The Laffer Curve: Proven twice this week

The Laffer curve is named after Arthur Laffer and is a curve describing tax rates versus tax take. Here is an example.

The principle is as follows: If you tax at 0% there will be no tax taken. If you tax at 100% nobody will bother to work, and so no tax will be taken here too. In between these two points there will be tax taken for certain tax rates, but the key is to find the rate which generates enough revenue without destroying the inspiration to work.

One of the underlying essences of this curve is that tax will change people's behaviour, so any calculations made when deciding to increase or decrease a rate of tax need to take changes of behaviour into account. The bigger the change in tax, the bigger the effect, and the greater likelihood of calculations being wrong.

The Labour Party has pledged to bring back the 50% tax rate, after the coalition reduced it to 45%. There were disagreements on the projected effect of the reduction in the tax rate. The Tories said it would likely have no effect or as maybe reduce revenue by as little as £100 million. The Labour Party said it would cost £9 Billion. We now have the figures. For 2012-13 £40Bn was taken from the top rate. For 2013-14, when the rate was reduced to 45%, the tax take was £49Bn. A whopping £9 Bn increase.

It's counter-intuitive, but remember the effects of behavioural change.

A similar change has happened to Capital Gains Tax. It was 18%, but the coalition has increased this to 28%. In 2011-12 the tax take was £4.3 Bn, it has now dropped to £3.9 Bn or a 10% fall. Again, it is shown that a higher rate of tax of tax doesn't necessarily bring in more money. For something like CGT it is very easy to change behaviour, you merely hold on to your assets for longer!

Looking at the economics, it's pretty clear that 45% is better than 50% for income tax, maybe 40% is even better. For CGT, it's clear that 18% is better than 28%. Sometimes lower rates bring in more money.

If the economics are clear, then we must look to the politics. Why would a party want higher rates if it brings in less money? Symbolism is the only answer, it's a statement of what is acceptable and what isn't. To me, that's the same old ideology of old socialism, I'm much more interested in what works!

So bring on the tax cuts (as long as they raise money).

Squiffy.