Observations of an ex pat: The Laffer Curve

It is an economic model called the Laffer Curve and it reeks of common sense and good economic stewardship. It is also being studiously ignored by the Labour and Conservative parties in their headlong race to buy votes with expensive election promises.

The Laffer Curve is basically a bell-shaped curve which starts at zero on the left , rises to an optimum figure in the middle and then drops back down to zero on the far right. The zero on the left is the expected tax revenue that would be raised if the tax rate was zero, which is fairly self-explanatory—no taxes, no revenue.  Halfway up the left side of the curves means taxes are too low and revenue is insufficient.

The zero on the far-right may appear at first glance to be counter-intuitive.  The higher the price (taxes) the higher the revenue. But if we use the shop analogy the fallacy of that argument is exposed.  If a shop charges more money than the customer can afford than they just go elsewhere. In the case of taxes they vote with their feet and move to another country and refuse to invest in an economy which fails to give them a return with the result that the pool of money from which taxes are drawn shrinks.

The key is to find the happy median. This is the highest point on the Laffer Curve where the tax rate—like Goldilocks’s porridge—is neither too high nor too low but set just right so that it draws in the maximum tax revenues.

The Laffer Curve is named after American economist Arthur Laffer from the Chicago School of Economics. Professor Laffer did not invent the theory. But he did popularise it during the Ford, Reagan and Bush Senior Administrations. The theory actually has its antecedents in 14th century Tunisia; was popular in 19th century American economic planning and a cornerstone of the policies of US Treasury Secretary Andrew Mellon during the Roaring Twenties.  Even John Maynard Keynes made some admiring references to it, but it was largely forgotten in the 30 years after World War II.

Ignoring the reality of the Laffer Curve has consequences. Ten years of relatively low taxes and austerity was deeply unpopular and disincentivising.  In 2012 Robert Chote, the chairman of the Office of Budget Responsibility, reckoned that the British exchequer was happily “strolling along” at the top of the Laffer Curve with a top rate of 50 percent. Then it was cut to 45 percent the following year and tax revenues dropped £100 million a year.

Of course, neither the Conservatives nor Labour are concerned with any consequences other than that of losing the 12 December general election. The result is that the Tories are promising big spending rises but without increases in income tax, VAT or National Insurance. Labour pledges to launch a multi-billion pound social revolution funded by taxing the top five percent earners.

According to Paul Johnson at the respected Institute of Fiscal Studies, neither of two main parties is “being honest with the voters.” He reckons that there is no way that a Johnson government will be able to stick to its no tax rise promise, and when it breaks that pledge the revenues will go way over to the right side of the Laffer Curve. As for Jeremy Corbyn and John McConnell, their proposals already put them well down the right side of the curve, so much so, that Paul Johnson reckons that tax revenues would shrink so dramatically that Labour would be unable to deliver on its spending pledges. The result would either then be the downward spiral of even higher taxes or increased borrowing.

More borrowed money is already part of the Conservative and Labour manifestos. Both parties argue that they want to take advantage of historically low interest rates to borrow for capital investment. The problem with that logic is that the more government borrows the less likely it is that interest rates will remain low as they are subject to the same market forces as any other service or product. There is also the problem that the money has to be paid back. If the borrowed money fails to increase tax revenues at current tax levels than taxes will need to rise to offset borrowing costs. This in turn, will push the economy down the right side of the Laffer Curve. Alternatively, the government can borrow money to pay off its borrowings. But as any pay day loan victim will testify, therein lies the road to penury.

The trick is not to gear your taxes to your policies, but to gear your policies to your tax revenues. Tax levels are set at the top of the Laffer Curve to maximise revenues. Political choices are then made about how to divide the revenues between the competing demands of society. This requires hard, honest choices which are unfortunately a rare commodity at election time.

* Tom Arms is membership secretary for Tooting Lib Dems. He also broadcasts on foreign affairs for US Radio, regularly contributes to Lib Dem Voice, lectures and is working on a book on Anglo—American relations which is due to be published next year.

