• Tax rates are currently under scrutiny
  • Rates of taxation should be fair, not cut too low nor cast too high
  • Retrospective action should be against loose legislation, not legitimate practice

The “Laffer Curve” is a theory developed in 1974 by the “supply-side” economist Arthur Laffer. It sought to demonstrate the relationship between rates of taxation and the overall amount of tax revenue that governments would collect.

The curve is used to illustrate Laffer’s main premise that the more an activity such as production is taxed, the less of it, i.e. tax revenue is generated.

The now famous story is that whilst dining at the “Two Continents” restaurant in Washington DC in December 1974 Arthur Laffer, an economist at the University of Chicago, famed for its belief in monetary economics pioneered by Milton Friedman, convinced the future, Vice President Dick Cheney and Secretary of Defence Donald H. Rumsfeld, who were then mere aides to President Ford, that raising tax rates would simply serve to reduce tax revenue by hampering growth.


Source: Arthur Laffer and US Global Investors

The Laffer Curve, shown above illustrates that when taxes rise above 50%, individuals and corporations judge the tax rate as provided a disincentive to economic activity. Hence labour and commercial action is withdrawn, and tax revenue begins to decline…or at least simply level off.

Of course, in the mid 1970’s the US and indeed the world was in a totally different place as in the US the top marginal income tax rate was 70%. (The same rate as applied in the UK at the time).

The mode of economic thinking then was, in a free enterprise economy market forces would widen income inequality at early stages of growth, however, further economic development would ultimately lead it to narrow as a growing middle class began to enjoy an increasing share of national earned income. Developed economies would also see the wages of the working class rise as the economy advanced along the “value-added” chain as the more basic job functions and processes would migrate to developing nations.

Indeed, one of the main concerns in the 1970’s was how the developed world raise its levels of industrial productivity as the threat of cheap imports from Asia was beginning to emerge?

Discouraged workers or tax havens?

For many economists, Laffer’s key argument that high taxes would, at a specific tax level discourage effort and reduce growth made intuitive sense. After all, what incentive was there to work an extra hour if the government had set a penal tax rate that meant that took 50% or more of one’s marginal income?

The centre-right then, just as now, pointed out that imposing a tax regime on high income earners to pay for welfare or back to work programmes would slow growth down, in part by reducing the incentive of the entrepreneur or high earner to work harder. In fact, it was argued that the very wealthy would simply become tax exiles and the required tax revenue would have to be found by squeezing the middle classes. This has happened time and time again.

Did the theory work?

This is always a moot point as politicians of all hues will try and seize any economic metric that will bolster their argument.

In the US following the election of Ronald Regan in 1980 there was a move to engineer a lower tax rate structure and in 1986, during his second term the US dropped the top income tax rate from 50% to 28% and the corporate tax rate from 46% to 34%. GDP growth on an annualised basis simply rotated between 4.7% and 2.5%. In short, GDP growth did not accelerate.

Moving forward 43 years since Laffer first drew his curve and we see that in the US the top 1% of the population takes home over 20% of the nation’s income. That is over double their share in 1974. At the same time the current top marginal tax rate stands at 39.6% is a little over half what it was then.

This plays into questions of income distribution and what are the right methods of stimulating an economy that appears to have become addicted to near zero bound interest rates.

Second Chart

Source: Tax Policy Centre

I will not reach back as far as 1867 and the publication of “Das Kapital” by Karl Marx, why should I when we can go back to 2013 for the work by Thomas Piketty “Capital in the Twenty-First Century”.

Piketty argues against lower taxes on the rich as he contends that the rate of return on capital (r) is greater than the rate of economic growth (g) over the long term, the result is concentration of wealth. This unequal distribution of wealth will create social and economic instability.

Piketty proposed a global system of progressive wealth taxes to help reduce inequality and avoid most of the wealth coming under the control of a tiny minority.

I must disagree with Dr Piketty regarding the notion of a wealth tax.

I propose that the lowest paid workers should be freed from any tax burden. Also, I want the middle classes to be given a fair tax rate of no more than 40% at the margin or perhaps a flat tax of 28% until one reaches a very high income at five time the national average. Once into the realm of higher income that can be scaled at 35% and then 45% at the margin as their top rate.

Most certainly whilst I support a low rate of corporation tax I would absolutely say that any income earned by a company on sales where it makes the final sale should be paid in that geographic domain. They should pay a fair and appropriate tax share in that country. I reject all corporate tax schemes that park all earning back to a low rate tax region.

However, surely, we must draw a line on wealth taxation.

Say an individual works hard and they pay income tax on their earnings. If from their post-tax or net disposable income they save and invest sensibly and accumulate a gain in that income surely taxing their “wealth” which they accumulated from post-tax income is no less than double taxation…i.e. it is theft. It stifles any incentive to be thrifty and prudent.

Of course, any civilized state looks after the most vulnerable, however, we will not lift the majority up by pushing the talented and creative down.

No retrospective action

Looking at a set of industrialized countries from the 1970s until the years preceding the financial crisis, data shows that tax reductions did not encourage a great swathe of corporate investment that would have benefited the entire economy. There are far too many cases of top executives rigging the system that fed their own pay packet whilst not expanding overall GDP growth.

Therefore, what needs to be tackled is corporate governance and the economic agent problem not hammering hard workers that have played fair and saved or invested wisely.

So, whilst companies should pay a fair and appropriate level of tax I cannot support the European Union (EU) in retrospectively chasing Amazon over a sweetheart tax deal they struck with Luxembourg.

Last time the EU hammered Apple for Euro 13 Billion and would no doubt look to penalise Amazon to a similar degree. However, did Apple or Amazon do anything illegal? No they did not.  Surely the fault lies with the Luxembourg authorities and the EU itself. After all, Luxembourg has been a member since 1958 and is the heart of the EU.

A tax base needs to be sufficient to pay for the key services we expect from the state, however, it should be excessive. I support the Trump idea of a tax holiday to bring back Dollars parked offshore, but I cannot ever condone tax evasion. That is totally different from legal tax avoidance. If politicians do not like loopholes,  fix them and accept the fault is found with the legislators that allowed such a gap in the law to exist in the first place.

Read more articles on fundamental and macroeconomic analysis