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Keynes and the Laffer Curve

December 17th, 2010 Posted in Uncategorized by

Supply-side economics, summed-up neatly by the Laffer Curve, seems to annoy many self-styled progressives. To be fair, there is something of the air of having one’s cake and eating it about the idea that one can cut tax rates and thus raise more tax revenue. But one cannot help but feel that the detractors of supply-side factors are simply struggling to overcome their desire to punish rich people for being so successful.

Anyway, the logic is irrefutable: at some point the effect of raising tax rates must diminish rather than increase tax revenue, if only because at 100%, taxes would eliminate all wealth creation utterly. But don’t take my word for it. Just ask the 20th Century’s most influential economist:

…to create wealth will increase the national income and that a large proportion of any increase in the national income will accrue to an Exchequer, amongst whose largest outgoings is the payment of incomes to those who are unemployed and whose receipts are a proportion of the incomes of those who are occupied…

Nor should the argument seem strange that taxation may be so high as to defeat its object, and that, given sufficient time to gather the fruits, a reduction of taxation will run a better chance than an increase of balancing the budget. For to take the opposite view today is to resemble a manufacturer who, running at a loss, decides to raise his price, and when his declining sales increase the loss, wrapping himself in the rectitude of plain arithmetic, decides that prudence requires him to raise the price still more—and who, when at last his account is balanced with nought on both sides, is still found righteously declaring that it would have been the act of a gambler to reduce the price when you were already making a loss.

"I understood the Laffer-curve before Laffer was born!"

"I understood the Laffer-curve before Laffer was born!"

 

8 Responses to “Keynes and the Laffer Curve”

  1. Stephen MacLean Says:

    These are wonderful quotes on the substance of the Laffer curve, and serve to hoist progressive followers of Keynes upon their own petard, as it were.

    How does the rest of Keynes’s The Means to Prosperity stand up to classical liberal economic theory?


  2. Chris H Says:

    Ok, so 100% tax stops you working 100%, but what about the diminishing improvement in lifestyle with extra cash. For example; going for 5k a year JSA to a job of 18K is a massive change in lifestyle. Whereas going from 100K to 113K will make no difference at all, from the point of view of how happy you are anyway.


  3. Richard Laming Says:

    “Anyway, the logic is irrefutable: at some point the effect of raising tax rates must diminish rather than increase tax revenue, if only because at 100%, taxes would eliminate all wealth creation utterly.”

    In which case, if a reduction in tax rates always leads to an increase in tax revenue, a reduction to zero taxation should deliver tax revenue of infinite size.


  4. Tom Papworth Says:

    Richard,

    That is one of the most fascile comments I’ve ever read!

    Obviously, 0% tax rates also yield zero tax. That’s why it’s a curve. The $64 billion dollar question is at what point revenues are maximised.

    That being said, maximising revenue may not be the only consideration. The two other things one might want to maximise (at the expense of maximising revenue) are welfare or growth.

    Chris,

    While it may be true that each additional pound earned has a diminishing return, it does not follow that redistributive taxes (which is I guess what you are thinking about, inspired by Wilkinson and Pickett) are advisable. While it might in the short term move pounds to where they have a greater marginal effect, it would destroy the incentives that lead individuals to create more wealth, which in the long run will raise the incomes of everybody.

    Whether this would improve their happiness is a moot point: happiness is remarkably sticky over time, with no notable improvement in reported happiness despite changes that one might assume would make people happier, such as increased life expectancy, reduced infant mortality and death in childbirth, etc.

    Personally, I don’t think (pace David Cameron) that we should focus on making people happy. I think we should focus on freeing people to find their own path to happiness.


  5. Tom Papworth Says:

    Stephen,

    The rest of Keynes’s The Means to Prosperity stands up very badly! It’s basically a treatise arguing that governments should borrow to fund public expenditure programmes to counter the recession. The value of this has been disproved in numerous economic studies since 1933. But more shockingly, the evidence on which Keynes bases the theory is shockingly flimsey: he conjours the ‘multiplier’ (£1 of government expenditure yields £2 of growth) out of thin air with absolutely no sign where it comes from – not even a footnote!

    He also at one point makes favourable noises about protectionism.

    As the quote above shows, Keynes does at least recognise that reducing taxes can increase revenues, but he (and many of the Supply Siders of the 1980s and since) believe that it is therefore justifiable to borrow to finance the tax cuts. My view is that one should aim to balance the budget while at the same time reducing taxation, thus creating a more dynamic and vibrant economy that grows quickly, raising the welfare of everybody.


  6. Tim Worstall Says:

    The thing I like most about this quote is that Art Laffer himself uses it to point out the obvious truth (and non-originality) of the Laffer Curve.

    http://www.heritage.org/research/reports/2004/06/the-laffer-curve-past-present-and-future


  7. Tom Papworth Says:

    Okay. I’ll admit it. I came across the quote in the Heritage Foundation report.

    My efforts to look like somebody who spontaneously reads Keynes is in tatters.


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