Just for a Laff

Sinclair Davidson has written a CIS policy brief arguing that Australians pay too much tax. On its face, this is about as surprising as Richard Neville telling us that George Bush isn’t his favourite President. But Sinclair also throws in a new argument – that we’re on the wrong side of the Laffer Curve. In other words, the government could get more tax revenue if it cut top tax rates.

It’s a novel argument, and Sinclair carefully discusses all the evidence. But from everything I’ve read, I reckon it’s just got to be wrong. As he points out, the only convincing instance in which a Laffer Curve has been shown to exist is Sweden in the 1960s and 1970s, and Australian tax rates aren’t anything like that high. He suggests that we might learn something from falling top tax rates and rising top income shares – but the income share (and hence the tax share) of the top 1% is also going up because of other factors, such as changing norms about inequality and the internationalisation of the market for english-speaking CEOs.

Ultimately, as the University of Chicago’s Austen Goolsbee has put it:

The notion that governments could raise more money by cutting rates is, indeed, a glorious idea. It would permit a Pareto improvement of the most enjoyable kind. Unfortunately for all of us, the data from the historical record suggest that it is unlikely to be true at anything like today’s marginal tax rates. It seems that, for now at least, we will have to keep paying for our tax cuts the old fashioned way.

Still, the nice thing about this debate is that we’re about to have a very clean policy experiment, thanks to JWH pushing up the top tax brackets in 2005-06 and again in 2006-07 in a way that disproportionately favours the rich. So perhaps Sinclair and I can revisit this issue in a few years’ time, and see what happened. I expect we’ll see an increase in earnings for those whose tax rates fall – what I don’t expect is that the total tax take from the rich will be higher in real terms.

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2 Responses to Just for a Laff

  1. Sinclair Davidson says:

    Thanks for the publicity. There are three points worth making.

    First, I don’t think anyone disagrees with the theoretical notion of the Laffer curve. The 1970/80s Swedish example is where everyone agrees an economy was on the wrong side of the curve. The issue of our tax rates being as high as (approx) 80% overlooks the importance of labour market flexibility. As recent governments have reformed labour markets so the tax that that maximises revenue has fallen. My view is that it has fallen below the current 47 percent (not counting Medicare levy, super contribution and various other semi-permanent once-off levies).

    The second point (out of sequence I know) is whether the current tax relief offers a clean experiment. I don’t think so. The group that should respond are those who have fallen out of the top bracket – but these individuals are less likely to have high tax responses and if they do will quickly re-enter the top bracket. If we had had a reduction in the rate (i.e. abolition of the 47% bracket) then we would have a clean experiment. But Andrew is correct, something will happen, and it’s going to keep both of us busy over the next few years. Some of Andrew’s colleagues at the ANU reckon there will be a huge impact, but I saw the article written up in the Sydney Morning Herald the day my report was published and was only able to include a footnote referring to that research – I haven’t read the original work yet.

    The third point relates to the Goolsbee quote. I quickly ran off to check the report, with my worst fears confirmed. I also quoted Goolsbee (Andrew’s exact quote) and commented on it in an earlier version of the report. Unfortunately, it was edited out (with many other points) of the final version. The published version of Goolsbee’s comments is referenced at footnote 89 (1999 not 1995) in my paper and I do include some of the comments by the discussants to his paper (last para pg. 14). My personal view though is along these lines. Australia is above the revenue maximising tax rate. So taxes rates can be reduced without a loss of tax revenue. But Australia is also above the growth maximising tax rate. To get from the revenue max point to the growth max point would require a cut is government revenue. This would have to be done the old fashioned way. Indeed, I saw in the Australian this morning reports that Craig Emerson was arguing that tax cuts could be traded off against welfare cuts. My view that government spending can be cut is also being proposed by ALP backbenchers! (Andrew has kindly sent me Emerson’s paper – I haven’t read it yet, so my interpretation may change). If Australia followed Emerson’s idea and cut tax and welfare for middle and upper income earners, I suspect we would see a reasonably clean experiment. I predict budget surpluses would increase and taxes would be cut again very quickly.

  2. Andrew Leigh says:

    Sinc, apologies for not acknowledging that you’d mentioned that Goolsbee piece. BTW, I really enjoyed your discussion of the literature on Laffer, albeit that I came to a different conclusion at the end of it.

    So far as I know, Xiaodong & Bob’s paper (a structural model suggesting that the tax cuts will boost the labour supply of the rich) isn’t written up yet. So you shouldn’t apologise at all for not citing it. And besides, whether or not they find a big enough labour supply response to raise tax revenue (I suspect they don’t) only depends on the LS parameter they put into the model, which we mightn’t want to place full faith on.

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