Chris Dillow's Blog, page 182

45p: Power beats evidence

In yesterday's Budget, George Osborne said:

Let me tell the House what HMRC say about the difference between 50p and 45p.
Their figures tell the story.
The direct cost is only £100 million a year.

However, it is not really HMRC figures (pdf) that tell this story. The estimate that the 45p rate will cost the Exchequer only £100m is based not so much upon the evidence of the impact of the 50p rate so much as upon a 2008 report (pdf) to the Mirrlees committee by Mike Brewer, Emmanuel Saez and Andrew Shephard.

The key thing here is the taxable income elasticity (TIE)- the extent to which people reduce their (reported) pre-tax income in response to a cut in their after-tax income. The higher is the TIE, the less a tax rise will bring in to the Treasury - and the less a tax cut will cost.

The Treasury's estimate that the cut to 45p will cost only £100m is based upon a TIE of 0.45; it had earlier assumed a TIE of just 0.35.

This TIE is almost identical to Brewer, Saez and Shephard's estimate, of 0.46.

The HMRC report corroborates this, in that it estimates a TIE of 0.48. But given the difficulties of distinguishing between genuine long-term behavioural responses and one-off forestalling responses (pulling income forward from 2010-11 into 2009-10), this estimate adds little to BSS's work. The standard error around it is 0.33.

And even BSS's estimate is not precise. There's a SE of 0.13 points around it. This implies that there's a two-thirds chance that the TIE is between 0.33 and 0.58 - and a one-in-six chance that it is below 0.33.

If we take the TIE of 0.58, the cut in the top rate to 45p will save the Treasury almost £1bn*. Mr Osborne was keen to point that out. What he didn't say is that if we take the lower TIE, of 0.33, then the cut in the top rate to 45p will cost the Treasury not £100m but over £1bn. In other words, it would be a big giveaway to the rich.

And the HMRC suggests a reason to believe a lower TIC. It says (par A.17):

There is some reason to believe that these elasticities may not be symmetric for reductions in tax rates that follow increases. This is because tax planning arrangements to mitigate the tax increase may not be unwound if the tax rate subsequently falls again, as the costs of making the arrangements have already been incurred. Individuals who have emigrated since the tax increase might not decide to return after the tax cut. Likewise, some individuals who have chosen to retire earlier in response to the tax rate may decide not to return to work if the tax rate falls. This suggests the elasticity for the rate reduction could be slightly lower than observed by HMRC for the preceding rate increase.

Now, I don't say all this to take a definite view on whether the cut in the top tax rate will or will not raise money. We just don't know.

And this is the point. The fact that Osborne was willing to take a decision based upon such flimsy evidence shows that policy-making is determined more by the interests of the rich than by the objective empirical evidence. And this, as Simon says, signals that there's a political problem which has potentially serious economic effects.

* My estimate, based on HMRC methodology described on p15 of their report.

Stamp duty & labour supply

Imagine - and you'll probably have to - that you have a large six-figure salary and live in a £1m+ house in London. You're hoping to buy a more prestigious place. And then the government raises stamp duty on £2m houses to 7%. What do you do?

You could pay an extra £40,000 for the privilege of living in a tatty terraced house or a dark two-bed maisonette in Chelsea.

Or you could decide that, if it's a big house you want, you should move out of London. In the civilized world, you can get a mansion with pool, tennis court and paddock for a little over a million - with the bonuses of increasing your chances of not having a complete cunt for a neighbour, and being within 15 minutes drive of one of the Britain's best music venues.

But of course, there's a problem. Unless you can work from home, moving to the civilized world requires some upheaval. If you're of a certain age, you might be able to retire early. You could sell your business a  earlier than you intended. Or you could downshift and do consultancy work, popping into London only a few days a month.

And here's the thing. To the extent that people do this, their labour supply falls. Stamp duty can therefore "deter effort" just like income tax can - maybe more so. This is because a tax on expensive items - given the foregoing we can hardly call it a tax on luxury goods - in effect reduces the returns to work, just as an income tax does.

The question is: how likely is this? Naturally, I'm biased, having made a similar move myself. But isn't at least possible? The notion that top rates of income tax have disincentive effects but higher stamp duty does not is, surely, very questionable.

