The Laffer Curve

A couple of weeks ago an email went round asking if anyone wanted to ask a question at a live TV economics debate. I don’t have to be asked twice.

The show was Mehdi Hasan’s “Head to Head” on Al Jazeera. The interviewee was Arthur Laffer, the Chicago School supply-side economist who was prevalent in the 80s as an advisor to Reagan and Thatcher – and famous for the “Laffer Curve”.

I had come across the Laffer Curve when reading around Krugman’s criticisms of supply side economics. The theory itself is very seductive, but, under scrutiny, reveals itself to be accurate only under extremely narrow conditions and is subsequently a very dangerous idea when applied to real world policy.

Arthur Laffer himself is full of charm and laughter. (Even his name makes him sound like a cheery music hall act.) It is easy to see why he won over the hearts and minds of right wing policy makers.

So what is the Laffer Curve? Well, here it is.

File:Laffer-Curve.svg

The idea is that, as the government increases the tax rate, it generates more tax income – but only up to a point. After that point the curve describes a fall in tax receipts caused by a disincentive to generate income now that the tax rate is so high. When the government plans to take 100% of your earnings, the result is zero tax income because no one can be bothered to earn any money.

This makes sense… at first.

Here are the buts.

1. It assumes that the tax payer is not getting anything back from the state.
2. It assumes the only incentive that exists is the accumulation of units of currency.
3. It assumes that “wealth creators” will always be dis-incentivised by higher tax on their income.

Ken Binmore in his “Very Short Introduction to Game Theory” states that it is incorrect to assume that players necessarily maximise money. So let’s challenge these assumptions by suggesting some unusual contexts.

First, imagine an iron age agrarian community of about thirty people. (I am not advocating this as a desirable model for the perfect economy – just as an illustration.) In that non-monetary community, it is likely that the reward for each individual’s labour does not come to each individual as private income. It is more likely that the community benefits as a whole from the combined efforts of everyone together. This is a (sort of) real world example of a 100% tax situation. Would we see a drop off to zero of each individual’s labour? No. Because the rewards from the state / community are so significant.

So, the first problem with the Laffer Curve is that it exists with no context of:

1. what people get back from the state
2. what people perceive to be getting back from the state

This second one is important. Imagine a crazed communist state where the state television channel tells the people that they are getting much more for their efforts than they really are. In that case the Laffer Curve does not drop – in fact, it might even rise.

Alternatively, if you lived in a crazed free market economy where all the media was owned by business magnates who had an anti-tax agenda, you might get a skewed idea of how much value you were getting back in return for your tax.

Let’s also consider what the drop off to zero in people’s labour would really mean.

Would people really stop working?

In the iron age community who would stop working?

Would it be the people who wanted to see a better future for the community?

Or would it be people stood around whinging about why they should have to do any work when that lot from the other end of the village don’t do nearly as much work but still get the benefits?

In order for the labour effort to drop off to zero in the community, there would have to be a morale problem, a fragmented community or a disincentive based on inequality (perceived or real). This could sorted out by good leadership, strong social cohesion – or of course better times.

It brings to mind the examples given by Partha Dasgupta in his intriguing “Very Short Introduction to Economics”. In a smaller community, there is less option to opt out. Whereas in a bigger community such as a western society, the opt out / digruntlement / disincentive element is stronger. The trust issue is crucial in viewing how successful the state or community can be.

In fact, the idea of reducing your labour to zero in a small inter-dependent community is more likely to be rewarded by some serious social and possibly violent consequences.

BUT the Laffer Curve is divorced from this possible cultural context and so is very limited to the types of scenarios of which it is representative.

The question I asked Arthur Laffer on the night was roughly this:

I like paying tax. I like contributing some of my income to pay for public services and to help the vulnerable. I would be happy to pay more tax to provide more help for vulnerable people, to reduce class sizes or to provide more access to legal aid. And I don’t think I’m not alone in that. Isn’t the drop off in Laffer Curve more a representation of the behaviour of a small group of people who are paranoid about state corruption and benefit fraud, than an accurate observation about how much most people would be prepared to contribute for a strong society?

Unfortunately, the practicalities of returning the microphone to the TV crew precluded me from processing the answer. So I look forward to seeing what he said when the programme is broadcast on Boxing Day. [Having now seen the footage, Laffer used the beginning of my over-long question to justify his argument (probably only used in front of a hostile audience) that he wants more tax revenue and that is why the tax rate should be flat. Unfortunately he did not address my criticism of the drop off in the Laffer curve – which is the main thrust of this blog.]

There are three other areas that I want to make brief reference to with regard to Laffer.

Helping the Unemployed

This was the point where I found it hard to stomach Laffer’s cheerful persona. When justifying not giving financial aid to the unemployed, he said that he’d never heard of a poor person spending his way to solvency. He was so confident in this assertion that he openly asked the audience if they could disagree with the statement. It was met with a strangled silence.

A business that tried to cut its way out of tough times will simply go bankrupt. A business does need to spend when in difficulty. It needs to invest in marketing, in finding new markets or maybe developing new or adapted products or services. The idea that there’s no point in giving the unemployed help to get back on their feet is typical of Laffer’s ideological short term-ism. He maintains that we shouldn’t have bailed out the financial institutions, regardless of the fact that millions of people may have lost their homes, pensions and savings as they got swallowed up into the failed banks assets. Again, in technical economic terms it makes sense, but the social and personal damage caused in that short term restructuring is not considered. Unfortunately a person going into liquidation is slightly more messy that the corporate equivalent.

“I’m an Incentives Man”

The other question I had up my sleeve was this:
There is a popular belief that individuals are responsible for their own success and that they shouldn’t dragged into an unhelpful dependency on money from the government. If it is beneficial for individuals to have to make their own way in life, isn’t this also commensurate with significantly higher inheritance tax?

I imagine Laffer wouldn’t agree with this, but I don’t know for sure. What I do know is that this short-termism is directly comparable with Scrooge’s famous declaration about the surplus population.

In terms of incentives, of course, there are incentives other than currency accumulation. Aside from the iron age community, a modern day example where individuals get no financial reward for their labour is voluntary work. Volunteers get no pay, but they get other rewards such as a feeling of well-being, self-esteem and even an opportunity to socialise or develop new skills.

The most important and all-pervading example of non-monetary reward is in the family. Parents endlessly work hard for their children – feeding them, clothing them, taxi-ing them around parties and sports clubs every weekend. But the reward they get is immeasurable. No doubt Mr Laffer would say that those kids are just a pension plan. I’m not sure how he could financially justify looking after elderly relatives.

It might just be that there might be more to life than the accumulation of units of currency.

The more I look at it, the more it becomes clear that the Laffer Curve only really applies to people who meet the following criteria:

1. They do not need to generate income because they have enough saved wealth.
2. They live in isolation from the larger community.
3. They perceive that they get nothing back from the state that they couldn’t get cheaper or better themselves.

Perhaps the fact that this programme is going out on Boxing Day is not a coincidence. Maybe Arthur Laffer will be visited by the ghosts of Reagan and Thatcher and wake up on the day of broadcast and ask a young Chigagoan to fetch him the biggest turkey in the shop. One can only hope.

The programme, “Head to Head” with Mehdi Hasan will air on Al Jazeera English on Friday December 26th at 20.00 GMT, and will be repeated on Saturday December 27th  at 12.00 GMT, Sunday December 28th at 01.00 GMT and Monday December 29th at 06.00 GMT.

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