The Impossible Art of Taxation

Tax will always be a touchy subject for all politicians; it eventually comes down to trying to annoy the least amount of people when trying to fiddle with rates or tax credits. So it would surely come as a relief to have some economic theory backing you up when facing the pitchforks? Wouldn’t it?

The Laffer curve is arguably the most notorious when it comes to theories on taxation, not only due to the part it plays in supply-side economics but also its frustrating ambiguity. It describes the relationship between tax rates and the actual tax revenue raised for the government. Taking the shape of a parabola, as tax rates increase on the x-axis, the revenue gained also rises (y-axis) but after reaching a peak it actually falls back down. In other words, there should be an optimum rate where revenue is at its maximum and would fall if the rate of tax either fell or rose.

The first half seems obvious; it is intuitive that making people pay more tax will result in more money being given to the government.  But why would increasing tax also decrease revenue? Supporters would argue that past a certain point, people would be not incentivised to work at all so their personal tax contribution falls to zero. In addition, some workers (or companies) may attempt to avoid paying their share through legal or illegal methods. Theoretically, at a 100% tax rate, everybody would stop working, start trading chickens for iPhones (as all their money has been taken away) and possibly rise up in fury against their government.

This all sounds very sensible and it probably is. The only problem is that no developed country in modern history has ever been seen on the ‘right’ side of the curve where cutting taxes would increase revenue. During the Reagan administration in the 1980s, the Laffer curve was used as a justification for tax cuts; however, economists estimated that tax was in fact 10% lower than the optimum level. Predictions put the optimum rate at an average of around 34% but the actual rates only averaged 19%. Of course, what one economist says is probably completely the opposite of what another will say but the general consensus is that we are all on the left of the peak.

Another issue is that different tax rates are more or less acceptable at different times. During the Second World War the top rate of tax in the UK was over 92%. There was no uproar or massive unemployment (but that’s probably because all working age men were being shot at in other countries) as the general population understood the need for government revenue. War is expensive; guns, explosives and Spitfires can’t be magicked from nothing. So the British people were happy for the government to take their money as long as they kept the Nazis from goose-stepping into Dover.

Looking at a more recent example, the Panama scandal makes for interesting analysis. UK corporation tax has been falling since the 1980s from over 50% to the current 20%. Despite this, companies are still incentivised to ‘move’ their headquarters to tax havens such as Panama or Jersey. Does this mean that the tax rates are still too high? Probably not. Even if the UK dropped corporate tax to 10%, companies could still get away with 0% by moving to Panama and why wouldn’t they? If neoclassical rationalism was true, then every single company would do so if they profit from it.

A sample of Mossack Fonseca’s papers suggests that most of the money arriving in Panama seem to be from Russia and China. China has a rate of 25%, though companies which work with the government or in approved industries may benefit from a reduction of up to 10%. Russia shares the title of ‘Lowest Corporate Tax Rate in the G20’ with the UK and Turkey at 20%. This suggests that it isn’t the level of tax that incentivises avoidance, at least at current standard levels.

For some, the Laffer curve represents everything wrong with economics whereas to others, it represents something undeniable and rational. Who is right remains yet to be seen but as for now, all the numbers point to a struggle up the slope rather than a backpedalling effort to stop ourselves from sliding down the other side.

Contributed by Jeremy Chen, Editor-in-Chief

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