Conventional wisdom maybe - but it’s never the truth
Whether it’s the belief that higher taxes are needed to pay for the government’s Covid-related debt; or that tax hikes should target the wealthy; or that more infrastructure spending by the state will create more jobs; or that import tariffs are needed to protect domestic industries; or that currency manipulation can boost exports; or that a statistical figment called GDP can be used by the state to guide economic policies; or that QE got us out of the last recession and it’s necessary to repeat it to prevent another depression - these, and scores of other economic platitudes are simply accepted. No further scrutiny is sought because they are seen to be self-evident, and taken for granted.
But no matter how obvious they seem, nor how widely accepted, what they have in common is that they’re mistaken – indeed, in many cases the reverse is closer to the truth. For example, the idea that government can raise more revenue by lowering tax rates seems to be counterintuitive, but it’s true. In extremis, a tax rate of zero per cent will of course yield nothing. But a tax rate of 100 percent, being confiscatory, will also yield no revenue because no one will have any incentive to work.
Tax rates & tax yields
This concept was initially explained by Arthur Laffer, economics professor at Chicago University. Its simplicity resonates powerfully with common sense and to this day it is referred to as the “Laffer Curve” – a bell-shaped graph showing the tax rate on the X-axis and the tax yield on the Y-axis. It entered economic folklore when Laffer sketched it on a napkin while dining with his friends Donald Rumsfeld and Dick Cheney at the Two Continents Restaurant in Hotel Washington in DC in 1974.
Implicitly, there must be a rate of tax (X-axis) that yields an optimum amount of tax (Y-axis) represented by the summit of the bell. This, of course, is invariably a lower rate than Treasury officials are prepared to believe – mainly because the curve doesn’t factor in what happens to the tax revenue once it has been raised. We can refer to this as the “squander” factor that lies in the realm of “big projects” - or, more likely, just waste, necessitating the need to raise more revenue! The tax-yield shown by the graph may therefore be notional rather than actual.
Laffer did not claim ownership of his eponymous curve. He himself attributed the idea to Ibn Khaldun, a 14th century political scientist who observed that “at the beginning of the dynasty, taxation yields a large revenue from small assessments. At the end of the dynasty, taxation yields a small revenue from large assessments.”
The principle applies to any tax
The beauty of the Laffer Curve is that it’s principle is applicable to any tax - whether based on income or consumption. A zero percent tax on alcohol sales, for example, will raise no revenue - although it would help the hospitality sector to become more productive and thereby increase its own “taxable capacity”; while a 100 percent tax on alcohol sales would effectively confiscate their entire proceeds - equivalent to classifying its products as contraband and re-establishing the esteemed profession of bootlegging. Effectively, the government’s miniscule tax “haul” would be far outweighed by the cost of collection! They might just as well impose an outright ban on alcohol. (This is where we are on the question of growing and selling cannabis – but we don’t expect officials to learn from past follies!)
Tax is usually thought of as an unwanted imposition, a burden we have to live with, but which may be avoided if you are clever enough or in receipt of expensive “advice”. But this view is negative and misconceived. It assumes the existence of a pre-created “tax base” - a quantum of wealth, earned by honest toil, whose owners are understandably reluctant to see it pillaged by state profligacy. The Hong Kong experience demonstrates that free markets, unhampered by regulatory excess, generate tax revenue so naturally that it is scarcely noticed – still less is it thought of as burdensome.
As its Financial Secretary from 1961 to 1971, Sir John James Cowperthwaite, guided Hong Kong to develop from one of the poorest places on earth to one of the wealthiest and most prosperous. What he called “positive non-interventionism” was the focus of his economic policy, promoting free trade, low taxation, budget surpluses, limited state intervention and sound money - an approach that drew more from Adam Smith than Keynes. He was a pragmatist rather than a theoretician who steadfastly refused to compile GDP statistics, arguing (i) that such data was useless for guiding economic policy; and (ii) that it would simply encourage officials to meddle in the economy. Indeed, when asked to name the key thing that poor countries could do to improve their growth, he replied: "They should abolish the office of national statistics!” He summed up his own economic philosophy in this down-to-earth reformulation of Say’s Law: “In this hard world we have to earn before we spend” – a truth than runs counter to everything being enacted now.
Cowperthwaite’s pragmatic approach is still abundantly evident. He observed that every infrastructural development that enhances community life, notably transport, causes the value of affected sites to rise. Putting two-and-two together (and making 5!) it was obvious that the incremental wealth created by those improvements was the natural fund for meeting their cost. Both Singapore and Hong Kong use a low rate of tax on land values, not state subsidies, to fund their new metro systems.
Prior to the Chinese handover Hong Kong was often voted the world’s best city for business and the freest for residents. Hopefully any loss of its civil freedoms will not extend to its economic freedoms.