Saturday, July 28, 2007

TAX POLICY AND LAFFER CURVE

It is often heared how designing a pro-growth tax policy scheme based on the principal assertion of the Laffer curve is a "bunch-of-free-lunch-crunch". The arguments entailed into such critical interpretations of the Laffer curve and pro-growth tax policy are weak and could be applied to the course of revenue-maximizing tax policies around the world. It would be misleading to believe that high and progressive tax rate on individual and corporate income lettingly maximize the revenue resulted from the taxation of income and capital. The higher the marginal taxation extends, taxable basis shrinks.

The consequence is wrongly understood as one may think that the loss may be compensated by pushing-up the tax rate on individual or/and corporate income through a complex system of deductions, loopholes and exemptions which, in turn, open-up a space to avoid paying taxes on work, saving and investment. In the age of dynamic capital mobility and greater openness to investment in jurisdictions around the world, a complex and anti-growth tax system may damage the economic growth, productivity growth, new investment, and savings nevertheless.

Recently, Wall Street Journal captured the attention of corporate tax competition in the world by showing that higher rates of corporate taxation lead to the loss of revenue measured as the percentage of the GDP. Also, Albania recently announced the adoption of the flat tax system to compete with neighboring Macedonia in attracting foreign direct investment to boost GDP growth through supply-side reforms and structural convergence.

The critics of the supply-side economics often claim that Laffer curve is an absurd notion whose theoretical design has either no virtual nor real connection to the course of economic and tax policy. If the assertion of the Laffer curve is entirely wrong why the World Bank reports the following:

"The design of the tax system can have significant economic impacts and can influence multinationals in deciding where to invest. Tax regimes with relatively high marginal rates and which include a number of exemptions and allowances tend to be less economically efficient in relation to encouraging employment, saving and investment. Such regimes generally also impose higher tax compliance and administration costs. Evidence suggests that simpler tax systems promote economic growth and can help achieve a win:win for governments and industry...high tax rates do not always lead to high tax revenues. Between 1982 and 1999 the average corporate income tax rate worldwide fell from 46% to 33%, while corporate income tax collection rose from 2.1% to 2.4% of national income. A better way to meet revenue targets is to encourage tax compliance by keeping rates moderate. "

See: Paying taxes, Global picture (link)

Further, if Laffer curve notes absurd conclusions, why has the European Commision (hardly a powerhouse of pro-growth policy) has then concluded exactly the same as what is the basic notion from Laffer curve:

"It is quite striking that the decline in the corporate income tax rates has not resulted, so far, in marked reductions in tax revenue, both the euro area and the EU-25 average actually increasing slightly from the 1995 level." (link)

The evidence of benefits from lower taxes on productive behaior were recently measured by Trabandt and Uhlig (2006), emphasizing the role of tax cuts on labor and capital as majorly self-financing, yielding higher revenue from lower marginal rates on labor and capital themselves:

"We show that the US and the EU-15 area are located on the left side of their labor and capital tax Laffer curves, but the EU-15 economy being much closer to the slippery slopes than the US. Our results indicate that since 1975 the EU-15 area has moved considerably closer to the peaks of their Laffer curves. We find that the slope of the Laffer curve in the EU-15 economy is much flatter than in the US which documents a much higher degree of distortions in the EU-15 area. A dynamic scoring analysis shows that more than one half of a labor tax cut and more than four fifth of a capital tax cut are self-financing in the EU-15 economy."

Mathias Trabandt, Harald Uhlig: How Far Are We From the Slippery Slope? The Laffer Curve Revisited, CEPR Discussion Papers, 2006 (link)

What about the cases studies of Ireland and Iceland where capital tax reductions yielded a spinning revenue? In Ireland, 12,5 percent flat-rated tax on corporate income sizzled the revenue-maximizing rate from less than 2 percent of the GDP to more than 3 percent of the GDP, coinciding with rapid stunning GDP growth rates in 1990s. Iceland periodically imposed corporate tax reductions moving from 50 percent in 1985 to 33 percent in mid-1990s and 18 percent in 2002. Following the critics of Laffer Curve and pro-growth tax policy, corporate tax reduction should have resulted in the loss of revenue as the share of the GDP. Contrary to such assertions, tax revenue rate jumped from 0,9 percent of the GDP in 1985 to 1,5 percent in 2002, following a powerful increase in incentives to invest. Thus, corporate tax cut did not result in the loss of revenue but rapidly coincided with rapidly growing revenue from corporate tax.

In tax policy, it is possible to note poorly designed tax schemes such as Keynesian tax rebates and credits whereas it is illusionary to expect a growing revenue from a growing complexity of the tax system, producing disincentives to entrepreneurship, work, saving and investment. It is also an equally misunderstood assertion that tax reductions do not impact economic performance.

Static assumption are therefore empirically invalid because, as Ed Prescott showed, labor supply is highly sensitive to taxes, while revenues do not simply rise and fall when tax reductions are imposed, but change as the preference of the productive supply changes, whereas high taxes cause more incentives to avoid paying taxes levied on taxpayers. Also, macroeconomic performance is strongly affected by taxes as a numerous volume of empirical research has shown clearly.

Governments which failed to impose pro-growth tax policy, should learn a lesson for tax policy, undisputably a lesson saying that high taxes on labor and capital cause distortions and fewer incentives to boost GDP growth through productive power of value-adding process resulted from lower aggregate tax burden on individuals and companies.

1 comment:

Bill Shears said...

Rok,

I quoted you from this post concerning taxation and BEER at www.infinitybound.com.

A student of economics myself. education on the topic is woeful in the US.

Interesting blog overall. I'll add you to my list of links and check back myself often.