Bad economics lead to bad decisions…

Yet again, we are being told that there are special economic laws that mean that there are perfect and imperfect tax rates. The theory concerned is highly flawed, and it isn’t even showing the thing that it is claimed to show.

Oh, here we go again... Of all the bad economics out there, there are few concepts that get more attention with less consistent thought about it than the mythical 'Laffer Curve'. It's back this week, and the sight of the Laffer Curve rearing its head is never a good sign.

Scotland is awash with the Laffer Curve right now because the Scottish Government put a tax rate up and it seems to have raised less money, apparently proving not only that Laffer was right but that we now know Scotland's 'perfect tax rate'. Both are nonsense so allow me to just roll my eyes and explain some stuff.

You have probably heard of the Laffer Curve. That is in large part because the idea is so simple/stupid it is easy to remember, and because it is incredibly handy for the low tax, pro-oligarchy brigade. But it isn't what others seem to think it is and it's not even an original idea, having been discussed by a 14th century Islamic Scholar and Adam Smith long before the fateful night concerned.

That night saw right-wing economist Arthur Laffer having dinner with Dick Cheney and Donald Rumsfeld in Washington. Chatting about tax, Laffer made a point that is really so facile it is hard to believe the traction it has gained. He said 'if you tax someone zero per cent, you won't raise any money, but if you tax them 100 per cent there is no point in them working so you won't raise any money either'. He literally drew this on the back of a napkin to make his point.

Yet we know you can raise tax because it's been happening for millennia, which seems to lead to an inescapable conclusion – if the two ends of this imaginary graph (zero and 100) return a value of zero but points between them return not-zero values, they must form a curve. And if there is a curve, there must be a highest point on the curve. That point is the 'perfect tax rate'.

Where to begin with this? First of all, the current use of this concept and its original meaning are pretty far apart. Neither Ibn Khaldun nor Adam Smith were thinking about the tax avoidance industry in Edinburgh or London but rather of incentives or disincentives to work. It is this which 'tax-behavioural relationship' theory began.

Obviously if I tax you zero it raises zero. But if I tax you at 20 per cent it does raise money, and if you can earn more by working more hours, then each extra hour worked will pay you another 80 per cent of what you earn.

Now let's ramp it up a bit; let's imagine you're taxing at say 40 per cent and you're working a seven hour day. You pay 60 per cent tax on your working hours, but you are offered overtime. Now you have the chance to work an extra hour – but you only get 60 per cent of the wage. Is it worth it? Possibly.

But what if I tax you 60 per cent and you get 40. Is it still worth working an extra hour? What if it was 80-20? By this point I think I can safely say that few of us are voluntarily going to work an extra hour for 20 per cent of the hourly pay. So no, we don't choose to do that extra hour.

Now imagine that you can work out precisely the number at which the wage incentive to work tips over into the tax disincentive to work. For the sake of argument let's say its 55 per cent. That means that if I tax you at 54 per cent you'll do overtime and so I'll raise more money. If I tax you 50 per cent you'll still do the overtime but I'll raise less money, but if I tax you 56 per cent you won't do the extra hours and the amount I raise goes down again.

That's it; that's the original theory that became the Laffer Curve, and as a conceptual model for understanding the relationships between tax, pay and work incentives, that's fine. It's just not really true, for loads of reasons.

First of all, mostly the tax avoiders don't exist in this kind of universe. People who pay tax accountants are not generally on hourly wages or reliant on overtime. People who work overtime which is paid by the hour do not have tax accountants. The theory doesn't describe the modern world. People are working three part-time minimum wage jobs to survive; being able to eat is a stronger incentive than tax is a disincentive.

And it definitely doesn't describe what is happening in Scotland. Because if we've lost income from putting up a top band of income tax then its not because they have reduced their working hours and therefore taken a pay cut, it's because they're using tax avoidance techniques. More importantly, they're using tax avoidance techniques where are not available to the rest of us.

Let's take another theoretical example just to help us here. Imagine for a second that Britain's tax system was designed in such a way that for some reason you pay a zero rate of tax on earnings but only if they are precisely £30,000. That is, if you earn £29,999 or £30.001, you pay full tax on all your earnings, but you pay zero if your salary is exactly £30k.

