Home > Economics - General > Sinclair Davidson rediscovers the Laffer hypothesis

Sinclair Davidson rediscovers the Laffer hypothesis

June 10th, 2004

In today’s Fin (subscription required), Sinclair Davidson, author of a recent Centre for Independent Studies monograph on income tax, restates the hypothesis[1] , most famously associated with Arthur Laffer, that governments could reduce revenue by raising tax rates. He claims that his own calculations have revealed that revenue would be maximized with a marginal tax rate of 35 per cent.

Does the CIS endorse this claim? I don’t recall seeing it in the monograph. But the article refers to Davidson as the author of the CIS monograph, and this piece is associated with a broader campaign by the CIS on this issue, which has included a number of policy monographs and opinion pieces, including a recent attack on me by Peter Saunders. In the absence of some specific disclaimer, I think it’s reasonable to take this piece as part of the CIS campaign[2].

I commented previously that the Davidson monograph represented an alarming lapse in quality control on the part of the CIS, but I’m now coming to think that the problem may be more systemic.

fn1. It is common to refer to the Laffer curve, but the idea behind the curve is obvious, and had been observed by many writers before Laffer. Laffer’s justified claim to fame is the assertion that the US in the early 1980s was on the declining section of the curve. This was one of the arguments supporting the Reagan tax cut. Of course, revenue fell after the Reagan tax cut and Reagan partially reversed it.

fn2. Of course the CIS doesn’t have an official set of policy positions. But it seems reasonable to speak of a CIS viewpoint and to regard Davidson as being representative of that viewpoint as regards tax policy.

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  1. Harry Clarke
    June 10th, 2004 at 09:58 | #1

    John, I agree there is no evidence to back up this claim — and the estimated marginal tax rate sounds low. I also read Sinclair’s study and I also can’t find any support for it there.

    But to state the boringly obvious the claim is not necessarily wrong. If increased taxes cut work effort sufficiently they do reduce revenues, the standard result being that increased taxes reduce tax revenues if the wage elasticity of labour supply is greater than one so the supply of labour is very wage elastic.

    So you are saying is that, for most people on about average incomes the supply of labour is not that sensitive to the after-tax wage. This sounds reasonable to me and certainly true for high income earners whose demand for leisure rises when wages increase.

  2. Uncle Milton
    June 10th, 2004 at 10:25 | #2

    John,

    do you really think it is wise for you to picking on Sinclair Davidson likes this? While you are of course right and he is wrong on the substantive, you are a very distinguished economist and he, to put it charitably, has not achieved anything like your level of distinction.

    It looks to me like the strong picking on the weak. I am reminded of the time, so the story has it, that my namesake Milton Friedman chastised one of his distinguished Chicago colleagues for ripping apart at a seminar a bad paper given by a second rate (at best) economist. Friedman’s point was that those in the first tier need not and should not stomp all over those of lesser ability. I think he’s right.

    It would be better if, on economic matters, you fought only in your weight division.

  3. Tom N.
    June 10th, 2004 at 13:19 | #3

    WHAT A SWEATHEART LIKE Q IS DOING IN A DUMP LIKE CIS

    I disagree with Milt on this one. If Sinclair is going to write a CIS manuscript and publish articles on economic matters in the quality press, he is well and truly fair game for economists – even good ones! Personally, as a economist with not nearly as many academic stripes on my shoulder as Q, I am very glad to have had Q take the time to scrutinise some of my arguments. It has caused me to adjust my position in some cases (horizontal equity in education), has sharpenned others (speed), and – where Q’s counterpoints have been less than convincing – has reaffirmed to me the veracity of my original position in yet others (parental subsidies). :)

  4. Ken Parish
    June 10th, 2004 at 13:46 | #4

    Milton,

    JQ can speak for himself, but I for one strongly disagree with you. Whatever Sinclair Davidson’s perceived prestige level among economists may be, he seems to be part of a co-ordinated push by CIS to shift public opinion and the general political climate in favour of substantially lowering tax rates (in preference to maintaining and improving government provision of public goods). Most members of the public have no way of distinguishing between eminent economists and “those of lesser ability”. Public policy advocacy isn’t judged by an expert tribunal, nor is it refereed under Queensbury rules.

