The Laffer Curve

It is an economic model called the Laffer Curve and it is reeks of common sense and good economic stewardship. It is also being studiously ignored by the Labour and Conservative parties in their headlong race to buy votes with expensive election promises.

The Laffer Curve is basically a bell-shaped curve which starts at zero on the left , rises to an optimum figure in the middle and then drops back down to zero on the far right. The zero on the left is the expected tax revenue that would be raised if the tax rate was zero, which is fairly self-explanatory—no taxes, no revenue. Halfway up the left side of the curves means taxes are too low and revenue is insufficient.

The zero on the far-right may appear at first glance to be counter-intuitive. The higher the price (taxes) the higher the revenue. But if we use the shop analogy the fallacy of that argument is exposed. If a shop charges more money than the customer can afford than they just go elsewhere. In the case of taxes they vote with their feet and move to another country and refuse to invest in an economy which fails to give them a return with the result that the pool of money from which taxes are drawn shrinks.

The key is to find the happy median. This is the highest point on the Laffer Curve where the tax rate—like Goldilocks’s porridge—is neither too high nor too low but set just right so that it draws in the maximum tax revenues.

The Laffer Curve is named after American economist Arthur Laffer from the Chicago School of Economics. Professor Laffer did not invent the theory. But he did popularise it during the Ford, Reagan and Bush Senior Administrations. The theory actually has its antecedents in 14th century Tunisia; was popular in 19th century American economic planning and a cornerstone of the policies of US Treasury Secretary Andrew Mellon during the Roaring Twenties. Even John Maynard Keynes made some admiring references to it, but it was largely forgotten in the 30 years after World War II.

Ignoring the reality of the Laffer Curve has consequences. Ten years of relatively low taxes and austerity was deeply unpopular and disincentivising. In 2012 Robert Chote, the chairman of the Office of Budget Responsibility, reckoned that the British exchequer was happily “strolling along” at the top of the Laffer Curve with a top rate of 50 percent. Then it was cut to 45 percent the following year and tax revenues dropped £100 million a year.

Of course, neither the Conservatives nor Labour are concerned with any consequences other than that of losing the 12 December general election. The result is that the Tories are promising big spending rises but without increases in income tax, VAT or National Insurance. Labour pledges to launch a multi-billion pound social revolution funded by taxing the top five percent earners.

According to Paul Johnson at the respected Institute of Fiscal Studies, neither of two main parties is “being honest with the voters.” He reckons that there is no way that a Johnson government will be able to stick to its no tax rise promise, and when it breaks that pledge the revenues will go way over to the right side of the Laffer Curve. As for Jeremy Corbyn and John McConnell, their proposals already put them well down the right side of the curve, so much so, that Paul Johnson reckons that tax revenues would shrink so dramatically that Labour would be unable to deliver on its spending pledges. The result would either then be the downward spiral of even higher taxes or increased borrowing.

More borrowed money is already part of the Conservative and Labour manifestos. Both parties argue that they want to take advantage of historically low interest rates to borrow for capital investment. The problem with that logic is that the more government borrows the less likely it is that interest rates will remain low as they are subject to the same market forces as any other service or product. There is also the problem that the money has to be paid back. If the borrowed money fails to increase tax revenues at current tax levels than taxes will need to rise to offset borrowing costs. This in turn, will push the economy down the right side of the Laffer Curve. Alternatively, the government can borrow money to pay off its borrowings. But as any pay day loan victim will testify, therein lies the road to penury.

The trick is not to gear your taxes to your policies, but to gear your policies to your tax revenues. Tax levels are set at the top of the Laffer Curve to maximise revenues. Political choices are then made about how to divide the revenues between the competing demands of society. This requires hard, honest choices which are unfortunately a rare commodity at election time.

Tom Arms is a regular contributor to the Whatandthewhy.com. He also presents a weekly world affairs broadcast for American radio and is completing a book on Anglo-American relations.

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2 Comments on "The Laffer Curve"

  1. I wonder why the curve is that particular shape rather than the more familiar Bell Curve? Over thirty years ago I did a course in statistics as part of a business course so this may have been mentioned, but it’s over half a lifetime ago and memories fade.

    As for the politicians promises I don’t believe any of them. If Corbyn, Trump or Johnson promised me that the sun would rise tomorrow I would still make sure the torch was charged up the night before. As you pointed out Tom, ALL of them are promising to spend money that they don’t have on projects that are not technically possible, only illustrating their lack of a decent grasp on reality.

  2. William Beausire | 3rd December 2019 at 11:15 am | Reply

    A few unrelated points.
    I think the Zero revenue point on the right is better characterised as being the point where nobody works because there is no marginal financial benefit to working.

    Happy medium. Like Doris Stokes after a lottery win.

    Why is it assumed that the sweet spot on the Laffer curve is the rate of taxation that produces the highest tax revenues? Is that the objective of the tax regime?

    You say tax revenues fell by £100m when the top rate of tax was cut. Is this a typo? That would be roughly 0.005% of GDP. (I think ….I hope I’ve got that right…)

    I don’t think anyone knows what shape the Laffer curve is.

    Regards

    Will

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