TAKING STOCK: Laffer and taxes


Let me ask you two hypothetical questions. What would a country’s income tax collections be if the tax rate was zero? And, secondly, what would these collections be if the rate was 100 percent of your income?

The answer to both these questions, as you might have guessed, is the same: zero. Based on this reasoning, Art Laffer, an economist, drew his famous curve on a napkin in 1974. The Laffer curve, as it is now called, shows how tax collections vary with changes in the income tax rates. It is in the form of an inverted U.

What it means is that tax collections are zero when the rate is zero and then increase as rates go up. However, after a certain threshold rate is reached, tax collections max out and start to go down again and touch zero when the rate reaches 100 per cent.

Dupuit, a French engineer and economist had first recognised this effect in the 19th century and stated that there is such a thing as a maximum-revenue rate of tax and any rate increase

beyond this point will lead to loss of revenue for the government.

What then is the rate at which the government can maximize tax collections? We cannot know for sure but what happened in Russia under its president Vladimir Putin is instructive.

In January 2001, Putin reduced the income tax rate to a flat 13 per cent from the earlier variable rates which averaged approximately 20 per cent. The result: tax collection went up by 28 per cent in the first year itself, and in the first two years the increase was over 50 per cent. Russia’s economy which was contracting earlier is now growing at a respectable seven per cent annual rate.

This has proved categorically that a 13 per cent tax rate is superior to a 20 per cent rate. Why? At lower rates, people work harder, the incentive to evade taxes goes down, the black economy tends to be marginalised, and investments are based on economic feasibility of projects, not on tax based wasteful considerations.

More than all this, great benefits come from leaving cash in private hands. Money with private citizens multiplies and earns even more money in the future via expansion of businesses etc. Money with government is lost on unproductive expenditures, frittered away by mismanagement, and disappears in corrupt hands.

Thus the best investment that the government can make is to leave the maximum possible amount with businessmen.

As they invest and reinvest in their businesses, the government’s tax base for the future keeps rising. A Rs 100 with the government is a Rs 100 wasted; in our hands it is probable that this Rs 100 becomes Rs 110 after a year and doubles to Rs 200 in seven years - thus increasing the government’s tax base in later years.

What would happen if Russia was to reduce its rate to below 13 per cent? This would be beneficial. Tax collections would again rise in subsequent years - perhaps more slowly but surely - as money with the people earns a higher return than with the government.

What then should the income tax rates be? The maximum revenue to the government would come if there is a single flat rate below 10 per cent and the tax code is easily Understandable.

Does this mean that I am endorsing a flat, simplified, low-rate income tax? No. I am merely stating what would make sense for the government to do if it wants to maximize its revenues over a period of time. Government officials would do well to understand the Laffer curve.

Personally, I would like to see the income tax eliminated. It is an intrusive tax, involves snooping by officials, results in a loss of taxpayer’s right to privacy, retards investment and employment, and lowers growth rates.

If, however, the government does not consider it politically feasible to sell the idea of abolition of income tax to its citizens, it would still be rational for it to reduce it to a flat rate below 10 per cent. This would be good for the government, for it would collect more; great for the taxpayers, as their rate goes down; and the best of all for the country, as its growth rate will go up. When it comes to taxes — any taxes —less is indeed more.

(The writer can be contacted at: everest@mos.com.np)