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.