The Laffer curve

In 1974, Arthur Laffer, then a professor at the University of Chicago, famously sketched in a cocktail napkin how he believed the theory of diminishing returns applied to tax policy. To a small dinner party that included Republican stalwarts Donald Rumsfeld (then President Ford’s White House Chief of Staff) and Dick Cheney (then Rumsfeld’s deputy), Laffer explained that the relationship between tax rates and tax revenues is not completely linear – tax revenue will not necessarily increase (or decrease) with every increase (or decrease) of the tax rate. Instead, he argued that when tax rates reach a prohibitive range, the state will, in fact, be able to collect more taxes if the tax rates are decreased. 

His model is not difficult to grasp. A linear explanation of the relationship between the tax rate and tax collection assumes that the tax base will remain unaffected by the tax rate. Laffer instead points out that high tax rates may disincentivize economic activity and therefore shrink the tax base. As Laffer himself explains:

“At a tax rate of zero percent, the government would collect no tax revenues, no matter how large the tax base. Likewise, at a tax rate of 100 percent, the government would also collect no tax revenues because no one would willingly work for an after-tax wage of zero (i.e., there would be no tax base). Between these two extremes there are two tax rates that will collect the same amount of revenue: a high tax rate on a small tax base and a low tax rate on a large tax base.”

Laffer’s theory steadily gained traction with the Republicans thanks to the advocacy of Donald Rumsfeld. The parabola-shaped curve that Laffer drew was eventually named after him by another member of the dinner party, Jude Wanniski, in a 1978 article, “Taxes, Revenues, and the `Laffer Curve,’” in conservative journal, The Public Interest.

Laffer’s theory was raised to a status of orthodoxy in succeeding Republican administrations. It was adopted as a major foundation of the so-called Reaganomics Revolution which was characterized, in part, by progressive cuts in the marginal earned income tax rates, and in the capital gains tax rate. Its influence on the George W. Bush dividend and capital gains tax rate cuts is also undeniable. American conservative think tanks and publications continue to claim that the adoption of Laffer’s theory to a noticeable increases in the US federal tax revenue in the Reagan years and during the first term of George W. 

2. 

The echoes of Laffer’s theory reverberate in the halls of our Senate. Senator Juan Ponce Enrile recently filed Senate Bill 3147 which seeks to impose a uniform three-percent franchise tax on power distribution utilities in lieu of all other taxes, including the value added tax.

The Department of Finance, predictably opposed the measure and projected a revenue loss of P6 billion. Senator Enrile cast aside the DOF’s concern as inaccurate, stating that the money not collected from the power distribution utilities will be spent by consumers for other needs and will therefore be subject to taxation.

It appears that Senator Enrile believes that the tax cut from the measure will generate increased economic activity in other sectors of the economy. Such increased activity will then lead to a broadening of the tax base of other taxpayers and therefore compensate for the reduced collection from the power distribution utilities.

Businessman Raul Concepcion recently also batted for a gradual decrease in the corporate income tax rate from the current 30 percent to 25 percent by 2012. He also allays fears of dropping government revenue by stating that “Lowering the tax rate will not only boost tax compliance but will also encourage the underground economy to surface. Hence our tax base will be expanded.“

3.

The initiatives of Senator Enrile and Mr. Concepcion are certainly welcome developments for consumers and the business community.

It would however be interesting to examine the financial models on which they base their Lafferesque assurances on government collection, especially in light of the dangers of exacerbating the National Government’s fiscal deficit.

It bears mentioning that the Laffer curve and the arguments touting its effects on tax revenue were initially directed towards analyzing the impact of a decrease in direct taxes on individuals. The claimed beneficial effects of these tax cuts are historically traced to the increased incentives to work, to invest in active businesses and to spend, not just to increased spending. It is difficult to connect a decrease in the indirect tax such as the VAT on a targeted service to a heightened will to work and invest in or expand a business. Furthermore, not all goods and services are subject to VAT and given the structure of our VAT system, it is not unlikely that the consumers will be directing the savings from their electricity bills towards the purchase of non-VATable goods and services.

Mr. Concepcion’s proposal and assurances seem to have more support in recent studies. For example, a January 2008 working paper by economists connected with the International Monetary Fund suggested that small tax rates may lead to an increase in the tax base and increased compliance among taxpayers. What is interesting in this paper by Tamás K. Papp and El_d Takáts is that they considered among others, the limits in the ability of the state to run after tax evaders. They concluded that for tax cuts to lead to increased revenue, enforcement by the tax authorities should more or less be consistent. They warned that “if the tax authority is relatively weak, no tax rate changes will induce compliance.“

Finally, it should also be mentioned that mainstream economic literature is actually dismissive of the soundness of the Laffer Curve. Laffer’s many critics point out that the US budget deficit ballooned during the Reagan and George W years and were controlled when George H.W. Bush and Bill Clinton raised taxes in the 1990s. Gregory Mankiw, the Harvard professor and onetime chairman of George W.’s Council of Economic Advisors, concluded in a paper with Prof. Matthew Weinzierl, also of Harvard, that cuts on the rates of labor and capital taxes are not entirely recouped by tax collections due to the attributable increased economic activity.

(Jude B. Ocampo is a Partner for Tax & Corporate Services of Manabat Sanagustin & Co., CPAs, a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative.

The views and opinions expressed herein are those of Jude B. Ocampo and do not necessarily represent the views and opinions of Manabat Sanagustin & Co, CPAs. For comments or inquiries, please email [email protected] or [email protected]).