The Laffer Illusion

An interesting discussion about the Laffer Curve on Radio 4 this morning ((June 27th). If you don't know the Laffer Curve, it relates to a theory that the amount of total tax collected by the government will vary according to the tax rates. It is based on the idea that, if the tax rate is zero no tax will be collected (obviously), and if it is 100% no tax will also be collected because nobody will do any work (also obviously). Between the two extremes, as tax rates rise, more TOTAL tax will be raised, but then the tax revenue will reach a maximum (the top of the curve) and will then start to fall, even though tax rates are still rising. This is because, when higher rates of tax are charged, people will increasingly have an incentive to find ways of evading or avoiding tax. In pure economic terms, therefore, it is futile for a government to continually raise tax rates in the hope of collecting more tax. This was the centre of the discussion when the highest rate of income tax in the UK was reduced from 50% to 45%. Osborne claimed he would raise more total tax. We shall see. Laffer is undoubtedly accurate in essence, but it ignores a number of considerations. First, it underestimates greed. There are many people who would try to get out of paying tax whatever the tax rate. Second, and similarly, it is naive to think that by reducing the highest rates of tax people will abandon their tax avoidance or evasion schemes. Think about it. A person earning, say, £500,000 per annum reduces their tax bill to, say, £100,000 through one of these schemes. Such a person should be paying close to £250,000. If we reduce the top rate to 40%, as result of which the well paid individual abandons his or her scheme and starts to pay tax, they will be paying something like £180,000. They will, therefore, be £80,000 worse off after tax. The Laffer theory therefore won't work. People are greedy. Third, it implies that we should reward people who illegally evade or legally avoid tax. We are saying, if you give up your illegal or antisocial tax schemes, we will give you money; we will give you a tax incentive. This is like approaching a burglar and offering him or her, say, £50,000 to stop burgling houses. This may make very good ECONOMIC sense in terms of reducing our insurance, policing, law enforcement and prison bills (not to mention eliminating the distress caused by burglaries), but it is rewarding criminal behaviour. Incidentally, as burglars have a criminal state of mind, they may well take the money and still commit burglaries (the same as wealthy tax avoiders getting the tax break but still using the illegal or immoral schemes). Finally it ignores the possibility that we might, with sufficient intelligence, determination and clever law making, be able to change the dynamics of Laffer by successfully hunting down tax evaders and closing down tax avoidance schemes. Then, raising the tax rates WOULD result in substantial increases in total tax revenue.