In 1974, the economist Art Laffer famously sketched out his theory of taxation on the back of a napkin. It would later be called the The Laffer Curve.
Laffer’s point was that tax rises are subject to diminishing returns and eventually negative returns. As tax rates rise, taxpayers will increasingly avoid or evade those taxes; or if they cannot do that, leave the country entirely. A corollary of that argument was that by discouraging profitable activity, high taxes actively shrink economic activity. Excessive taxes, therefore, mean you end up collecting a smaller proportion of a shrunken GDP.
Though there’s plenty of debate about what optimal tax rates actually are, the basic concept underpinning the Laffer Curve is now widely accepted, and we can see evidence of it aplenty. Before Emmanuel Macron scrapped it, France’s wealth tax was prompting thousands of millionaires to move to countries like Switzerland and Singapore every year. Even for a country the size of France, that was an extraordinary drain of both tax revenues and productive people.
We can also see the deleterious effects of high taxes here In the UK. Shortages of senior public sector workers, such as consultant surgeons, are being exacerbated by crippling tax rates on income and pensions. Why would anyone bother working extra hours when over half your wages will be taken away?
Governments should beware because in a highly connected world, these trends are only accelerating. The benefits of raising taxes in already high-tax jurisdictions has reduced, the costs have increased and lower tax economies have become both attractive and easy to access.
Underlying that acceleration are three global megatrends: technological advance, inequality and globalisation.
To start with technology, in a digital economy, it’s much easier to shop around for the best jurisdiction. To take a simple example, in February my second son was born. A few weeks later I set up a Junior ISA account for him using my existing online broker account. It took all of five minutes, and allows us to save £9000 a year tax free, and all without recourse to a lawyer or filling in any tedious forms. Technology makes things both quicker and cheaper. if, for instance, you wanted to set up an offshore company, you can go online and set one up for roughly the price of a Big Mac.
The rise in tech is closely connected to globalisation, which makes it much easier for people and companies to move abroad and escape high domestic taxes. Every major city has good schools, often with English as the primary language of instruction. The cost of travel is much lower than in previous generations and, for the very well off, several countries offer attractive ‘golden visa’ arrangements.
The third megatrend is the growth in inequality. Simply put, more of the world’s wealth concentrated in the hands of both private individuals and mega-corporations who have access to sophisticated tax avoidance schemes.
Taking those factors together, the Laffer Curve has shifted. The mobility of both people and capital means there are fewer incentives for governments to bring in very high taxes, particularly at the top end. It’s not just about rates but clarity. High-tax Sweden, for instance, scores much better than the UK on the Tax Foundation’s International Tax Competitiveness Index because it has a more logical, business-friendly approach.
With UK tax rates at 70-year highs, the Government has almost certainly travelled way past the peak of the Laffer Curve, which produces the double whammy of dampening economic growth and reducing the tax take. While the desire to pay down the Covid debt is commendable, doing so with measures that stifle economic activity is clearly counter-productive.
As if the cost of living crisis weren’t enough, this is yet another reason for bold tax cuts and simplification: fortune favours the tax cutters.
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