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     Mar 28, 2012

The Laffer Curve key
By Martin Hutchinson

Younger readers probably don't remember this, but before 1980 much of the world was subjected to extraordinarily high marginal tax rates - 91% in the United States before 1964, 98% in Britain from 1974-79 (and 135% in 1968). The Laffer Curve, which states that tax revenues are zero at marginal tax rates of 0% and 100% and peak somewhere in the middle, reportedly sketched on a cocktail napkin by Arthur Laffer in 1974, was thus an enormous intellectual breakthrough, even if in retrospect it appears blindingly obvious.

However, in the nearly 40 years since then, there has never been agreement on the Laffer Curve's most important parameter: the tax rate at which revenue is maximized.

The Laffer Curve is so intuitively obvious that even the left has been forced to acknowledge it. Their defenses against its policy implications have come in two forms: either suggesting that the


peak revenue is reached only at very high tax rates, or like Barack Obama in his 2008 presidential campaign or French socialist presidential candidate Francois Hollande recently, suggesting that the moral imperative of high tax rates on the rich is such that taxes should in some circumstances be raised even if government revenue is thereby reduced.

Hollande's proposed 75% income tax clearly comes into this category. Conversely, Obama's initial proposal of an increase in the capital gains tax rate from 15% to 20% probably doesn't. The high US and British tax rates before 1980 were unquestionably of this type.

In British Chancellor of the Exchequer's George Osborne's budget speech of March 21, he suggested that the 50% top income tax rate on incomes over 150,000 pounds (US$240,000) introduced by the Labour government in 2009 was similarly counter-productive.

Certainly the decline in UK self-employed tax payments in January, for the 2010-11 tax year, strongly suggested that for the self-employed, at least, the 50% tax rate was counterproductive - although it may still have yielded net revenue from those with salary income, notoriously more difficult to hide (legally or illegally) from the taxman.

All this assumes the Laffer Curve is a smooth curve rising to a single well-defined peak and then declining. This is intuitively attractive, but there is no reason for this simplicity to hold in all cases, since a multitude of factors affect both taxpayer behavior and economic outputs.

For example, the very high tax rates from the 1930s to the 1970s may have suppressed top management remuneration, since boards of directors were not able to get useful additional effort out of managers by paying them extra cash. Pharaonic perquisites would frequently avoid tax, but it was much more difficult to tie them effectively to performance. Hence management played a lot of golf, and economic output maybe suffered. In the real world, boards of directors' incentives are not very closely aligned with shareholder reward, and management's own incentives are different again.

There are a number of factors on which the Laffer Curve peak might conceivably depend:

One is the efficiency of tax collection. In a very inefficient system, such as Russia, high marginal rates of tax are completely ineffective, because the costs of tax evasion are relatively small, and consist mostly of paying off the right officials. Tax collection becomes an instrument of state control: Those with good political connections negotiate a favorable tax deal, whereas those who have alienated the authorities (such as Mikhail Khodorkovsky) find the tax code used to impose draconian criminal penalties.

In such a system, the 13% flat tax introduced by Russia in 2001 produced a huge increase in revenues, indicating that the Laffer Curve optimum tax rate there was not much above 13% and may even have been below it.

At the opposite extreme, Britain in the 1950s and 1960s, a land of extraordinarily high compliance with legal demands (at least among the richer sections of the population) probably had a Laffer Curve optimum at a higher marginal tax rate than other societies. While the top tax rate reduction from 98% to 60% in 1979 increased revenue, as Laffer would suggest, the further 1988 reduction to 40% may have reduced it.

That suggests that in law-abiding un-entrepreneurial Britain, at least short-term tax yields were maximized at a marginal rate above 50%. The apparently different experience in 2009-12 with a 50% top marginal rate doubtless reflects the changes in Britain as much as anything else; the society is more heterogeneous, and the social forces reinforcing legal compliance are much weaker.

Another factor affecting the Laffer Curve peak is the type of tax. Capital gains tax yields are typically maximized at considerably lower marginal rates than income tax yields, because the alternative of simply not selling the investment concerned is always available. The 1978 US move from a 49% capital tax rate to 28% increased the tax's yield, and there is evidence that the 1997 tax rate reduction from 20% to 15% at least did not reduce the tax yield much.

Similarly, inheritance tax rates of 40-50% are far too high to maximize revenue, since the tax is relatively easy for the ultra-rich to avoid. Given the damage this tax does to family-owned small businesses, it's likely that revenue would be maximized by a rate below 20%.

There are in fact two points of Laffer Curve tax yield optimization: the short-term optimum, at which the tax yield in any given year is optimized; and the long-term optimum at which the yield is maximized on the basis of discounting to infinity the yield from the tax, taking into account the economic effect of levying it and the effect on other tax revenues of its economic disincentives.

For minor taxes, the two optima are close together. Extensive efforts by British chancellors of the Exchequer to find Laffer Curve maximizing tax rates for alcohol, tobacco and petrol duties appear to have produced general agreement on the best levels. These optimum levels are relatively higher (for tobacco and alcohol) than in the 18th century, when enforcement was poor and smuggling rife, but lower than in the 1960s, when lower population mobility and better law compliance limited the potential for illegal imports from continental Europe or elsewhere.

