The other day, I briefly stopped by a raging debate on Twitter about the Laffer Curve and “trickle-down economics” and got frustrated for the umpteenth time about how readily people mix those concepts up.
So much so, that I suspect many of the people in the debate don’t get the point on purpose because it would put a hole below the waterline in some of their predetermined conclusions.
Before I get into the meat of this article, though, let me say two quick things.
Firstly, I’m an accountant, not an economist. Professional economists may feel I’ve over-simplified some of these issues, which I probably have – both in the interests of space and also in the interests of not having too many people fall asleep while they are reading this article.
Secondly, I’m not taking a political stance here, for or against any side in the debate. I’m just trying to explain the issues the best a humble accountant can. Admittedly, partly in the hope that I don’t end up arguing with you on Twitter about it at some point in the future.
But in popular culture, if not amongst professional economists, nearly everybody gets this wrong and thinks the Laffer Curve and trickle-down economics are the same thing. So I’m trying to untangle the nonsense you’ve probably been fed over the years, in the interests of both your sanity and my Twitter feed.
The Laffer Curve
Famously drawn on the back of a restaurant napkin by economist Arthur Laffer, the Laffer Curve is usually drawn something like the image at the top of this article – essentially a bell curve.
Sometimes people talk about the napkin-drawing episode in derogatory terms: “it’s just nonsense some bloke drew up on the back of a napkin”.
But it’s a big mistake to think that.
An early boss of mine (different times…) used to say “if you can’t explain something on the back of a fag packet, you don’t understand it well enough”. (For non-Brits, that’s a packet of cigarettes, back when people routinely smoked in the workplace. Although, ironically, not my old boss, who was a confirmed non-smoker.)
For me, almost the purest form of explanation is something that can be reduced to a single image. It’s one reason I’m such a big fan of newspaper cartoonists who sum up the biggest stories of the day in a single image that forces you to think more deeply about the headlines. The Dilbert comic strips and the Alex cartoon in the Telegraph are also great examples of this style of impactful storytelling with just three or four images and a handful of words.
There’s a big difference between “simple”, ie reduced to its essential elements for impactful communication – like a newspaper cartoon – and “simplistic”, ie delivered at the level of a 5-year-old by someone who doesn’t know what they’re talking about – like when a professional politician of any party speaks, for example.
So, the Laffer Curve is simple. It’s not simplistic.
And if you think about it for more than 2 seconds, and you’re even a tiny bit smarter than the average politician (to be fair, that’s not hard – I own pencils for which that statement is true), the message of the Laffer Curve is inarguable.
What’s more, it’s inarguable because pretty much every person in the world applies the principles which underpin the Laffer Curve whether they choose to recognise that or not.
Its principles are simple. If taxes were set at 0% across the board, Arthur Laffer illustrated that a government would collect no tax revenues.
And if the tax rate was 100%, government tax revenues would also be pretty much £0, because nobody would have any incentive to work, so the government wouldn’t collect any tax.
In between the 0% and 100% tax rates, however, there is a point at which a government will maximise its tax revenues. Below that point, they are “leaving money on the table”. Above that point, there is an increasing disincentive to work, so people choose not to, leading to a reduced tax take.
It’s the real world
Many people would have you believe this is some sort of right-wing free market messaging, but the concept behind the Laffer Curve reflects the real world almost perfectly.
If you have ever employed a tradesperson who insisted in cash for the job, they were applying the Laffer Curve. By the time they had declared the income and been taxed on it, they would rather have been sat at home watching the telly than fixing your blocked sink.
At the moment in the UK, there is a significant cluster of business reporting revenues just under £90,000pa because if they go over that level they have to start accounting for VAT and pass on an extra 20% tax hike to their customers, which (so those businesses believe) would reduce their income. (I accept this might be more a regulatory compliance cost factor, rather than the tax itself, however it illustrates the principle, so I’m leaving it in.)
And if you are lucky enough to be in a salaried role in the UK which pays £100,000 a year, the last thing you want is a pay rise, because between £100k and £125k a year, the government currently takes 60% of your salary in extra income tax. (Which reduces to 45% once you get to £125k – see my comment above about how smart politicians are compared to pencils.)
So, people who would otherwise earn, say, £110k a year often lock away that extra £10k in a pension fund they can’t touch until retirement, instead of taking the extra pay and spending some of it, after taxes, in the real economy and thereby boosting economic growth.
While people might disagree on what the precise tax rate at which government tax revenues are maximised might be, very few people think that suddenly paying 60% tax on your income at £100,001-plus would encourage people to work harder and earn more money, given how little of it ends up in their pockets.
Love it or hate it, the Laffer Curve reflects a real dynamic in ordinary people’s lives every day of the week. It may be politically inconvenient to some, but we all make decisions based on the principles underpinning the Laffer Curve.
