From the TUC

Introducing the Austerity Curve

23 Jan 2012, by Guest in Economics

The Laffer Curve is a concept close to the heart of many economists who advocate lower taxes.

The concept is actually quite an old one but it was popularised in modern times at a lunch meeting attended by economist Arthur Laffer and officials from the Ford administration (including Donald Rumsfeld and Dick Cheney) in the mid 1970s, when Laffer drew the curve on the back of a napkin to illustrate how a rise in personal taxes proposed by Ford might lead to lower tax revenues.

Laffer argued that if tax rates were set at zero then tax revenues would clearly also come in at zero, but if taxes were set at 100%  then no one would bother working and so tax revenues would again be zero. He sketched something like the below to demonstrate this:

Whilst Laffer was almost certainly correct to suggest that there is curve, the key question facing tax policymakers is where about on the curve are tax rates currently. Are they on the left hand upward sloping slide, in which case tax rises will raise revenue, or on the right hand, downward sloping side, where tax rises will lead to less revenue?

For what it’s worth,  the point at which tax rates move to the downward sloping, right-hand side of the curve, appears to be around the 70% mark, so in most cases Laffer analysis suggests that higher rates can indeed raise revenues, despite what the Curve’s usual proponents argue.

But I’ve thinking recently about the Laffer Curve not as it relates to tax policy but in terms of how the concept might relate to austerity.

Last week international policy makers (including the IMF’s Christine Lagarde) urged a slowdown in fiscal consolidation – i.e. less austerity. They worry that austerity programmes across the developed world are leading to weaker growth, higher unemployment and ultimately higher deficits and bond yields.

Just before Christmas, as I blogged at the time,  the IMF noted that some preliminary analysis suggested that it was possible, that beyond a certain point, austerity led to higher, rather than lower, yields on government debt:

The IMF are suggesting that in certain cases (presumably like those we currently find ourselves in, with weak growth, very low central bank interest rates and depressed demand) that cutting government spending can mean the yield on government bonds rises rather than falls.

This makes intuitive sense. If cutting government spending means weaker growth and a higher deficit then it would be perfectly rational to demand a higher interest rate in return for holding government debt.

Might it then be the case that something like a Laffer Curve exists for austerity? That is to say that cutting government spending up to a certain point leads to lower deficits but beyond a certain point, the impact of lower growth and higher unemployment means that deficits get worse as the government cuts more?

The graph below attempts to illustrate this (and I would have drawn it on a napkin but didn’t have one to hand):

Like the Laffer Curve it suggests that there is a point at which cutting government spending becomes self-defeating, it simply lowers growth, depresses tax revenues and pushes up social security spending by more than the government is cutting.

The question for policy-makers then, is are they past the point and at which the curve becomes downwards sloping? Will more austerity simply lead to higher deficits?

Judging by the tone of S&P’s downgrade of several European sovereigns last week, it certainly seems to think that many countries have passed this point.

19 Responses to Introducing the Austerity Curve

  1. Andreas Paterson
    Jan 23rd 2012, 12:12 pm

    Interesting question this raises is, if you’re at the peak of the curve and still have a high deficit, what possible policy response is there?

  2. Frances Coppola
    Jan 23rd 2012, 12:59 pm

    Andreas

    At the turning point of the curve cuts make absolutely no difference to the deficit. In which case there is no point in making them.

    Duncan

    Great curve. It needs lots of metrics, and no doubt will generate huge argument between deficit hawks and doves as to exactly where the turning point is.

  3. Migeru
    Jan 23rd 2012, 1:09 pm

    Fighting pseudoscience with pseudoscience?

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  5. James Mac
    Jan 23rd 2012, 8:49 pm

    This idea is not new. Go back to the middle and late 1980s and look at what happened in Ceaucescu’s Romania, where instead of “austerity” the desired outcome was “we have no international debt”.

  6. Mydogsgotnonose
    Jan 24th 2012, 7:58 am

    You clearly haven’t a clue. The Laffer curve applies to a normal economy in which most people provide added value by their work. Our economy is biased towards Statist economics which borrow from the future to subsidise employment. And we are connected to a whole lot of other economies for which the same applies.

