The Laffer Curve is a fact, not a theory
The Laffer Curve is a concept in economics that illustrates a theoretical relationship between tax rates and tax revenue. The basic idea is that there is a tax rate between 0% and 100% that maximizes government revenue. The case for the Laffer Curve rests on both logical reasoning and empirical observations, though there is, not surprisingly, significant debate about its policy implications.
The case for it in theoretical logic rests on two things. Zero tax yields zero revenue. At a 0% tax rate, the government collects no revenue. This is self-evident. A 100% tax also yields zero revenue. If all income is taxed away, individuals and businesses have no incentive to work, invest, or earn income legally.
Between no yield at 0% tax and no yield at 100% tax, there is a curve, and some tax rate must maximize revenue, hence the Laffer Curve. This argument is largely uncontroversial as a theoretical construct. Even critics of Laffer accept that the curve exists in principle.
There are historical and empirical examples which back this up. In the 1920s the US cut high marginal tax rates from 73% to 25%, and federal revenues increased.
In the 1980s there were the Reagan tax cuts. The Reagan administration cut top marginal tax rates from 70% to 28%. While revenues fell in the short term, proponents point out that economic growth was spurred and eventually led to higher revenues than otherwise expected.
Also in the 1980s in the UK under Chancellors Geoffrey Howe and Nige Lawson, top tax rates were cut from 83% (or 98% including the investment income surcharge of 15%) to a top rate of 40% and a basic rate of 25%. The economy surged and not only boosted Treasury revenues, but saw the richest pay a much larger share of the total.
In post-Soviet economies, countries in the Baltic states adopted flat taxes at relatively low rates and saw large increases in tax compliance and revenue. In Sweden in the 1990s, they significantly reduced marginal tax rates and saw rising revenues as compliance and economic activity increased.
These examples are cited to show that high marginal rates can reduce incentives to work, invest, or report income, and that lower rates can broaden the tax base. And there is academic support. Mainstream Economists, including those not ideologically aligned with supply-side economics, generally accept the Laffer Curve as a theoretical truth.
Empirical studies, including research by economists such as Martin Feldstein, has suggested that taxable income is elastic with respect to tax rates especially among high earners. That supports the idea that higher rates can sometimes reduce total revenue.
Policymakers should bear in mind that higher rates may backfire if they discourage productive behavior or encourage tax evasion and avoidance.
However, the location of the peak, the revenue-maximizing rate, is highly context-dependent. The curve’s existence is broadly accepted, even by critics. But the notion that “we are always on the wrong side of the curve” and that tax cuts always increase revenue is much more controversial and not always supported by data.
The Laffer Curve is not a justification for all tax cuts, only for those starting from tax rates above the revenue-maximizing point. The case for the Laffer Curve being real is strong in theory and supported in many historical cases. The key dispute is not whether it exists, but where we are on the curve.
It is highly likely that in the UK we are above the tax-maximization points for both income and capital taxes. There is an incentive to avoid (legal) and perhaps even evade (illegal) the high taxation. The high rates act as a disincentive to work more and to invest more.
Current rates on income and capital could be increased if the aim is to punish the rich, but there would be revenue losses. If they were reduced, there would be sufficient growth to broaden the tax base, raise more revenue, and have the rich paying a higher share of the total.
Madsen Pirie