Maximising tax revenue is good for politicians – but not the rest of us

Jamie Whyte
HIGH taxes encourage black markets. For example, ever increasing “sin taxes” mean that a large portion of the cigarettes and alcohol consumed in Britain is now bought in the black market, where these taxes need not be paid. The Taxpayers’ Alliance complains that this costs the government £7bn a year in lost tax revenues.

Implicit in this complaint is the idea that tax policy ought to aim at maximising revenue for the government. The same argument was used regarding the 50 per cent top rate, now reduced to 45 per cent. Many argued that it was a poor tax because it reduced the amount of tax collected. I blame the Laffer curve.

The Laffer curve shows the relationship between tax rates and the amount of tax collected. As tax rates rise from zero, the amount of tax collected increases. But as rates continue to rise, the line flattens out and eventually begins to decline, because the level of tax discourages economic activity, and hence reduces the tax base, and encourages tax avoidance and evasion.

The Laffer curve is not fixed over time or across economies. The rate at which tax revenue increases with tax rates and the point at which it turns negative depend on the structure of the economy and on the temperament of the population (compare Sweden and Greece). And it is difficult to know where the Laffer curve lies. It was not obvious, in advance, whether the 50 per cent top rate would increase or decrease the government’s revenue.

But this uncertainty should not matter. Because the common idea that the optimal tax rate is at the “tipping point” of the Laffer curve – that is, the rate that maximises the government’s revenue – is outrageous. It makes tax policy follow the logic of extortion.

Imagine you run a protection racket. You charge local businesses protection money and fight off potential rivals for providing this “service”. How much should you charge? You want as much as you can get. But if you demand too much, you will drive your “clients” out of business, which will do you no good. In other words, you face the logic of the Laffer curve; you need to find the rate of extortion that delivers the most revenue.

It is not surprising that politicians should think this way about the optimal tax rate. Although they do not keep tax revenues for themselves, they choose how they are spent. The more they have at their disposal, the greater the gifts they can bestow on electorally important groups. Or, to put it bluntly, the more effectively they can buy votes.

But it is surprising and disheartening that the Taxpayers’ Alliance, along with most other commentators on tax issues, should have adopted the extortionists’ logic. After decades of propaganda about the virtue of government spending and the fairness of high rates of tax, we seem to be suffering some kind of mass Stockholm syndrome.

Jamie Whyte is senior fellow of the Cobden Centre.