Wednesday, February 28, 2018

“A flat tax is for a flat Earth”

This was my answer to Grzegorz Kolodko, Poland’s Minister of Finance and First Deputy Premier for the Economy (1994-97 and 2002-03), when in the mid-‘90s he asked me – his adviser sponsored by the European Commission – for an opinion on the feasibility and desirability of introducing a flat tax.  I recommended instead a reduction of indirect taxation and the introduction of a tax on capital gains. To his credit Grzegorz listened to me on the flat tax, he reduced the number and level of marginal tax rates but at the same time he raised public expenditure on investment and on re-distribution, introduced an industrial policy that did not seek to pick winners but promoted high value added and export activities, and his package worked well.

The introduction of a flat tax has become a major issue in the policy discussions on the eve of Italian elections, as it is being vigorously propounded by Silvio Berlusconi and the leaders of his right-wing coalition. My views on the flat tax have not changed at all in the the intervening years.

There are two main arguments in favour of a flat tax:
1) the presumed existence of a Laffer curve, whereby government tax revenue is supposed to rise with the increase of the tax rate up to a maximum, beyond which a higher tax rate would actually reduce tax revenue, and
2) lower taxation would encourage the emergence of activities that at present evade taxation, and therefore raise additional government revenue in that way. 

According to established legend (Wanniski 1978) in 1974 Arthur Laffer, then a professor at Chicago University, drew the curve named after him, depicting tax revenue as a function of the tax rate, on a napkin at a dinner in a Washington restaurant to illustrate the effects of President Ford’s tax cuts. Except that he did not draw it on the basis of empirical evidence, but simply noting that for a zero tax rate tax revenue would obviously be zero, and assuming that for a 100% tax rate there would be a zero revenue because nobody would work or invest for a zero after-tax return. He also presumed that there would be a continuous parabolic shaped curve in between those two points and drew a maximum around a 50% tax rate. Thus you could obtain the same tax revenue with a low tax rate on a large tax basis or with a high tax rate on a smaller basis.

Laffer (2004) acknowledged that already in the 14th century the Tunisian philosopher Ibn Khaldun had noticed this possibility, which had also been asserted by many other thinkers including Keynes: “… taxation may be so high … that … a reduction of taxation will run a better chance than an increase of balancing the budget” (quoted by Laffer).
The trouble is that actual empirical estimates of revenue-maximizing tax rates have varied widely, with a mid-range of around 70% (Fullerton 2008, which fits with the “so high rate” stipulated by Keynes), while current tax rates in OECD countries average about half that rate. So much so that the IMF Fiscal Monitor of October 2017 actually recommends raising tax rates in a progressive fashion in order to reduce current excessive inequality of income and wealth, for “There is little evidence that increased progressivity reduces growth”.

More importantly, a 100% flat tax rate is plainly silly, for a progressive tax can reach fairly high marginal rates, historically even 90% and higher, without ever yielding a zero tax revenue. Indeed it has been argued that the Laffer curve might well be increasing monotonically, and in any case even a flat tax of 100% might yield substantial revenue in special circumstances like wartime or even in normal times depending on behavioural assumptions.

As for the second argument in favour of a flat tax, there is absolutely no evidence that a low tax rate – flat or not – encourages the payment of taxes otherwise evaded at higher rates. And why should it, as Schumpeter put it there is no good reason for anybody not reaping a benefit just because it is small.

Critics of a flat tax lament its lack of progressiveness.  Supporters – such as Berlusconi – are quick to point out that in most OECD countries, including Italy, there already is a flat tax on capital incomes, at a constant rate lower than the higher progressive rates on earned incomes, so that a uniform flat tax levied at an intermediate rate would be more progressive than the current system. And anyway the presence of a tax-exempt threshold maintains a degree of progressiveness, as required for instance by the Italian Constitution, art. 53; “The tax system shall be progressive”.

These answers to critics of the flat tax lack of progressiveness are not good enough, because the first comma of art. 53 states also that “Every person shall contribute to public expenditure in accordance with their capability”.  The progressiveness of a flat tax is minimal, depending exclusively on the size of the tax-free initial threshold, and may be regarded rightly as constitutionally inadequate: the average tax rate rises slowly approaching gradually from below the flat fixed rate on taxable income, and significant progressiveness would only be achieved for extremely large tax-free thresholds, counterproductive for tax revenue. The corresponding reduction in the current progressive tax on earned income would not benefit ordinary workers but only overpaid managers, making after-tax distribution of earned incomes more unequal. While the reduction of current excessively high levels of public debt, as well as the reduction of excessive degrees of inequality of income and wealth, are best served by a genuinely more progressive tax system of the kind recommended by the IMF (2017).

