Wednesday, 17 March 2021

Abandoning voodoo economics


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.


dafis said...

There is a point beyond which a high marginal tax rate is a disincentive to work or earn more. This point will vary for most individuals (and corporates). If one works hard to earn money then I would argue that the disincentive is more evident, if the income is passive or requires relatively less effort then the disincentive is possibly less evident. However one has to factor in greed and other issues such as insecurity. So the psychology of individuals plays an important part in determining whether tax rates influence their behaviours. Laws which permit the continued use of "tax mitigation" techniques by individuals and corporates play a role in these decisions too.

I buy into a Laffer type theory beyond a certain point but where is that point ? Right now as a pensioner on modest earnings from the State and small private pension I am reluctant to see the State grab a bigger share out of my pot especially as they appear unable or unwilling to address the major problem of waste and highly debatable priorities. Independence might be an answer but our current crop of wishful thinkers don't inspire much confidence either.

John Dixon said...


"I buy into a Laffer type theory beyond a certain point but where is that point ?" The theory of the Laffer curve seems logical enough, I agree. But no-one knows where the alleged 'sweet spot' is - if it even exists - which makes it an interesting theory but of little use in terms of practical policy making.

"Independence might be an answer but our current crop of wishful thinkers don't inspire much confidence either" Independence, per se, does nothing to solve the problem of waste or priorities, nor to improve the quality or honesty of the politicians. But more local decision-making allows more chance for citizens to influence decisions.

dafis said...

I agree with localising decision making but most of what I've seen of politicians over the last c.55 years leads to a less than optimistic conclusion. They all like to grab decision making power into a central hub no matter whether that is Brussels,London, Cardiff ......Indeed that urge seems to have increased with the growth of career politicians who have little or no grasp of managing organisations or service delivery.

John Dixon said...


"They all like to grab decision making power into a central hub..." Sadly, I an only agree with you on that. One of the disappointments of devolution for me has been the way in which people who had previously argued for decentralisation as a principle now seem to want to centralise within Wales, and to neuter local government in the process.

Spirit of BME said...

Being Jeffersonian in my politics and having been bought up on the principles of Payne`s publications, you can add me to the list of those that are disappointed in lack of decentralisation. It appears that all central bodies like cancer,see growth as the natural order of things.

John Dixon said...


I'm sure that you, like me, will recall earnest discussions in conferences and summer schools about empowering local authorities and moving from an ultra vires model (authorities can do only that which they are specifically permitted to do) to an intra vires model (they can do anything not expressly forbidden). It seems to have been replaced by a mindset of controlling ever more tightly what local authorities can do in the interests of 'maintaining common standards', or avoiding what is called (in that truly horrifying phrase) a 'postcode lottery' or, as some of us prefer to call it, local democratic choice. It's the Westminster model writ small.