Another thing: there is, of course, another effect here. As the smart money moves out of London, house prices there fall, thus imposing a cost onto their existing owners, but mitigating the cost to prospective buyers - thus transferring wealth from one sort of rich to another.  

Marx was right

Here's a new paper:

We use a vector autoregression (VAR) methodology to assess the empirical relevance of an augmented CPS [cyclical profit squeeze] model for the U.S. economy…Our results are consistent with the operation of the CPS mechanism, both under regulated and neoliberal capitalism. This suggests that Marx's analysis of the fluctuations of the reserve army of labour…remains a powerful analytical framework for understanding macroeconomic fluctuations in capitalism.

This, of course, is not the only empirical support for Marxist insights. We can add:

- Some work by Jeremy Greenwood vindicates Marx's claim that "the mode of production of material life conditions the general process of social, political and intellectual life."

- The labour theory of value, much maligned as it is, does a rather good job of explaining relative prices.

- Daniel Kahneman's work on cognitive biases can be read as corroboration of Marx's theory that capitalism generates an ideology which prevents people seeing its injustices.

- A lot of work in public choice is quite consistent with the Marxian view that "the executive of the modern state is but a committee for managing the common affairs of the whole bourgeoisie."

Of course, Marx got some forecasts wrong*. Capitalism has not (yet!) collapsed - though it might yet - but in forecasting this he was largely elaborating upon the stationary state discussed by Smith and Ricardo.

But the fact is that, viewed from a narrowly empirical basis, Marxism scores rather well - and (arguably) quite possibly better than a lot of mainstream or neoliberal economics. Which raises the suspicion that the appeal of the latter over Marxism might rest on considerations other than empirical fact.

* We can leave central planning aside, as Marx probably wrote about as much on central planning as Adam Smith did on the invisible hand - which is to say, very little.  

Why privatize the roads?

There are two arguments for road privatization that are plain daft.

One is that it will "unlock large-scale private investment" from pension and sovereign wealth funds. This argument fails because the government can already borrow from these through the gilt market at almost zero cost - the on 50-year index-linked gilts is below 0.2%. The cheapest way to invest in roads is for the government to borrow. To think otherwise is merely irrational debt phobia.

The second argument is that the private sector can manage the roads better than the Highways Agency. This fails because, insofar as the private sector is more efficient than the public, it is because the pressure of competition forces it to be so. But giving private firms long-lived leases over natural monopolies is no way to increase competition.

So, what is the case for privatization? Jonathan sees it as a step towards road pricing. But there is another argument.

It originates in perhaps the most important fact about western capitalism in recent years - that there is a dearth of investment opportunities; this is why business investment as a share of GDP has fallen in recent years, and why companies have for a long time been saving much more than they've invested in real assets.

Faced with this problem, one function of the state is to create new investment opportunities. And road privatization - like steps towards NHS privatization - does just this.

This is, of course, nothing new. In the 50s and 60s, the state helped create profitable investments by maintaining aggregate demand through increasing public spending - in the US especially upon the military. In the 80s, it did so by attacking workers' bargaining power and thus relieving the profit squeeze. Although the precise form in which the state helps foster private sector profits and investment varies according to circumstances (and maybe ideology)*, the fact is that a key function of the state in capitalist economies is to help create profit opportunities. As Paul Sweezy wrote in one of the classics of Marxist economics:

We should naturally expect that the state power under capitalism would be used first and foremost in the interests of the capitalist class since the state is dedicated to the preservation of the structure of capitalism. (The Theory of Capitalist Development, p248)

* There's no inconsistency between profits being raised sometimes by full employment policies and at other times by engineering recession. If we're in what Marglin and Bhaduri call a stagnationist regime, the former works, but if we're in an exhilarationist regime, the latter does so.  During the 70s, the UK moved from the former to the latter, necessitating - from capitalists' point of view - different policies.

Gay marriage: an economist's perspective

The "debate" about gay marriage is a dialogue of the deaf. Perhaps economics can help. The solution is to trade.

Right now, gays don't have a right to marry. But they could, in theory, buy it. They could pay religious organizations to drop their objections. If the right to marry is more valuable than believers' hostility to gay marriage, both parties will find a price at which the right to marry can be bought. If, on the other hand, gays don't value the right as highly as believers value its prohibition, they'll not agree a trade, and so they won't get the right.