Now go away and draw me the corresponding Laffer curve. It doesn't make any sense, does it? Let's say standard tax rates are 20 per cent; that means for a start that no-one would be interested in a job that pays £35,000 rather than £30,000. To get more income than earning £30,000 you'd have to earn about £40,000 or more.

But now you can charge 80 per cent tax on all salaries over £150,000 and, in the absence of tax avoidance, it still creates an incentive to take the pay because you'll still take more money home. You don't have a curve at all any more, you have an all-but random wobbly line. It literally doesn't make any sense because the premise is daft. If the tax system allows people not to pay tax, behavioural theory doesn’t mean anything.

Yet this is the premise we're arguing about on Scotland's top tax tier. It's not that we have't learned anything, it's that we've learned something so facile it is hard to see why we're bother learning it; if you allow a group of people to totally avoid tax then they will. Congratulations Arthur, your theory is great at predicting the bleeding obvious.

“It’s not that we have’t learned anything, it’s that we’ve learned something so facile it is hard to see why we’re bother learning it; if you allow a group of people to totally avoid tax then they will”

Now before anyone gets onto me, yes there are other things we could be seeing as effects. The favourite is the 'well I'm off' argument – that wealthier people will just leave the country if you tax them. Again, this is one of those facile statements which on the face of it sounds true but can be shown not to be significant.

In the US, if you track where wealthy people live, it is very distinctly not in the states with the lowest tax rates but generally in high tax states. Why? Because it's a better quality of life, because infrastructure there is much better. Wyoming is perhaps the lowest tax state in the US, but the billionaires haven't all moved there.

In fact, in the US only about 2.5 per cent of rich people relocate to another state in any given year, making them by far the least mobile group in society. Why? Because when your rich you choose the place with the best quality of life and that is seldom in the lowest tax state.

Back in Scotland for a second and I'll show you the point again. In Scotland you pay three per cent more than in England for any taxable income over about £125,000. That means that if you earn £150,000 (placing you waaaaay at the top of the income spectrum in Scotland) you'll pay about £60 a month more in tax.

So let's say you can find another job in England at the same pay and where housing costs aren't higher, emigrating across the border will save you – well, less than the removal van will cost. Oh, unless your kids go to university in which case you've just lost all your gains.

I am very much not claiming that there are no incentives effects from tax rates that change behaviour, I'm saying that they are utterly dwarfed by the incentive to use the tax loopholes the system contains. I mean, we're only talking about income tax here and very rich people don't bother with wages much these days since it is capital gains that makes them truly rich.

And that is where we get the stupidity. We have actively designed a system that lets the rich avoid tax and then we use a cockamamie theory that is measurably flawed to retrospectively pin the blame for this on income tax rates. It's all ludicrous. Rich people didn’t avoid tax when it was 70 per cent but the tax laws weren’t designed to be evaded. They avoid tax precisely as much as we let them.

Because the 'perfect tax rate' implied by the Laffer Curve theory has been assessed many times and it falls between about 40 and 75 per cent, with most economists accepting that western societies set tax rates well to the left of the nominal peak of the Laffer Curve. We don't even follow the theory.

And that's if you believe in the perfect tax rate. If you have a zero-avoidance system then you literally need to make it substantially cheaper to leave the country to see any effect. Also, I don't even accept the curve idea in the first place. If I hate red and violet, does that mean all the other colours are spread out along a neat curve which proves the one I like most? And that it’s green? You can’t just go drawing random curves between two extreme points and calling that science.

So when this week you hear all the right wing ideologues going on about how they've been proved right because tax income fell, you might just want to point out that the fact a bucket has a hole in it doesn't mean buckets don't work, just that you need to find one without a hole.

Take out all the tax freebies for the very rich, tax capital gains at the same rate as income tax, crack down on low-tax inheritance tricks and tax property and assets fairly and you can set tax at any rate short of that which chases everyone out of the country – which is much higher than you think.

Meanwhile, I'm off to get a napkin so I can draw two dots representing negative infinity and infinity, and then I’ll just draw some plausible-looking curve between them. It’ll prove that mathematics doesn’t work. So hurray me.