Some Concerns About the IFS Analysis of Labour’s Economic Proposals

On the 26th of May, the Institute of Fiscal Studies (IFS) published a scathing attack on the election manifestos of the Labour and Conservative parties. The IFS declared that neither party “has set out an honest set of choices” to the public in its published tax and spending plans and that both manifestos come with “big risks” to the economy. The IFS calls into serious question whether either party could deliver on its manifesto commitments.

These are very strong statements, which the media have circulated largely without question or criticism. As a researcher on tax policy, this worries me. The IFS analysis is based on careful research, but needs to be understood for what it is. The think tank has essentially produced a forecast of the effects of different party policies on the economy and therefore on government revenue, which needs to be taken with a heavy pinch of salt, just as any other economic forecast should be. The public and the media are all too aware of the mistakes economic forecasters have made in the past. The IFS analysis is subject to as many caveats as many other economic predictions and should be treated with just as much caution. That neither party “has set out an honest set of choices” is the IFS’s opinion, based on its own predictions about the effects of the parties’ policies. It is not incontrovertible fact.

It is also important to understand that the IFS view of the party manifestos does not represent a firm consensus in the economics profession. There are many economists out there who disagree considerably with the IFS report, just as there are many other economists who would broadly agree with it. On Sunday, more than a hundred economists wrote to the Guardian asserting that, contra the IFS, Labour’s manifesto proposals are “fiscally responsible and based on sounds estimations”. To a significant degree, these divisions among economists reflect ideological differences. Those economists who ideologically disagree with the Labour party’s view of the world will be very sceptical of Labour’s ability to meet its manifesto commitments, and similarly for those who disagree with the ideology of the Conservatives. My strong suspicion is that the IFS disagrees ideologically with both manifestos, and that its response to them reflects this.

All these concerns should be remembered when reading the IFS’s response to either party manifesto. However, I am going to focus on their response to Labour’s manifesto. This is because the IFS’s criticism of the Conservative manifesto mostly concerns its views on the effects of spending cuts on public services and the effects of immigration cuts. These are topics I know relatively little about, so I will leave them to others to discuss. The IFS critique of Labour’s manifesto is mostly about the economic effects of tax rises, which I like to think I know a little more about.

So what could one disagree with in the IFS analysis of the Labour manifesto?

Primarily, the IFS criticises the Labour manifesto on the grounds that it believes Labour’s proposed tax rises will not generate enough tax revenue to fund the party’s spending commitments, such as free university tuition. This sounds like a simple accounting exercise, but it isn’t. The reason that Labour would struggle to meet its manifesto commitments, according to the IFS, is that its policies would harm the economy. This would make taxpayers poorer and therefore reduce government tax revenue. Whether or not we should agree with the IFS’s assessment of Labour’s budget hinges entirely on whether or not we think Labour’s policies are likely to be harmful. Crucially, the IFS’s analysis implies that Labour could potentially pay for its spending commitments with only the tax rises in its manifesto, if Labour’s tax rises and minimum wage increases did nothing to damage the economy. The IFS emphasises that the economic damage wrought by Labour’s policies would not only force a Labour government to “raise other taxes, spend less or borrow more” but are also “likely” to lead to “lower wages” or “higher prices” and risk “the employment opportunities of many young people”. Therefore, according to the IFS, the cost of Labour’s policies “would inevitably need to be borne by large numbers of us”.

The key question with this is whether the IFS is right that Labour’s policies are likely to be economically costly. Many economists would, no doubt, agree with the IFS in this regard, but many other economists do not. The letter on Sunday of over a hundred economists to the Guardian argued that “The Conservative manifesto calls for continued austerity, which will tend to slow the economy at a crucial juncture” whereas “Labour’s manifesto proposals are much better designed to strengthen and develop the economy”. The Oxford Economics Consulting group agrees that Labour’s policies would “offer better outcomes in terms of GDP growth” than those of the Conservatives “without putting the public finances under strain”. This is because, not in spite of, Labour’s more ambitious public spending and investment proposals, financed in part by higher taxation.