For example, say that in a society of 100 people six gays would pay £1000 each for the right to marry, and that there are 20 people who find the thought of gay marriage abhorrent, with the rest of the society indifferent. Let's say the discomfort of those 20 people has a monetary value to them of £100. Then their discomfort could be bought out, as 6 x £1000 more than pays off 20 x £100. If, on the other hand, the 20 people's discomfort has a monetary value of £500, gays would be able to buy the right to marry.

Now, you might object that the present status quo should not be the default position, but that gays should have a right. No problem. We could start from this position and then ask believers to buy out gays' right to marriage. If they value their objections to that right by more than gays value their right to marriage, then they'd agree a price at which the right to marry could be forfeit.

In theory, under some assumptions, it doesn't matter where we put the right. Trade will ensure that gays get the right to marry if they value the right by more than others value the prohibition.

What I've just described is the Coase theorem. My thinking was triggered by ch 7 of Robert H Frank's The Darwin Economy.

There are three objections here:

- Contrary to Coase, the original position does matter. People value the status quo. So asking gays to buy the right to marry and asking believers to buy its prohibition are not equivalent.

- Asking people to pay does not reveal the value of the right so much as the value of money. It gives undue power therefore to the wishes of the wealthy.

- There are terrible transactions costs and free rider problems involved here, in getting gays and believers to club together.

These objections, though, don't matter. The point is that the location of the right should go to where it would if free and efficient trading were feasible.

This principle applies to the rights we actually have. The reason why I have a right to life is that I would pay more for that right than others would pay to kill me. A similar thing is true for rights to, say, free speech, association or religious belief.

I suspect that this principle would give gays a right to marry; I say this simply because heterosexuals value marriage so highly that they pay fortunes for ceremonies, and I suspect a similar thing would be true for many gays.

But this is not the point.  The point is that economics can help find ways of solving problems that otherwise seem intractable; everything I've said also applies to abortion rights.

And herein lies a paradox. I suspect that many of the participants on either side of the argument about gay marriage or abortion have something in common. Many liberal lefties and religious believers are sceptical about free markets, believing that they encourage an individualism that erodes social cohesion. In this case, though, the use of markets - if only as a thought experiment - can bring people together and create social cohesion whilst it is strident statements of religious or egalitarian ideology that weaken social ties.

50p: it's not just about revenue

Remember the economy? Looking at the debate about the 50p tax rate gives me the impression that people have forgotten it. This is because the debate is being framed solely in terms of whether the rate raises revenue or not. But this is not the same as the effect it has upon economic growth.

It's perfectly possible in theory for the tax to raise revenue but to stifle growth. This would happen if top tax-payers reduce their productive activities in response by the tax, but not in aggregate by so much as to fully offset the higher tax rate they pay.

It's also possible for the opposite to happen. Let's say - for the same of argument - that the 50p rate does raise only "hundreds of millions" rather than billions. This could be consistent with the 50p rate being positive for GDP growth. This would happen if:

- the new rate triggers widespread tax avoidance or evasion by people who carry on working as before.

- some other people respond to the rate by working harder, as the income effect offsets the substitution effect.

- insofar as the higher tax rate does deter some others from working, it deters them from activities with negative externalities, such as office politicking, political lobbying, or entering careers such as banking which have large negative externalities.

There is one colossal fact which is consistent with this hypothesis. This is that in the 23 years since Nigella's dad cut the top tax rate to 40p, real GDP grew by an average of 2.1% a year, compared to 2.4% per cent a year in the previous 23.

Now, you could object to this that lots of other things affect GDP growth too. But opponents of the 50p tax rate are in a weak position to do this. For one thing, if they are to engage in simplistic post hoc ergo propter hoc reasoning when they claim that Lawson's tax cuts led to a rising share of income tax being paid by the richest 1%, they can hardly moan when others engage in such reasoning. And for another thing, defenders of the 50p rate like to think that other reforms of the Thatcher era boosted the economy. Which makes the slower GDP growth since then all the more troublesome for them.

I don't say this to take sides. My point here is rather that looking only at the impact on tax revenues is to take too limited a view of the impact of the 50p rate. And the passions in the debate seem rather stronger than the evidence base.