    The spectacular success of right-wing advocacy “thinktanks” like the HR Nicholls Society in shifting the Australian political landscape in favour of massive labour market deregulation, downsizing, outsourcing and casualisation provides an object lesson in what can happen when right wing zealots are ignored and treated with the contempt they undoubtedly deserve. Some of those labour market reforms were on balance desirable IMO, but quite a few of them continue to have disastrous social consequences for which we’ll be paying the price for generations.

    JQ is correct to engage publicly with this CIS-sponsored nonsense. I for one value the way JQ takes the time to explain in clear, accessible layman’s language detailed economic arguments that contradict the prevailing neoliberal policy orthodoxy. As a non-economist, I lack the background knowledge to analyse and debunk them coherently, even though my gut level intuition tells me that many of the zealots’ arguments are fundamentally flawed. Surely much of the point of “public intellectualism” in general and blogging in particular is to make complex areas of expertise accessible to a generally-educated lay audience, and to make available alternative viewpoints and information that differ from the mainstream media and political party orthodoxy. Economists may be well aware that Sinclair Davidson is an intellectual lightweight, but blogs are not predominantly aimed at an audience of economists.

  5. Uncle Milton
    June 10th, 2004 at 13:49 | #5

    Tom, criticism offered with the aim of improving the product, even harshly delivered, is one thing. Pissing on someone from a great height, for sport, is something else.

    John Quiggin taking on Sinclair Davidson is like Matthew Hayden taking on a park bowler and hitting him all over the ground. It’s just not cricket.

  6. gordon
    June 10th, 2004 at 13:49 | #6

    Relevant stuff, since I saw the egregious Allan Jones on a TV morning show this AM arguing for tax reductions.

    I agree it is a campaign, with Labor on side with tax cuts for the rich and (I seem to remember) a fairly strong campaign by the Business Council (?) before the Budget.

    Frankly, I no longer take much of an interest in the so-called economic arguments – Laffer curves, inefficiencies, “dead weight” and such. These all seem to me now to be just stalking-horses for the real objective of weakening governments, ie. the prior and fundamental objective IMHO is small government, not tax reduction. Tax reduction is just a means to that end.

    The benefits of small government will accrue to the usual suspects, and will be attained through less regulation, both administrative (via agencies of executive govt.) and legal (through the courts).

  7. Uncle Milton
    June 10th, 2004 at 14:26 | #7

    Ken,

    I welcome JQ’s contribution to the tax debate. I just don’t see that there is anything to be gained by heaping ridicule on another economist who is not even close to being in his league.

    That doesn’t mean that public policy advocacy has to be conducted accorded to the Queensberry rules. The CIS has a whole stable of eminent conservative economists who are affiliated with it and if JQ wants to declare open season on them, that is fine with me. But not poor old Sinclair Davidson. (And, yes, I know he started it with his letter to the AFR.)

  8. John Quiggin
    June 10th, 2004 at 14:26 | #8

    It’s been pointed out to me that there’s some danger here of going beyond the bounds of civilised debate, though I don’t think the suggestion that I should have said nothing can be sustained.

    Davidson attacked my work in the CIS monograph. I don’t think it would have been appropriate for me to say, on the basis of my higher academic status, that I wasn’t going to respond to criticism by a fellow-academic. Davidson would be more entitled to take offence at such a stance than at the critical comments I have made.

    However, I’m going to try to avoid any more comments that might be seen as directed at Davidson personally while continuing to respond to the CIS campaign.

    In this context, I’ll restate that the primary interest in my post is not whether Davidson supports the Laffer hypothesis but whether the CIS either endorses it or thinks that it deserves public debate. If they want debate on the topic, I’ll be glad to oblige.

