Wednesday, November 28, 2012

The Laffer Curve is alive and well in the UK


The Laffer Curve (a stylized version of which is shown above) is a very simple statement about the relationship between tax rates and tax revenues. For example, the Laffer Curve says that tax rates that are too high can result in reduced revenues. The UK has just proved that this is true. A few years ago, the UK raised the top tax rate on those making more than £1 million to 50%. The result? Tax collections from millionaires fell by £7 billion. Many millionaires (perhaps as many as two thirds) left the country, while others figured out how to reduce their reported income.

Here are the facts:

In the 2009-10 tax year, more than 16,000 people declared an annual income of more than £1 million to HM Revenue and Customs.
This number fell to just 6,000 after Gordon Brown introduced the new 50p top rate of income tax shortly before the last general election.
George Osborne, the Chancellor, announced in the Budget earlier this year that the 50p top rate will be reduced to 45p from next April.
Since the announcement, the number of people declaring annual incomes of more than £1 million has risen to 10,000.
Last night, Harriet Baldwin, the Conservative MP who uncovered the latest figures, said: “Labour’s ideological tax hike led to a tax cull of millionaires."
Far from raising funds, it actually cost the UK £7 billion in lost tax revenue.

To further explain the Laffer Curve: We don't know the actual shape of the Laffer Curve (the red portion of the chart above), but we do know where three points on the curve lie: if tax rates are zero, tax revenues obviously will be zero (#1); if tax rates are 100%, tax revenues will also be zero, since no one will be willing to work (#2); and there is a tax rate "C" that maximizes revenue (#3), because it minimizes tax evasion, maximizes the incentives to work and invest, and strikes the most efficient balance between the size of the public and private sectors, thus boosting overall economic growth and increasing the tax base. Furthermore, we know that in the region "A" of the curve an increase in tax rates will lead to reduced revenue, while in region "B" an increase in tax rates will lead to increased revenue.

As Jean Baptiste Colbert once said, "The art of taxation consists in so plucking the goose as to get the most feathers with the least hissing.”

This is what the fiscal cliff negotiations now underway in Washington are all about: Will higher rates on the so-called "rich" produce increased tax revenues or not? The Democrats say they will, believing that we are in region B of the Laffer Curve, while the Republicans say they won't, believing that we are in region A.

As a supply sider, and in my experience, I think politicians too often underestimate the impact of taxes on people's incentives to work and invest. In fact, when the CBO projects the budget impact of proposed changes to tax rates, it explicitly ignores the dynamic effect of changes in tax rates, assuming that an increase in tax rates will always produce a proportionate increase in tax revenues. The UK has just proved that you can't always assume this will be true. Higher tax rates do reduce people's incentives to work harder, save, and invest, and that can lead to a weaker economy and a smaller tax base. Moreover, higher tax rates can lead to increased tax evasion, or to increased tax avoidance activities.

The UK's experience with raising taxes on the rich provides a timely lesson for our politicians in Washington. We would all be much better off if they avoided higher tax rates on the rich, and instead focused on simplifying the tax code (by eliminating or limiting deductions, loopholes and subsidies), reducing taxes on business wherever possible (consumers are the ones that ultimately pay the bulk of corporate taxes), and reducing spending, particularly on entitlement programs.

39 comments:

Bill said...

Take a look at the Powerline entry regarding incentives to work. If you make less than 70K, you're better off working less and collecting more government benefits so that you actually net more. We're screwed.

Duncan said...

Thanks for the insights. I have been looking too at the elasticty of labor supply particularly for the upper incomes. Studies show this around .25 to .50. So all else the same, a decrease in take home income becuase of a tax of say 10% would decrease overall labor by 2.5%-5.0%. This reaches a similar conclusion as your statements on the Laffer curve. Thanks

GraySailor said...

Just look at the loss of wealth in high tax states in the East like: NJ,MD,CT. You won't hear the politicians talking about it; but, the transfer of wealth is on the order of many billions of dollars. Where does it go? To lower tax states in the So. and W. Some, even finds it's way to the Virgin Islands. The property tax alone in NJ is twice what it is in MD. Put that in your pipe and smoke it.

Jake said...

In the U.S., for individuals earning more than $1 million (a lower threshold than the 1 million pounds), almost 50% of all income is in the form of capital gains and profits within partnerships / S corps.

Thus, a more likely explanation for the figures you sight than moving from the country.... UK stocks were up in 2010 (stocks doubling from their 2009 lows), down in 2011, and up this year.

