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Cocktail napkins
We’ve all done it.
Overcome by inspiration and without paper or a notebook, we resort to using whatever there is to hand. Cigarette packets, envelopes, hands….
Or, in the case of American economist Arthur Laffer, a cocktail napkin.
50 years ago, after dinner in a Washington restaurant with officials from President Gerald Ford’s administration, Mr Laffer sketched out his objections to proposed tax increases.
What did he doodle?
In his doodle, he drew a curve to illustrate how the level of tax set by governments can impact on the amount of revenue which it receives from taxpayers.
Specifically, across the X axis, we have the tax rate, and on the Y axis, we have the total tax revenues. Where tax rates were 0% and 100% then the tax revenues were plotted at nil. He then drew a free hand bell curve in the bit in the middle.
Now, regardless of public pronouncements, of course, there are few individuals who would describe themselves as willing to cough up more tax.
If taxation is high or punitive enough, people might not bother to work, restructure their affairs or follow the examples of David Bowie and Rod Stewart in the 1970s and become tax exiles.
It is these behavioural changes that are difficult to calculate.
Where is the Tax Sweet Spot?
Nevertheless, what Arthur Laffer was effectively arguing was that there exists what might be described as a ‘sweet spot’ at which the disincentive element is so reduced as to fuel economic growth and, therefore, result in a higher amount of taxes being collected by the authorities.
Of course, the obvious problem with the Laffer curve is that, other than at both extremes of the spectrum, no one knows where we are on the bell curve!
In other words, at any one time, are we to the right or left of the ‘sweet spot’?
Something borrowed
So, Laffer’s curve is, let’s face it, pretty short on answers.
It also wasn’t terribly original.
Indeed, the concept was first set down by the 14th-century Muslim scholar dubbed the ‘father of economics’, Ibn Khaldun.
He was, as you might say, six hundred years ahead of the ‘curve’.
He explained in a wide-ranging science book entitled ‘The Introduction’ – later seized upon by influential financial thinkers such as John Maynard Keynes – how the appeal of the model was somewhat limited.
Whilst high taxes act as a disincentive to growth, Khaldun noted, continued reductions mean that the novelty of the ‘sweet spot’ soon wears off and the tax incomes themselves start to drop.
In vogue?
So, whether one attributes the theory to Laffer’s napkin or Khaldun’s work in the 14th century, the principle keeps popping up like a bad penny.
Indeed, back in the Summer of 2019, Mr Laffer himself was presented with the Presidential Medal of Freedom by Donald Trump.
However, the US is not the only country interested by Laffer’s famous curve in recent times.
Indeed several of the recent Conservative Chancellors, and Boris Johnson, have all been bewitched with finding the sweet spot.
Osborne embraces his curves
One of the first modern Tory Chancellors to get himself ‘all in a Laffer’ was George Osborne (remember him?) Way back in March 2016 he said the following:
“Figures published this morning by HMRC contain, for the first time, the income tax data for 2013-14, which was when the 50p rate was reduced to 45p.
“The data reveal that in that year there was an £8 billion increase in revenues from additional-rate taxpayers, which completely defies the predictions made by the Labour party at the time”.
Of course, Osborne was talking about the reduction in the 50% tax rate to 45% in April 2013.
The total amount of tax collected from additional rate taxpayers rose from £38 billion (2012/13), to £46 billion (2013/14). This represented a rise of £8 billion despite the 5% reduction in tax rate. Empirical proof that Laffer’s principle was alive and kicking.
Not so fast.
The problem with this conclusion that it did not take account of behavioural changes such as:
- Where possible, payments of income were accelerated to take account of the rise to 50% – meaning the receipts for 2012/13 were artificially low; and
- Where possible, payments of income were also deferred until 2013/14 and the reduced 45% – meaning that 2013/14 receipts were artificially high
Not accounting for behavioural changes is one of the problems of assessing how much revenue new measures might raise. It is an area constantly overlooked time and time again.
Hey ho.
Sajid Javid – the low tax guy
On this side of the Atlantic, when he was Chancellor of the Exchequer, Sajid Javid (remember him?) possibly betrayed a twin love of fiscal policy and John Lennon’s solo hits in declaring that “I’m a low-tax guy”.
His stated desire to set taxes “at a rate where we are trying to maximise revenue” had the curious ring of the Laffer model.
Even the Mini-Budget 2022 chaos evokes Laffer
Perhaps, the mini-Budget 2022 omnishambles, which was the beginning of the end of Truss’ short premiership, will be remembered for a lot more than its references to Laffer.
If you recall, Truss and Kwarteng were proposing removing the 45% rate of tax completely. In the relevant Mini-Budget Bumf (now seemingly called “Fact-sheets”) we were told the following:
“Despite the reduction in the additional rate from 50% to 45% in April 2013, the share of total Income Tax liabilities accounted for by the top 1% of taxpayers by income rose from 25.1% (£39bn of £157bn total) in 2012-13 to 28.3% (£71bn of £251bn total) in 2022-23.
This has echoes of George Osborne’s comments in 2016, and set out above and certainly evokes our man Laffer.
However, like Osborne, this “fact sheet” simply parrots the justification and therefore repeats the error by not taking into account any distortion in the figures due to behavioural changes.
Hunt’s channel’s Laffer in 2024
This brings us up to modern budget events (you’ll be pleased to hear.)
Not to be outdone by his predecessors, in his 2024 Budget speech, Jeremy Hunt said:
Perhaps for the first time in history both the Treasury and the OBR have discovered their inner Laffer Curve…
… So today I am going to reduce the higher rate of property Capital Gains Tax from 28% to 24%.
The new Laffer induced rate of 24% applies to disposals of residential properties in the UK by higher rate taxpayers only.
But where is the evidence that 24% represents the CGT sweet spot on property sales by higher rate taxpaying landlords?
Is it a sweet spot that does not apply to other assets?
Who knows?
Conclusion
So, Laffer’s fanboys and girls still study that cocktail stained napkin desperately trying to find that ‘sweet spot’.
Many have tried, few have seemingly succeeded – with the unknown quantity generally being the behavioural consequences of those affected by the new policy.
I’m sure that there will be more than myself who imagine that anyone inclined to bet a country’s entire economic fortunes on a half century old, cocktail-fuelled doodle must be having a Laffer.
If you have any comments or queries on this article then please get in touch.
