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Saturday, September 08, 2012

The Laffer Curve Primary Effect Is On Government Revenue - But Secondary Effects On The Whole Economy Are Far Greater

  This is the WSJ's assessment of the Laffer Curve - the curve of tax rates and the amount they raise.


Which suggests that the optimum level for raising the maximum as a proportion of GNP is about 26

  Professor John Brignal of Numberwatch explains it as somebody whose expertise in maths greatly exceeds that of virtually everybody in the "science" of economics. If economics were a "hard science" like engineering, bearing in mind its importance, it would seek to attract the very best mathematicians. But instead it is a political "science" where advancement depends more on knowing what the employing government wants to hear than on what is true.

The Laffer curve is not just a hypothesis that can be, as some left wing commentators suggest, debunked: it is a mathematical necessity.

Consider a function y(x) which has the following properties:

The independent variable x lies between two bounds. Let us call them x=0 and x=100 for convenience.

The continuous function y(x) is non-negative between these two bounds.

The function y(x) is zero at the bounds: x(0) = x(100) = 0.

We discard the trivial case of y(x) = 0 everywhere.

We do not have to appeal to the theorems of elementary algebra. It is common sense that y(x) must exhibit a maximum somewhere in the range (0,100).

In the case of the Laffer curve x represents the percentage rate of tax and y represents the total tax take. It is clear that the relationship has the properties above. If x = 0 there can be no tax taken. If x = 100 there can also be no tax taken (unless you allow the proposition that people will work for nothing, which has not been relevant since the abolition of slavery)......

The mechanisms by which such a decline is effected are many and various and are largely anecdotal.
As an example, consider the experience of the UK during the Chancellorship of Dennis Healey, who allegedly vowed to tax “the rich” until the pips squeak”. Whether he ever made that remark is moot, but the results of his actions are not.

This author was a young(ish) academic at the time and was bemused to find himself sitting round a swimming pool with a bunch of private businessmen (it was a summer party for parents whose children were in the same class at school). The main topic of conversation was “amusing ways of wasting your company’s money to avoid making a profit”. The effects were, however, much wider than that. A subterranean cash economy sprang up almost overnight. There were two prices for almost everything; the invoice price and the much lower cash price. Even the local vicar was known to inquire whether there was a cash reduction. A basically honest society was corrupted forever.

You can see other phenomena in modern times, such as mobile businesses upping sticks to move to Dublin or Geneva , where the corporation tax rate is lower.

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    Ireland's place above the graph probably reflects such movement of tax payment to Dublin, but its place is not that much higher than local industrial success suggests.

    However it seems to me that the normal use of this curve, to show the effect on taxes raised, is limited and reflects the interests of the state rather than society as a whole.

    Tax avoidance obviously involves making decisions and allocating resources (including to pay accountants) which subtract from national wealth well beyond the loss in revenue. My guesstimate, including Brignal's anecdotal example, is that the loss to the economy, including tax, will be measured by extending the straight line of the graph up to 12.5%. That would mean that for Britain at the rate shown, while CT takes aboutt 3% of GDP it removes just under 8% of GDP from the economy (admittedly that government spending will then find its way back into the economy, or probably about 2/3tds will due to inherent inefficiency) which means the cost to the country is about 6% of GDP. Even at the the rate which maximises the tax take, 26%, the cost to society as a whole is still about 5%.

     The 2nd unaddressed factor, larger but more difficult to assess, is the higher rate of growth available to countries with lower CT rates.

     Between 1989 and 2007 Ireland grew at 7% a year going from 60% of British per capita GDP to 140%. This cannot have been entirely, probably not mostly, having CT less than half the average of their competitors, because they also carried out substantial regulatory reform, but I think we should reasonably ascribe 1/3rd of the growth to that.

     That means lower 15% lower CT rates raised GDP by about 1/3rd (this involves a bit of discounting for compounded growth rates).  I'm going to assume, for no good reason, that rates of zero would not have increased Irish growth rates further. I don't think any supporter of high taxes will quibble with that because if I assumed otherwise the case for CT would get MUCH worse.

    So the countries with around 30% CT rates over 2 decades lost 33% growth in GDP.

     This means that the amount of GDP lost to the people, as opposed to the government from having around 30% CT rates is, after 2 decades, 33% + 5% = 38% for the whole of us. Even from the point of view of government, not only do they get a marginal reduction on actual tax rake of the real economy, they, assuming that government spending would, unfortunately, remained the same percentage of GDP, they have lost 1/3rd of their total income.

     Making that assumption about there being no benefit in cutting CT below 12.5% the sensible thing to do for the interests of the nation & in anything but the very short term, the interests of the Treasury, is to cut CT to Ireland's 12.5%. Then we can see if it makes sense to cut further.

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Comments:
Agreed.

But what's also interesting is that 'large' countries tend to have higher tax rates than 'small' ones, and tax haven countries are usually tiny. This makes perfect sense if you think about it.

Norway is an outlier because they get so much corp tax from oil industry, which is huge compared to the size of their economy.

And if we're on the topic of Laffer, why not mention the one potential big tax that has no Laffer effects at all?
 
Oops, used wrong log in, that last comment was from me.

MW.
 
Thanks for the explanation of Norway Mark. I have previously described thr virtues of land Value Tax (except when building new land in orbital space settlements and Aquarius floating islands) but, as this answer shows, we each have our own hobby horses.
 
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