Wednesday, February 29, 2012

In the run up to the budget, there is much interest in the top 50% rate of income tax. Some commentators argue for retaining this band, while others would like to scrap it – the latter group claiming that such a high rate of tax carries the risk that high income entrepreneurs will choose to leave the country rather than pay the tax.

Some evidence on this issue comes from the work of Mathias Trabandt and Harald Uhlig, who calculate ‘Laffer curves’ for a variety of countries. Laffer curves plot tax revenues against the tax rate. Tax revenues are low when the tax rate is low for obvious reasons; they are also low when the tax rate is high because there is then a strong disincentive effect. The Laffer curve therefore takes on an inverse U shape, low at the extremes and peaking at some non-extreme rate of tax. For the UK the Laffer curve peaks at an income tax rate somewhere between 50 and 60 per cent. This suggests that the current top rate is about right.

Tuesday, February 21, 2012

Results that are apparently strong emerge from simple models of the economy such as those that appear in the textbooks used by our students. In reality, the world is rarely as simple as these models might suggest. More complex models often generate more complex results - in other words, things are rarely so simple as they appear.

The current generation of macroeconomic models is based on building blocks of utility maximising individuals and profit maximising firms, all with the ability to make sensible forecasts of the future evolution of the economy and with the ability to adjust their behaviour in line with the current and expected future economic environment - which includes, amongst other things, government policy. There is a lot going on in these models - just as there is a lot going on in the real world. In many cases, the results obtained from these models are the same as those that emerge from the textbook models. In some cases - unusual cases, perhaps - they are not. Since we live in unusual times, it is not altogether ludicrous to consider some of these unusual cases.

A recent paper does just that. It asks the question: in a world where sovreign debt is approaching the limits of sustainability, does fiscal policy work in the same way as textbook models say it should? The answer is: it may do, it may not. Under certain (extreme) circumstances it may even be the case that austerity can stimulate the economy. Under more plausible scenarios, however, the results of the paper emphasise the 'benefit of delaying fiscal adjustment until after the economy has recovered from the worst of the initial recession'

Giancarlo Corsetti, Keith Kuester, Andre Meier and Gernot J. Mueller (2012). Sovreign risk, fiscal policy, and macroeconomic stability International Monetary Fund Working Paper

Thursday, February 16, 2012

The operations of the European Central Bank since December have helped stabilise what had, until then, looked an increasingly precarious state in the financial sector. Spreads (measuring the difference between the interest rate that a country needs to pay on debt and that which Germany needs to pay) had, until December, risen in a number of European countries and were reaching disturbing levels. The spreads are still high for Greece, of course, and are still high in Portugal (though it recently dipped below 10 after hitting a high of over 15). In Spain, the spread has fallen from over 4.5 to around 3.5; in Italy from about 5.5 to 3.8; and in France from around 2 to around 1.1. Moreover, in the UK, the LIBOR - often seen as an indicator of how confident banks are in lending to one another - has started to fall, thus suggesting that some confidence is being restored in the system - though it still remains more than half a percentage point above the central bank's rate of interest.

Meanwhile, consumer confidence has started to rise.

It remains far too early to suggest that a corner has been turned. Future developments in Europe remain unclear. While monetary policy, with renewed quantitative easing, is likely to stimulate the UK's economy, fiscal policy is still restricting growth. And the labour market situation remains bleak; unemployment typically rises for some time after output starts to recover. But, while still very fragile, the overall economic outlook now looks more promising than has been the case for some time.