Public Library said...
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Public Library said...

I firmly believe we should have a flat tax. However, I also believe it is time to stop spreading the fallacy that tax rates significantly impact incentives to work + invest = revenues. As you reported; they can/do change reporting behavior. Maybe this is why the GOP has trouble communicating their cause. It simply does not square up with most peoples experience.

Time for the GOP to reframe the argument in proper terms so we have a better shot and moving towards flat taxes.

Scott Grannis said...

There is no doubt that changes in tax rates change reporting behavior, and they also change behavior. I personally know several people who are going to be investing less in California in the wake of Prop 30, and I would be stunned if the number of upper income taxpayers and small businesses leaving the state does not increase. This is not a fallacy.

Jeff said...

Public said: "stop spreading the fallacy that tax rates significantly impact incentives to work + invest = revenues"

Are you smoking something? Everyone I know (1%-ers) are changing spending/investment patterns based on the expectation of going over the cliff. EVERY F-ING ONE.

Get a real-life education.

Benjamin said...

I would like to see the USA move to a ceiling on federal outlays at 15 percent of GDP (now over 20 percent) and to collect revenues primarily through a national sales tax, with extra taxes on recreational drugs (including alcohol and cigarettes), gasoline and some other items.

I believe we could hold outlays to 15 percent of GDP, and that could be done through elimination of the USDA, Commerce, Labor and HUD departments, and radical reductions in defense, VA and homeland security outlays.

We also will have to raise the retirement age to 68 or so.

And no public pensions for anyone under age 65. Period. In uniform, in dress shirts, in overalls.

The GOP will never agree to my proposals, nor the D-Party.

Good luck everybody.

Jeff said...

Except for the "radical" reductions in defense (one of the constitutionally enumerated powers of the Federal government) and the VA, I think you'd get a lot of agreement from Republicans.

Tom said...

Why can't we get CBO to use dynamic scoring? Is it because no one can agree on the shape of the curve?

mmanagedaccounts said...

I am mostly with you, Benji, but I would be cautious about the extent to which we cut national defense. Scott, you and your wife certainly enjoy Calafia Beach, but we'd love to have you down here in Florida and I know Texas would welcome you too.

Timothy Clontz said...

The Laffer Curve can be calculated, ironically, if you assume no change in investor or work behavior. I did so for capital gains rates on my own blog just a week ago:

http://market-mousetrap.blogspot.com/2012/11/11172012-how-to-really-soak-rich.html

As you can see, maximum revenue for capital gains is generated as 15% long term rates and 35% short term rates.

For income taxes this can also be done by taking each of the 50 states in the US with an equal starting point, giving the average tax rate for the entire study period, and totaling revenue growth during that study period.

In other words, the Laffer Curve may be unknown, but it is not unknowable. The 50 states give enough variety to generate a reasonably accurate optimization of the curve, if state and income taxes are totalled together to show total tax burden for someone living in the state.

Tim

Dr William J McKibbin said...

@Benjamin, I enjoyed your last post -- we need you in the Libertarian Party -- more at:

http://www.lp.org

I'm fine with going off the fiscal cliff by the way -- whatever it takes to balance the US budget -- the fiscal cliff is a very small down payment to that end -- what is truly needed is an immediate 40% cut in Federal spending -- from what accounts those spending cuts come, I could care less.

Gil Rodveltz said...

As you know Krugman & DeLong will disagree with The Laffer Curve message. Problem is it can be talked about by two-handed economists but not proven scientifically

Scott Grannis said...

Tom asked "Why can't we get CBO to use dynamic scoring?"

Many economists have been asking this question for many years, and no one has come up with a definitive answer. If I had to pick one reason, it would be that dynamic scoring involves making assumptions about how people would react to changes in tax rates, and assumptions about the economy's inner workings are usually colored by one's bias. Dems are biased to think that changes in rates don't influence behavior, Reps are biased to think they do. The CBO is supposed to be nonpartisan, so they try to avoid even the appearance of bias.

But of course, that ends up making the Dems happy, even though CBO forecasts have proven to be hugely wrong many times in the past.

Paul Puletti said...

Doc said "I'm fine with going off the fiscal cliff by the way"

Agreed. Many of us are. The problem is that we all know what will happen because we've seen this movie before. National Parks shut down for a few days. Government workers are sent home. Blah, blah, blah. Then they come up with a solution which ALWAYS includes back pay for all the government workers. Net effect is we put a hiccup in the economy while giving millions of government employees an extra paid vacation.

