Following on from last week’s “Cut Taxes To Boost Economy and Reduce Inflation” post, I thought it might be worth re-visiting one of those economic theories that gets applied a little too broadly: the idea that decreasing tax rates can raise tax revenue. Which is the principle behind the Laffer Curve.

The Laffer Curve For Beginners

The Laffer curve is based on the assumption that all governments want to maximise the tax revenue that they collect. Given that – what tax rate should they impose? Does it always logically follow that the higher the tax rate, the more revenue you collect?

This was a question that plagued Mr Laffer, who began to engage in some hypothetical scenarios (for the benefit of Mr Reagan, who would eventually follow this conclusion into radical tax cuts):

  1. If the tax rate is set at 0%, then there will be zero tax collected. That makes sense – you can’t collect tax if there is no tax to collect.
  2. If we go to the other extreme, and set the tax rate at 100%, then you will be asking your people to work for benefits (ie. communism). And that’s not really good for incentives – because if you were working only for benefits, and everyone else gets the benefit regardless of how much work they do, then you might fairly assume that no one would work, and thus, no taxes would be available to be collected.
  3. Therefore, we have boundaries: tax rates of 0% and 100% will likely result in no tax revenue.
  4. As you step from 0% to 1%, you’re going to start earning tax revenue. And people will be generally quite willing to continue working and pay that 1% – it’s not a huge imposition.
  5. At 2%, it’s still not unreasonable. And the higher tax rate will mean higher revenue – because most people would prefer to comply rather than not.
  6. On the other end, if you drop the tax rate from 100% to 90% – you’re going to get a bit of revenue. That is: there is some incentive to work a bit harder than the next guy, because you’ll get your standard benefits, plus a bit extra. So in this case, lowering the tax rate will increase the amount of revenue collected.
  7. So Mr Laffer drew a graph:



At least, that’s the rough approximation of what it looks like in economics textbooks – as though, somehow, the optimal rate is somewhere in the 50% region.

The green line is my general suspicion of what it actually looks like in practice:


My reason for that: the higher the tax rate, the greater the incentive that exists to evade it. And if you take into account the cost, risk and effort of tax evasion, I think you’ll find that people will rapidly become willing to bear that cost as soon as it becomes economically cheaper to evade tax. Which means that there’s an earlier maximisation of revenue collection than Mr Laffer’s curve predicts.

And I think that the skewing of the Laffer Curve is something that gets worse as you try to take advantage of it. If you lower a tax rate to try and capture more tax revenue, you reset people’s expectations of what tax they’re willing to pay – because the minute there’s talk of a tax increase, people just threaten to go underground on you. Even though, 10 years ago, they were paying the same amount that you’re asking them to pay today.

Republicans VS Democrats

That opinion aside, when you hear the Republicans arguing for lower tax rates (or tax breaks), they’re still of the opinion that America’s tax rate for high income earners sits somewhere to the right side of the peak (and therefore, lowering the rate will increase tax revenue because more people will become compliant). The Democrats, when they argue for closing tax loopholes, are effectively saying that the current tax regime places America on the left-hand side (so increasing the tax rate will increase tax revenue collection).

Hauser’s Law

Going back to something I mentioned last week, after Mr Laffer drew his curve, successive American presidents have used it to argue in favour of lowering tax rates. So the USA is really the best empirical example of what happens when the Laffer Curve is applied in practice.

Unfortunately, this graph:

Back in 1993, William Hauser (an investment analyst) pointed out that for all the Laffer theory application, tax collection as a percentage of GDP has not really moved off the 20% mark of GDP mark since the 1950s.

And what this seems to suggest is that the populus will pay in tax what it will pay in tax. The tax law can change – but if it gets too draconian, people will find ways around it. And when it becomes less draconian, people will stop finding ways around it, and just pay what they’ve always paid.

Or the Laffer Curve should actually look like the orange line:


And if you think about it – it makes more intuitive sense than anything else. Because would people really stop working if a government imposed 100% tax?

Not at all. Private enterprise always tends to find a way. What’s more likely to happen:

  1. Everyone continues to work as they did before.
  2. But they only declare some of their income.
  3. The rest gets hidden, spent, or smuggled into a more reasonable tax jurisdiction.

And then, over and above that, I think that you’ll find the “tolerable” tax threshold (as a percentage of GDP) is largely driven by the corresponding “benefit” that is received by the taxpayer. So the Scandinavian countries, which provide a lot of social benefits for your tax buck, are able to pull in higher taxes. And other jurisdictions face a much more hostile tax base…

Just a thought.

Happy Monday.

Rolling Alpha posts about finance, economics, and sometimes stuff that is only quite loosely related. Follow me on Twitter @RollingAlpha, or like my page on Facebook at Or both.