Value-added tax (VAT) in this respect is attractive to taxmen (as are consumption taxes in general), because the disincentive effect of higher rates is minor, and even the economic effects of high VAT rates are not too severe. Thus the Laffer Curve bends down only gradually.

In Mediterranean countries, notably Greece recently, it would appear that VAT levels above 20% lead to so large a "black economy" that the taxes' yields decline (Hungary's 27% VAT may also be too high to be effective, for example.) However in countries like Germany, Scandinavia and the United Kingdom, where tax compliance is high and tax enforcement effective, we may well not have seen the Laffer Curve optimum, which may occur only at VAT rates of 40-50%, higher than any yet experienced in practice.
Apart from Hungary's 27%, Sweden's 25% is the highest VAT rate in the European Union. In general, high VAT rates are more effective in large tax areas (because of the potential for smuggling) so the European Union is ideally set up for them. No doubt in the near future we will see the EU tax apparatus test the revenue limits of VAT with a 40-50% rate, at which point human knowledge will be advanced, at the expense of unfortunate European taxpayers.

For capital gains tax, income tax and estate tax, the short-term and long-term Laffer Curve optima are potentially further apart. Capital gains tax affects capital formation and investment, the engine room of the economy, so although compliance can be quite high and the taxes are fairly difficult to evade, the long-term Laffer Curve optimum is no more than 20%.

Rates higher than this adversely affect economic performance, even if they produce short-term revenue. In the UK, capital gains tax was increased in 2010 only to 28%, after a study concluded that an increase to 40%, as had originally been proposed, would lose revenue. In the longer term, even 28% may be too high.

For estate duties, the picture is quite clear. These taxes are easier to avoid than income tax, or even capital gains tax, so the short-term Laffer Curve optimum is at correspondingly lower rates, probably around 15-20%. It is difficult to assess the adverse economic effect of the taxes, because it occurs only on generational transfer, but as they form a one-off capital tax of 20% or more the adverse effect can certainly be severe, as is the difficulty for heirs in paying them.

In any case, since their yield is relatively modest, the optimum long-term Laffer Curve estate duty rate may well be zero, since with a zero estate tax rate the yield of other taxes is increased by the economic benefits from not destroying small businesses. Even in the short term, there can be no justification for estate duty rates above 20%.

For income tax, the position is between the two. The yield of income tax is high, so unlike estate duties a very low or zero rate is not warranted even in the long term (unless public spending itself is reduced to Calvin Coolidge-era levels of the 1920s, which alas is unlikely). However, the disincentive effect is severe when a 50% all-in rate (including state and local taxes) is passed, so even the short-term yield optimum in the United States is almost certainly at an all-in rate no higher than 45-49%.

Given the differences in state income tax rates, the Laffer Curve optimum federal income tax rate will be higher in New Hampshire, where there is no state income tax, than in California or New Jersey, where the marginal rate of state income tax approaches 10%. Overall, it's likely that the Bill Clinton-era top federal income tax rate of 39.6% (minus the Medicare supplement to appear in 2013) is about the short-term optimum for the nation as a whole, with high-tax states suffering economically as their overall tax rate is higher than the optimum.

However, the long-term Laffer Curve optimum is considerably lower than this, probably around the 28% top rate of the 1986 tax reform.

In this context, it should be noted that tax deductions that do not affect the marginal rate have little economic effect overall, but simply divert activity into their chosen area. It is thus well worth abolishing the home mortgage interest tax deduction and the charitable donation tax deduction, and reducing marginal tax rates correspondingly. The state and local tax deduction, however, affects marginal tax rates as well as receipts, and hence is less obviously due for the chop.

Laffer Curve theory thus has clear recommendations as to the form a US tax reform should take. Capital gains tax rates should be no higher than 20% and estate tax rates no higher than 15-20%, though there is a case for abolishing the tax altogether. Marginal income tax rates should be no higher than 25-28%, and deductions should mostly be eliminated.

If that produces insufficient revenue to feed the state Leviathan, then a VAT can be introduced, with a rate of no more than 10% (making federal and state VAT/sales taxes no higher than 20%). Less fashionably, modest tariffs, at a rate no higher than 10% that does not greatly distort trade, are also a possibility.

At all costs, the left should avoid imposing punitive income tax rates, because they will sharply reduce tax compliance. Do that for long, and you will find that a Russian-style flat tax of 12-15% becomes the only effective way of raising revenue.

Martin Hutchinson is the author of Great Conservatives (Academica Press, 2005) - details can be found on the website www.greatconservatives.com - and co-author with Professor Kevin Dowd of Alchemists of Loss (Wiley, 2010). Both are now available on Amazon.com, Great Conservatives only in a Kindle edition, Alchemists of Loss in both Kindle and print editions. (Republished with permission from PrudentBear.com. Copyright 2005-12 David W Tice & Associates.)

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