Tim Worstall

So here’s an interesting little idea.

Yes, we’ve a new report out from our retired accountant from Wandsworth today. About the huge amounts of tax revenue that are lost to governments as a result of the grey economy….the legal activities but illegal because they’re not paying tax, not the black economy which is illegal activities whether they pay tax or not….

And now we need to introduce Richard to the most important part of neo-classical economics: marginalism.

Forget all about the rest of neo-classical econ for a moment: rational agents, blah blah blah, and think on just this idea that things happen at the margin. The arrival of neo-classical economics was after all called the Marginalist Revolution.

Now while we’re thinking about this we can see that it’s obviously true. For example, we know absolutely that the first beer is worth more to the consumer than the 38 th of the day. We also know that it works the other way, with costs as well. Cleaning up the first 10% of pollution is simple (just tell people to shit in holes) while cleaning up the last 1% of pollution is impossible (things just will turn to dust, whatever you try and do about it).

Excellent, these same thoughts can be turned to taxation. Getting the first bit of tax revenue is simple. There really are law abiding people out there who just love to give money to the State. Last time I looked there were actually 5, four of whom were dead, who sent extra cheques to the Treasury. Getting the last bit of tax revenue is harder: there are always accountants out there who perform income splitting, dodge employers’ NI by paying low salaries plus taking dividends, even those who blatantly refuse to pay business rates on the spurious grounds that they don’t actually owe them.

And there is one more concept that we need to introduce: the deadweight costs of taxation (good paper here). Deadweight costs are that economic activity which does not occur because we’ve imposed the tax.

The concept is obvious: we deliberately impose taxes on fags so as to reduce the number of fags smoked. The same is true of just about every other tax (except LVT!). Tax something and you get less of it.

Excellent, so, now let us put together our marginal idea, our marginal costs idea, with deadweight costs of taxation.

As tax rates get higher we would expect those deadweight costs to rise. (See paper already mentioned.) We would also expect those activities which currently dodge taxes to be more sensitive to such deadweight costs than those that do not so dodge. This again is obvious: people are taking risks in dodging so the economic activity they are undertaking must be more sensitive to deadweight costs than activities where people happily pay up.

So, we’ve deadweight costs (read paper!) estimated at anything from 8% of revenue raised to 50% and more of it. Depends upon the tax, the activity, whether we’re talking about average or marginal etc. And for the reasons that we’ve already discussed we’d expect our currently tax dodging activities to be at the higher end of this spectrum (which actually goes rather higher than 50%).

So, what does this mean? It means that, assuming the logical and empirical chain of reasoning above is correct, that there’s a level of grey economy, of illegally untaxed activity which we should simply put up with. For to insist upon taxing it would make us all poorer.

For, from Ritchie’s paper, we can see that the average tax as percentage of GDP in European countries is 38.9%. Let us imagine that the sensitivity of currently untaxed activities to taxation is 40%. So, we go off and collect, on the next £10 billion of economic activity, our 38.9%. We get £3.89 billion in tax revenue.

Well, actually, no we don’t. For by taxing it we’ve reduced that economic activity by 40%. So, when taxed, there’s only £6 billion in activity. We actually get £2.33 billion in revenue. But economic activity has fallen by £4 billion.

We’re poorer overall.

We’d be better off just not worrying about what those criminal bastards, the tax dodgers, are doing over there in hte last 10-15% of the economy. We’re made richer by ignoring it.

Which is where our retired accountant goes wrong: he just doesn’t, ever, bother with the economics of things.

NB. I do not say that the sensitivity of the next £10 billion of the grey economy is 40%. But only that there will come a point when it is.

Tim Worstall blogs on http://timworstall.com