Robin van Persie & the cost of inequality

Two of the great issues of our age are: what impact does inequality have upon economic performance? and: should Arsenal give Robin van Persie a massive pay rise to hold onto him? A new paper bears upon both questions.  It studied serie A games in 2009-10 and 2010-11 and found:

Pay dispersion has an overall negative impact on team performance…doubling pay dispersion [as measured by the Theil index] decreases by 6% the probability of winning a match.

This is a big effect. The authors estimate that if a team changes from everyone being paid the same wage of €600k pa (the average in their sample) to a superstar earning €1.5m pa and everyone else in the team getting €510k, the chances of the team winning a game falls by 20 percentage points. That's almost as big an effect as having to play every game away from home.

This adverse effect comes because pay dispersion worsens individuals' performance, as measured by  newspapers' (highly subjective) ratings. And it seems that the highly paid players' performance suffers as much as that of regular players. It seems that the "pressure of expectations" can depress superstars' performance, whilst other players' do worse because they (subconsciously?) relinquish responsibility as they look to the superstar to win them the game.

All this confirms what all sentient beings already knew - that Arsene Wenger knows best. There's a logic behind his traditionally relatively egalitarian wage structure.

Or is there? All this applies to the pay of the players who appeared on the pitch. Looking at the dispersion among the entire squad, which includes non-playing members, things are different. Pay dispersion here might actually have a positive effect upon performance. This suggests that the optimum structure is one of relatively equality among first-team players, but inequality between first-teamers and squad players.

However, whilst this is an important caveat for football, it hardly applies to companies generally where all employees are in effect players. This, then, is more evidence that paying huge wages to superstars can often backfire. And it's evidence that inequality can be economically damaging.

Markets wrong, says Osborne

It's being reported that George Osborne is planning to issue 100-year gilts or even perpetual gilts in order to "lock in today's low borrowing rates." From several perspectives, this makes no sense.

Put it this way. If the government issues a perpetual, it could "lock in" a borrowing cost of at 3.8% per year (the current yield on War Loan). But why pay 3.8% when it could issue a five year gilt and pay 1.06%? 

The answer's simple. Borrowing costs are expected to rise, so that when the five year gilt matures, the government will have to pay a higher interest rate.

But the total cost of a perpetual should be the same as a five year gilt, rolled over indefinitely. This is because the cost of borrowing to the tax-payer is just another way of saying the expected return to the investor. Investors should, in theory, expect the same returns on a perpetual as on five year gilts, rolled over; if they expected higher returns on the perp, they'd all buy the perp and none would buy the five year. Prices should adjust so that total expected returns on gilts of all maturities are the same. Which means total borrowing costs are the same. This is what the expectations theory of the yield curve predicts.

This has, in effect, been the view of the DMO for several years. It has tended to issue gilts fairly evenly across the curve, consistent with the theory that borrowing costs are the same for all maturities.

Now, you might object here that the expectations theory is wrong. You'd be right. But the ways in which it is wrong suggest that Osborne is even more wrong. I'm thinking of two things:

1. The "preferred habitat" view of the yield curve. This says that the expectations theory fails, because it assumes that bonds of any maturity are perfect substitutes for each other. But this is not necessarily the case. A pension fund wishing to match long-term liabilities prefers long-dated gilts, whilst banks wanting liquid assets prefer short-dated ones.

This theory, though, says that the government should issue short-dated gilts, because yields on these are lower, implying that demand is greater.

2. Mistaken expectations. History shows that the expectations theory is wrong, because an upward-sloping yield curve, such as we have now, does not reliably lead to gilt yields rising; this is consistent with the US's evidence (pdf) over quite long periods (pdf).

But this too suggests Osborne should issue short-dated gilts, as it suggests that borrowing costs might not rise as much as the expectations theory implies.

All this poses the question: why, then, might Osborne want to issue long?

There's only one good possibility. It's that Osborne fears that market expectations are wrong in the opposite direction from what they have often been in the past, and that he believes gilt yields will rise even more than the expectations hypothesis implies. In other words, he expects the cost of government borrowing to rise even more than investors expect. It is this - and only this - that justifies "locking in" today's low rates.

But there's a problem here. In announcing this, he has set the gilt market wondering whether he knows something they don't. As a result, gilt prices have fallen. And in this sense, Osborne has increased the costs of government borrowing .  

