The Abominable Laffer Curve

Supply-side economics are all the rage again, it seems. Here is Tory leadership hopeful Sajid Javid appealing to the tax-cutting instincts of his core supporters:

Cutting tax rates could bring in billions of extra revenue, which would mean:
More nurses 👩‍⚕️👨‍⚕️
More teachers 👩‍ðŸ«ðŸ‘¨‍ðŸ«
More police 👮‍♂️👮‍♀️

“I would cut [top rate] if it brings in more revenue and gives us better public services” – @sajidjavid #TeamSaj pic.twitter.com/MxVUVcI5q2

— TeamSaj (@TeamSaj) June 2, 2019

Cutting taxes for the rich in order to generate more public revenue. The Laffer curve is back.

Not that it has been absent for long. Seven years ago, to much applause, George Osborne cut the top rate of tax from 50% to 45%. When the cut took effect there was a large increase in tax take. At the time, Conservative pundits crowed that this proved not only that the Laffer curve was real, but that we now know where its peak is.

Sadly, they were wrong. The tax cut was advertised a year in advance, giving rich people plenty of opportunity to reorganise their finances so as to avoid the 50% rate and take advantage of the tax cut (this is known as “reverse forestalling”). Predictably, there was a large fall in tax revenue from the rich prior to the cut taking effect, and a large increase afterwards. The 50% rate itself had also been advertised a year in advance, so there was also large increase in tax take from the rich before it took effect and a fall afterwards. Thus, throughout its short existence, tax take from the 50% rate was distorted by forestalling and reverse forestalling effects. We will never know how much tax it would have raised, and we therefore don’t know whether or not it was the wrong side of the Laffer curve peak.

But  there is an even bigger problem. The Laffer curve plots total tax take versus top tax rates, not tax take from the rich versus their tax rates. It thus relies for its shape on multiplier effects from tax changes. The idea is that if you cut taxes for the rich, the additional spending and investment that they will make with the money will raise GDP, generating jobs and increasing the incomes of ordinary people. This is the philosophy behind the Trump administration’s tax cuts: it is no surprise that Arthur Laffer has just been awarded a gong by President Trump. But no simple causal relationship between economic multipliers and tax income has ever been established. Indeed, attempting to discern such a relationship leads to some bizarre conclusions, such as the notion that the purpose of taxation is to cause unemployment.

We have no idea what the Laffer curve looks like, let alone where the peak is. In fact there is no compelling evidence that it even exists. It seems obvious that 100% taxation would induce people to stop working, and we do know that very high marginal tax rates due to benefit withdrawal do discourage the poor from working. But arguments that even a small increase in the top rate of tax would result in mass flight of talent, resulting in economic disaster, are unfounded. Similarly, Javid’s claim that cutting the top rate of tax could bring in “billions of extra revenue” is a statement more of faith than reason.

The Laffer curve is rather like the Yeti, sometimes known as the “Abominable Snowman”. There are stories of white shapes in the woods; there are strange depressions in the snow that could be footprints; there is even, apparently, some forensic evidence that a large white furry animal exists somewhere in the Himalayas. But no-one actually knows what a Yeti looks like, because no Yeti has ever been found. So it is with the Laffer curve. Opinions as to the “optimal” rate of tax on the very rich differ wildly, from 40% (IEA) to over 80% (Piketty and Saez). The IMF suggests that there is scope for tax rises for the very rich in most countries and especially in developed Western countries, although they don’t go as far as Piketty & Saez. But until someone actually captures a Yeti proves conclusively that at some rate of tax, revenue generation always reverses irrespective of other effects, the Laffer peak will remain mythical.

And if the Laffer curve is the Yeti, the “trickle-down” economics on which it relies is the Loch Ness Monster. There is even less evidence for the existence of the Loch Ness Monster than there is for the Yeti, but widespread belief in its existence has generated a sizeable tourist industry. Similarly, no-one has ever proven conclusively that reducing taxes on the rich increases jobs and prosperity for others, or that prosperity for the many depends critically on the work of a few. But an entire political and economic ideology has been built on these assumptions.

Advocates of tax cuts for the rich point to the fact that for the last few decades, general prosperity has risen while tax rates on the rich have fallen. But prosperity can be adequately explained by technological change and increasing global trade. Furthermore, most of that prosperity increase has occurred in developing countries: in many Western countries, wages have stagnated and a growing proportion of the population is in unstable employment. There is no demonstrable causal link from tax cuts for the rich to rising prosperity for everyone else.

It could equally be argued that the causal link runs in the other direction: the rich have benefited disproportionately from rising general prosperity due to technological changes and trade, and lower tax rates simply enable them to keep more of the wealth they have extracted. Indeed this explanation seems to fit the evidence better. If the rich are able to extract wealth disproportionately, we would expect inequality to increase over time. This seems to be exactly what is happening in countries that have explicitly cut taxes for the rich. Although general prosperity in Western countries has risen since the 1980s, the very rich are capturing a larger proportion of total income, while their effective rates of taxation have fallen and it has become ever easier for them to avoid tax. If the causal link does run in this direction, then there is a strong case for raising taxes on the wealthy rather than reducing them.

