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Tuesday, 10 April 2012

YOU SHALL NOT HAZ!

Dear readers,

I've waited a long time for a juicy academic paper to come along that discusses the state and prospects of the Greek economy and have come up with the occasional gem now and then. But I think I found a real good one the other night.

Through this discussion on VoxEU.com, I became aware of a new working paper by Matthias Traband of the Fed (yuk!) Board of Governors and Harald Uhlig of the University of Chicago which tries to answer a very fundamental question: how much can sovereigns tax before they reach their maximum tax take?

This question is based on the Laffer Curve hypothesis: if zero effective tax rates produce no government revenue, and 100% effective tax rates also produce no government revenue (as all economic activity ceases), then there must be a point in between where the economy is taxed as much as it possibly can be; further increases in headline tax rates will simply reduce the government's tax take by providing disincentives towards work and investment. I know many readers on the Left will resent the idea of the Laffer curve: filthy neoliberals telling them what they can and cannot do, as though the world were not infinitely malleable to their political preoccupations! And true enough the Laffer curve is hardly as fixed and stable as it looks on a blackboard. Today's Laffer curve is tomorrow's laughingstock.

But the core insight is undeniable - no government anywhere in the world taxes its citizens and businesses above a certain point, as they implicitly know that beyond a certain point they will only end up hurting themselves.

Anyway, I strongly urge you to read the Traband and Uhlig paper, as it specifically calculates two core variables to any future model of the Greek economy - the maximum sustainable interest rate and the maximum sustainable tax take. As p. 26 indicates, the highest interest rate Greece could have sustained back in 2009 was 7.4%. I'm pegging this to 2009, as the 2010 calibration uses 2009 figures and is therefore completely useless in our case. This indicates that, although the Greek state is insolvent, the actual interest rate imposed by our creditors is currently just about sustainable. More importantly, the highest amount by which we could sustainably increase tax revenues to GDP compared to 2009 was 4.8%, on top of the 37.9% we were getting in 2009 - so essentially 42.7%.

This is important because the tax revenues assumed by the IMF's debt sustainability report  are 41% of GDP - a sustainable figure as it turns out. However, it also means that, barring a fundamental shift in the structure of the Greek economy, 42.7% is the maximum amount of primary government spending we can sustain. It's the limit to the size of the state.


How do we get there is the question. Traband and Uhlig show that taxing capital alone can only provide an additional 2.4% of GDP and take us to 40.3%. Taxing labour alone would only provide 4.4% of GDP and take us to 42.3%, which is sustainable but sub-optimal. Whatever happens, we'll have to rely more on labour taxes than capital taxes. And whatever happens, it's simply not possible for the Greek state to sustainably grow to more than that 42.7% of GDP. People should bear a realistic calibration of the Laffer curve in mind before they make comparisons between Greece and other European countries - the argument is often made that the Greek state is not too big, given that the EU average for government spending is higher than ours. The simple answer is, that's their Laffer Curve; not ours.

In the words of LOL-Gandalf, YOU SHALL NOT HAZ!


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