The IMF has published a paper on the Laffer curve that concludes:
The paper shows how tax rate cuts can increase revenues by improving tax compliance. The intuition is that tax evasion has externalities: tax evaders protect each other, because they tie down limited enforcement capacity. Thus, relatively small tax rate cuts, which decrease incentives to evade taxes, can lead to increased revenues through spillovers - creating Laffer effects.
The supply siders will be over the moon with joy. There's just one problem. The assumptions that make this work are:
We investigate an economy populated by a unit volume of taxpayers. There is a single tax authority with limited resources, which audits taxpayers. The model is set up in three steps. First, we describe how tax enforcement works. Second, we introduce the maximization problem of the taxpayer, in particular the decisions on compliance and labor supply. Third, we introduce taxpayer heterogeneity and solve the model.
In other words, this is a blackboard based model. Well, we all already know that Laffer works on a napkin. Adding a formula or forty makes no difference: there is no evidence for it in reality.
This economics is a bit like Nintendo's Wii. Right around the world now there are millions of people believing they can play championship tennis or beat Tiger Woods at golf. That's because the assumptions have been changed in the virtual reality model of their world to achieve the illusion they desire. So too with mathematical modelling that creates the assumptions that deliver the result you first thought of. In reality these people can hardly play tennis or golf. And they're not doing either: they're playing make believe. This economics is also playing make believe.
So don't get too excited guys: we won't be buying the argument. It's wrong, as almost all evidence based research shows.
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And of course we don’t need the Laffer curve to tell us that increasing the effective rate of CGT from 10% to 18% will encourage tax avoidance. The cost/benefit ratio is seen to be more acceptable – to those tempted by such machinations. Thus it will be easier for the purveyors and promoters of such schemes to find people willing to take a risk given the prospect fo saving 18% tax. Shame.
The really bizarre thing about this paper is that it is intended to be a contribution to the study of tax avoidance behaviour, and yet it models individuals in exactly the way that we know they do not behave.
The authors assume individuals maximise some combination of their consumption and their leisure time. Tax evasion in the model therefore increases their consumption-leisure possibilities. However, it also requires some effort (which reduces, by less, their consumption-leisure possibilities), and generates the risk that evaders will be caught and have to pay the tax due and a further cost (further reducing the expected value of their consumption-leisure possibilities).
In reality, all the evidence from every country studied (including those with the largest shadow economies) shows that individuals pay many times more tax than is predicted by any conceivable maximisation of the naive type assumed in this paper.
In fact, individuals pay systematically more tax when the government uses its revenues to obtain greater redistribution of income, and when individuals believe that other people are also complying. For this reason, one of the most damaging factors for general levels of tax compliance is the high-profile avoidance and evasion of rich individuals (non-domiciles in the UK, anyone?) and large businesses (see e.g. Richard’s Mind the Tax Gap). Why should individuals pay if they see the rich don’t bother?
The payment of tax is a social act, reflecting a commitment to a community of citizens and a contract with government. For this reason, tax cuts that undermine redistribution also contribute in the longer term to lower compliance and lower revenues. This is just one reason why the Laffer curve is wrong – the general economic arguments are well-known.
Returning to the IMF paper; the authors claim that their original contribution is to focus on the tax compliance channel (which thereby, it is suggested, rehabilitates the long-discredited Laffer curve). In fact, the paper is weakest in exactly the area in which its authors claim credit – the modelling of compliance. By ignoring the considerable literature in this area, in favour of naive agents maximising simple economic outcomes, the authors effectively assume the answer they then herald as a discovery.
Not, all in all, a great triumph.
Thanks Alex
[…] Nice comment on this issue here. Worth reading as a follow up to my recent comment on the issue. […]