Skip to main content

The weakness of the Laffer theory

The Laffer curve is based on the theory that if the rate of tax is reduced, then more tax is collected. In so far as it is true, it is an expression of the fact that, with the exception of a tax on the rental value of land, taxes give rise to a deadweight loss; the tax suppresses economic activity that would otherwise have taken place. This is either because locations become sub-marginal, as is explained by Ricardo’s Law of Rent, or because labour is marginal—it is not worth the extra effort of earning more if too much of the higher wages disappear in tax. I noticed this when I was working in a large organisation; middle managers were reluctant to take promotion, and the responsibility that went with it, if it took them over the higher-rate theshold. This meant that the employer had to offer a lot more to make up for the higher rate of tax. This is another example of how income tax is a burden on employers.

Another way of looking at deadweight losses is through standard supply-and-demand curve analysis. This is well-known to economists and as there are numerous explanations on the topic on the internet, there is no need to repeat them here. Which brings us to the Laffer curve. If you were the chancellor and decided to make £100 billion in tax cuts, there are many ways you could do it, such as

  • Cut the VAT rate overall; or
  • Zero rate a selection of goods and services and leave the rest at the standard rate; or
  • Cut the rates of income tax; or
  • Raise income tax thresholds and allowances; or
  • Cut or abolish Council Tax; or
  • Cut or abolish the Business Rate; or
  • Any combination of the above; or
  • Cutting some and increasing others.

How do you decide which course of action is likely to give the most benefit? What guidance does Laffer’s theory give? Is it not time that the idea was buried even as popular economics? Its prevalence does nothing to inform public debate, let alone policymaking.