Does a lower tax rate produce a higher tax take?
The debate over optimum tax rates goes back centuries, mixing principles and pragmatism: where should rates be set to maximise revenues? As Donald Trump plans a sweeping set of tax cuts, Gavin O’Toole explores the evidence, and examines its use – and misuse – in public policymaking
Much of the west is experiencing a fiscal perfect storm – making heavy weather for the ship of state. Ever since the financial crisis, many people in the developed world have seen their real incomes steadily declining, whilst austerity policies and fast-rising demand for public services reduce access to key public sector functions such as healthcare, education and social care. Meanwhile, though, a tiny slice of the population is – very publicly – making more money than ever, creating an ever-growing gap between the struggling majority and a gilded elite.
The result – in countries such as the USA, UK, Greece and Spain – has been a process of radicalisation amongst the supporters of many mainstream left-of-centre parties. When people are asked how we can properly fund public services, often the cry goes up: “Tax the rich!” Business leaders are increasingly portrayed as leeches, sucking their workers dry then spiriting their profits into overseas tax havens; and left-leaning politicians fund their manifesto pledges by proposing hikes in business rates and higher rates of income tax.
Given that the very rich often pay a lower proportion of their income in tax than the working poor, this call has a natural justice to it. But right-leaning politicians have a brutally pragmatic response. The very rich can afford the advisers and lifestyles required to avoid tax, they respond, whilst heavily taxing businesses reduces growth and drives down the total tax take: to increase public revenues, they argue, it’s best to tax businesses and the rich as lightly as possible.
Whilst arguments over natural justice appeal to the heart, the libertarian right’s pitch to the head is persuasive; unless we act in ways calculated to maximise tax revenues, then aren’t we building our policies on prejudice rather than hard evidence? But recently those calling for governments to hike taxes on high earners and businesses have found an unusual ally: in its latest half-yearly Fiscal Monitor, the International Monetary Fund explicitly rejected the argument that forcing the top 1% of earners to pay more tax would hit growth in the advanced economies.
A longstanding debate
The IMF’s intervention has prompted condemnation and support in equal measures from the two ends of the political spectrum. In the US, President Trump’s budget director Mick Mulvaney attacked the IMF, in which the US is the largest shareholder. And in the UK, the Labour Party – which has proposed new 45–50% tax bands for high earners – cited the IMF report as justification for its call for higher taxes on the rich.
The IMF cannot have been surprised by these very polarised reactions – for its report dropped into an animated debate that goes back at least as far as 1377AD, when the Arab historian Ibn Khaldun wrote about the relationship between the levels of tax and of revenue in his universal history Muqaddimah.
Khaldun noted that at the beginning of each dynasty, tax rates tended to be low yet generated ample revenue for the kingdom’s needs; whereas in later years, when dynasties had grown in size, they often raised taxation rates in attempts to compensate for falling revenues.
In the modern world, the advocates of light taxation argue that high levels of taxation disincentivise business investment; pull financial activity from the private into the public sector, where spending generates less economic growth; encourage tax avoidance by wealthy individuals and businesses; and prompt businesses to shift their operations to low-taxation jurisdictions. And this side of the debate has long dominated thinking on the libertarian right; it is, unsurprisingly, one that finds a receptive audience amongst the wealthy individuals and major corporates commonly found amongst the funders of right-wing parties.
The Laffer curve
Underpinning this perspective is the ‘Laffer curve’. Created by US economist Arthur Laffer, this suggests that, as taxes rise from low levels, revenue also increases; but that at a certain point, high taxes act as a brake on economic activity and the tax take begins to fall. While Laffer mainly had income tax in mind, the premise can apply to every type of tax, including corporation tax.
Academic research has found some evidence for Laffer’s theory. A recent study of OECD countries found strong statistical evidence of a Laffer curve in international corporate tax data, arguing that the revenue-maximising corporate tax rate was about 34% in the late 1980s but has – largely thanks to the growing mobility of business activity and ever more sophisticated tax avoidance methods – since declined to about 26%.
Other papers have suggested that real-world tax rates actually sit below the revenue-maximising point. But the right have tended to use the Laffer curve as an argument for lower taxes: the concept famously underpinned ‘Reaganomics’, which in 1981 produced one of the largest tax cuts on the USA’s history.
The American experience
Under Ronald Reagan’s 1981-89 presidency, the top tax rate fell from 70% to 31%. And economic growth was strong, apparently supporting the idea that low tax rates stimulate the economy: per-capita GDP grew by 23.4% to $35,097, at an average annual rate of 3.05%.
