Abusing economic analysis: UK Treasury edition

For US readers, this is about the misuse of dynamic scoring in analysing tax changes

Ask most people if they think a particular tax - like fuel duty - should be reduced, and they will say yes. If you ask people do you think income taxes should be raised to pay for a cut in fuel duty, you will get a rather different response. So just asking people if they would like one particular tax to be cut without saying how it will be paid for is pretty meaningless. Unless of course your aim is to provide ‘evidence’ that taxes are too high, and you are not too worried about the nature of that evidence.

There is a slightly more sophisticated version of this trick, and the UK Treasury have just played it. Each individual tax potentially distorts the pattern of economic activity. If that pattern without any taxes is near some ideal, then we can call taxes ‘distortionary’. If we taxed apples and used this money to subsidise the production of pears, people would eat too many pears and not enough apples. However there is one tax that is not distortionary, because it does not influence incentives and therefore this pattern of economic activity. It is a poll tax - a tax levied on each individual independent of their income, wealth or what they spend their money on. Economists call this a lump sum tax. So cutting any distortionary tax, and paying for this by raising a poll tax, is bound to produce beneficial results in terms of reducing distortions.

There is only one problem with paying for a particular tax cut by raising a lump sum tax - in the UK we do not have a poll tax. We did very briefly - it was not very popular, because people care about fairness as well as the distortionary impact of taxes. For this reason, you should not expect to find a government department like the Treasury modelling the benefits of cutting fuel duty by assuming it was paid for by raising a poll tax. Unfortunately, that is exactly what has been done in a Treasury/HMRC report released this week

George Osborne is not planning to reintroduce a poll tax - veneration of a past Conservative Prime Minister would not go that far. I think the argument the Treasury would use to justify what they have done is simplicity. If you pay for a cut in fuel duty by, say, raising income taxes, you have to model the impact of two taxes on economic behaviour rather than just one. I don’t think that is a very good excuse, but even if we think it has some validity it has a direct implication: an individual study of this kind is meaningless on its own. It can only be used in conjunction with other studies that look at the impact of raising other taxes. Will Treasury officials therefore stop their masters using the numbers from this exercise to justify cuts in fuel duty? No prizes for guessing the answer. (They might if they could but they don’t have that degree of influence.)

So what could have been the beginning of an intelligent discussion of the costs and benefits of particular taxes (as in the Mirrlees review, for example) has been turned into a simple propaganda exercise.

Unfortunately it gets worse. Fuel duty is particularly ‘distortionary’ because its rate is high (see Chart 2.1 of the Treasury paper). There might be a good reason for that. The tax could be high because it is trying to offset damage that is not prevented by the market: road congestion, pollution and of course climate change. In terms of the language of economics it is (at least in part) a Pigouvian tax designed to offset externalities. In that case the tax is not distortionary at all: a world without fuel tax would not be ideal, and imposing a fuel tax gets us nearer that ideal. As Chart 3.1 from the paper indicates, these beneficial impacts of fuel duty are not modelled by the Treasury’s CGE model. (This is why, as John McDermott notes, this kind of partial dynamic modelling tends to be attractive to right wing outfits. Is it significant that the paper does not actually include the words ‘climate change’, and just uses the vaguer term environmental damage?)

So what the Treasury have done is modelled all the benefits of cutting the tax, but ignored all the costs. If this was but one stage in a process that would subsequently look at the cost of these externalities, and would realistically model how these tax cuts were paid for, fine. As a stand alone exercise, I’m afraid the Treasury study is worthless.

As Chris Giles notes in an excellent report, this is really part of a political exercise to build the case for tax cuts. It has two unfortunate side effects. First, it just encourages the suspicion among many that anything coming out of the UK Treasury at the moment is worthless propaganda. Second, it encourages those on the left who think that mainstream economics is inherently biased. But if you saw an opinion poll that asked people if they thought a particular tax was too high, without also asking what tax they would increase to balance the books, you would not say that this shows opinion polls are inherently biased. Instead you would just conclude that the person commissioning the poll had a political agenda. You might also ask whether the polling company should have accepted the commission.