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19 Comments

  • You are on a sticky wicket with the Laffer curve

    Brownback’s tax consultant, supply-side economist Arthur Laffer, predicted the cuts would support job growth,[41][9] calling Brownback’s policies “amazing … Truly revolutionary.”[25] Influential anti-tax activist Grover Norquist defended Brownback’s tax cuts as “the right thing for the economy”, and claimed that Kansas was in better economic shape than the tax-cut critics alleged, and that the state had “provided a model, a successful model, that will phase out the income tax.”[10]

    Results Edit
    By early 2017, Kansas had “nine rounds of budget cuts over four years, three credit downgrades, missed state payments”, and what The Atlantic called “an ongoing atmosphere of fiscal crisis”.[14] To make up the budget shortfall, lawmakers tapped into state reserves set aside for future spending, postponed construction projects and pension contributions, and cut Medicaid benefits.[17] Since approximately half of the state’s budget went to school funding, education was particularly hard hit.[17]

    In addition to budget problems, Kansas was lagging behind neighboring states with similar economies in “nearly every major category: job creation, unemployment, gross domestic product, taxes collected”.[42]

    https://en.m.wikipedia.org/wiki/Kansas_experiment

    As to having to borrow money, well as Peter will no doubt say “You can print your own”. And you can while faith in the currency remains and it will remain longer if you use the printed money to build assets. The problem with economists is they have such cunning theories which reality then trashes.

  • Peter Martin 29th Nov '19 - 11:51am

    Nearly always, the flaw in this kind of conventional economic thinking is to think of the government as a household – except on a larger scale. The assumption, always incorrect, is that the revenue raised from one tax doesn’t affect the revenue raised from another tax. Or the effect of a govt spending change doesn’t affect total taxation revenue.

    The Laffer theory is fine as far as it goes. But that’s not very far. If we tax, say, cigarettes, at the optimum level then we’ll raise the maximum in taxation from cigarettes. Ignoring the health effects, we can say maximum taxation revenue will also occur when total spending on cigarettes is optimised. That inevitably means everyone will have less than they would otherwise to spend on different things. So alcohol revenue will be less. VAT revenue will be less too. If people are spending more on cigarettes that means they likely won’t have enough money to take their family out for a meal. The wages of the waiters and kitchen staff will be less. Income tax revenue will fall.

    We can make the same argument over the higher rates of income tax and capital gains tax etc. Change the revenue from one and you’ll inevitably change the other.

    It really doesn’t matter to the government if the revenue from one particular tax is maximised. It might make more sense to say that they should aim to maximise total taxes. But even that might not be desirable. Taking out too much taxation revenue from the economy is contractionary. That should only be done if inflation is an issue.

    So Laffer’s theory “reeks of common sense and good economic stewardship”? Really? Maybe it does to those who haven’t properly thought things through!

  • Peter Martin 29th Nov '19 - 12:06pm

    ‘Peter will no doubt say “You can print your own” ‘

    I don’t actually say that because that’s not how the monetary system works. Money is largely created and destroyed in a computer these days. The printing presses are increasingly redundant.

    Having said that all currency issuing Governments create their money first and impose taxation afterwards. Logically it has to be this way around. The money has to be created and spent into the economy before it is available to be collected as taxation revenue.

    This is not my opinion. It is an observation of the way the taxation system works.

  • Phil Beesley 29th Nov '19 - 1:14pm

    There are multiple Laffer curves for any form of taxation, aren’t there? They are not bell-shaped and the shape changes according to how tax payers change their behaviour.

    Most people can’t change their wealth much (except for different paying work or life changes which alter tax codes) so we have to consider high income people for the most flexibility. High income people can take deferred payments (pension or share schemes) or may receive income in other jurisdictions or, as us commoners say, dodge their taxes.