However, Reagan’s landmark 1981 tax cuts reforms on average shrank tax revenue by about $111bn annually – nearly 3% of GDP – during the first four years. By 1989, federal government revenue had fallen from 19% to 18.4% of GDP. And his final budget, set for the 1990 fiscal year, showed that by 1988 the ‘81 tax cuts had led to a cumulative revenue loss of $264bn. The US government budget deficit grew from $74bn in 1980 to $221bn in 1990. And had it not been for a set of social security payment increases put in place by Reagan’s predecessor, Jimmy Carter, and subsequent tax rises by Reagan, the government’s finances would have ended up in an even worse place.
Moreover, during this period economic growth was also given a boost by a sharp reduction in interest rates by the Federal Reserve, an economic rebound from the recession of 1981-82, and the Reagan administration’s high level of defence spending.
In 2005, the US Congressional Budget Office estimated the impact of a 10% reduction in all income tax rates on overall future growth – concluding that only 28% of the revenue lost as a result of tax cuts would be recouped over 10 years, resulting in rapid growth in the budget deficit. So whilst Laffer’s curve may hold true, its deployment as an argument for tax cuts in 1980s America appears to have been – as president George HW Bush later said – “voodoo economics”.
The British experience
A parallel debate has been underway in the UK, where falling tax revenues have placed public services under huge pressure – making it all the more crucial that tax revenues are maximised.
In Britain, income taxes are crucial to the budget – in 2016-17 they were the largest source of government revenue, alongside National Insurance and VAT – and in 2009, the Institute for Fiscal Studies asked whether government proposals to increase income tax rates for people on incomes of £100,000 or more would generate more revenue to help meet public sector borrowing targets. It concluded that individuals on high incomes would respond to attempts to extract more tax by reducing their taxable income, and that a proposed income tax rate of 45% on incomes above £150,000 would reduce, rather than raise, revenue.
Just as controversial are corporation tax rates, which governments have been cutting since 2008 in a bid to attract investors. Champions of low taxes point to a surge in UK corporation tax receipts to a record high in the 2016-17 financial year, despite the main rate falling from 30% in 2008 to 19% today. Yet it’s not necessarily true that this growth in receipts is a result of falling rates: a 2013 paper by HM Treasury estimated that only 45-60% of the cost of cutting corporation tax is be recouped in the long term through increased growth and consequent higher tax revenues from profits, wages and consumption.
Britain’s corporation tax rate cuts reflect a global ‘arms race’, as countries compete to attract business investors with ever-lower tax rates. The rate of corporation tax has fallen in both advanced and developing economies by an average of 20% since 1980; and whilst revenues have increased over that period in the advanced economies, in developing economies they have remained steady. Analysts now warn that this price competition may end up impoverishing even the winners, as lower tax rates drive down revenues even whilst new businesses are attracted to their territory.
The IMF’s position
So where does the IMF stand on this debate? Interestingly, its Fiscal Monitor doesn’t argue for higher tax rates on the wealthy in order to drive up short-term tax revenues; instead, it builds its case around the need to reduce the economic harm caused by ever-growing levels of inequality.
Progressive forms of taxation – which impose a bigger burden on the rich, reducing inequality – are key to redistributing wealth from the wealthy to the poor, says the IMF; but the body points out that marginal tax rates for top income earners are falling in many countries. The progressivity of income tax declined steeply in the 1980s and 1990s, with the average top income tax rate for OECD member countries falling from 62% in 1981 to 35% in 2015. In an allusion to Laffer’s curve, the IMF insists that some advanced economies can now increase progressivity – by raising taxes on top earners – without hampering growth.
What’s more, the IMF argues that growing income inequality in the advanced economies has fuelled a backlash against globalisation; its suggestion is that the resulting social polarisation and political changes – Brexit being the obvious example – ultimately weaken economic growth. And if, as the IMF believes, excessive inequality is bad for economic growth, then raising the tax burden on the rich makes sense to the head as well as the heart.
Of course, all this will cut little ice with US president Trump, who is attempting to introduce a set of major tax cuts that – analysts say – will both favour the very rich, and further deepen the US federal budget deficit. Trump won many votes from people who were angry to see their incomes falling whilst the rich grew rapidly richer. Those same people are now watching the president introduce tax changes that accelerate income inequality; and the IMF’s research suggests that this growing inequality will, over time, weaken America’s growth. Yet these days, the relationship between politics and economics is a strange and distorted one; often, the people who attract the support of angry voters are not those who have a solution to their problems, but those who best channel their anger.
About Gavin O’Toole
Gavin O’Toole is a freelance writer and editor in London. He has written for leading newspapers, magazines, wire services and business schools about financial markets, business and regulation around the world. He has a particular interest in international relations, and a specialism in Latin American affairs. He has conducted research on this region’s political economy and has also published a number of books about its politics and natural environment. His latest title, Environmental Security in Latin America, will be published by Routledge in September 2017.
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