On 24 January last the Washington Post reported that Mike Hughes, a 61-year limo driver from California and a flat-Earth strong believer, has been planning to launch a self-built rocket to propel himself 52 miles into space in order to be able to see for himself that the Earth is flat, for “in many months of research I’ve not been able to prove otherwise” – he said. The trouble is that the project would cost 2 million dollars to finance the building and fuelling of the rocket, a space-suit and a hot-air balloon (Mike Hughes is a bit vague about his logistics), and he was only able to raise $8,000 from GoFundMe. As he now has a fellow flat-Earther in billionaire Silvio Berlusconi, it would be best for Silvio to fund the project in exchange for a lift in the same rocket, and all will end well both in California and in Italy, in the best of all possible worlds. 

Addendum 1
Trabandt and Uhlig (2019) estimate the Laffer curves for labour taxation and capital income taxation for the US, the EU-14 and individual European countries for 1995-2007. They find that the US can increase tax revenues by 30% by raising labour taxes and 6% by raising capital income taxes. For the EU-14 they obtain 8% and 1% respectively. Germany could raise 10% more tax revenues by raising labour taxes but only 2% by raising capital taxes. The same numbers for France are 5% and 0%, for Italy 4% and 0% and for Spain 13% and 2%. Only Denmark and Sweden are on the “wrong” side of the Laffer curve for capital income taxation.

Addendum 2 
In the latest Italian elections the Lega proposed a Flat Tax at 15% over the €7,000 tax-free threshold (plus minor further exemptions on households), while Berlusconi proposed its introduction at 23%. According to the Lega their flat tax would create an initial shortfall of €63bn (i.e. €103bn tax revenue from households and €18bn from companies instead of the combined current tax revenue of €184bn from IRPEF-IRES). 

They propose to cover this shortfall first of all from 25 expenditure cuts and additional taxes (including €5bn savings on centralised public procurement, €2,5bn on military expenditure, €5bn tax increase on gas prospection, €900mn from abolition of interest charges deduction by banks and insurance companies, €800mn for official cars abolition for hospitals, €700mn cuts in "golden pensions" (of dubious constitutionality). The bulk of the coverage would come, however, from the emergence of the black economy, reduced tax evasion, additional VAT and income tax on additional transactions and incomes expected from the tax reduction. Pie in the sky.

Fullerton Don (2008). "Laffer curve", In Durlauf Steven N., Lawrence E. Blume, The New Palgrave Dictionary of Economics (2nd ed.),

International Monetary Fund IMF (2017), Fiscal Monitor: Tackling Inequality, October.

Laffer Arthur B. (2004), “The Laffer Curve: Past, Present, and Future”, 1 June, Backgrounder #1765, The Heritage Foundation,  

Selk Avi and Amy B. Wang (2018), “Can this flat-Earther’s long-delayed rocket launch be saved? We may soon find out.” The Washington Post, 24 January,

Trabandt Mathias and Harald Uhlig (2010), “How far are we from the slippery slope? The laffer curve re-visited”, ECB Working Paper Series No. 1174, April, Frankfurt,

Thursday, February 22, 2018

Piketty: “Why have democratic regimes failed to reduce inequality?”

This is the question asked by Thomas Piketty in a recent presentation on “Brahmin Left vs Merchant Right: Rising Inequality and the Changing Structure of Political Conflict - Evidence from France, Britain & the US, 1948-2017 (February 2018). His answer, which is documented by very extensive and useful data, is fairly complex but it could, in a nutshell, be summarised thus: in the '50s and ‘60s the Democratic Party in the US and social democratic parties in Europe were supported by a variety of voters characterised by low education and low income. Globalization (by raising the issue of internal and external inequality) and the expansion of education (creating educational inequalities next to wealth inequalities) have created new multi-dimensional conflicts about inequality and redistribution.
Democratic regimes – answers Piketty – have failed to reduce inequality because "without a strong egalitarian and internationalist platform, it is unlikely that voters by low education and low income will all vote for the same party. The division between racism and nativism is a powerful force that divides the poor in the absence of a strong unifying platform. Politics has never been a simple conflict between the rich and the poor; we need to look more carefully at the content of political cleavages." Piketty argues that since the '70s and' 80s a political system has evolved that pits two transversal coalitions against each other: the intellectual elite of left wing Brahmins against the business elite/merchant right, both sharing the divided support of a working class whose interests are radically different and are not reflected in the parties.
A similar argument, without the massive documentation provided by Piketty but perhaps more fully argued, has been provided by Jan Rovny on the LSE Europpblog on 20 February: “What happened to Europe’s Left?”  I confess that being a left-wing economist I found the argument rather appealing, so I circulated both Piketty’s presentation and Rovny’s paper to a circle of colleagues and friends who I knew would be interested. However one of them, a political scientist whose views on the subject I had specifically solicited, was provoked by those arguments to provide a long critical comment, which I thought deserved to be aired more widely. Therefore I am very glad to post such a Comment below, with the author’s permission on condition of anonymity. DMN

