The Laffer Curve And All That - Reducing Personal Taxes To Drive Growth

​The September 2022 Trussonomic “mini-Budget” by UK Chancellor of the Exchequer (finance minister) Kwasi Kwarteng claimed that cutting personal and corporate taxes will drive economic growth and pay for themselves. Some have suggested that this is the same as the “Reagan” tax cuts of the early 1980’s that cut taxes and increased the US fiscal deficit.
 
Underlying both sets of tax cuts is a price of economic theory, the Laffer Curve, that was dreamed up (although its author claims it has deeper roots) on a restaurant napkin in 1974 during a lunch between economist Arthur Laffer, US politicians Dick Cheney and Donald Rumsfeld and a journalist. The famous napkin has been memorialised as a museum item in Washington DC! The Laffer Curve theory asserts that growth rises when taxes, especially personal taxes, are cut. It has been extended over the years by some US based think tanks to suggest that personal tax rates need to be set below an optimum level to drive growth.
 
Easy to comprehend, and as we saw in Kwarteng’s 2022 statement easy to claim as a growth generating measure how does it perform in the real world? According to a detailed study performed by US economist Austan Goolsbee in 2009 such policy delivers poor and unsubstantiated results (Goolsbee 2009). Coincidently, these results should be no surprise as they reflect similar historical experience. For example, when the Roman Colony of Britannia decided to stop paying its taxes to Rome at the start of the 5th Century in response to the Roman Emperor moving the army (that the taxes were paying for) away from Britannia to deal with trouble in Gaul, the dramatic tax cut (to zero) led to demonetarisation and economic stagnation.
 
Notwithstanding, dropping a personal tax rate from, say 98% to 40% will likely impact economic growth, provided this is only occurring in one nation. Big changes in single nations do make a difference as President Hollande of France found when he increased the top rate of tax in France and key entrepreneurs left in response. Large changes in personal tax rates and large differences in tax rates between countries do make a difference, but smaller changes such as abolishing a 45% top rate tax band to leave income taxed at 40% is unlikely to change entrepreneurial behaviour.
 
Instead, such tax cuts are likely to increase the public sector deficit whilst having no material impact on economic growth. Could this be one reason financial markets reacted so strongly to the Kwarteng September 2022 tax cutting announcement?