Can countries lower taxes and raise revenues?

RARELY has a dinner-table scribbling created such a legacy. In 1974 Arthur Laffer, an economist, sketched a simple diagram on the back of a napkin to illustrate a truism of tax policy. Set income-tax rates to zero and governments will not collect any revenue. Set them to 100%, and they will also collect nothing because people will have little incentive to work. Somewhere in between lies a sweet spot where government revenues are maximised. From this simple proof, it follows that when tax rates are very high, it might be possible both to lower tax rates and raise revenues. Tax cuts might thus pay for themselves, and more.

Mr Laffer’s scribbling caught on. Some 45 years later some 15,000 journal articles mention the “Laffer curve” in their title. Today President Donald Trump will award the Presidential Medal of Freedom, America's highest civilian honour, to Mr Laffer—an adviser to Mr. Trump’s 2016 presidential campaign and co-author of the book “Trumponomics”. In its announcement of the event, the White House described Mr Laffer as “one of the most influential economists in American history.”

Budget hawks might disagree. Supply-side economists have long used the Laffer curve to justify tax cuts, including Ronald Reagan’s in 1981 and George W. Bush’s in 2001. Both resulted in lower revenues. In December 2017 Mr Trump’s administration cut income taxes across the board, and slashed the corporate-tax rate from 35% to 21%. At the time, Steven Mnuchin, America’s treasury secretary, argued that the plan would “pay for itself” and even “pay down debt”.‬ But the promised revenues have yet to materialise. Federal tax revenues actually fell in 2018. The Congressional Budget Office, a government watchdog, now reckons that the national debt will hit 95% of GDP by 2027, up from 89% two years ago before the tax cuts.

America is not the only country that appears to be on the wrong side of Mr Laffer’s curve. A paper published in 2017 by Jacob Lundberg, an economist at Timbro, a Swedish free-market think-tank, estimates Laffer curves for 27 OECD countries. Using data on Sweden’s income distribution and assumptions about how taxpayers respond to different tax rates, Mr Lundberg found that, even though five countries in his sample have top income-tax rates that exceed their revenue-maximising levels, only Sweden could meaningfully boost revenue by cutting tax rates on high-income earners. Most countries, in other words, appear to have set their highest tax rates at or below the optimal rate suggested by the Laffer curve.

This may explain why many economists are so critical of Mr Laffer’s supply-side policies. In 2012 the Initiative on Global Markets, a research centre at the University of Chicago’s Booth School of Business, asked a panel of 40 economic experts whether a cut in income-tax rates in America would raise enough revenue to pay for itself in five years. Not one of them agreed. Richard Thaler, winner of last year's Nobel prize in economics, responded simply “That's a Laffer!”.

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