    If you tax a Statist economy more, you still further reduce its efficiency thus accelerating the crash. This is encapsulated in the recent shenanigans concerning the UEA’s CRU which has just lost a major appeal concerning its tactic of refusing to release information. In essence, it was falsifying scientific results to provide an excuse for the State to tax the population to a greater extent than before.

    Thus we were already at the limit of the Laffer curve.

  7. Guido Fawkes
    Jan 24th 2012, 8:37 am

    The problem with the austerity curve concept is that we have no evidence to support the theory and plenty of evidence from previous cycles that expansionary fiscal contractions are the norm.

  8. Andreas Paterson
    Jan 24th 2012, 9:27 am

    ??? The problem with the austerity curve concept is that we have no evidence to support the theory and plenty of evidence from previous cycles that expansionary fiscal contractions are the norm

    No examples? How about that little Mediterranean country named Greece? As for evidence of expansionary fiscal contraction, you clearly have no idea what you’re talking about, there is no evidence for it.

  9. Gareth
    Jan 24th 2012, 11:27 am

    This is all basically meaningless unless you define the term “austerity”. The government is aiming to hold government spending roughly fixed in nominal terms, that requires a pretty odd definition of “austerity” to me.

    If falling spending/GDP is “fiscal contraction”, the UK in 1993 to 2000 is an excellent example of “expansionary fiscal contraction”. It can be contrasted with the subsequent period of fiscal expansion up to 2008, where real GDP growth was slower. Correlation != causation, of course.

  10. UnlearningEcon
    Jan 24th 2012, 12:23 pm

    Gareth, nominal spending is utterly meaningless by anyone’s standards.

    And yes, allowing government spending to fall during a boom, when the economy is at full employment may well be expansionary. But we aren’t in a boom.

    Are you being disingenuous? If not, you should know that more nuanced analysis is needed.

  11. Andreas Paterson
    Jan 24th 2012, 12:56 pm

    “If falling spending/GDP is “fiscal contraction”” – a falling spending to GDP ratio is a very silly definition of fiscal contraction because it would mean that almost all economic recoveries become “expansionary fiscal contractions”. Recessions generally occur as a result of falling private sector economic activity, public sector activity doesn’t really change (unless the government makes it so) so when the private sector recovers of course you’ll see a fall in the spending/GDP ratio.

  12. Gareth
    Jan 24th 2012, 4:10 pm

    Yes, guys, I agree a more nuanced approach is necessary, some cet.par. assumptions on monetary policy in particular. That’s kind of my point.

    Duncan’s graph has “austerity” on the X axis, as a measure of the fiscal stance. If it is not nominal fiscal spending (TME?), and it is not fiscal spending with some deflator applied (spending/GDP, spending/CPI, etc)…. what is it? You tell me.

    It cannot be the deficit, because the deficit is the Y axis.

  13. Duncan Weldon

    Duncan Weldon
    Jan 24th 2012, 4:13 pm

    I’d use discretionary change in fiscal policy (i.e. taking a narrative approach).

    The following might interest:

    http://elsa.berkeley.edu/~cromer/Written%20Version%20of%20Effects%20of%20Fiscal%20Policy.pdf

  14. Dan Sutton
    Jan 26th 2012, 10:54 am

    Is there some link to Modigliani and Miller’s work on Weighted Average Cost of Captial here?

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  16. Gareth
    Jan 26th 2012, 3:32 pm

    “discretionary change in fiscal policy” -> good luck graphing that in Excel ;)

    Problem also in that most policy changes are made many years ahead.

    Again, the question really is what variables you hold constant. If monetary policy can e.g. hold total spending constant then fiscal spending is irrelevant, you can collect whatever % of total spending in revenue as you want to collect.

    Sweden has been running contractionary fiscal policy (as in taxes > spending) for many years, and have an excellent growth record to go with it. Austerity par excellence.

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