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Stop The Laffer Curve Thinking

by on April 12, 2012

Laffer curve thinking is wrong. The political thinking seems to be that tax rates cannot reasonably be reduced unless the reduction will raise more money. This is the wrong way of thinking about the role of the state. If the treasury wants to deal with the deficit, the goal of the treasury should not be to maximize tax revenue, but to minimize distortions.  Frazer Nelson rightly tells us that the decision for a 45p income tax is essentially a political victory for Labour. 

A Labour Party that believes in the benevolent omnipresent knowledge of the mandarins in Whitehall, may debate how to gain maximum revenue for this monolith. The revenue maximizing level of taxation would not worry past conservatives. Edmund Burke, Michael Oakeshott, Karl Popper, and Socrates  would question how much we can ever really know, and they’d prefer the small and the local over the big and the central. Current conservatives, too, should change the structure fo the state to reflect our limited knowlegde.

Empirical Evidence of The Laffer curve

An interesting paper by Karel Herbst, which looks at France, the UK and Ireland specifically and the OECD as a whole has interesting conclusions. The study compares changes in tax rates within countries over time (time-series analysis),  compares the effect of different taxes rates among different countries (cross-section) and tries to take time and country specific effects into account. The final “panel-data studies” is the most interesting. As it tries to eliminate country specific and time effects to isolate the tax effect. We see that the laffer-curve has got steeper over time. Technological advances and increased globalisation mean that tax avoidance is becoming easier, especially for the relatively well off. Thus the maximizing rate is likely to be lower rather than higher.

In its time-series model, (which includes errors which I will not go into here), the revenue maximizing rate is 44% in the UK, yet this is based on results from the 1980’s. The world economy has changed significantly since then. Many of these changes cannot be and are not taken into account. We must remember that all estimations are a “guestimate”. Especially as we see that the model has a maximizing rate of 26% for Ireland. All studies choose to include and omit different variables which may be important in explaining both the tax-rate and the revenue. Accurate estimates have proven to be an illusion and we often see wide range in the significance intervals.

We must  conclude that nobody knows the true present revenue maximizing level of taxation. Is this really a problem? I believe it is not. The laws of economics still apply. Making labour less attractive by taxing part of the income will decrease the amount of labour a worker is willing to produce  and the amount of labour an entrepreneur will want to hire, as he will need to compensate the worker with a higher wage to offset the  extra tax burden.

The rule of thumb should be that decreasing taxes on labour income will increase the amount of labour used in the economy.

Dynamic effects and the deficit

Of course decreasing taxes in a static world does not deal with the deficit. However with the dynamic effects of more work, leading to a higher employment, less unemployment benefits, more output and more profits, the deficit will be reduced.  The conservatives should challenge the conventional wisdom of maximizing government revenues and start changing the structure of the state to match the distribution of knowledge in society.

The ambition should be to decrease the power of Westminster and strengthen communities. It is time the tax-system reflectes this conservative ambition.

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