  9. Jack Strocchi
    June 10th, 2004 at 16:15 | #9

    Davidson attacked Pr Q personally, and can’t complain if he gets as good as he gives.
    As it happened, Pr Q’s attack was on the intellectual competence of the CIS, not just Davidson.
    The Laffer curve hypothesis, that tax cuts would pay for themselves with higher growth in tax revenues, was refuted by the appearance of chronic deficits in the US after the Reagan tax cuts in 1981.
    Only after three tax increases from the mid-eighties to the early nineties, and the reduction in unproductive defence expenditure in the mid-nineties, did the US begin to grow fast enough to return tax-revenue surpluses in the late nineties.
    Davidsons application of the Laffer curve to Australia faces the immediate problem that our growth rates were higher when our tax rates were higher, during the 1941-73 post-war period.
    These periods were generally characterised by structurally balanced budgets.
    In order to sustain the argument that lower tax rates would increase the supply and quality of labour and capital, he must argue that these factors are underutilised at the moment.
    Davidson must further argue that these factors have supply curves that will be elasticly responsive to higher prices/lower tax rates.
    Given the increase in working hours by high marginal tax-rate persons in the past generation, this appears unlikely in relation to labour.
    Given that we have access to cheap global credit markets and are borrowing like crazy, this appears implausible in relation to capital.
    In fact the high tax rates have encouraged capital investment through negative gearing.
    As far as I can see, Davidsons argument implicitly relies on a theory that Australian high income earners will flock here, or not leave for the US/UK, or high income earners from the US/UK will flock here, in response to a lowering of high marginal tax rates.
    It is not clear that there is any evidence for this. Many Australian expats invested in real estate in Australia after the CGT was halved.

  10. Jason Soon
    June 10th, 2004 at 16:39 | #10

    “In this context, I’ll restate that the primary interest in my post is not whether Davidson supports the Laffer hypothesis but whether the CIS either endorses it or thinks that it deserves public debate.”

    Personally I don’t know the full story and my co-blogger Andrew Norton probably has more inside knowledge – probably they think it deserves public debate but unless this Laffer argument is explicitly in the monograph then it would be fair and plausible to say they don’t endorse it. Scores of people have written for CIS monographs and then gone on to write other things, including me. Far as I know Sinclair doesn’t hold a permanent position with the CIS. If Sinclair’s endorsement of this theory is meant to imply CIS endorsement just because he’s written a monograph for the CIS … well, I’ve written monographs for the CIS too – does that mean the CIS endorses my calling Howard an ‘arselicker of Bush’, my endorsing Labor at the next election, or come to think of it. Andrew’s endorsement of gay marriage (given that Andrew actually has a permanent position with the CIS?) No.

  11. John Quiggin
    June 10th, 2004 at 16:49 | #11

    Jason, I agree with the points you make. OTOH, the link is a lot closer than in your example – this is part of a string of recent publications on the same topic by Davidson and Peter Saunders, most of which are endorsed by the CIS.

    In any case, the appropriate way to resolve this is to debate the substantive issue and see what people affiliated with the CIS have to say about it.

  12. June 10th, 2004 at 19:15 | #12

    I’ve checked on the origins of this morning’s Sinclair Davidson AFR article, which was commissioned by the AFR, and not offered to them by the CIS. Does it then represent the views of the AFR? Or RMIT? Or just Sinclair?

    CIS work routinely contains the disclaimer ‘views expressed are those of the authors and do not necessarily reflect the views of the Centre’s staff, advisors, directors or officers.’ While anything substantial I write for the CIS goes through a refereeing and editorial process, in the end I take personal responsibility for it if there are errors, bad arguments etc. The disclaimer protects both publisher and author, since I and other authors would be overly constrained if we had to achieve agreement on points of substance, and not just that something was worth putting out for debate.

    Even though I am on the CIS staff, the CIS does not endorse or even know about all I write unless they choose to read it after publication. What I post on Catallaxy I do entirely on my own behalf, without consulting the CIS.

    On the more substantive issues, while I think just about everyone associated with the CIS supports lower tax, they don’t necessarily support every argument for it. I’m not going to sign up to calculations Sinclair himself describes as ‘back-of-the-envelope’. I need to look more carefully at the issue before supporting or rejecting his stance. My own lower-tax views come much more from beliefs about the appropriate role of the state in society. Work incentives etc are at most a sub-set of a much bigger argument.

  13. John Quiggin
    June 10th, 2004 at 19:27 | #13

    “I’ve checked on the origins of this morning’s Sinclair Davidson AFR article, which was commissioned by the AFR, and not offered to them by the CIS. Does it then represent the views of the AFR? Or RMIT? Or just Sinclair?”

    In these circumstances, I would say “just Sinclair”. My previous experience of these issues has been that think tanks have lobbied the AFR for space to respond (directly or indirectly) to things I’ve written. For example, my last column was on the Murray and Alan Moran had a piece shortly afterwards which didn’t directly take issue with me, but pushed the IPA line that over-allocation is not a problem. When I read Davidson’s piece I thought it likely (though not certain) that the same sort of process had taken place.

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