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What’s Wrong With The LSE Paper On Tax Cuts For The Rich

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Much excitement over in lefty circles about this new paper from the alma mater showing that tax cuts for the rich don;t have any effect upon GDP growth. In fact, all they do is increase inequality and to, Yah! Boo! we shouldn’t have tax cuts for the rich. In fact, whack ’em back up to Roy Jenkins levels – he did once tax capital incomes at 130% of last years revenues. Announced after the end of the tax year.

There’s a problem with this. GDP is not the right measure to be using here.

The results suggest that tax reforms do not lead to higher economic growth. The effect size of
major tax cuts for the rich on real GDP per capita is close to zero and statistically insignificant.
The findings are very similar when matching upon pre-treatment covariate trajectories (right
panel). Major tax cuts for the rich do not lead to higher growth in either the short or medium
run.

Just for giggles we’ll accept what they say. Even, agree that it would be true if GDP measured what we generally think it does. But it doesn’t.

Our general belief is that it measures one of and all three individually of all value produced, all real incomes and or all consumption. It’s embedded in our definition in fact, all production, all incomes, or all consumption, that’s what we try to tot up, each of the three is equal to either and both of the other two.

Except it isn’t that at all. It’s all of those, and any of those, at market prices. Meaning that we have two problems here – our definition of real prices at which all this takes place and all those things which are not encapsulated in market prices.

Real prices are a problem. For we discount GDP at the consumer price index (perhaps, for the UK, RPI, not sure of that detail). But we know that the CPI overstates inflation. When we adjust GDP therefore, from nominal to real figures, we understate the growth in GDP.

If this was a constant problem over time then this wouldn’t make a difference. But it’s technological change which causes our CPI problem. Things only enter the basket of goods that we calculate inflation from after they’ve become commonplaces. A Rolls Royce isn’t in the set of goods that we calculate inflation from, a Ford Focus (or summat like it) is. But some to most of the price decline of a new technology happens in that move from something being a new a luxurious item to a commonplace. ABS braking for example, it started out on an RR or equivalent and it was a decade or three before it turned up in the Ford. But we count the fall in price in ABS only from when it was already in the Ford.

This problem becomes greater the faster technological change happens.

What is the defining feature of the economy of the last 30 to 40 years? Technological change, clearly. So, it’s something that is a greater problem then it was before. And yes, economic chatter is indeed about how much the CPI overstates inflation, thus understates GDP growth. There’s discussion over how much but not about whether.

What are our Bubbas using here? GDP growth over the past few decades and mapping that against the general decline in high end income and capital taxation over the same decades. Which isn’t going to work if we know that we’ve been understating GDP growth over the same period, is it?

Our second problem is that GDP isn’t even the thing we’re interested in. We want to know about real, real incomes. What can people consume? We calculate at market prices because that’s something real we can grasp ahold of to do so. But we all know that this isn’t right. Or, rather, when people discuss the details of GDP this is the sort of thing that is agreed. Non-market output doesn’t get counted – all that caring economy stuff. Vide any feminist economist for a discussion of that.

But real, real income – or real, real, consumption and thus also production – includes the stuff we get from market priced goods but that we don’t have to pay for. That’s what’s known as the consumer surplus. The rule of thumb here is that it’s about equal to GDP itself. In normal times that is.

Again this is something that is agreed by all who consider the question, the discussion is about how much it matters. A lot is my answer and there’s even the possibility that I am right:

Tim Worstall is, I think, 100% right here. The key difference is between “Smithian” commodities–where it is a safe rule of thumb that the consumer surplus generated is about equal to the producer cost, so that GDP accounts that value goods and services at real producer cost will capture a more-or-less stable fraction equal to half of true standards of living–and… I might as well call them “Andreesenian” commodities, where consumer surplus is a much larger proportion of monetized value because what is monetized is merely an ancillary good or service to what actually promotes societal welfare. What is the proportion? 5-1? 10-1? Somewhere in that range, I think–at least.

And:

and Marc Andreessen were disagreeing… over the effects of technology on the passing landscape…. Take, for example, Facebook. As far as the general economic statistics are concerned, GDP, labour productivity and all that, the output of Facebook is the advertising it sells…. Valuing Facebook’s contribution to living standards as being the advertising it sells is near insane… but that advertising is the only part of the value which we do ascribe to Facebook that is actually monetised. And given that GDP, labour productivity and all that are described only in monetised terms then we’re missing a very large part of what it’s all about.

