The Laffer Curve is a concept close to the heart of many economists who advocate lower taxes.
The concept is actually quite an old one but it was popularised in modern times at a lunch meeting attended by economist Arthur Laffer and officials from the Ford administration (including Donald Rumsfeld and Dick Cheney) in the mid 1970s, when Laffer drew the curve on the back of a napkin to illustrate how a rise in personal taxes proposed by Ford might lead to lower tax revenues.
Laffer argued that if tax rates were set at zero then tax revenues would clearly also come in at zero, but if taxes were set at 100% then no one would bother working and so tax revenues would again be zero. He sketched something like the below to demonstrate this:
Whilst Laffer was almost certainly correct to suggest that there is curve, the key question facing tax policymakers is where about on the curve are tax rates currently. Are they on the left hand upward sloping slide, in which case tax rises will raise revenue, or on the right hand, downward sloping side, where tax rises will lead to less revenue?
For what it’s worth, the point at which tax rates move to the downward sloping, right-hand side of the curve, appears to be around the 70% mark, so in most cases Laffer analysis suggests that higher rates can indeed raise revenues, despite what the Curve’s usual proponents argue.
But I’ve thinking recently about the Laffer Curve not as it relates to tax policy but in terms of how the concept might relate to austerity.
Last week international policy makers (including the IMF’s Christine Lagarde) urged a slowdown in fiscal consolidation – i.e. less austerity. They worry that austerity programmes across the developed world are leading to weaker growth, higher unemployment and ultimately higher deficits and bond yields.
Just before Christmas, as I blogged at the time, the IMF noted that some preliminary analysis suggested that it was possible, that beyond a certain point, austerity led to higher, rather than lower, yields on government debt:
The IMF are suggesting that in certain cases (presumably like those we currently find ourselves in, with weak growth, very low central bank interest rates and depressed demand) that cutting government spending can mean the yield on government bonds rises rather than falls.
This makes intuitive sense. If cutting government spending means weaker growth and a higher deficit then it would be perfectly rational to demand a higher interest rate in return for holding government debt.
Might it then be the case that something like a Laffer Curve exists for austerity? That is to say that cutting government spending up to a certain point leads to lower deficits but beyond a certain point, the impact of lower growth and higher unemployment means that deficits get worse as the government cuts more?
The graph below attempts to illustrate this (and I would have drawn it on a napkin but didn’t have one to hand):
Like the Laffer Curve it suggests that there is a point at which cutting government spending becomes self-defeating, it simply lowers growth, depresses tax revenues and pushes up social security spending by more than the government is cutting.
The question for policy-makers then, is are they past the point and at which the curve becomes downwards sloping? Will more austerity simply lead to higher deficits?
Judging by the tone of S&P’s downgrade of several European sovereigns last week, it certainly seems to think that many countries have passed this point.