I will now discuss the specific claims made by the IFS in some detail, and highlight areas where economists can and have contested the IFS’s view. I will clarify exactly why the IFS view rests entirely on the idea that a Labour government would harm the economy and why many economists would disagree with this view. Fundamental to the IFS view, I think, is an ideological belief that redistributing from rich to poor is economically harmful and that publicly funded investment “risks waste”. This reflects a belief that the hard work of the rich is essential for wealth creation, and that this wealth then trickles down to the rest of us. Taxing the rich reduces their tendency to create wealth, harming the rest of us. This ideological perspective colours the IFS’s perspective on Labour’s income tax rises, its corporation tax rises, its proposed rises in the minimum wage and its plans to increase public investment. By contrast, the Labour Party manifesto reflects, I think, Labour’s scepticism about this kind of “trickle down” economics. In this sense, the disagreement between the IFS and Labour Party is primarily ideological.

I do not mean this to be a criticism of either the IFS or the Labour Party. Predicting the effects of economic policies is an extremely difficult business, and economists frequently have no choice but to fall back on ideology to fill the gaps where the data is lacking. The IFS’s analysis is no more and no less ideological than many other economic analyses. This means, however, that we can only trust the IFS’s judgements insofar as we agree with the ideology on which those judgements rest.

The IFS states that “the Labour manifesto comes with two big risks. The first is that they might well not raise anything like the tax revenues they want from their proposed measures. The second is that some of [Labour’s policies] would turn out to be economically damaging.” This language is, I think, a bit misleading. The IFS analysis implies that these two risks are actually the same problem: the reason that the IFS believes that Labour will not raise the tax revenue it expects is because its policies would turn out to be economically damaging. This is most clear in the case of the IFS’s analysis of Labour’s planned increases in personal taxation. Labour expects that its higher income taxes on the rich will raise £4.5 billion. The IFS thinks this is likely to be an overestimate. At the same time, the IFS argues that, if everyone’s pre-tax taxable income remained unchanged as part of the policy, then Labour’s tax rise would actually raise £7 billion. The IFS views Labour’s £4.5 billion target as ambitious because it does not believe that everyone’s taxable income will remain unchanged. Instead, “some high-income individuals would respond to the higher tax rates by working less (e.g. retiring earlier), increasing the extent to which they (legally) avoid or (illegally) evade taxes, or even emigrating (or not moving here in the first place).” For this reason, the IFS produces a middle estimate that the tax will raise only £2.5 billion, putting Labour’s fiscal responsibility into question.

With the exception of tax avoidance or evasion, what the IFS is really claiming is that the higher taxes will reduce the national income of the country, by leading those who create the wealth to work less hard or emigrate. It performs its calculations using estimates of how the tax changes will reduce the taxable income of each individual, but when you add these together, the IFS estimates imply that national taxable income will be lower. This amounts to saying that Labour will not get the revenue it expects because its tax rises will either lead to much more tax avoidance or tax evasion or shrink the economy. The IFS’s sums do not really cover the tax avoidance case, because when someone avoids taxes they often do this by e.g. reclassifying private income as capital gains, which still carry a positive tax rate and the IFS ignores this. The IFS also do not really cover the tax evasion case, since the revenue loss from tax evasion could presumably be lowered by Labour’s policies to combat this. So, in practice, the IFS numbers only make sense if we fall back on a judgement that the economy will shrink under Labour’s plans.