Public Library said...
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Public Library said...

Jeff,

Take the 99% for example. How many people will reduce their hours of work because of tax rate changes? Zero. Discussing the incentives of the bottom 5% is a complete waste of time so no need to go there. Now let’s look at the 1%.

I am part of the 1%, live in California, and will not be visiting my bosses office to let him know I would like to work less + earn less so I can join a lower tax bracket. On the contrary, I am continually looking for investment opportunities.

Tax rates impact tax reporting far more than they impact incentives to invest and work. Especially if you consider the effects on the % of total population. Which is the whole premise of my argument. However, you clearly need to smoke something or hop on the Xanax bandwagon.


Joseph Constable said...

Ok PL. You wouldn’t change your behavior. An in-law of mine renounced his citizenship and now has dual Austrian and Mexican citizenship. His tax home is Mexico. He and his wife spend a lot of time in the U.S. skiing and visiting us relatives with the fortune he saved in taxes when he isn’t travel to other places in the world checking his investments.

William said...

Joseph Constable said..."He and his wife spend a lot of time in the U.S. skiing and visiting us relatives with the fortune he saved in taxes..."

That is actually impossible. When a US citizen officially renounces his citizenship, he must first pay a 25% tax on his net worth and second he forfeits his US passport and may NEVER enter the US again for any reason - not a child's wedding and not even the funeral of a family member.

A former US citizen is prohibited from ever visiting the U S again.

Public Library said...

Like I said, consider the % of total US population. Everyone seems to know 'a guy' who intends to change states, countries, or spending patterns. In reality, this is mainly hearsay and but a fraction of the total population anyway.

Changing hours, jobs, states, countries is kind of like changing your bank, cable/internet provider, or cell phone company. Definitely possible, but such a pain in the a** that hardly anyone ever does.

I am pretty sure companies build this 'stickiness' into their forecasts...

Tom Nugent said...

To support Scott's analysis one can look at what happened to personal income tax revenues after the Kennedy, Reagan and Bush tax rate cuts. In each case revenue growth actually accelerated. Therefore the notion that a tax CUT for the rich as proposed by Mitt Romney would have to be paid for is a myth.

NormanB said...

We'll soon get another lesson in the Laffer Curve with California's passing of Prop 30. Here's what it is supposed to do (from the LA Times):

"Under Prop. 30, the sales tax would go up by a quarter-cent on the dollar for four years. The measure will also raise the income tax on people who earn more than $250,000 for seven years.

In total, that would generate an extra $6 billion annually for public schools. If there is any additional tax revenue, that could be used to fund other state programs.

The tax on the 'wealthy' is retroactive for 2012.

djakel said...

Tom said..."Why can't we get CBO to use dynamic scoring?"

Congress mandated that the CBO use static scoring. Only Congress can mandate a change. The Democrats have blocked even a dual comparison of "static" and "dynamic" scoring.

Republicans could have changed these rules as well as eliminate baseline budgeting rules in 2002 when they had complete control. They didn't. Both parties are spendaholics. That speaks volumes about why we are in a debt crisis.

Jeff said...

Public,

Of coarse those who dont pay taxes wont change their behavior. Duh!

If you don't either...fine. Bend over.

The rest of us will act rationally. We will actively search for ways to avoid confiscatory tax rates.

PS Read Scotts other post about low income folks having more net benefit with lower income rather than making more. That is rational behavior as well.

Jeff said...

BTW California is 24/7 Wall St.’s “Worst Run State” for the second year in a row

Public Library said...
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Public Library said...

Jeff, you are a socially challenged individual. That much we've discovered so far.

My argument is; framing the tax battle around the impact on incentives to work + invest does not stack up with the actual change in behavior of 99.75% of the US population. Then it is not a surprise Romney lost and lost big. His entire platform was based on lowering ‘marginal’ taxes for everyone because it will…let me guess…increase peoples incentive to work and…let me guess again…invest. People act completely rationale given the stickiness of their job, family structure, and possible asset/home ownership situation.

So if the goal is to move towards a flat tax, then it is time to craft a new message. The fact that people like you keep doubling down is actually a disservice to the rest of us wanting to see a fairer tax system and freer marketplace. You’re message resonates with the 3 people in your inner circle who are supposedly putting their homes up for sale, cutting work hours, and moving the family to Texas in order to beat the system. And the rest of us who do not race out of town immediately are simply dumb and taking it up the rear with no vaseline. Ironically, the rest of us includes many rich + intelligent people. In fact, Scott lives in CA. By your estimates, he should get out of town asap or is acting completely irrational.
Good luck with your message dude.

