3.2.4.6 Limits to How High Taxes Can Go
There are limits to how high taxes can go, before the point is reached where higher rates of tax reduce the government’s receipts. There is a limit on each tax category and a limit on the overall tax burden.
Limits on any one tax category: the Laffer curve
There is a theoretical limit on how much tax can be levied in a particular category, as illustrated by the ‘Laffer curve’. A YouTube video, The Laffer Curve, Part I: Understanding the Theory, explains the concept: total government income from a tax initially increases in proportion to the tax rate applied, but receipts start to level off as people take evasive action or reduce their effort. The curve then shows that government revenue starts to fall as the tax rate is further increased and the avoidance effects become dominant. No-one would do any work if the tax rate were 100%, so the government revenue would be nil.
The Laffer effect, though, only applies if tax rates are set very high. An analysis of the Laffer effect can be found in Samuelson and Nordhaus’s book Economics (pp. 313-316), which argues that American tax rates at the end of the 20th century were set low enough for the Laffer effect to be irrelevant: reductions in tax rates simply reduced revenues almost proportionally, whilst having no detectable impact in generating growth. The Economist argued that “The Laffer curve exists in principle, but the sweet spot is hard to find” and that President Trump’s tax cuts in December 2017 simply increased America’s national debt.
Limits on the overall tax burden that an economy can bear
The more practical limit on how much tax can be raised in total is its effect on growth: if people don’t have money to spend there is insufficient demand for wealth to be created and the total tax revenues shrink as the economy contracts. This is a Keynesian argument, which is briefly described in Samuelson and Nordhaus’s book Economics (p. 603). It applies most directly to taxes on low-paid and middle-income people. Tax cuts for these people stimulate growth, whereas tax increases can be used to dampen growth – and thereby reduce the risk of inflation (3.3.8.3).
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