The costs of taxation and other Laffering matters

The Laffer curve is nothing new.  The philosopher Ibn Khaldun (1332-1406) wrote in his 1375 masterpiece al-Mugaddimah:

''At the beginning of the dynasty, taxation yields a large revenue from small assessments.  At the end of the dynasty, taxation yields a small revenue from large assessments.''

Adam Smith, JB Say and John Maynard Keynes have all written similar comments.

John F Kennedy famously said, ''It is a paradoxical truth that tax rates are too high today and tax revenues are too low and the soundest way to raise the revenues in the long run is to cut the rates now''.  Critics who dismiss the Laffer curve as being ''wrong'', or a joke, or discredited, or belonging to some fringe element of ''voodoo economics'', forget it has a long and distinguished ancestry.

This curve plots the hypothetical relationship between tax revenue and tax rates.  When tax rates are zero, no revenue is raised, but when tax rates are 100 per cent, no revenue is raised either (because nobody will work for nothing).  In between those two extremes there are two tax rates associated with every level of tax revenue -- a high tax rate and a low tax rate.  At some point there is a tax rate that maximises tax revenue.  For those economies on the ''wrong side'' of the Laffer curve a decrease in tax rates will lead to an increase in tax revenue, while an increase in tax rates will lead to a decrease in tax revenue.

Textbook writers are usually hostile to the Laffer curve.  Many make the argument that tax revenue fell in the US after the 1982 tax reform.  But the US was in recession at that time.  Tax revenues could be expected to fall.

Over the decade of the 1980s, however, a very different picture emerges.  Despite a huge decline in marginal tax rates, the tax revenue from the top 1 per cent of taxpayers increased by 51 per cent after inflation.  Tax revenue for the bottom 50 per cent of taxpayers fell by 9 per cent after inflation.  In other words, a decrease in the top marginal tax rates had a progressive impact on tax revenue.

The US budget deficits under Reagan, and subsequently Bush II and Obama, were due to increased expenditure.  Any government that expands expenditure relative to revenue will always experience a deficit, irrespective of the tax rates.

So we know that cutting tax rates in the US increased revenue in the 1980s.  But increased tax rates increased revenues in the 1990s.  What about tax revenues closer to home?  The Howard government cut capital gains tax rates (for individuals) in the early 2000s and saw revenue increase.  So the Laffer effect works if and when tax rates are on the wrong side of the Laffer curve.

The more interesting question though is whether government should maximise the revenue that it could earn from taxation?  Clearly some people suggest ''yes''.  The more money government has the more it can spend on the apparent good things in life.

Yet that view overlooks the fact that raising tax revenue is a costly process.  Over and above the actual cost of running the tax system (quite small in comparison to the amount of revenue raised) there are opportunity costs associated with taxation.  Economists call these ''deadweight costs''.

The Henry Review estimated that the personal income tax had a cost of 24 cents in the dollar.  The corporate income tax costs 40 cents in the dollar.  Payroll tax has a massive 41 cents in the dollar.  Economists argue that deadweight costs are a function of the square of the marginal tax rate.

So the challenge facing government is how to raise the revenue needed to finance necessary government expenditure at the least cost, while still being equitable.  The most efficient tax is the very regressive poll tax.

The point being that even if the economy is on the ''correct'' side of the Laffer curve, government should always be looking to lower the tax burden, not on equity grounds, but because the costs of taxation are often high compared to the revenue being raised.

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