The left side of the Laffer curve

Tax-cutting Tories love the Laffer curve. Just in case your memory needs refreshing, Mr Montgomerie has a helpful link here.

Laffer's key insight is that after a certain point, tax increases act to reduce government income due to avoidance, evasion and the deadening effect on the economy. Thus by cutting taxes one can actually increase government revenue, the upshot being that tax cuts pay for themselves.

What the Lafferites tend not to dwell on is that the bell-shaped curve has a left side where the opposite conditions hold true, meaning that tax cuts certainly do not pay for themselves. Thus what tax cutters need to demonstrate is not the existence of the Laffer curve, but which side of it we're on.

Now, I'm no economist – and no doubt some bright spark from the TaxPayers' Alliance can put me right – but I can't help noticing that Gordon Brown keeps putting up our taxes and increasing the government's revenue at the same time. This rather suggests that we're still on the left side of the Laffer curve – or, at least, have been until now.

Of course, all this extra tax may well be hurting the long-term growth rate of the UK economy and hence the tax base. However, for the purposes of medium term fiscal policy, this doesn't mean that tax cuts pay for themselves. Tax cutters still have to say what they'd cut in terms of spending or raise in terms of borrowing in order to fund their tax cuts.

I'd love to be wrong on this.

Comments

[Bill]

I would have thought a meaningful measure is what is happening to GDP per capita/productivity.

[Matt Kellett]

Interesting Peter. I've never bought Daniel Finkelstein's criticism of supply-side benefits but it does make sense in this case.

[Corin Taylor]

The reality is that most tax cuts will partially pay for themselves (and hence most tax rises will raise some extra revenue). But the key point is that you lose less revenue than you think with a tax cut, and you gain less revenue than you think with a tax rise. This is why the Treasury has consistently overestimated tax revenue in the last few years - those tax rises just didn't generate as much revenue as they thought.

If you assume that tax cuts will pay for themselves by, say, one third (and corporation tax cuts are likely to do more than that), then you can cut taxes by one and a half times as much as you thought. e.g. a 5p cut in corporation tax would cost £10 billion on a static basis. If you get a third back through dynamic effects then it only costs £6.66 billion. The original £10 billio therefore allows you to cut the corporation tax rate by 7.5p.

Of course, it's hard to precisely predict tax revenues on either a static or a dynamic basis, so why not cut taxes, score them on a static bases, and allow the dynamic revenue feedback to reduce the deficit below the baseline. A win win - lower taxes and lower deficits.

[Acorn]

"Tax cutters still have to say what they'd cut in terms of spending or raise in terms of borrowing in order to fund their tax cuts".
Ah-ha, the ultimate question, that never gets answered! Let's face it, we have no idea why the governments current spending is £560 billion.
Some guy said that the people can do anything they like as long as there is not a law that stops them. Likewise, the government can do nothing unless a law allows them to do it.
As we have more laws / regulations than you can shake a stick at means that we never know what each of these laws cost us to initiate and operate.
Until some one sits down and works out an answer to this ultimate question; and, decides what is / is not good value for money, we will sit here, spinning our wheels for evermore.

[Phil Whittington]

I'm no economist either, but I would imagine that something as complicated as tax / revenue would involve hysteresis

(http://en.wikipedia.org/wiki/Hysteresis#Informal_definition)

That is to say that Brown's increase in tax to lift revenue may be correct in the short term, but that moving tax-take backwards (as opposed to letting the long-term effects of his hike set in) may also be beneficial.

I think we need some proper economists to explain this to us... :(

PDW

[Charlie Groome]

An interesting read. Though consider that in a complex tax system where the whole of society is split into different tax and welfare brackets the laffer curve is different for each group.

From this perspective consider that Labour's tax increases fall adversely on people with lower incomes who, at a lower tax rate than high income folk, are located to the left of the peak of the laffer curve. By comparison the wealthy are to the right of the peak and consequently tax increases on them would reduce government revenue as you would expect from the theory.

Of course it's not just through income tax that Labour have raised income from the relatively poor. Presumably behavioral modification taxes such as the tax on cigarettes effect the less educated more than the well educated – and the correlation between relative poverty and less education is fairly self-evident.

It's not hard for me to see how Labour have raised income through taxes yet not disproved the Laffer Theory – they've simply heaped the burden onto the poor through maintaining and developing a complex tax system.

I'd like to see an index of laffer curves for different tax groups/income levels.

Great, short and simple lecture from CATO on Laffer Curve here: http://www.youtube.com/watch?v=fIqyCpCPrvU