30 May 2018

Why the Laffer Curve should really be called the ‘Khaldun Curve’


Ideas change the world. A good example of this is how the global view of taxation quietly began shifting one afternoon in 1974.

That afternoon, the American economist Arthur Laffer met with Dick Cheney and Donald Rumsfeld, who both were working for the Nixon-Ford Administration at the time. The topic at hand was taxes, a pressing matter at a time when the highest marginal tax rate in the US was fully 70 per cent.

During the meeting, Laffer explained that the relationship between the tax revenues and the tax rate was not as simple as one would expect. Doubling the tax rate, for example, does not double the tax revenues, because higher taxes disincentives people from working. To illustrate his point, Laffer famously sketched a curve on a napkin. It showed that both a tax rate at zero per cent and one at hundred per cent would yield no tax revenues.

A tax rate of zero per cent would logically mean zero revenues, and one at 100 per cent would disincentives people completely from working, which also means zero revenues. The implication, Laffer noted, is that somewhere between zero and hundred per cent, there is a tipping point. Above this point, raising the tax rates actually would actually lead to such a damaging effect on economic incentives, that the collected taxes would actually be lower after the tax rate was raised.

Since then, the Laffer Curve has been used by supporters of low taxes around the world to reinforce their ideas. In the US, it has helped to inspire a downward shift in taxation. Ronald Reagan’s administration introduced massive changes, which dropped the marginal tax rate to 28 percent. Since then, the taxes have again risen to 39.6 per cent. However, even the proponents of high tax policy are aware of Laffer’s warnings: there is a limit to how high taxes can be raised.

The funny thing is that Arthur Laffer’s theory was far from new.

He was rediscovering a concept that had been acknowledged during the Golden Age Islamic period of free market policy. Laffer has himself explained that he didn’t invent the curve, but took it from Ibn Khaldun, a 14th-century Muslim, North African philosopher. Indeed, many of the ideas we today associate with Western free-market thinkers originated in the Islamic world during the Islamic Golden Age.

The Islamic Golden Age lasted from the 8th century AD to the 13th century. During this period, much of the Middle East and North Africa was ruled by various caliphates. This was an era of scientific progress, economic development, and cultural achievements. Much of this was a continuation of the advancements that had been made in the high-cultures of Persia and Byzantium before the Islamic conquest.

At the beginning of the 6th century AD, the Persian king Khosrow introduced property rights and tax collection reforms, which weakened feudal control and strengthened private ownership. After the Arab conquest of Persia, which occurred in the middle of the 7th century AD, the system of private property was further strengthened which stimulated economic growth and dynamism. A bourgeois class of merchants, capitalists, and craftsmen arose in Persia, which was despised by conservatives who favoured a feudal economy.

In the book Decline and Fall of the Sasanian Empire, Parvaneh Pourshariati cites a text from this era which shows the contempt that the traditionalists had for the new bourgeois class.

The bourgeois are described thus: “They busy themselves like tradesmen with the earning of money and neglect to garner fair fame. They marry among the vulgar and those who are not their peers, and from that birth and begetting men of lower rank appear.”

For a society to accept free markets and the wealth it creates, an intellectual tradition in defence of capitalism needs to exist. This tradition developed in the Middle East many centuries before it reached the west.

Hamid S Hosseini writes about the Islamic economic tradition in the book A Companion to the History of Economic Thought. He explains that medieval Muslim writers held a much more favourable view of economic activity and wealth accumulation than contemporary Christian thinkers.

Hosseini cites several influential Persian Muslim thinkers, who praised wealth accumulation and self-interest. He notes: “In contrast to their European counterparts, medieval Muslim writers praised economic activity and the accumulation of wealth, viewed individuals as acquisitive, and scorned poverty.”

The most prominent supporter of low taxes was Ibn Khaldun. Born in 14th century Tunisia, Khaldun was a prominent scholar and one of the founders of economics and social sciences. Khaldun believes that a just government should only, in accordance with Islamic law, impose low taxes. This stimulates business activity and thus creates wealth, which makes it possible to collect more taxes.

However, rulers tend to increase the tax to benefit themselves. High taxes hurt commerce and trade. When tax rates are raised to pay for a bloated government, it will finally cause the tax base to shrink so much that the government cannot meet its obligations.

The modern theory of high taxation is simply that it will ultimately erode the tax base. Khaldun went further, and explained that ultimately the government would be bloated and the tax base eroded – at this point the state would often implode under its own weight, leading to a period of chaos and the rise of a new state.

This in fact is a key explanation for the rise and fall of historic empires, including the Roman Empire, the first Persian Empire and numerous other world powers. Often these empires begun by imposing low taxes, and thrived. With time, as the power of central state grew, so did also taxes – with stagnation and ultimately state failure as the result.

Arthur Laffer started an intellectual tradition of questioning high-tax policies, because he knew of the work of Ibn Khaldun many centuries before, and built on this tradition. Knowing the history of free markets is valuable for guiding the present. The ancient free-market intellectual tradition that existed in the Middle East, and independently also arose in China, is not well known today. Yet, it addressed the very same issues that are relevant today, pointing to the damaging effects of high taxation, government attempt to control market exchange, lack of respect for private property and public debt.

Besides Khaldun, there are numerous other Muslim scholars who contributed to free market economics and whose work deserves a renaissance in the modern world. Al-Mawardi, who was born in the 10th century, believed that public borrowing by the state should only be considered as a last resort and in rare cases.

Abu Yusuf, an 8th-century chief judge of Baghdad who wrote a treatise on taxation and fiscal problems of the state, thought that development projects whose benefit is general should be financed through public revenues. However, projects that benefited specific groups should not be part of public expenditure, but rather funded by the particular group itself. Yusuf applied cost-benefit analysis when he wrote: “the authorities must cancel the project of digging any canal whose damage is greater than its benefits.”

That the public sector should only fund projects that favour all of society, and leave projects that favour only one group to be funded privately, would be seen as an extremist small government stance today. But it wasn’t very shocking in the Middle East during the Islamic Golden Age period, where limited taxation was the norm. The state did have a role in funding infrastructure and also welfare, including hospitals. Yet it was very much a minimal-government approach.

Libertarian ideals and policies, it turns out, are anything but new. They have been tried out historically, with positive results. This is worth remembering, since ideas and knowledge of the past can both change the present world.

Dr. Nima Sanandaji is the president of the European Centre for Entrepreneurship and Policy Reform (ECEPR) and author of some 30 books. The sources in this article can be found in the book 'The Birthplace of Capitalism: The Middle East'.