The Laffer hypothesis in Australia

I didn’t have time to respond, but the IPA brought Arthur Laffer out to Australia a month or two ago. For those interested, over the fold is a relevant extract from Zombie Economics.

Of rather more concern is the evidence that both the Secretary of the Treasury, John Fraser, and his Deputy for Revenue, Rob Heferen are adherents of the Laffer hypothesis or something very close to it. Fraser gave evidence to the Senate endorsing the Reagan tax cuts (based on Laffer’s hypothesis), while Heferen has claimed that something like 50 per cent of the revenue lost through a company tax cut will be returned through dynamic effects.

Although no issues are ever truly resolved in economics, this informal survey published by Ezra Klein is revealing. Klein asked various people about the tax rate at which revenue would be maximized. His respondents fell into three groups: left/liberal economists, who mostly gave answers around 70 per cent, rightwing pundits with zero credibility who gave answers around 20 per cent, and serious right/centre-right economists, who declined to give a direct answer to the question.

This suggests to me that the debate over the Laffer hypothesis has been won fairly conclusively by the left, and that those on the right would prefer to frame the question in the more defensible (though still, in my opinion, incorrect) claim that we face a long-run trade-off between equality and growth.

Everyone knows the story of how Laffer drew a graph on a napkin, illustrating the point that tax rates of 100 per cent would result in a cessation of economic activity and therefore yield zero revenue. Since a tax rate of zero will also yield zero revenue, there must exist some rate of taxation that yields a maximum level of revenue. Increases in tax beyond that point will harm economic activity so much that they reduce revenue.

Wanniski christened this graph the ‘Laffer curve’, but as Laffer himself was happy to concede, there was nothing original about it. It can be traced back to the 14th century Arabic writer Ibn Khaldun. Laffer credited his own version to the nemesis of supply-side economics, John Maynard Keynes. And while few economists had made much of the point, that was mainly because it seemed too obvious to bother spelling out.

What was novel in Laffer’s presentation was what might be called the ‘Laffer hypothesis’, namely that the United States in the early 1980s was on the descending part of the curve, where higher tax rates produced less revenue.

Unfortunately, as the old saying has it, Laffer’s analysis contained a mixture of correctness and originality. The Laffer curve was correct but unoriginal. The Laffer hypothesis was original but incorrect.

For the Laffer hypothesis to be supported, tax cuts would have to increase revenue more rapidly than would be expected as a result of inflation and normal income growth. In fact, as Richard Kogan of the Center on Budget and Policy Priorities reported, income tax receipts grew noticeably more slowly than usual in the 1980s, after the large cuts in individual and corporate income tax rates in 1981.

To the extent that there was an economic response to the Reagan tax cuts, and to those of George W. Bush twenty years later, it seems largely to have been a Keynesian demand-side response, to be expected when governments provide households with additional net income in the context of a depressed economy

34 thoughts on “The Laffer hypothesis in Australia

  1. @TerjeP

    “do you dispute the notion that the private sector will cease to produce if they are taxed at a rate of 100%? Or is your point merely that it isn’t a smooth ride between 0% and 100%?”

    Terje, your question is too vague. If it is of assistance to you, one concept of ‘perfect competition’ is characterised by “zero profits” (in equilibrium). Zero profits does not entail ‘no production’. In this world of ‘competition’, any positive profit which would be taxed at 100% would still not entail no production. (References: older econ textbooks)

  2. EG – no it is not of assistance to me. Anybody that has spent any time in the real world knows that we don’t have “perfect competition” and that the world of commerce is not characterised by “zero profits”. If it was then I suspect we would quickly have zero investment but given it’s a hypothetical I’m not too worried about that unfortunate prospect.

    For what it’s worth in a world of perfect people everything would be awsome. I hope this is of assistance to you.

  3. It would be quite possible for example to reduce taxes for the lower income-earning 80% of the population and increase taxes for the higher income-earning 20% of the population. This could be done in a revenue neutral manner. The economic evidence is that this would increase total activity in the economy over current settings. One might even think you would be in favour of tax cuts for 80% of the population.

    I agree with cutting taxes for the bottom 80% of people. It’s a no brainer in my book. The tax free threshold should be increased to at least $40000.

    I don’t see any virtue in raising the tax rate for the top 20%. But they should be free to pay more tax than they have to if they feel so inclined.

  4. @TerjeP

    You forgot your original question (which I considered to be too vague) to which I replied by means of trying to elicit what it is on which the 100% tax rate is supposed to be applied.

    Now you tell me there exist people who do not exist or people who lived some time in the past and now know that ‘perfect competition’ does not exist. But if these dead people would be alive now then at least some of them could tell you there is a large part of the ‘private sector’ who do ‘produce’ at zero profits. Indeed the most private part of the ‘private sector’, the family, produces a lot at zero profit for own consumption.

    I still don’t know what it is to which the 100% tax rate is supposedly applied. I give up.

  5. <blockquoteIndeed the most private part of the ‘private sector’, the family, produces a lot at zero profit for own consumption.

    When I cooked dinner for the family this evening it was not for zero profit.

  6. Terje,

    I intentionally did not cover the 100% end of the argument as you suddenly introduced the notion of a “private sector” something which is not a feature of the Laffer Curve definition, even though it might be assumed. Can there be a private sector when the re is 100% taxation? On the surface of it there appears to be a contradiction.

    Where there is a working economy and 100% taxation there would have to be taxation and subsequent redistribution. It would largely depend on how that redistribution occurred.

    The fact is that very large private corporations, where all invoicing and cash flow (100% taxation) is managed through a head office, work in this exact manner. Large businesses have departments that process product without any funds changing hands locally at all. Materials are ordered, received, processed, packaged and dispatched without any funds changing hands locally, or within that state, and in the most extreme within that country.

    My business actually operated a function in entirely that manner. We warehoused, processed, and dispatched product for a NZ business. The invoicing was done from NZ and all proceeds were directed straight to NZ. We performed our part of the operation enthusiastically for our post distributed share of the turnover.

    So, no, your argument does not hold up at all, neither does the Laffer hypothesis. As I said above the outcomes of taxation are entirely governed by the specific circumstances.

  7. @TerjeP

    I agree with cutting taxes for the bottom 80% of people. It’s a no brainer in my book. The tax free threshold should be increased to at least $40000.

    I don’t see any virtue in raising the tax rate for the top 20%.

    As so often, you get it half-right while totally missing the point.

    You may like the idea of living in Galt’s Gulch, but I prefer to live in a society. Societies cost money to run, so they need to collect taxes. Where better than from the wealthy, who have benefited the most from living in a society?

  8. Has a 100% marginal income tax rate ever been seriously proposed in the world? Like for example anyone earning over (a really big number) say $10M p/a in $today’s will be taxed at 100% for every dollar earned over that threshold in an attempt to cap income levels for the very rich? I realise it’s probably not practically possible, but was curious to hear if it’s even been seriously considered.

  9. @Troy Prideaux

    I considered it after I wrote the post @16. The clue is the term ‘bracket’. The convention is that [ ] denotes a closed set and ( ) denotes an open set. The so-called progressive tax system in Australia (and probably in most countries) looks like this: [ ], [ ], [ ], [ . Ah, there is a bracket missing! What if we write [ ], [ ], [ ], [ ], and [ )? No cap on income is specified. But whatever is in the last bracket is taxed at 100%. I suspect a lot of people would like to have many more tax brackets than what we have now (approximating a continuous function).

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