Neoclassical Endogenous Growth and a 50% Tax Rate

Former UK Chancellor Alistair Darling’s memoir describes Gordon Brown’s approach as ‘a shambles’. As illustration, the much quoted description of a speech by the former Prime Minister about “neoclassical endogenous growth theory”. Brown started before the speech was fully written, so that part way through delivery, “a hand appeared from behind a curtain and handed him the rest of the speech.” It may sound pretty shambolic, but much more important than that: what was Gordon Brown doing talking about neoclassical endogenous growth theory in the first place? He was shadow chancellor at the time, not some first year economics undergraduate. It’s an example of what Keynes described as the “madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.”

In this regard at least, Gordon Brown was far from unique. Politicians, bankers and business people tend to retain a residual belief in the academic ideology they learned at university and business school. When it’s relevant they seem likely to act according to its dictates, and to be eloquent in its defence, no matter how obviously stupid it appears to be. Thus the current debate about retention of the 50% tax rate for those earning over £150,000 pa.

The neoclassical argument is that it is savings which encourage investment. Therefore reducing taxes on the wealthy will in the long term be good for growth. Therefore the 50% rate must go and we know that there are still at least 20 leading neoclassical economists (authors of a letter to the Financial Times) who are fervent in that belief. Prior to the 1980s deregulation, there may have been some justification for that approach, though even that is doubtful. But new mechanisms, processes and ‘products’ in the financial sector, notably in banking, have destroyed that connection between savings and investment in the real economy.

Increasing the wealth of the already well-off, no longer results in more being invested in business start-ups, or increased support for entrepreneurial innovation, or even education. Instead, it will be invested in the sort of opaque, swaps and derivative, pseudo ‘products’ which caused the current mess. The total value of such was estimated by mid-2008 to be worth £54tn, close to the world’s GDP and many times the value of the world’s stocks and shares. These are what the wealthy’s surplus funds are invested in today, not R&D or start-ups.

So reducing the 50% tax rate would not be productive in terms of investment in the real economy. On the other hand, reducing taxes on the low paid, would increase their spending and thus the general level of demand, and that would be a short term stimulus for the real economy. Increasing taxes on the higher paid – Adam Smith argued they should pay more than proportionately towards the common good – would not harm investment in the real economy and any funds raised could be channelled into R&D and improved education which would have the long term stimulus effect on the real economy.

So much may be no more than common sense. Unlike Neoclassical Endogenous Growth Theory! That bit of academic scribble held that, in the long run, growth would be determined by how much people save, or by technological progress, neither of which could be explained by neoclassical models. The endogenous bit suggested that technological progress would be assisted by public investment in R&D and education. Perhaps the only people who found that idea surprising were neoclassical economists.

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