over time by borrowing and lending, so one way of seeing the government accounting identity is that it’s just the analogue of what you and I do. Now, that’s clearly false because the government doesn’t die, and the revenues are coming in from different people from those who benefit from the spending. 

One group of economists sees the government accounting identity as analogous to a household constraint. Government spending plans must be consistent with its income plans over a very long horizon. In this view, the government must make spending plans that are consistent with taxation. There is an extreme version of that argument, called Ricardian equivalence, which says that it doesn’t matter whether a given government expenditure plan is financed by debt or taxes. Different plans simply rearrange the timing of the payments, and the representative agent who must pick up the tab, is the other side of that borrowing and lending. Now, most people think that’s probably wrong.

PA: Yeah, certainly MMT-ers!

RF: Indeed. Now, the other way of looking at this accounting identity is that it is a debt valuation equation. The government has a stream of primary surpluses that it will be running for the conceivable future. It has some existing debt in dollar terms. The price level must adjust to make sure that the value of the nominal debt is equal to the discounted present value of the surpluses. So, the sequence of accounting identities is a price level determination equation.  I suspect that some of these issues arise in modern monetary theory. Perhaps you could say more about what modern monetary theorists mean by money?[2]

PA: Well, I think that what modern monetary theorists would argue is that money is credit and nothing but credit.

RF: Fine, so a treasury bill is money. Or not?

PA: Well, no – a treasury bill isn’t money, because money is simply a ledger entry. For example, what a modern monetary theorist would conceptualise is that there is no government budget constraint, it’s simply an ex-post description of what’s happened. So, in other words, if the government wants to spend, if you want to conceptualise as a model, the first thing it has to do is spend by issuing new money, i.e. new debt, and that doesn’t have any corporeal existence.

RF: You said new money and new debt in the same breath.

PA: For a modern monetary theorist, credit and debt are the same thing, made at the same time. Therefore, new money is new debt.

RF: Perfect, I’m totally on board. In the models I write down, that’s true because there are multiple equilibria and because the actions the government takes help to select one of the equilibria. Maybe I should write a paper called ‘Modern Monetary Dynamic Stochastic General Equilibrium Theory.’

PA: If the government spent money, what would you think would happen to the balance sheets and the economy, or do you not think in those terms? So if the government bought, say, a new nuclear submarine from a private defence contractor, what would be the monetary movements in that? 

RF: The government has a bank account that it uses to purchase new nuclear submarines. I’m honestly bemused by the question.

PA: A modern monetary theorist, would say that if the government buys a new submarine, its balance at the Bank of England goes down. The receiving bank’s reserves would go up, which would mean there’s an internal transfer on the liabilities side of the Bank of England, there’s a reduction in the reserve account of the government, and an increase in the reserves held by the receiving bank. The asset total value of the Bank of England balance sheet remains the same. 

Regarding the bank which holds the account of the company that makes the submarine, that bank’s balance sheet will expand. It will have liabilities – say it was £5 billion, and now that company has a liability at its own bank of £5 billion and on its assets side, the receiving bank’s reserves have gone up. That’s how a modern monetary theorist thinks. But you won’t be surprised to know that when I ask economists that question, they don’t answer it in those terms. 

RF: How does a modern monetary theorist deal with the difference between the world we live in now and the Gold Standard?

PA: Under the Gold Standard, the government’s ability to issue debt, or to spend, is limited by its gold stocks. Because, for example, if the government runs a deficit under the Gold Standard - say it’s spent a billion pounds and took in £800 million, there would be £200 million’s worth of convertible gold currency.

RF: So, its an entirely different world.

PA: Yes. Under the Gold Standard, the interest rate was determined by the central bank to compete with the option of conversion, which is why big deficit countries under the Gold Standard would raise the bank rate.

RF: So, the question about buying a nuclear submarine would have very different implications in an economy under the Gold Standard than it would under the current standard.

PA: Yes, it would. I don’t know if you’re familiar with the employer of last resort (ELR) policy?

RF: No, I’m not.[3]

PA: Modern monetary theorists don’t believe that the main policy tool for maintenance of price stability should be interest rates, they don’t believe this approach is effective. And an ELR also maintains full employment. Under an ELR policy the state offers an unlimited number of jobs and hence, unemployment effectively falls to zero. If a person were unemployed, the government would provide one. It is, in effect, a stock control policy – in times of recession – people move into the employed labour buffer stock.

RF: I am sympathetic to both points.  I agree that the state has a responsibility for maintaining full employment. But full employment is not easily defined. It is possible to have too much employment just as it is possible to have too little employment.  A job for everyone who wants one is a meaningless concept for someone who thinks in terms of search. 

You ask, “Do you consider the employer of last resort policy to be a viable means to ensure full employment and price stability?” I’m certain it could be a successful means of ensuring full employment, we saw that in Soviet Russia. I don’t think it was very efficient – the state allocating people to jobs is not my ideal society. Also, I don’t think that full employment, implemented by this policy, would guarantee price stability.

PA: The final question is what role do you consider that MMT might have to play in the practise of heterodox, or indeed any economics? Do you see it as something that’s so far from what economists are thinking about that you don’t even see it on the horizon?

RF: There are many pluralistic views. I’m not sure why anyone would put a label on themselves, I refuse to be labelled as anything. I don’t know why anyone would want to be labelled as an ‘MMT person’ as opposed to someone who seriously considers the ideas in Modern Monetary Theory and tries to integrate them with other things that they found useful. 

PA: Well, that, in a sense, is just as good an answer as any other. That if you kind of pick apart the question, that’s really what I want to do with the questions, if you see what I mean. Well, that concludes the formal interview. Many thanks, Professor Farmer.

[1] This statement was true when I spoke to Philip in 2018. A lot has changed since then and MMT is now being more widely discussed as a policy approach to government finance.

[2] For a more complete account of my views on the Fiscal Theory of the Price Level see my recent working paper with Pawel Zabczyk (Farmer & Zabczyk, 2020). 

[3] I certainly know now as a consequence of the impact of MMT on the 2020 US presidential campaign.