The “back of a napkin” thing is simple. But it isn’t simplistic. It’s an insightful summing up of an essential truth.
What it isn’t, though, is an endorsement of “trickle-down economics”, as some people like to claim – either in ignorance or as a deliberate attempt to mislead.
The Laffer Curve is purely a way to talk about how to maximise the government tax take, and puts forward the proposition that there is an optimum tax rate at which government tax revenues are maximised. Taxing at rates either below or above that point leads to a reduction in tax revenues.
You might like the Laffer Curve, or not like it, but like the famous Winston Churchill quote about the truth, in the end, there it is.
Everyone in the whole world – including you – applies the principles behind the Laffer Curve every time the question of how much tax they pay comes under consideration.
Precisely where the optimum tax-maximising point is, is another matter and it’s not something Arthur Laffer built into his curve.
It’s likely to be different between countries, and even between different groups in the same country. But overall, if you aggregate all the decisions in the country, the Laffer Curve reflects the reality of human decision-making.
The trickle-down
I don’t especially like the expression “trickle-down economics” because it always suggests someone with a bladder problem to me. However, I’ll use it here as it’s a commonly-used term.
The principle behind trickle-down economics is also simple…albeit possibly simplistic.
The principle here is that if you cut tax for high earners, they will go and spend more money in the economy at large which, in turn, will create more jobs – and, in time, higher incomes – for everyone else too.
A bit like the “just a scribble on the back of a napkin” critique of the Laffer Curve, “trickle-down economics” is a deliberately slightly derogatory term for what might more properly be called supply-side economics.
Popularised by the influential Chicago School of economists – and much loved by political leaders on both sides of the Atlantic in the 1980s – supply-side economics suggests that low taxes and reductions in government regulations will encourage companies to invest, thereby boosting economic growth and bringing prosperity to all.
Now, at some level, this isn’t the craziest concept in the world either.
Some of the applications of it have, arguably, been crazy, but the concept is sound.
To give a bit of a real world example (and I accept this isn’t strictly an issue of trickle-down economics) it’s been quite fashionable of late to let businesses pay lower taxes “to stimulate investment” by giving generous allowances against their corporation tax for capital investments businesses make.
The theory is that the effective reduction in tax (that’s where the trickle-down but comes in) will motivate business owners to spend more – and specifically to spend more on capital equipment which will help grow the economy and provide jobs.
That’s a reasonable enough theory. But it’s just theory. In the real world something a bit different is going on.
A good recent example is when small business owners in the UK were able to fully expense capital equipment purchases, up to a limit, in the year in which they bought their equipment. At least some small businesses bought more items of capital equipment because they got an immediate 100% allowance against their tax bill for doing so.
So far so good, right? Working exactly as planned.
Where the principle goes a bit iffy is that, for a while, some of the capital investment was in things like a new electric BMW for the company’s owner. Now, I have zero objection to company owners buying themselves BMWs, or anything else for that matter, but the principles of supply-side economics fall away somewhat when a UK business owners buys a new BMW.
In that scenario, if there is any economic benefit to businesses at all (and that’s pretty marginal if you’re buying a car, however cool it might make you feel), it is flowing mostly to the good folk at Bayerische Motoren Werke in Munich, together with the people across Germany who make up their supply chain.
While a tiny amount of economic benefit will stick with the UK-based dealer who sold you that new beemer, the dealer element of the total bill you get stuck with for a new electric BMW is a tiny proportion of the whole.
Not, by the way, that I’m advocating protectionism. Far from it.
I’m just illustrating that not all capital spend you get allowed as a write-off against your UK tax will necessarily deliver an economic benefit to the UK economy. The same dynamic is true if, for example, you buy a new assembly-line robot from Japan, or a bunch of microchips for your datacentre from Taiwan.
That’s why, under the principles of trickle-down (or supply-side) economics, you can have high levels of tax-allowable capital investment, whilst still having a moribund UK economy which isn’t seeing the benefit of that tax allowance in jobs or incomes.
While the loss of tax revenues is borne by UK taxpayers, the benefits of economic growth from those investments flow mostly to the citizens of Munich, Tokyo or Taipei. So substantial capital investment in the UK economy can be significantly less beneficial to UK citizens as a whole than a simplistic view of trickle-down economics might suggest.
There is some benefit to the UK, of course. Those new machines are presumably making a UK business more productive to some extent as well. But the nature of capital investment is that you accrue the benefits over a long period of time – perhaps 5 or 10 years or more.
So all the up-front tax loss might take 10 years or more to come back again – and factor in the time-value of money (which I’m not going to do here) it’s probably more like 15 years before the UK taxpayer is back to the point they started, following a decision to use reductions in tax, through stimulating capital investment, in the hope of growing the economy.
