Opinion: Laffer curve still hangs over mainstream tax debate
Arthur Laffer's famous bell curve still looms large in tax policy even though the evidence for it doesn’t stack up.
US President Joe Biden is set to make his budget proposal on Thursday, March 9, and he's already hinted at higher taxes. If these plans are confirmed, Biden will likely face criticism from Republicans that tax hikes will hurt the US economy and not raise tax revenue.
At the same time, the UK government is due to make its spring budget statement next Wednesday, March 15. Former Prime Ministers Boris Johnson and Liz Truss have reiterated their calls on the government to cancel its plan to raise corporate tax from 19% to 25%. However, the government shows no sign of backing down.
These demands to either keep taxes low or cut rates further are all based on the assumption that lower taxes will generate greater economic growth and increase revenue as a result. We can thank US economist Arthur Laffer for making this assumption popular with the so-called 'Laffer' curve.
This bell curve shows that tax revenues reach zero when rates are set at either 0% or 100%. One extreme is asking too little, but the other is asking too much. It’s an argument for moderation and caution in tax policy.
“It’s not left wing, it’s not right wing, it’s economics,” Laffer is fond of saying in interviews.
Higher tax rates hold back the economy, so lower tax rates must unleash prosperity. Laffer argues any rate above 50% is prohibitive on economic growth, but the lower tax range below this point is where the optimal level of tax can be found.
Laffer ends up arguing that the best levy is a flat rate of around 10% to 13%. It would be a radically simple tax system with one low rate for personal income with room for just one sales tax. His arguments are mainly focused on income taxes, but the same logic can be applied to corporate tax.
The basic idea of the Laffer curve is that there is an optimal tax rate at which revenue will be maximised with minimal negative impact on the economy. This sounds like common sense, which is why the idea has been so influential.
Both President Ronald Reagan and Prime Minister Margaret Thatcher listened to Laffer’s advice and presided over tax cuts. However, the two leaders took different approaches to fiscal matters.
The Thatcher government cut the top rate of income tax from 83% to 60% in 1979 and then to 40% by 1990, while corporate tax was reduced from 52% to 35% over the same timeline. This was a more cautious approach supported by spending cuts and privatisation.
By comparison, the Reagan administration reduced the US corporate tax rate from 46% to 34% and, even more dramatically, slashed the top rate of income tax from 73% to 28%. These tax cuts came at a huge cost to the US Treasury and the budget deficit ballooned as defence spending was never reined in.
Truss thought she could take the Reagan strategy in the UK, but she spooked the financial markets. She came up with her tax plan on the same idea – that tax cuts will produce growth and generate more tax revenue.
It didn’t matter because the markets didn’t buy that the tax cuts were sustainable. Nevertheless, many Conservative politicians are now arguing for Truss’s policy of keeping corporate tax at 19%.
The sleight of hand in the Laffer argument is that the broad-based, simplified nature of a flat tax could raise a lot of revenue just because it would be so much harder to avoid. In other words, the rates could be set higher but it’s really about the structure of the tax system.
Many mainstream economists reject Laffer’s argument for flat taxes and low rates. Economists including Paul Pecorino have approximated the optimal rate would be around 65%, while others have argued it would be between 32% and 35%.
It’s unlikely that the optimal rate is static and doesn’t vary according to economic circumstances. The search for an optimal rate continues because tax isn’t an exact science (despite what VAT specialists say).
Laffer has been so influential not because his arguments are supported by indisputable evidence, but because he gave politicians a compelling case to justify the low-tax policies they want. It’s political, whether people want to admit it or not.