Sunday, 29 August 2010

Could the Laffer curve slash the deficit through lower taxes?

LibDem Chief Secretary Danny Alexander doesn't think a government which makes deficit reduction its number one priority can hope to have a lower level of tax in 2015 than it inherited in 2010.

Iain Martin of the WSJ, while joining the economists of the centre-left in noting that the answer to deficits is economic growth, wants to introduce Alexander to the Laffer Curve, whereby taxes could be reduced and revenues increased.

Well, nobody wants to look a gift horse in the mouth. Have the Labour leadership contenders all missed a trick here too? Could, say, Andy Burnham have said "my deficit reduction plan is scrap the 50p rate, knock 5p off the top rate, 5p off the basic rate - and then we'll have much less need for spending cuts" - AND got the applause of the political right. Sounds tempting, doesn't it?

Still, a Chief Secretary may need to perhaps ask one or two questions first.

If you draw the Laffer Curve on the back of a napkin, then you know that revenue is zero with 0% tax and zero with 100% tax too. The important missing bit of information is where the peak is. Whether we're currently on the upwards or downwards slope would determine whether tax cuts will cost or gain revenue. (Ezra Klein of the Washington Post asked US economists of the left and the right about this recently - and it probably isn't a 19% flat rate that maximises revenue).

And the Laffer curve has some political history when it comes to deficits.

The Reagan government used it to argue that slashing taxes would increase revenues, notably in its massively tax-cutting 1981 bill. However, the 1981 Act in fact reduced government revenue by around 3% of US GDP over the next four years.

So Reagan began with national debt at 32.5% of GDP in 1981 and left it at 53.1% of GDP in 1989. (Graph, via Scott Willeke, using Congressional Budget Office data)

Reagan's Budget director David Stockman said of the Laffer curve:

[T]he whole California gang had taken [the Laffer curve] literally (and primitively). The way they talked, they seemed to expect that once the supply-side tax cut was in effect, additional revenue would start to fall, manna-like, from the heavens. Since January, I had been explaining that there is no literal Laffer curve."

Iain Martin says that Art Laffer is coming to London this Autumn. It is a reminder that one of the great political arguments of the next few years should take place within the right - between fiscal conservatives and those like the Taxpayers' Alliance who argue an "oppose all tax increases" philosophy.

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