Janet Albrechtsen has thrown her support behind the idea that a cut in tax rates will lead to an increase in tax revenue.


The biggest problem when you hit the rich with higher taxes is behavioural. Here, the please-tax-me-more brigade might wish to take a look at the work of Arthur Laffer, a prominent economist during the Reagan administration. He and Ronald Reagan understood that lowering tax rates, rather than hiking them, led to increases in taxable income revenues…. When you tax people more, their incentive to work more and earn more income drops off. It’s “pure commonsense”, Laffer says.

Albrechtsen seems to believe that we are always to the right of the peak in the Laffer curve. On this view, tax revenues would presumably be maximised with tax rates of 1%. This implies that we don’t need to choose between higher tax rates with higher revenues on the one hand, or lower rates with lower revenues on the other. We can have low tax rates and maintain or increase our current revenues! All that is standing in our way, seemingly, is a bunch of short-sighted politicians, prodded along by class warriors who seek higher rates for no reason other than spite or envy.

The problem is that there is little empirical support for claims that cuts in tax rates from the rates that currently prevail in countries like the US and Australia will result in increased revenue. Even conservative Republican economists dispute the notion that tax cuts pay for themselves.

Bruce Bartlett, an official in both the Reagan and George H.W. Bush administrations, has said:

The original supply-siders suggested that some tax cuts, under very special circumstances, might actually raise federal revenues…

But today it is common to hear tax cutters claim, implausibly, that all tax cuts raise revenue. 

Here’s what N. Gregory Mankiw, Chairman of the Council of Economic Advisers in the George W. Bush administration, had to say about the Laffer curve and the Reagan tax cuts in the 1998 edition of his textbook:

An example of fad economics occurred in 1980, when a small group of economists advised presidential candidate Ronald Reagan that an across-the-board cut in income tax rates would raise tax revenue. They argued that if people could keep a higher fraction of their income, people would work harder to earn more income. Even though tax rates would be lower, income would raise by so much, they claimed, that tax revenue would rise.

Almost all professional economists, including most of those who supported Reagan’s proposal to cut taxes, viewed this outcome as too optimistic. Lower tax rates might encourage people to work harder, and this extra effort would offset the direct effects of lower tax rates to some extent. But there was no credible evidence that work effort would rise by enough to caues tax revenues to rise in the face of lower tax rates. George Bush, also a presidential candidate in 1980, agreed with most of the professional economists: He called this idea “voodoo economics.”

Nonetheless, the argument was appealing to Reagan, and it shaped the 1980 presidential campaign and the economic policies of the 1980s…. Congress passed the cut in tax rates… but the tax cut did not cause tax revenue to rise… tax revenue fell.

Mankiw’s position seems to be that, over the long run, tax cuts do have a positive effect on incentives. This means that some of the revenue lost via tax cuts is recouped via increased economic activitiy. This is a fairly uncontroversial proposition. However, his work on the size of this behavioural effect suggests it’s much smaller than Albrechtsen claims.

Here’s Mankiw in 2007:

In a paper on dynamic scoring, written while I was working at the White House, Matthew Weinzierl and I estimated that a broad-based income tax cut (applying to both capital and labor income) would recoup only about a quarter of the lost revenue through supply-side growth effects

This estimate accords with studies of the effect of the Reagan tax cuts of the early 1980s. Lawrence Lindsey, who was Senior Staff Economist for Tax Policy in the Reagan Administration and later served in the G.W. Bush administration, found that:

at least one-sixth, and probably one-quarter, of the revenue loss ascribable to the rate reductions was recouped by changes in taxpayer behaviour.

In other words, for each dollar of tax revenue that is given up through tax cuts, the Government recoups around 15-25 cents through an increase in taxable income. Bear in mind that these estimates are those of conservative economists who worked in the White House under Republican Presidents. Their estimates of the effect of tax cuts on revenues should therefore be assumed to be on the high side.

Such tax cuts, on the Republicans’ estimates, still leave three-quarters to five-sixths of the lost revenue to be accounted for in some way. This can either be done by raising other taxes, cutting spending, or running persistent budget deficits.

If conservatives want to argue for a diminished role for Government, they should make the argument on its own terms, rather than hiding behind spurious suggestions that we can have our cake and eat it too. As Laffer himself has said, “”The Laffer Curve should not be the reason you raise or lower taxes.”

UPDATE: Here’s a useful summary of various views as to where the peak in the Laffer curve lies.