    Thus the right hand tail of a Laffer curve for income tax will waggle a bit whilst tax advisors discover loop holes and tax collectors close them. The hump on the left hand side is largely unable to change (people moving into higher paid jobs often replace other people moving on or retirees or career breakers or the ultimately departed) — except when tax breaks are given to the rich, when the left hand side hump increases in area. The Liberal way to change the left hand side of a Laffer curve is to increase worker productivity and to pay accordingly.

    Treasury ministers and civil servants periodically juggle tax rates, exemptions etc in order to maximise income based on political criteria. They all know about Laffer curves and joke about them. Laffer curves belong with trickle down theory and Reagan Voodoo Economics — discredited and dangerous.

  • The thing about the Laffer curve is that while the two endpoints (at 0% tax and 100% tax) are fairly uncontested, the theory says absolutely nothing about the shape of the curve between those points, which is probably not an actual curve since whether it’s raised as income tax, sales tax, corporation tax, excise duty, etc. will make a difference too.

    In other words there’s basically no way to tell from “the Laffer curve” if raising or lowering taxes would lead to more revenue. (For things like e.g. fuel taxes or tobacco taxes, the tax might be considered a success *especially* if it reduced revenue from that source, of course.)

  • John Samuel 29th Nov '19 - 1:39pm

    The most commonly accepted Laffer value is 70%. Raising tax thresholds to the level raises tax revenue, rises above lower revenue.

    That provides no justification whatsoever for tax cuts. You say “low taxes” and I hear “shit services”.

    https://www.economicshelp.org/blog/140859/economics/the-laffer-curve/

  • “was popular in 19th century American economic planning and a cornerstone of the policies of US Treasury Secretary Andrew Mellon during the Roaring Twenties” – you mean the horse-and-sparrow economic policy, right? And don’t forget what happened after the Roaring Twenty.

  • Phil Beesley 29th Nov '19 - 4:46pm

    @Geoffrey Payne: “That of course was a time of great prosperity and we benefited from a great reduction in inequality. No wonder it was forgotten.”

    Average GDP increases in the western world were immense from 1947 onwards for 30 years. Europe rebuilt after WWII with kick start loans and humanitarian aid, but self economic growth made Europe, including UK/GB.

  • Did anyone read the OP?

    He actually gives an example of tax cuts in the UK leading to lower revenue. Just because someone talks about Laffer curves (or Laffer squiggles) it doesn’t mean they consider the country to be currently to the right of the peak. Also, just because Laffer himself sometimes considers places to be to the right of the peak when they’re not doesn’t mean there isn’t a relationship between taxes and revenues that has a peak somewhere.

    The OP advocates setting taxes on a “managerial” basis so as to maximise revenues (which in the UK context means an increase) and leaving the “political” element to be about how that money should be spent. Interesting proposal and I only partly agree (it seems to be based on the idea that tax not taken and left with the citizens is effectively wasted), but it definitely deserves to be read and debated.

  • The Laffer curve? Really? The ‘graph’ regularly trotted out by right-wingers to prove that you shouldn’t tax the rich? The graph that was drawn on a napkin?

  • Tony Greaves 29th Nov '19 - 9:04pm

    The Laffer curve is a load of rubbish. Just a Laff in fact. But a very dangerous one.

  • Innocent Bystander 29th Nov '19 - 11:56pm

    Tom,
    Nice idea to try and inject some intelligent debate into the tax question but the sneering Pavlovian responses were inevitable.
    Firstly everyone, without exception agrees there is a curve (and you can call it what you like) because no intelligent human would think that business and personal taxes levied at 100% would be effective.
    All right then, so you accept there is a curve. Well you must because if it’s zero at 0% tax and 100% then it must go up and down, mustn’t it?.
    So pay a little more attention to Tom’s views. Because like it or not (and you don’t) those who are taxed have choices too. They can move away (and the big money has already) and those who stay can choose to sit on their hands and remain economically inactive. We already have a major lack of national ambition, entrepreneurship and appetite for growth and taxing those with money making ideas is not going to help if they are pushed to the point where they don’t bother.
    You can not force people to make themselves rich. If you can understand this you might be partway to a national revival.