"We are all average"

One of the most ubiquitous cognitive biases is overconfidence. As Daniel Kahneman writes:

The observation that "90% of drivers believe they are better than average" is a well-established psychological finding that has become part of the culture and it often comes up as a prime example of a more general above-average effect. (Thinking, Fast and Slow, p259-60)

However, this is not the only cognitive bias that arises when people are asked to estimate their position on a statistical distribution. A new paper by Daniel Sgroi and Eugenio Proto describes another one - that "individuals tend to see themselves as more "average" than is the case.":

Those at the extremes tend to perceive themselves as closer to the middle of the distribution than is the case. For example those who are left-wing see the population as more left-wing and feel themselves to be more typical, and those who own a particular type of mobile phone are likely to misperceive their own brand as more popular than is the case…taller and heavier individuals think that there are more tall and heavy individuals in the population.

This is not always a self-serving bias, nor is it the same as overconfidence; tall men, for example, would probably feel better about themselves if they had a more accurate image of their superior height.

The explanation for this might be straightforward. Likes tend to attract likes - lefties associate with lefties and lardies with lardies - and this, combined with the availability heuristic, leads people to over-estimate the extent to which others are like them.

I suspect this bias might have significant social significance. I can think of two ways, and there are probably more:

1. It leads to the "middle England error" - the tendency of rich people to assume that their incomes are more typical than they really are. This can in turn cause the rich and influential to under-estimate the depth and breath of poverty.

2. Criminals often claim that "everybody's doing it", perhaps because many of their friends are.  In believing that behaviour is normal, though, they are more likely to do it. And so crime is higher than it otherwise would be.

Left vs right: out of date

For me, this post of Tim's raises a thought: could it be that much of the left and right are stuck in an out-dated mindset?

Tim points out that of the many ways in which UK banks failed, none would have been prevented by a financial transactions tax. I think he's right; the banking crisis was not due to a simple, single market failure. But what Tim doesn't point out is that the fact that banks failed in so many different ways highlights a systematic organizational failure. The problem wasn't (isn't) just that banks were (are) too big to fail. It's that they were too big to manage.

In other words, the issue is not one of "markets vs. state"  - "free" markets vs. "sand in the wheel" transactions taxes. It is: how can banks be better organized? And not just banks. The issue of NHS or schools reform poses the same questions.

In this sense, the traditional statist left and free market right are both wrong.

The right is wrong because it overlooked issues of the organization of private companies because it believed that the market would select against bad forms of organization and in favour of good ones. This belief ran into two problems - that bad organizations were (are) widespread*, and that selection against them can be a hugely disruptive and costly process.

The statist/Keynesian left is wrong because its faith that the state can manage the economy by macroeconomic policy and regulation ignored the organizational failings of the state - that there's a danger of regulatory capture, or that inadequate knowledge would yield bad regulation and policy.

Neither side, then, is naturally well-equipped to address issues of organization. To make a start, here are four principles:

1. Institutions are brittle, and prone to sudden collapse. The question is: how to minimize the costs of such collapse? In many cases, ordinary market forces are useful here: when Woolworths collapsed, people just got their pick n mix elsewhere. But in the case of banking collapses, market forces are not enough.

2. Behaviour is context-dependent. One reason the NHS works as well as it does is because of the power of conditional reciprocity; many staff provide unpaid overtime and many patients don't make huge demands on the system.  The trick is to maximize this gift exchange.

3. Power should flow to knowledge. Decisions should be taken by those in the know. The argument for the coalition's NHS reforms, for example, is that GPs should have more power because they are closer to the patient. The question is: is this true?

4. Principal-agent problems are ubiquitous. The alleged dumbing down of education and banks' excessive risk taking might look like different issues. But in a sense, they are not. Both arise from misaligned incentives which result in teachers teaching to the test and traders or mortgage originators taking on too much risk.

Although the principles are general, their application is not. But it is here - rather than in the paradigm of "markets vs. states" - that so many key issues lie.

* Remember, many of the banks that avoided collapse did so either because of dumb luck (if Barclays hadn't been outbid, it would have bought ABN Amro), or because they benefited from cheap money and the bail-out of their counterparties, or because - in the case of HSBC and Standard Chartered - their vintage capital gave them access to massive Asian savings.