Abandoning voodoo economics

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According to legend, the infamous Laffer Curve was first drawn by its author on a napkin at a lunch time meeting with some of America’s most notorious conservatives. It was completely devoid of any numbers along the x-axis, making it easy enough to draw. Almost 50 years later, the graph (and the underlying theory) is still an abstract theory with no numerical underpinning.  The concept of the Laffer curve is well-known, and the principle has every appearance of being rational and logical: it is “there is a tax rate between 0% and 100% that maximizes government tax revenue”. There are a number of reasons why this might, theoretically, be true but the theory is not necessarily reflected in reality. A rate of zero for any given tax will self-evidently produce no tax revenue, but the theory also argues that an income tax rate of 100% will also produce no income, because people will have no incentive to work. Whether that second conclusion is true or not is rather more arguable: it depends, at least in part, on the nature and values of the society and on what people get in exchange for their tax. It is not, however, a wholly unreasonable starting point for a theory. Since, as far as I’m aware, no modern economy has ever tried a 100% tax rate (although some economies have come close to a 100% marginal rate, which isn’t quite the same thing), there is no obvious empirical data on which to judge. But if we accept the ‘truth’ of the statement, then one can draw a curve between 0 and 100 showing how, in theory, tax initially increases as one increases tax rates before starting to fall off and return to zero as tax rates approach 100%. And that is all the Laffer curve is. Neither the curve itself, nor the underlying theory, require any hard numbers to support them – but to be of any use in practice, provable numbers are required, and they are notable only by their absence.

The flaw in using a graph which appears reasonable in theory but has no supporting evidence as a basis for a policy of low taxes should be obvious, but that hasn’t stopped proponents of low taxation from basing their whole argument on an unproven hypothesis. Even worse, they have generalised the argument to the point where they argue that lower taxes always increase government revenue. But the lack of hard data means that, even if the theory were true, no-one can accurately say when we are at or near the peak, nor what the shape of the curve should be. There is simply no empirical data to justify using any particular figures. Any attempt to derive figures is complicated by the tax systems in use in different economies – systems of tax reliefs and deductions mean that actual tax rates being paid by taxpayers are rarely the same as published headline rates. The result is that the circumstances in which direct lines can be drawn between tax rates and tax revenues are non-existent. That makes it easier for quack economists (and Tory politicians) to argue their case that lower taxes increase rather than reduce total tax revenues by providing incentives for compliance, investment, and effort. They can’t prove any of this – but they have the advantage that no-one can disprove it either.

Actually, that very last bit isn’t entirely true; there is some evidence of the impact of tax cuts on tax revenues from the US. And that evidence is that, on the whole, cutting taxes reduces taxation revenue. It’s a conclusion which most ordinary mortals, not armed with high-faluting theories and graphs like the Laffer curve, would instinctively expect. It doesn’t actually disprove the theory; it merely confirms that no-one actually has a clue about what the practical (as opposed to theoretical) optimum level of tax might be. Empirical evidence of revenue loss after the event only confirms that the level of taxes before the cuts wasn’t – as the proponents of tax cuts claimed – already above the optimum (if one exists), but was actually at or below it.

One of the lesser-commented aspects of the recent budget was that it represented at least a partial abandonment by the Conservative Party of Laffer-curve economics. The Cameron-Osborne plan for reducing Corporation Tax over a period was based on an assumption that allowing companies to retain more of their profits would result in more investment and thus more jobs and more tax revenue overall, but it didn’t happen in practice. There are a number of reasons for that (and of course, the pandemic and Brexit have further complicated things over the last year). But in promising to reverse the cuts over coming years, the Chancellor is very clearly stating that he doesn’t accept that the argument applies at anywhere near current rates of Corporation Tax and accepts – in line with most mortals – that, as a general rule, increasing tax rates generates more income for the government. Who’d have thought it? The significance of this U-turn looks to have been underestimated by many – although it’s only a start. There still seem to be Tories around trying to apply the Laffer curve to other taxes, as though there is only one tax for which their over-generalisation of the rule doesn’t work in practice. But a law of economics which only applies to some taxes some of the time and which has no means of telling us when it does or does not apply isn’t much of a law at all. It’s just a way of making voodoo economics sound like it has a valid academic basis in order to progress the interests of the richest in society.