  • Peter Martin 30th Nov '19 - 8:32am

    @ Innocent Bystander,

    “All right then, so you accept there is a curve. Well you must because if it’s zero at 0% tax and 100% then it must go up and down, mustn’t it?.”

    Blimey! This must be the second time in as many weeks that you’ve said something sensible. I forget what the first one was 🙂

    Maybe you can think of a way of getting it across that maximising the tax take from one particular tax won’t do any good if it simply reduces the tax take somewhere else.

    The third step is to find a way of getting everyone to question the idea that maximising even the total tax take may not be a good idea if it deflates the economy in the process. That one is a bit more subtle and is perhaps beyond the scope of this blog.

  • Tony Greaves
    Thank you for explaining this in terms I understand!

  • It is true that everyone has choices. The trouble is that some have more choices than others. It is also true that the need for taxation in a society depends on the services required. But the cost of many services depends on the quality of service provided in the following way.
    An example – education. There is a clear correlation in performance of children and poverty. Poor children tend to perform worse – they also provide a disproportionate part of our prison population at a later stage. Dealing with poverty will result in many savings. In other fields. The most dramatic example is looked after children. The results and life chances of children in this category are terrible. The reasons are complex, but the figures are horrendous. And they are our responsibility.
    So my main problem with the post is that there is presented a simplistic two dimensional picture of a multidimensional problem. Of course as humans we are limited in our experience of the world to three dimensions, but that is not adequate when dealing with multidimensional problems. Computers can be programmed to do deal with these issues of course, but how do we program ourselves understand the results?

  • Joseph Bourke 1st Dec '19 - 8:58pm

    If we look around for a model to test the propositions in this article we might look to to the Nordic model https://capx.co/the-nordic-model-is-about-more-than-high-taxes/ . The Scandanavian counties maintain a comprehensive universalised welfare state (with minimal means testing) and multi-level collective bargaining, with a high percentage of the workforce unionised, and a large percentage of the population employed by the public sector (roughly 30% of the work force) compared with 20% in the UK.
    The tax burden is high by OECD standards – around 44/45%. They have relatively flat tax rates, meaning that even those with medium and low incomes are taxed at relatively high levels.
    They consistently rank highest on the metrics of real GDP per capita, healthy life expectancy, having someone to count on, perceived freedom to make life choices, generosity and freedom from corruption. The Nordic countries place in the top 10 of the World Happiness Report 2018, with Finland and Norway taking the top spots.
    As the linked article notes “The flat tax nature of the Scandinavian countries, coupled with a welfare system tailored to work, reduces the effects of taxes on incentives. These policies entail considerably higher taxes on those with low incomes, and a range of public subsidies to middle-class families. Scandinavian welfare policy is not the same as progressive liberal policy.”
    So it is not so much about gearing your policies to your tax revenues, but rather prioritising public spending in areas that allow people to live and work with the support of childcare, health services and a social security system that takes much of the risk and stress of poverty of the shoulders of individuals while still allowing individual enterprise to thrive.

  • Innocent Bystander 2nd Dec '19 - 5:24am

    Joe,
    Keep your eye on the Swedish and Finnish economies before you offer them as paragons of economic success. Both look to be about to collect the consequences of the lifestyle you advocate.
    Norway is a special case. Sort of a very rainy Saudi Arabia.

  • Peter Hirst 2nd Dec '19 - 1:11pm

    At first glance, this is rubbish and The Laffer Curve is an american invention to justify a low tax state. Tax rates of 100% would cause people and firms to move, avoid taxes altogether or find some other way of existing. The system adjusts to maximise a firm’s profits. However, as other issues become more important such as job satisfaction and honoring workers’ values, perhaps tax rates become less important as long as there is an adequate safety net.

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