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James Graham's Do It Yourself Economics

CONSERVATIVES OFTEN ACCUSE the left of adopting and encouraging a Do It Yourself morality that recognises no objective notions of right and wrong. It is therefore pleasing to see Oliver Kamm tackling another side to this subjectivist approach in his Do It Yourself Economics posts. They have been generally excellent (see, for example, his post on trade protectionism and the discussion that followed), informative and highlight a trend one notices frequently the more one looks.

That the foul-mouthed and comically rude James Graham is one such offender has been touched on before by England's Sword's Telemachus, who noted that he seemed to be claiming that taxing investment dividends more would encourage investment*. Another example of this trend comes in a post attacking the Kammster himself, where he claimed that Gordon Brown had "created a new band of national insurance and taxed both employer's and employee's contributions by a penny each, thereby causing a significant spike in public sector pay".

A sceptical Cuthbertson asked whether he was saying that the pay spike was caused by the division of the burden between employees and employers. Surely he didn't think increasing the tax burden on employees had no effect on employees' wages? He answered:

If an employee's contribution rises, then they can demand a resulting pay rise, but there is no guarantee the employer will give it.

If the employer's contribution rises, then the employer's tax bill rises, full stop. No amount of foot stamping on your part will change this.

In other words, employees are better off the more national insurance employers pay, and vice versa. It is intuitive, of course. It is also complete bunkum. Henry Hazlitt has deemed the ability to think beyond the first effects of a policy the most important single lesson of economics. It is one James Graham should learn.

Let's imagine his scenario of the employer's contribution rising while employees' contributions remain unchanged. What you see first is the cost of employing people rising: the wage bill has not been reduced, but the tax bill has increased. A rise in the cost of employing people ensures that demand for labour drops. Because employees are not any worse off than before, the supply of labour remains static.

With demand down and supply the same, it is basic economics that the market wage rate will now fall to choke off the excess supply and stimulate demand. This will go on until the point at which demand and supply are equal again, because that is what the market wage rate means - the price at which the demand for and supply of labour are the same. This effect will take time to seep through in lower wages for new employees, and smaller wage rises for existing employees, than there otherwise would have been. But it is the inevitable result of making it more expensive to employ people that fewer employees will be sought, and so one can lower the average wage level to the (lower) level at which it will draw sufficient employees. Employees pay too.

But what if we imagined James Graham's 'nightmare' scenario instead, where the full increase in national insurance contributions is put directly on employees? Now it is less profitable to work, because a larger proportion of one's pay packet now belongs to the Exchequer. Those just willing to work at the old wage rate will now be unwilling. The supply of labour falls. But because the cost of employing people is initially the same, all the burden being carried by employees. So the demand for labour is identical.

So with supply down and demand the same, it is again basic economics that the market wage rate will rise to choke off demand and increase supply until the point at which supply and demand are equal.

Increase employers' contributions and much of the cost is passed on to employees in the form of lower wages. Increase employees contributions and much of the cost ends up being paid by employers in the form of higher wages. Whichever way one charges the tax - 100:0, 50:50, 13:87, 0:100 - it works out the same way, because you are essentially burdening the trade in the same way. Add ten pounds on to the cost of one person participating in the trade and he will charge more until the point at which the market rate is restored.

It is simple supply and demand that it makes no difference whether the employer or the employee is charged more in national insurance contributions, because both sides pick up the same share of the cost.

Think about what it would mean if additional costs in taxes to employers really were simply additional costs to employers "full stop" with employees unaffected by this change. One could charge all the cost of income tax to employers, and employees could take home their entire gross income without suffering any additional costs. Companies could be charged taxes on every product they sell without the price rising for consumers at all. This mythical view of the economics of taxation clearly exists in some minds, but the fact is the only reason taxes like national insurance are charged in the split way they are is the hope that gullible people will believe that who actually pays the tax makes a difference.

In James Graham's case they succeeded.

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* I should add that Mr Graham claimed in response to have been using a personal rather than the textbook definition of unearned income when he claimed taxing it would increase investment, his own definition not applying to dividends. This is fine, except that when I proposed a different personal definition as a more reasonable one, he cited this proposition as evidence of my own economic illiteracy. Obviously he has to decide whether he is using the textbook definition (in which case his criticism of Telemachus held no water) or a personal definition (in which case his criticism of me held no water).

Posted by Peter Cuthbertson | Permanent Link |