You’ve no doubt done this yourself: made some passing reference to the existence of the Laffer Curve only to have some lefty splutter that such a thing is just a creation of the neo-liberal objectively pro-fascist anti-taxation league and no doubt you eat babies too, don’t you, don’t you!

Sadly for that end of the political spectrum which did not attend their university’s “reality is not optional” lecture there really is something called the Laffer Curve. For each and every tax, in each and every society, there is a tax rate which will maximise revenues collected from that tax. Go over this rate and tax collected will fall. As this little example from the US shows us:

A random sample of littered cigarette packs reveals that 75 percent of the cigarettes used in Chicago bring no tax revenue to the city, according to researchers at the University of Illinois at Chicago. The lost potential revenue totals about $10 million per month, said David Merriman,……Chicago’s state and local taxes totaled $4.05 per pack, compared to $1.37 outside Cook County, in July 2007, when the teams collected the packs. The $2.68 difference reduced the likelihood that a pack was purchased in Chicago by almost 60 percent…….”This research suggests that an increase of $1 per pack in Illinois, as recently proposed, would drive more Chicago residents to buy their cigarettes in Indiana,” Merriman said.

Note that this research does not, in and of itself, show that current Chicago baccy taxes are beyond the peak of the curve. Only that we can see that people are changing their behaviour to avoid the tax and thus diminishing the amount collected from said tax. And if enough do that then we get indeed a decline in the revenues collected.

Now it might well be true that the people buying their fags outside Chicago and smoking them inside are breaking the law, which makes them very naughty boys and girls indeed. But that doesn’t change the fact that there is this Laffer Curve thing going on. Raise tax levels too high and revenue collected from said taxes will fall. It might be that people simply change their behaviour (smoke less, work less in the case of incomes taxe, take fewer risks with new business adventures with capital gains taxes, not bother squeezing the last drops of efficiency out of a company with corporation taxes) and it might be that they lie, cheat and smuggle (all taxes) but it really is true that raising tax rates and levels does not always raise the amount of tax collected.

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One of the hugely annoying things about the "debate" over the Laffer Curve is that there are still those who deny the very existence of the concept. Something which is absurd, for at the extremes it’s a simple mathematical truism. At times (say, a 100% tax rate) reducing taxes will increase revenues collected. The strongest Laffer Curve argument, that reducing tax rates always increases total revenues collected (reducing a tax rate from 50% to zero say) is as similarly incorrect as the denial that reductions ever do.

The true argument is always about at which tax rate do we increase revenues, at which reduce? This argument being complicated by the fact that we have several different effects going on, depending on which tax we’re talking about (effects on capital and labour taxation will be different, given different mobilities) and so on. Perhaps the most important point to make though is that cuts (or rises) in tax rates will not work in a linear manner. Amounts raised will vary dynamically.

But what is surprising in this latest working paper from the IMF is quite how low a tax rate can go and still show Laffer effects: not just a dynamic response to the lower rate, but more revenue collected both in total and as a percentage of GDP:

To illustrate the potential effects of tax rate cuts on tax revenues consider the example of Russia. Russia introduced a flat 13 percent personal income tax rate, replacing the three tiered, 12, 20 and 30 percent previous rates (as detailed in Ivanova, Keen and Klemm, 2005). The tax exempt income was also increased, further decreasing the tax burden. Considering social tax reforms enacted at the same time, tax rates were cut substantially for most taxpayers. However, personal income tax (PIT) revenues have increased significantly: 46 percent in nominal and 26 percent real terms during the next year. Even more interesting PIT revenues have increased from 2.4 percent to 2.9 percent of GDP—a more than 20 percent increase relative to GDP. PIT revenues continued to increase to 3.3 percent during the next year, representing a further 14 percent gain relative to GDP.

Yes, there really is a Laffer Curve, and its effects can be seen at much lower tax rates than those we currently tend to think they can be. It might also be worth noting that, as with the ASI’s own proposals for a flat tax, the heavily increased personal allowance raised (yes, raised, not lowered) the progressivity of the tax system as a whole.

More revenue, greater progressivity and lower tax rates. Well, why does anyone oppose such a system? 

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