Why the Laffer curve should not be laffed at

Civitas, 28 March 2011

Last week saw George Osborne announce his second budget. Some applauded it as being pro-growth and supportive of the private sector. This assessment is debateable, and in the important area of tax there were few significant decisions taken, other than the reduction of corporation tax by 2% with a proposal to reduce it eventually to 23%. Tax is a contentious issue, however some figures published by the Harvard Economist Greg Mankiw indicate that the chancellor could go a good deal further in simplifying the British tax system and reducing tax rates.

Britain is by no means a high tax country, if one examines tax revenues as a percentage of GDP. For instance according to the Index of Economic Freedom published by the Heritage Foundation Britain’s tax revenues as a percentage of GDP were 39% (as of 2010). This is compared to:

28.2% for the US.

46.1% for France.

40.6% for Germany.

33.4% for Canada.

In comparison to the country figures given above the UK has a median level of taxation, and this was before the recent announcement to reduce corporation taxes. However, Mankiw argues that these figures may be misleading as they suggest that tax can be increased as a percentage of GDP to generate a greater tax take. It is not difficult however to understand that tax levels cannot be increased indefinitely before increases become harmful by reducing economic activity and tax revenues. The relationship between government revenue raised by taxation and rates of taxation is represented by the Laffer curve. Although computing empirical Laffer curves for countries is a difficult and contentious process (it could be argued that one cannot indisputably work out a country’s optimal rate of taxation), Laffer’s insight remains valid and policy makers must be mindful and aware that tax rates may be increased with little extra revenue generated.

The question for the Chancellor is: to what extent is the UK near or at the point where increases in taxation may be counterproductive? Mankiw’s figures may suggest that the UK is at this point already. Mankiw rather than examining taxes as percentage of GDP examines taxes per person. His results are interesting (tax as a percentage of GDP):

UK – $13,714 (39%)

US – $13,097 (28.2%)

France – $15,556 (46.1%)

Germany – $13,893 (40.6%)

Canada – $12,789 (33.4%)

It is pertinent to note that the US with tax as a percentage of GDP of 28.2% has similar taxes per person as the UK with tax as a percentage of GDP of 39%. The UK is clearly not achieving a significantly larger tax take with far greater tax rates. Although I do not wish to suggest that the figures given above are definitive evidence that the UK has reached, or even passed, the peak of its Laffer curve, the figures are food for thought for the Government that needs to properly look into reducing and simplifying taxes, to encourage a private-sector-led recovery. The reduction in corporation taxes is welcome, but hardly revolutionary. Furthermore, the raft of tax incentives and tax breaks given in the budget only add to the complexity of the system, which could benefit more from simplification and a general reduction in rates.

Tax reductions are often viewed as politically unpalatable during periods of repressed economic growth and public spending reductions, however should this really stand in the way of a serious examination of tax rates? It may be unrealistic to expect popularity to be a subordinate value in politics, but it is time that the British Government considered the possible deleterious effect of our level of taxation, never mind the complexity of the system, which only adds to its costs.