Q89. Can an individual ever beat the market?

The efficient markets hypothesis is a largely discredited theory purporting to explain why the financial markets are very hard to beat. The basic insight is that the market price of any item (stock, bond, commodity) always reflects available information about it.

There is a joke between economists, about an economist strolling down the street with his son. They come upon a €10 note on the ground and, as his son reaches down to pick it up, the economist says, "Don't bother - if it were a genuine €10 note, someone would have already picked it up". This story tells you everything you need to know about the efficient markets hypothesis.

If a market is 'efficient', then it reflects all available information about assets for sale in the market. Take Apple computers, for example. Were the CEO of a major company to be hit by a meteor on the way to work and die, the news of his / her demise would cause the price of their company's stock to plummet, as worried investors would sell off the stock, bidding down the price. This is the market reacting to new information by changing the price of stocks. The insight of the efficient markets hypothesis is that, in an informationally-efficient market, price changes must be unforecastable if they are properly anticipated, that is, if they fully incorporate the information and expectations of all market participants.

In the strongest version of the hypothesis, the market has full public and private information - including the CEO's risk attitudes, his medical history, all available star charts, and so on. Weaker versions concentrate on 'event' analyses, like a CEO being hit by a meteor. The behaviour of everyone in the market makes the market price look completely random - it will not be possible to predict tomorrow's stock movements from today's prices if the market is efficient in this sense. There will be no trend to plot, because there will be no undiscovered information. All available information will be priced in already by the profit-seeking activities of market participants. And thus the market will be impossible to beat.

Q90. Should we tax more or less?

The Laffer curve is the only truly falsified empirical prediction in economics. Arthur Laffer predicted that the relationship between tax rates and overall levels of taxation revenue is parabolic. That is, at low levels of taxation, increasing the tax rate slightly will result in large increases in taxation revenue, because you are travelling up the curve, as shown in the diagram below.

The Laffer curve.

The Laffer curve.

At higher levels of taxation, increasing taxation rates makes no sense, because the increase in taxation revenue gets smaller each time, and exerts a negative effect on incentives to work, as well as to declare income for tax. There is a feedback effect at work as well: if the theory works, tax cuts can generate more tax revenue for the government because it changes people's behaviour, increasing the level of economic activity, which creates more taxable income, and the economy grows faster—this is a virtuous cycle.

Governments tried to follow the logic of reducing taxes, in order to increase incentives to work, increase income, and spend more in the economy. The logic failed utterly.

Should we tax more or less? When the feedback from increasing the topmost rate of tax actually decreases the amount of taxation revenue collected, it is time to lower taxes. In the vast majority of cases, most economies find themselves on the left hand side of the curve. This means that most taxation increases do increase the amount of money governments collect—so tax cuts don't usually pay for themselves. Nonetheless we should tax less if we can, as high taxes function as a disincentive to honest work.

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