Piketty's enthusiasm for his discovery of political science is heart-warming. You asked me for a view:

i)  to adopt a brush as broad as does Piketty is to empty much of his argument to rest upon historical and particularly statistical data available.
ii)  comparative politics can be useful but arbitrary lumping-together of very different political systems and cultures because of accessibility of chosen data sources leads to incoherence not to affirmation of a thesis.
iii)  the same goes for taking very long data series and arbitrarily cutting them off within his time terms of reference.
So what has he achieved?  He has produced a hypothesis, reflecting journalistic speculation, that the voting behaviours of electorates formerly possible to analyse in economic and class terms have altered across groups; this is causing the collapse of parties of the Left which he views as rooted in common economic and class interests.  Electorates are no longer voting for donkeys wearing a red rosette.  Electors in positions of authority are no longer voting in their economic self-interest.
Neither of these theses are correct; nor does the statistical, behavioural, historical evidence demonstrate that there is any past time in which they were.  Piketty picks and chooses his way through his data to show that they were but the clear association of change brought about by revolution, war, or some socio-economic or other catastrophe, is telling.
iv)  identifying a Piketty-esque Europe as Europe leads to warping of supporting evidence for his thesis; so does using United States data (size, lack of common history, slavery, just for starters; I could go on - that there is no 1945 break for the US as there is for Europe, that the living standards of the US and those of Europe are too far apart for long periods even within Piketty's dates...).  For Piketty Europe is the European Union, and mostly France at that.  Even within this narrowing of the study where is the data on Germany, Italy, the low countries, the East, the far North?  He should drop the US and start considering real Europe, not the EU.  There is a European community of culture, experience, economy and development, although that Europe tends to exclude the second of his data sources, the United Kingdom.
v)  Data series for the UK go back much further than for continental Europe; those on which Piketty relies can be produced from at least the beginning of the eighteenth century and many from the seventeenth and even earlier, both for electoral behaviour and for collections of data on conditions of life, state-organised welfare systems, educational records, health systems, social and work-related housing - the panoply of the modern welfare state is present and recorded.  Its roots make the electoral results of July 1945 the product of victory in war not the poverty of defeat as experienced by continental states, including France despite their pretences.  And as soon as the war economy had served to complete the installation of the redistribution that had been taking place for centuries in the UK, even if overshadowed by the Depression in the ‘20s and ‘30s where it had been fully used and available, nevertheless, the 1951 general election swept the Labour government away. 
The UK returned to something very similar to the redistributions that had been taking place for a long time, shedding the role of the state always associated with authoritarian regimes of Left or Right. The redistributive role of an extensive welfare state was fully accepted by all political groupings, there was no post-War watershed as there was in continental Europe (where populations were widely illiterate, still working the land and often as share-croppers, and urbanisation and modern industrialisation was still to come despite the best efforts of Left and Right).  Labour never recovered, and Margaret Thatcher moved every aspect of the state's role in government on to other ground that socialism or capitalism choices, as Blair's electoral success confirmed.
So, in many ways Piketty's use of UK data is as inappropriate as his use of that of the US.  He wants to tie together some kind of factual link between 'want, disease, ignorance, squalor, and idleness' and voting Right: what the UK data show is not that.  The Five have been tackled and defeated and the people vote Right for aspiration, self-fulfilment, the barring of the Five's reintroduction into their countries via third-world immigration, and a continued growth in their living standards and capacities to learn and achieve.
Yes the decline in voting for Piketty's Left is terminal for electorates have moved on as he and his Left have not. Political parties are re-grouping, that is very clear, but they regrouping to defend the people and their life-styles against out-dated ideologies of deprivation in all its forms.
Tony Judt spoke of 'ideological over-commitment' (although in another context, that of Israel, much of his work on France and the French Left embodies this critique); Piketty would benefit greatly from reading (or re-reading) Tony Judt. Another book he might add to his to read list is: Robert Trelford McKenzie and Allan Silver, Angels in marble; working class Conservatives in urban England, 1968.

Rovny is ponced-up Piketty.  There is a flat refusal to accept the role of Conservative working people in the construction of organisations, in institutions, in governance that has been present always (i.e. since records in the Piketty form) have been available.  It is the securing of decent wages, the legitimising of trades unions, the achievement of access to health care, the educating of every child to competent literacy and numeracy, the universal suffrage, pension support in old age, insurance, ... all the stuff the Left claims - it is all the product of skilled working people and the arrangements and agreements they have set in place over the centuries yes, centuries in the case of the UK.
The ideological Left cannot cope with the truth of this.  Their function has been to create revolutionary, i.e. war-like shocks that disrupt so much there must be destruction and then a settlement.  If the Left cannot produce a revolution then the Conservative working class can manage much better without them.  And often better than with them frankly.  There has to be technical backwardness, widespread illiteracy, gross deprivation of democratic governance, low life expectancy, and the general presence of the Five before revolution and the Left is required.  
Europe has been revolutionised and warred into what the UK did with working class conservatism (admittedly after the 17th century revolutions as a start-up shock, but that is a very long time ago) since capitalist industrialisation and urbanisation.  Even the localist organisations listed by Rovny are the result of municipal conservatism – why do you think it's modern Labour that individualises the social consumption of social provision, or closes pools, libraries, parks, evening classes etc. etc?
The Left is ineffective and very ugly.  Unless there's a revolution or a war to be raged.