People (for some unknown reason to me) like Facebook. Their lives are made richer by Facebook’s existence: they are in fact richer. We’re just not measuring that extra wealth that they derive from Facebook’s existence…. Brad Delong once pointed out (or perhaps pointed to someone who pointed out) that one way of looking at rising living standards in the 20th century was a factor of about 8. Rich world people in 2000 were 8 times better off than rich world people in 1900. Roughly true by those standard measures of GDP and so on. But if we than added what people could do, the improvements in quality, all something analagous to that consumer surplus. it might be more true to say that people were 100 times better off. That’s how I would explain (some of) that productivity puzzle….

Andreessen is… talking to that Facebook example above…. I do tend to think that the gap between “real living standards” and “recorded living standards” is growing simply because so much more of the value of the new technologies is not in fact monetised.

From Bjornolfson et al we even have a measure of that consumer value created by Facebook. People would need to be paid $800 a year in order to not have it. So, the value to them, the consumption value or their real income, is $800 a year. In our GDP accounts this is listed as being the ad revenue that Facebook gains per user. $40 a year? Something like that perhaps. So, rather than the consumer surplus being 1x GDP we find ourselves with it being 20x.

From the same source we have a valuation of search engines and email. The things we get free from Google – or rather the things that are in GDP at Google’s ad revenue. Say, what, $100 a year per punter? But the value in consumption is $18,000 a year.

GDP is not, therefore, giving us an accurate measure of how much lives are getting better – as measured by production, real incomes or real consumption. This problem coming from the advance of technology – something at the very least coincident with the general fall in higher end tax rates.

If we cannot measure how the world has been getting better by that GDP then an attempt to consider whether summat – say, changes in tax rates – has led to the world getting better or not cannot be calculated by using GDP.

And yes, it gets worse. Because their secondary conclusion is that inequality has got worse over this same period. But if we all gain the same access to Facebook and Google as Jeff Bezos and Elon Musk do – not Bill Gates, he has to use Microsoft – at the same price and this is worth $18,800 each a year then inequality has decreased, not increased. Or, at least, this same service, same price, reduces inequality in itself, something we’re not including in our estimation of whether inequality has increased.

That is, the bubbas here at the alma mater are using the wrong statistic – GDP – to attempt to measure the world. We need to correct that before we can gain any useful conclusions at all.

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4 COMMENTS

  1. I naturally feel that it’s my taxes that should be cut, not those of the rich. Of course if I was rich, I’d still think my taxes were the ones that should be cut.

    However I must agree with you about the value of the internet. After I retired, whenever I visited my sister and her family in Canberra, I’d go to the National Library and drag out a volume of Fortescue’s ‘History of the British Army’. Then one day a nice young lady at the desk showed me how to log into the Internet Archives, and read Fortescue whenever I wanted. They were all grinning when I came back to the desk after a couple of minutes to scrounge paper and pen to write down the address.

    Indeed even if the book isn’t available on the net, I can still order it from overseas. They evidently have huge stacks on hand of remaindered books that I’ve been wanting to read for half a century or so.

  2. There is also the minor point that the data *does* show that reducing taxes on the rich is correlated with higher GDP growth.
    The British “researchers” have chosen to omit from their study the British example of cutting taxes on “the rich” (and on others with high incomes) – Geoffrey Howe’s first budget – which was followed by a significant increase in GDP growth and claim that the combination of a group of studies which did not show a significant increase in GDP growth with a group of studies that *did* show a significant increase in GDP growth “proves” that tax cuts do not lead to faster growth in GDP – that is called a teminological inexactitude. The most that an honest man could claim would be that tax cuts for higher incomes do not *always* lead to higher GDP growth.

  3. ABS braking for example, it started out on an RR or equivalent and it was a decade or three before it turned up in the Ford

    Not really (the old RR prided themselves on not having much to do with modern tech – after all, there’d be a chauffeur at the wheel, who knew how to do cadence braking). ABS came out of aerospace – stopping a landing aircraft as quickly as possible whatever the condition of the runway being quite important. And it was FIAT who adapted it for automobiles.

  4. @ Quentin Vole
    The old RR prided themselves on having the *best* brakes and only adopted ABS when it had been developed up to standard that matched their own disc brakes. I remember reading a commentary (I was doubling up to cover Engineering companies at the time) when someone explained that RR was using “old-fashioned” brakes because their continuous refinement of existing technology meant that they were better than any so far produced using the new-fangled technology.

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