Around the World in 80 Ideas   


ECONOMIC POLICY
67: Soak the rich: cut taxes!
Lower rates extract more taxes more fairly



The problem: high taxes, no growth

It's every politician's worst nighmare. Your tax rates are as high as you can squeeze them, and yet your revenues are still insufficient. Wealthy people are sending their money abroad, or emigrating, to avoid the taxes, so the poorer population are paying more than they should. The economy is stagnating as investment capital dries up. What to do?

The solution: soak the rich - cut taxes

The answer is to soak the rich. But do not do it by putting taxes up further. Do it by putting tax rates down, especially taxes on income and capital.

Example: US income and capital tax cuts

The United States saw three big tax rate cuts in the 20th Century - in the 1920s under Presidents Warren Harding and Calvin Coolidge, in the 1960s under Presidents Kennedy and Johnson, and in the 1980s under Ronald Reagan. In each case, after the rates were cut, federal tax revenues increased - particularly the share paid by the top 1% of taxpayers.

The 1920s cut was a phased reduction in top income tax rates from 73% in 1921 to just 25% in 1925. As a result, tax receipts nearly doubled between 1923 and 1928 and the US economy boomed. And when rates fell, the rich paid a lot more. The share of taxes paid by those earning over $50,000 (the super-rich of the day) rose hugely, from 44% in 1921 to 78% in 1925.

Forty years - plus one world war and many tax hikes - later, the Kennedy plan cut the top tax rate again, though more modestly, from 91% to 70%. Income tax receipts rose by more than half during the following five years, from 1963 to 1968. The share of taxes paid by Americans earning over $50,000 (wealthy people, even then) increased from 12% to 15% of total receipts.

Ronald Reagan's cuts in the top rate of income tax, from 70% in 1981 to 28% in 1988, boosted total income tax receipts by 30% in real terms between 1983 and 1989. Once again, the rich paid a lot more. The top 10% of taxpayers contributed 48% of the total in 1981, but 57.2% in 1988. Meanwhile the share paid by the top 1% of taxpayers grew from 17.6% to 27.5%. And the contribution of the top 0.1%, the super-rich taxpayers, doubled from 7% to 14% (see chart).

The theory behind this surprising set of effects is now associated with the name of US economist Arthur Laffer. The 'Laffer Curve' suggests that when governments initially start to raise tax revenues, they pull in greater and greater receipts. But as rates continue to climb, receipts start to level off until, eventually, further tax rises produce falling receipts. This is because there comes a time when, facing large tax bills, people simply stop bothering to work, or move into the black economy, or go abroad, or lie about their income, or employ expensive accountants to help them avoid the tax (see the chapter One Law for All).

The US experience with capital gains tax is just as clear as the experience with income tax. After the 1981 cut in capital gains taxes, from 28% to 20%, the revenues brought in by the tax rose by nearly half, from $12.5 billion in 1981 to $18.5 billion in 1983. Following another another cut in the capital gains tax in 1997, receipts nearly doubled - from $62 billion in 1996, to 110 billion just three years later.

Examples: other countries

Other countries have discovered the same Laffer Curve effect, and have been aggressively cutting taxes. All have enjoyed a rise in economic growth, job creation, and government revenues.

In the Netherlands, for example, some of the biggest tax cutting plans were introduced by Wim Kok, a Labour prime minister and former head of his country's largest trade union and former deputy head of Socialist International.

In the United Kingdom, Margaret Thatcher came to power when top income tax rates were 83% - plus an 'unearned income' surcharge of 15% if the income derived from investments rather than from wages or salary - making the effective rate 98% for those living on pensions or other investment assets. She quickly reduced the top rate to 60%, and then to 40%. The 'brain drain' of ambitious Britons going to work overseas was staunched, while wealthy and prominent people like the actor Michael Caine and the novelist Frederick Forsyth returned from their tax havens. And for these and other reasons, the Treasury discovered that the top 1% and 5% of taxpayers were paying a far larger share of the tax burden than they had done before. Where the top 10% contributed 32% of the tax take before the cuts, they were contributing 45% of it afterwards.

In 1987, the Republic of Ireland's minority government brought in tax cuts that were possibly even deeper than those of Margaret Thatcher or Ronald Reagan. Taxes were cut from 40% of GDP in the late 1980s, to about 32%. There were other factors, such as a parallel cut in public expenditures and large relief payments from the European Union, but the years following the tax cut saw growth soaring (indeed, from negative growth to rates approaching 10%), a cut in the unemployment rate from 17% to around 3.5%, and again, talented people who had 'brain drained' abroad returning home.

Assessment: cut rates, raise contributions

The message is clear. There are limits to the willingness of taxpayers to see a higher and higher share of their earnings being confiscated in taxes. Indeed, in developed countries it is beginning to appear that a tax burden of more than 40% cannot be sustained, and the maximum sustainable rate is probably considerably lower than that.

High tax rates actually bring in lower revenues as people take measures to evade or avoid the tax by working less, cheating, going abroad, using tax loopholes, or other means. The effect is particularly profound with capital taxes, since people have many choices how and where to use their capital. High capital taxes lock people into outdated and less productive investments: when taxes are cut, they can re-balance their investments, and put money into new job-creating activities which boost growth and employment over the whole economy. If you want to soak the rich and make the rest prosper - cut taxes!

For further information: There are various think-tank reports on the flat tax, including:



Copyright 2002: Adam Smith Institute        Created and Maintained by: Cyberpoint Limited