The Laffer Curve

It is an economic model called the Laffer Curve and it is reeks ofcommon sense and good economic stewardship. It is also being studiously ignoredby the Labour and Conservative parties in their headlong race to buy votes withexpensive election promises.

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

The zero on the far-right may appear at first glance to becounter-intuitive. The higher the price (taxes) the higher the revenue. But ifwe use the shop analogy the fallacy of that argument is exposed. If a shopcharges more money than the customer can afford than they just go elsewhere. Inthe case of taxes they vote with their feet and move to another country andrefuse to invest in an economy which fails to give them a return with theresult 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 theLaffer Curve where the tax rate—like Goldilocks’s porridge—is neither too highnor 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 fromthe Chicago School of Economics. Professor Laffer did not invent the theory.But he did popularise it during the Ford, Reagan and Bush SeniorAdministrations. The theory actually has its antecedents in 14^thcentury Tunisia; was popular in 19^th century American economicplanning and a cornerstone of the policies of US Treasury Secretary AndrewMellon during the Roaring Twenties. Even John Maynard Keynes made some admiringreferences to it, but it was largely forgotten in the 30 years after World WarII.

Ignoring the reality of the Laffer Curve has consequences. Ten years ofrelatively low taxes and austerity was deeply unpopular and disincentivising. In2012 Robert Chote, the chairman of the Office of Budget Responsibility,reckoned that the British exchequer was happily “strolling along” at the top ofthe Laffer Curve with a top rate of 50 percent. Then it was cut to 45 percentthe following year and tax revenues dropped £100 million a year.

Of course, neither the Conservatives nor Labour are concerned with anyconsequences other than that of losing the 12 December general election. Theresult is that the Tories are promising big spending rises but withoutincreases in income tax, VAT or National Insurance. Labour pledges to launch amulti-billion pound social revolution funded by taxing the top five percentearners.

According to Paul Johnson at the respected Institute of Fiscal Studies,neither of two main parties is “being honest with the voters.” He reckons thatthere is no way that a Johnson government will be able to stick to its no taxrise promise, and when it breaks that pledge the revenues will go way over tothe 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 muchso, that Paul Johnson reckons that tax revenues would shrink so dramaticallythat Labour would be unable to deliver on its spending pledges. The resultwould either then be the downward spiral of even higher taxes or increasedborrowing.

More borrowed money is already part of the Conservative and Labourmanifestos. Both parties argue that they want to take advantage of historicallylow interest rates to borrow for capital investment. The problem with thatlogic is that the more government borrows the less likely it is that interestrates will remain low as they are subject to the same market forces as anyother service or product. There is also the problem that the money has to bepaid back. If the borrowed money fails to increase tax revenues at current taxlevels 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 dayloan victim will testify, therein lies the road to penury.

The trick is not to gear your taxes to your policies, but to gear yourpolicies to your tax revenues. Tax levels are set at the top of the LafferCurve to maximise revenues. Political choices are then made about how to dividethe 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.