A thousand little Laffer Curves

February 13, 2008 10:15 AM

Peter Franklin argues against the dynamic case for tax cuts, suggesting that if there is a Laffer Curve we are on the wrong side of it to get increased revenue when we cut taxes.


What needs to be remembered about the Laffer Curve is that it is an abstraction of a much more complex relationship between taxes and revenues.  It captures an essential truth that tax rises will not always increase revenue, and tax cuts will not always lead to a decrease.  However, it necessarily omits two crucial factors: time and the specific tax that is to be cut or raised.


Economic gains from tax cuts will often be felt over the medium to long term.  The European Central Bank studied the effects of growth in the state and found that a growth of 1 per cent in the size of the state led to a 0.13 per cent fall in economic growth.  Other studies have found effects at a similar order of magnitude.  That fall in economic growth won't mean a lot in the first year but over time becomes very significant.  Brown's spending splurge since 2000 may have left Britain's GDP almost £14 billion lower.


Different taxes will have different effects on the economy.  There is an ongoing debate over the kind of tax cuts most conducive to higher growth.  However, the conventional view is that the effects on growth will be at their largest when they affect incentives to work and invest in the United Kingdom.  Alistair Darling is retreating from taxing non-domiciles because it was expected that tax rise wouldn't increase revenue - even immediately.  A dynamic model (PDF) produced for the TaxPayers' Alliance by the Centre for Economics and Business Research suggested that pre-announced, phased cuts in corporation tax to the Irish level over 14 years would boost investment by 60 per cent and GDP by 9 per cent - and pay for itself within eight years.


The evidence that tax cuts and controlling spending will have a very positive effect on growth is quite well established.  Gains from increased growth quite quickly weaken and then overwhelm the effects on revenue of a tax cut.  Combine that with an easing of the burden on hard pressed taxpayers and the case for restraining growth in spending in order to cut taxes and unleash the dynamic potential of a low tax economy is incredibly strong.

Peter Franklin argues against the dynamic case for tax cuts, suggesting that if there is a Laffer Curve we are on the wrong side of it to get increased revenue when we cut taxes.


What needs to be remembered about the Laffer Curve is that it is an abstraction of a much more complex relationship between taxes and revenues.  It captures an essential truth that tax rises will not always increase revenue, and tax cuts will not always lead to a decrease.  However, it necessarily omits two crucial factors: time and the specific tax that is to be cut or raised.


Economic gains from tax cuts will often be felt over the medium to long term.  The European Central Bank studied the effects of growth in the state and found that a growth of 1 per cent in the size of the state led to a 0.13 per cent fall in economic growth.  Other studies have found effects at a similar order of magnitude.  That fall in economic growth won't mean a lot in the first year but over time becomes very significant.  Brown's spending splurge since 2000 may have left Britain's GDP almost £14 billion lower.


Different taxes will have different effects on the economy.  There is an ongoing debate over the kind of tax cuts most conducive to higher growth.  However, the conventional view is that the effects on growth will be at their largest when they affect incentives to work and invest in the United Kingdom.  Alistair Darling is retreating from taxing non-domiciles because it was expected that tax rise wouldn't increase revenue - even immediately.  A dynamic model (PDF) produced for the TaxPayers' Alliance by the Centre for Economics and Business Research suggested that pre-announced, phased cuts in corporation tax to the Irish level over 14 years would boost investment by 60 per cent and GDP by 9 per cent - and pay for itself within eight years.


The evidence that tax cuts and controlling spending will have a very positive effect on growth is quite well established.  Gains from increased growth quite quickly weaken and then overwhelm the effects on revenue of a tax cut.  Combine that with an easing of the burden on hard pressed taxpayers and the case for restraining growth in spending in order to cut taxes and unleash the dynamic potential of a low tax economy is incredibly strong.

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