Of course, some argue that rising inequality is fine as long as general prosperity is improving: “a rising tide floats all boats”, as they say. But The Economist warns that rising inequality boosts the political power of the rich, enabling them to influence tax policy in their favour. This sets up a feedback loop in which government increasingly pursues policies that favour the rich at the expense of the poor, thus further increasing inequality and progressively immiserating the poorest and most vulnerable. Since the financial crisis, this is exactly what we have seen in many Western countries.

The popularity of trickle-down economics is perhaps surprising, since it appears to be driven entirely by the desire of the rich to avoid taxes. Why do ordinary people vote for politicians who promote these policies? To be sure, cutting taxes can give a much-needed fiscal boost to an economy in a slump. But to be really effective, such cuts need to be broadly based. Cutting the top rate of tax is not only unlikely to generate more tax revenues, it is also unlikely to be much of a lasting stimulus. The effect of the Trump tax cuts is already fading. The U.S. could be in recession within a year.

Many of those who object to high taxation of the rich, even if they are not rich themselves, see it as a moral issue. Some see taxation as a form of theft, to be resisted at all costs. Others see taxation as payment for services: as the rich use fewer public services than the poor, the rich are far too heavily taxed and the poor are not taxed enough. There are increasingly strident voices claiming that people should “get out” what they “pay in”, and these beliefs are finding their way into policy: for example, withdrawal of benefits from young people on the grounds that they haven’t yet contributed enough.

But this is a fundamental misunderstanding of the purpose of a tax system. Taxes are the membership fees for clubs called “Britain”, “the United States”, “France”, and so on. And clubs can set their membership fees any way they like. If you don’t like the membership fee, you may try to negotiate a reduction – as Britain did with the EU, for example. Or you may leave – as Britain is now (wrongly in my view) trying to do. But refusing to pay the membership fee is not an option. If you refuse to pay, you have de facto left your club. Whether that means you leave the country, or end up in prison, is a matter for you and the courts to decide.

However unreasonable you consider it to be, taxation can never be defined as “theft” or “extortion with violence”. Taxation is a legal construction in exactly the same way as personal property rights are, and they are enforced using the same legal system that protects personal property rights. It is not reasonable to refuse to pay the membership fee for the country where you choose to live, while expecting the legal system of that country to protect your property from the desire of others to take it from you.

The moral argument that the rich should not have to pay in more than they get out is also inadequate.  Taxes collectively are payment for services received (or to be received in the future), but at an individual level, the amount “paid in” does not relate to the amount “taken out”. In progressive tax systems, the membership fees that the rich pay include an additional amount to support people who can’t afford the membership fee. The fact that the rich pay in more than they get out. and the poor pay in less than they get out, is not a bug, it’s a feature.

People who demand that taxes should relate exclusively to services received are rejecting the hallmark of a civilised society, namely care for the poor and weak. People who argue for a “smaller state” to be created by cutting benefits for the poor and taxes for the rich are making unjustified assumptions about the ability of the poor and weak to fend for themselves and the willingness of the rich to devote a substantial part of their incomes to philanthropy. There is vanishingly little evidence that the poor can pull themselves out of poverty, and even less evidence that the rich are prepared to help them do so.

Ever since the 1980s, the rich have had the advantage in the moral arguments around taxation. We hear statements such as “it is immoral for someone to lose half their income”, without considering whether that income was legitimately earned or obtained by extracting rents. And arguments that the rich create jobs and incomes for others do not stand up to close examination. Yet all too often, policy makers appear convinced by them.

We need a serious discussion about the morality of taxation. While the rich believe they are morally entitled to low tax rates, they will continue to avoid higher rates by taking advantage of the global mobility of capital and the fact that tax arbitrage is a survival strategy for small countries. And while their view dominates the political agenda, governments will continue to pursue policies that favour the rich over the poor. For higher tax rates to be both politically acceptable and economically effective, the moral case for them must be so clearly made that the rich themselves buy into it because they cannot in conscience do otherwise. We are nowhere near that point.

The economic and political arguments against higher taxation of the rich are snake oil. Yet they are still trotted out by politicians like Sajid Javid who need to buy votes, because underlying them lies the fundamental issue of our time – the battle over what constitutes “civilisation”.

Related reading:

Forestalling, tax avoidance and politics
Oh no, not again
Laffer and the Loch Ness Monster
Are inheritance taxes unfair?

Image of Yeti footprints by Gardner Soule – The World’s Most Mysterious Footprints. Popular Science. December, 1952., via Wikipedia. 

A version of this post originally appeared on Pieria under the title “Laffer and the Yeti”. 

Source: http://www.coppolacomment.com/2019/06/the-abominable-laffer-curve.html