Where it goes wrong
Where this goes wrong (especially on Twitter… 😉) is when people run those two concepts together and rail against both the Laffer Curve and trickle-down economics in the same breath.
They are two entirely different things, based on different principles, measured in different ways.
Now, it is true that, broadly, if you’re a believer in supply-side/trickle-down economics, you are also likely to believe that the Laffer Curve is true. In fact, people who promote trickle-down economics often use the Laffer Curve to illustrate how reducing taxes will actually lead to an increase in government tax revenues, which, they believe, bolsters their case for tax cuts.
There is an important pre-supposition here, of course, even assuming trickle-down economics works. And that is this assumes the tax rate is currently above the “maximum amount of tax collected” point.
I’m not expressing a view here on whether it is or not. And what might be true in some countries might not be true in others.
I’m merely pointing out that there is a potential flaw in thinking that a tax-cutting, supply-side economics agenda will necessarily result in increased tax payments flowing into the government’s coffers. If the “optimum collection point” was at a 40% tax rate, say, and proponents of supply-side economics pushed through a reduction to 35%, then the government’s tax take, according to the principles of the Laffer Curve which they used to justify the tax cuts in the first place, would be less, not more.
And, as I said at the outset, I’m an accountant, not an economist. There are, I am sure, a wide range of economic arguments for and against supply-side/trickle-down economics that I’m not qualified to express a view on.
But the point I want to make here is that the Laffer Curve is a pithy reflection of an economic phenomenon which accurately reflects real world behaviour by individual taxpayers. I say that without judgement as to what their behaviour should be – merely that those judgements are the judgements pretty much everybody in the whole world makes as they draw on the essence of human nature.
You might not like that answer, but it’s the truth.
Supply-side/trickle-down economics is conceptually fair enough, but has some problems when it comes face-to-face with the real world. I don’t have the technical expertise to say whether trickle-down economics works or not. I just know that, on its own terms, and applying the Laffer Curve which most people promoting the trickle-down economics agenda use as part of their justification, there are scenarios in which it might not be true that tax cuts automatically increase government tax income and/or boost the economy as a whole, along with increasing employment opportunities.
But whether you love supply-side/trickle-down economics or hate the concept to your very core, please don’t – on Twitter or anywhere else – make the mistake of thinking that the Laffer Curve and trickle-down economics are the same thing.
They are not.
What this means for business
This newsletter is supposed to be about business, not economics, so what’s the business insight here, you might ask?
Well, there are a few:
- Simple isn’t the same as simplistic. It really is true that if you can’t explain something on the back of a fag packet (or a napkin) you don’t understand it well enough. You don’t always need that 400-page report to make a decision. Sometimes the back of a napkin is plenty.
- Watch the concepts you lump together – people will often try to get you to link A and B because B is what they really want, but A makes the argument for B more plausible, even if they are not really connected at all. The Laffer Curve can be used to make trickle-down economics seem more palatable in the same way that convincing your boss that because people matter in your business, you ought to have 17 people in the HR department. In both those cases, one statement can be true without the other.
- Reality beats theory every time. The Laffer Curve reflects reality. Supply-side economics is a theory which may or may not be true in every scenario. To butcher one of my favourite business quotes, from Jeff Bezos: “when reality and theory throw up different results, usually the reality is right”.
- You don’t need to like it – you may not like the implications of the Laffer Curve shows, but the real world doesn’t care whether you like it or not. It just is what it is. Try not to let your emotions and beliefs get in the way of big decisions. You can argue against reality all you like, but in the end you can’t out-run it. At best, you can hold it off for a little while, but you’ll never escape it.
- “Directionally right” is usually good enough. For most business decisions, the nth degree of precision doesn’t matter – and the cost of working it out to six decimal places, even where you can, is generally prohibitive anyway. A common criticism of the Laffer Curve is that Arthur Laffer never said what the perfect tax-maximising % was, but that’s to miss the point. The lack of a precise % doesn’t invalidate the concept – and it’s almost certainly different in different countries anyway. In business, when a decision is directionally right, just make the decision and fine-tune is as you go. For example, there’s no need to wait three years for the £million study from a fancy firm of consultants to tell you that the reason all your customers are unhappy is because you don’t employ enough call centre agents to answer the volume of calls you receive on a daily basis. Just employ more people in your call centre, and when all your calls get answered in a reasonable amount of time, consider fine-tuning that a little.
And please, please, please – if we ever cross paths, on Twitter or elsewhere – please don’t confuse the Laffer Curve and supply-side/trickle-down economics. They are two entirely different concepts and one can be true without the other necessarily being true.