The Garrulous Jay – Laffer Minute

With only five days to go until we are all put out of our pre-Budget misery there has been recourse, amidst all the will-she-won’t-she speculation, to a debate about the work of US economist, Arthur Laffer, and his eponymous ‘curve’.

Despite the title of this week’s GJ, the Laffer curve may turn out to be no laughing matter for Rachel Reeves, the Government or taxpayers.

So what is the Laffer curve and why does it matter?

The curve describes the relationship between the rate of taxation and government tax revenues. Whereas it might simplistically be thought that as tax rates go up, so tax revenues will increase, Laffer argued against this.

According to Wikipedia, Laffer first sketched out his curve on a napkin in a meeting between himself, Dick Cheney, Donald Rumsfeld and Jude Wanniski in 1974, in the Two Continents Restaurant at The Washington Hotel. (See high quality diagram.)

He argued that governments would raise no tax if rates were set at 0%, but they would experience the same outcome if rates were set at 100%, as people would stop working or avoid paying. From this he concluded that somewhere between 0% and 100% there had to be an optimum rate of income tax.

Laffer has never claimed he invented the concept of his curve, and the term itself was purportedly coined by Wanniski.

By now you will have probably worked out why the Laffer curve matters ahead of next week’s Budget…

His Majesty’s last Official Opposition were frequently reminding us that the Tory Government had saddled UK “working people” with the highest tax burden since the end of the Second World War…until they crossed the aisle.

They have now found a £22 billion ‘black hole’ in the public finances, and this has subsequently been compounded by Rachel Reeves identifying a £40bn funding gap. She may be tempted to jack up taxes to plug this gap, but she will need to beware the Laffer curve.

With increases in some of the biggest taxes ruled out, the fiscal heavy-lifting will in theory have to fall on the likes of Capital Gains Tax, Inheritance Tax and (with a bit of a political pirouette) employer NICs.

Of these, CGT is arguably the easiest to avoid: just don’t do it (i.e. sell), and you pay no tax. Or leave the UK then do it. Laffer in action.

Inheritance Tax is a little tougher to duck for obvious reasons, but in 2022-23 total receipts still only reached £7.5 billion. An increase that made a meaningful difference to the Treasury coffers would therefore have to be on a scale that would very likely push revenues down the Laffer curve.

Employer NICs might work in the short-term, as companies suck up the additional cost. But it could be detrimental in the longer-term as businesses adjust compensation packages or reduce hiring.

Herein lies the challenge for Reeves. If she gets the balance wrong, she might find herself being Laffed out of the room.