There are several reasons to dispute the conclusion that a Labour government would shrink the economy. Most importantly, Labour is proposing replace the austerity policies of the Conservatives with a shift towards much higher public investment. This is important because austerity is very arguably a major cause of the truly pathetic rate of economic growth the UK has experienced since 2007. To put the word “pathetic” in precise terms, the last decade has seen the lowest growth in both GDP per capita and wages of any ten-year period in Britain since 1945. Cuts in government spending and government investment in the past ten years have reduced the incomes of government contractors and public sector workers, leading these workers to spend less. This fall in consumer spending has reduced private sector incomes and almost certainly discouraged businesses from investing, which has further reduced incomes and consumer spending. This vicious cycle resulting from cuts in government spending is known to economists as a multiplier effect and an enormous body of economic research suggests that these effects are large. Multiplier effects have been particularly large in the last decade because the very low value of interest rates has prevented the Bank of England from cutting rates further to stimulate the economy. The appalling rates of economic growth in the last ten years have also hurt the public finances because lower national income means lower government tax revenue. This has been a major reason that the Conservative government has been so unsuccessful in reducing the deficit during its period of office.

In contrast to austerity, Labour’s proposed increases in public investment and public sector pay will put money back into people’s pockets, which will most likely stimulate consumer spending, leading to a virtuous cycle where people spend more, leading businesses to invest more and people to spend even more. This multiplier effect coud take us from a cycle of low growth and investment to a cycle of high growth and investment. Labour’s policies of investing in infrastructure will also increase the productive capacity of the economy by making it easier to transport people and goods. A large economic literature supports the claim that public infrastructure investment boosts the economy (see Leduc and Wilson, 2012). The IFS’s view, by contrast, is that Labour’s proposed increases in public investment “does risk waste”, even if it may have “positive long-run economic returns”. Here the IFS’s view is evidently at odds with many economists and reflects, I think, the IFS’s ideological scepticism about increasing the economic role of the state.

If Labour’s public investment proposals lead to an increase in economic growth then the IFS’s criticisms about Labour’s ability to finance its policies falls flat, since these criticisms are based on the assumption that Labour’s policies are economically harmful. There are other reasons too to think that Labour’s policies would be much less harmful than the IFS claims. As mentioned earlier, the IFS believes that Labour’s proposed tax increases on those with high incomes will shrink the economy because “some high-income individuals would respond to the higher tax rates by working less… or even emigrating”. In order to estimate this effect on tax revenue, the IFS relies on past HRMC estimates of something called a “taxable income elasticity” which looks at the effect of previous tax changes on tax revenue. As I discussed, the IFS approach does not seriously consider effects of income tax rate changes on tax avoidance or evasion and so implicitly assumes that when past tax rises produced less revenue from the very rich than anticipated, this must have been because these taxes shrank the economy. This approach is arguably wrong. In an important recent article, the economists Thomas Piketty, Emmanuel Saez and Stephanie Stantcheva (2014) have shown that estimates of the effect of tax changes on the taxes paid by the very rich, as used by the IFS, may be misleading if they ignore the power of the rich to determine their own salaries. Higher taxes on top earners may lead corporate CEOs may push less hard to receive pay rises, knowing that much of this pay will be taxed. Then, a rise in taxes will reduce the reported income of a CEO even if these taxes do not harm the economy. This implies that the IFS estimates about the effect of taxes on revenue and the economy will be wrong, since lower pay to CEOs means higher profits to shareholders and therefore more tax paid by shareholders. Piketty, Saez and Stantcheva argue that there is no evidence that taxes on high earners have had much tendency to shrink the economy at all. In that case, Labour’s rises in income tax on the rich would yield much more revenue than the IFS suggests, and Labours policies look fiscally responsible.

The IFS’s view that taxing the rich is economically harmful is also reflected in its views on Labour’s proposed rises in corporation tax. The IFS asserts that the increased corporation tax will harm many more people than simply the generally wealthy owners of corporations. This is because “much of the cost is likely to be passed to workers through lower wages or consumers through higher prices”. Many economists would disagree with this view. According to Auerbach (2006), “probably… the most commonly held view” among economists is that the corporate income tax is “borne fully by the owners of capital, economy wide”. This implies that the cost of corporation tax falls on those with wealth. Since almost half of wealth in the UK is owned by the richest 5%, and almost all wealth is owned by the richest third of the population (Alvaredo et. al. 2016), this suggests that corporation tax is, in fact, a tax on the rich, just as Labour claims. The IFS also argues that “big increases in corporation taxes risk significant falls in private sector investment”, but the empirical evidence that taxes on capital significantly decrease investment is arguably lacking (see, for instance, Piketty and Saez, 2013). Lower private sector investment as a result of a corporation tax will likely be more than compensated for by Labour’s higher public sector investment. As such, the IFS claim that the cost of Labour’s proposed increases in corporation tax would fall upon “large numbers of us” is an opinion which is very much open to dispute.

