Reclaiming the Laffer curve from the propagandists

The Laffer curve explains why increases in the rate of income tax do not always generate more revenue for the government.

Consider the income tax system:

1. The government is free to set the rate of income tax anywhere between 0% and 100%
2. If the government chooses to set the rate at 0%, it will generate no revenue. 0% of anything is nothing
3. If the government chooses to set the rate at 100%, it will also generate no revenue. If an individual does not profit from working then there is no incentive to work at all. If no-one works then revenue from income tax will be nothing
4. In the real world, governments set the rate of income tax somewhere between 0% and 100%, and they do generate revenue
5. We can conclude, therefore, that there must be one (or more) rate(s) of income tax that will generate the maximum income tax revenue.

This is a great example of a thought experiment in economics. However, it is also an example of why economics is not a science, or at least why most economists (and almost all politicians) do not appear to be scientists.

What is missing from this description of the income tax system is a very obvious question. What is the optimum rate of tax which will generate the largest amount of revenue?

It seems to me that there are four possible answers to this:

1. A specific number. For example, perhaps 42% is the optimum tax rate. We’d need to be clear whether this rate included or excluded related taxes such as National Insurance, but this would be a really useful answer. The government could set the tax rate to this optimum rate and then watch the revenue flow in
2. Two or more specific numbers. For example, perhaps 32% and 52% both generate the same maximum amount of revenue. The government could then choose between these two rates depending on its political beliefs
3. It depends. Perhaps there is no universal optimal tax rate and the optimum depends on circumstances. For example, maybe culture is an important factor; maybe the optimum varies depending on the wider state of the economy; maybe it depends on political and religious beliefs; maybe it depends on age; maybe it depends on the government's spending plans. If this is the case, a scientist would want to explore this further before drawing any conclusions. Without further research, the government would have no clear cut method for using the Laffer curve to set the optimal tax rate
4. We don’t know. Although the Laffer curve is an interesting and useful thought experiment, there is no practical way of knowing the optimal rate in all circumstances.

This defines the dividing line between science and politics. Scientists would ask this very obvious additional question and demand an answer. Politicians would be happy to use the thought experiment to generate political propaganda. I’m not sure where economists sit in relation to this division.

Here is a typical diagram of the Laffer curve.

Laffer curve as political propaganda

This is an example of political propaganda. There is no scale indicating different taxation rates. There is an assumption that there is one peak taxation rate. There is another assumption that the current taxation rate is higher than the peak rate. This is propaganda for a politician who believes in tax cuts. The diagram could equally be drawn with the current tax rate to the left of the peak. With that minor tweak, the diagram would become propaganda for a politician who believes in tax increases.

The Laffer curve originated in the 1970s. At that time, income tax rates in many countries were above 90%. It’s not hard to imagine that this level of tax was a major disincentive. It’s almost certain that 90% is to the right of the optimum tax rate. However, that does not mean that we can conclude that any current tax rate is to the right of the optimum rate.

There are three key points arising from this argument.

Firstly, let’s assume that, when the governments in the 1970s set very high rates of tax, they were being self-interested, intelligent and rational. Mainstream economics assumes that all economic actors are self-interested, intelligent and rational, so that must include these governments. However, at best, these governments were only “intelligent and rational” from their own perspective.

If we increase the rate of tax then we will generate more revenue. Let’s increase the rate of tax as far as we can
An "intelligent and rational" government

The problem with this logic is that tax payers are also intelligent and rational, and many tax payers reacted to the higher rates by leaving the country, by closing their businesses, or by looking for loopholes in the tax laws.

Secondly, the Laffer curve is likely to apply to all exchanges in economics. The peak in the middle arises precisely because it is the most intelligent and rational compromise between the self-interest of the two actors involved. Not all exchanges take place at the peak, though, because it is in the self-interest of both parties for the exchange to take place away from the peak. If I can sell you a sandwich for £1,000 then that is a good deal for me but a bad deal for you. In that case, I have a better self-interest optimising strategy than you, but that doesn’t preclude the exchange from taking place if you are starving and I am a monopoly supplier, or if you are a fool.

Thirdly, economists need to decide where they sit in the science versus political propaganda divide.

In the meantime, non-economists should reclaim the Laffer curve from the political propagandists and challenge the economics profession to become scientists. The smartest people are the ones who ask the best questions, not the ones who think they have all the answers.