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

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