Another economic “risk” of a Labour government, according to the IFS, is that Labour’s proposed £10 per hour minimum wage will reduce hiring, “risking, the employment opportunities of many young people”. This is another example where the IFS is arguing that taking wealth from the owners of corporations (in the form of higher wages) will have adverse effects on ordinary people. It is also another example where many economists would dispute the IFS’s conclusion. In July 2015, more than 200 US economists wrote an open letter supporting an increase in the US minimum wage to $15 by 2020, on the grounds that the “literature has, for decades, consistently found that no significant effects on employment opportunities result when the minimum wage rises in reasonable increments.” If rises in the minimum wage serve to increase consumer spending, they may increase rather than decrease employment (Michaillat and Saez, 2015) In fact, recent research on the introduction of the $15 minimum wage in California anticipates a slightly positive effect on employment (Reich et. al. 2017). At current exchange rates, $15 US is a higher minimum wage than the £10 wage Labour is proposing for the UK and represented a larger percentage increase compared to the current US federal minimum wage than Labour is proposing for the UK. Compared to average productivity, minimum wages in the US were just as high in 1968 as Labour is proposing for the UK today, while US unemployment was relatively low at that time. This all suggests that we should probably not expect significant decreases in employment in the UK following the introduction of a £10 minimum wage.

The IFS analysis of Labour’s manifesto has repeatedly been raised by the media and the Conservative Party to suggest that Labour’s plans are fiscally unworkable. We are lucky to live in a society where parties’ policies are subject to critical review in this way. At the same time, the IFS opinion is just one of many. On income tax, corporation tax, public investment and the minimum wage it seems that the claims of the IFS can easily be contested, and have been contested by economists. There are even more examples beyond these where the IFS analysis can be disputed. For instance, the IFS claims that Labour’s proposed 15% levy on residential property purchased by offshore companies “likely to raise £0 after people respond”. That a tax could actually raise as little as £0 sounds hard to believe; Prem Sikka from the University of Essex has pointed out that international evidence would suggest this tax will raise closer to £3.5 billion. Once again, Labour’s proposed taxes could raise much greater revenue than the IFS is implying, helping the party to afford its proposed spending commitments. The IFS claim that Labour will not be able to afford these spending plans hinges on a claim that Labour’s policies will harm the economy, a view evidently not shared by the economists who wrote Sunday’s letter to the Guardian. These economists believe that Labour’s policies will instead promote economic growth and are fiscally responsible. It remains to be seen whether voters will agree.

References

Alvaredo, F., Atkinson, A. B., & Morelli, S. (2016). The challenge of measuring UK wealth inequality in the 2000s. Fiscal Studies, 37(1), 13–33.

Piketty, T., & Saez, E. (2013). A theory of optimal inheritance taxation. Econometrica, 81(5), 1851–1886.

Piketty, T., Saez, E., & Stantcheva, S. (2014). Optimal taxation of top labor incomes: A tale of three elasticities. American economic journal: economic policy, 6(1), 230–271.

Auerbach, A. J. (2006). Who bears the corporate tax? A review of what we know. Tax policy and the economy, 20, 1–40.

Michaillat, Pascal, and Emmanuel Saez. “Aggregate demand, idle time, and unemployment.” The Quarterly Journal of Economics 130.2 (2015): 507–569.

Leduc, S., & Wilson, D. (2013). Roads to prosperity or bridges to nowhere? theory and evidence on the impact of public infrastructure investment. NBER Macroeconomics Annual, 27(1), 89–142.