The Economics Book

271

Many tax havens formed in the

1970s, when small islands and

countries such as Monaco chose to

impose low taxes—or none at all

—in order to attract investment.

See also: The tax burden 64–65 ■ Gluts in markets 74–75 ■ Borrowing and debt 76–77 ■
The Keynesian multiplier 164–65 ■ Corporate governance 168–69 ■ Monetarist policy 196–201

CONTEMPORARY ECONOMICS

Supply-side economists argue that
the best way to make the economy
grow is to improve conditions for
the supply side, freeing companies
from regulations, and cutting
subsidies and high-rate taxes.

From tax to tax havens
The revenue argument for cutting
taxes came from US economist
Arthur Laffer. He said that if a
government takes no tax, it will get

no revenue. If it takes 100 percent

tax, it will get no revenue either,

since no one will work. But even

below 100 percent, very high

income tax rates discourage people

from working. This reduction in

hours worked outweighs the high

tax rate, and the result is a fall

in tax revenue. When top-rate taxes

are very high, revenue can also be

lost by the highest income earners

leaving the country or putting their

money in tax havens—countries

charging little or no tax. Laffer

drew a bell-shaped curve (left) to

show that somewhere between the

extremes of no tax and 100 percent

tax, there is a point at which a

government will maximize revenue.

The argument then is that from

a starting point of high tax rates,

tax cuts, along with other policies

to strengthen the supply side, can

enhance economic efficiency and

generate more tax revenues. In the

1970s, when Laffer developed his

theories, some countries taxed

some people at 70 percent, and a

few taxed the highest earners at

90 percent. Economists disagreed

about where the peak on the Laffer

curve lies. Those on the political

Right argued that the economy was

at a point to the right of the peak of

the curve, meaning that tax cuts

would increase revenue. Those on

the Left disagreed.

A win–win situation

For politicians on the Right, Laffer’s

theory was attractive. It meant that

they could make themselves

popular by cutting taxes, yet

pledge to maintain public services,

too. In 1981, President Ronald

Reagan was able to cut top-rate

taxes and still be a hero to many of

the poorest US citizens. However,

there is little evidence that the idea

actually works. In the US and other

countries tax rates are far below

the level of the 1970s. However, the

supposed tax revenue bonanza has

not arrived. Instead, tax cuts have

been funded largely by rising

borrowing deficits. ■

The theory of supply-side

economics generated a

considerable amount of

controversy when it was

developed in the 1970s. It

emerged in response to the

apparent failure of Keynesian

policies of government

intervention (pp.154–61) to deal

with a flat economy combined

with high inflation—a condition

known as stagflation. The

term was popularized by

US journalist Jude Wanniski,

Supply-side economics

but it was US economist Arthur

Laffer’s tax curve that caught

economists’ attention. The

Laffer curve was developed

under the guidance of Canadian

economist Robert Mundell

(p.254), who argued that if tax

rates were cut, national output

would increase, and tax

revenues would rise. After a

quick dip revenues did actually

rise, but there has been huge

debate ever since over whether

he was proved right.

The Laffer curve displays the
relationship between tax rates and
government revenue. It shows that
higher taxes do not always result in
increased revenues.

0

GOVERNMENT REVENUE

TAX RATE (PERCENT)

100

maximum

revenue

ideal tax

point