Public Library said...

Btw, this all kind of reminds me of trying to convince your wife of something using pure logic. Everyone with a wife or former wife knows, this is a total losing strategy.

marmico said...

In each case revenue growth actually accelerated

Well, it certainly didn't happen during the Bush era. Assuming the base year of 2000 (t), nominal individual income tax receipts were lower in 5 of the next 8 years and real receipts (as measured by percent of GDP) never recovered to the base year. It is the same record at t+1.

Dr William J McKibbin said...

Is California going to make it? I was told that the goal of the Democrats in the California Assembly is to close the pay gap between state workers and movie stars -- in other words, massive pay increases are being considered in order to bring state worker pay in line with the earnings of film stars and professional athletes -- Democrats are doubtful that Prop 30 will generate sufficient revenue to fill that gap -- what they are talking about now is requiring that a certain percentage of all private sector defined benefit retirement plans be invested in California equities -- I understand that California is also considering a measure that will require all private sector pay to be routed through the California treasury, which will assume the role of "ADP" for California -- the state would provide these services for fee similar to what ADP charges, thus enabling a more efficient collection of state (and Federal) tax revenues directly by the state treasury, while dispersing payroll checks from the state to private sector workers (this is also being considered in the UK) -- I also understand that consideration is being made to require withdrawals from qualified retirement accounts to be strictly amortized based on an age 95 life expectancy, thus slowing withdrawals from qualified retirement plans with zero tolerance for early withdrawals -- I guess too many men have been drawing down their retirement accounts via accelerated retirement withdrawals, thus leaving their wives broke upon their deaths -- these kinds of ideas are being bantered around in private by California's Democratic lawmakers according to my source -- I'm glad I am not a resident of California -- my fear is these ideas will find their way to Pennsylvania...

marmico said...

There is scant evidence to support the view that U.K. high income tax payers are on the wrong side of the Laffer Curve.

The U.K. data

Recall the 1986 tax reforms in the U.S. Capital gains tax were scheduled to rise in 1987 to 28%triggering a tsunami of capital gain realizations in 1986. Perfectly acceptable tax avoidance.

I would posit that high income taxpayers (150£+ threshold) in the U.K. did likewise. Accelerated as much taxable income as possible into the 2009-10 tax year at 45% tax and then reporting lower income in the subsequent year at 50% tax. The 2008-09 data is not yet available to test that theory but it makes more "real world" sense than what Grannis is suggesting.

Jeff said...

I don't know wtf you are arguing. What am I "doubling down" on? What the hell does my wife have to do with anything.

A flat tax would be great. But 4 million people left California last year.

People flee high taxes.

Capital flees high taxes.

I didn't say every rich person flees or that only rich people flee. You are an idiot.

Jay Kaplan said...

Public Library misunderstands that the impact of higher taxes doesn't cause everyone to change their behavior....it influences people on the margin, i.e. everyone does not have to lower their earnings but if just 3 out of 100 stop earning (retire early or go under the table, what you get is lower GDP. And then also have some of the other 97% who reduce their income.

Public Library said...

My point Kaplan is that to win the war on taxes, the message needs to resonate wqith the 97 out of 100, not the 3 out of 100. I completely understand the marginal implications. However, marginal analysis is taking place by 3 out of 100 people.

Jeff, I would love to forward you comment posts to your employer. I am sure they would love to see what type of footprint you leave on the internet.

Public Library said...

Btw Jeff, those comments are not very Christian like. I noticed you barren blog has links to Bible CD sales sites. You might want to pop that CD back into your hard drive for a refresher course.

Jeff said...

I am my own employeer. As Arthur said, "I am my own boss". So report to me.

Kaplan is right and makes my point. And you are changing your argument. You STARTED by saying it is a "fallacy" that tax rates don't change behavior. That is false. That was my point. They clearly do.

BTW, God only demanded 10% from His people. A flat tax. So you, me and God agree.

I think a government that takes more than God is being unbibilical. Our governments are taking HALF!

But in the end, I will render unto Ceasar what is Ceasars. But it's not unbiblical to take (legal) actions to give less to Ceasar. It's also not unbilbical to call an idiot an idiot. Christ died for all--even you Public. He says I need to love you, not agree with you.

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