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Analysis

Trump rides the Laffer curve

Why president is right on corporate tax

by Brian Reading in London

Fri 17 Mar 2017

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The US economist Arthur Laffer was an early exponent of supply-side economics at a time when most others were discarding John Maynard Keynes for Milton Friedman. In 1974 his ‘Laffer curve’, an illustration of the theory on optimum tax rates, became popular with US policy-makers. Laffer later served on President Ronald Reagan’s economic policy advisory board. The history of Reagan’s supply-side experiment provides precedent for the incumbent president’s proposed economic policy – Trumponomics.

The Laffer curve is simple. As tax rates rise from zero, tax revenue increases. There comes a point when revenue is maximised but, according to Laffer, if tax rates continue to rise, revenue starts to fall because people are deterred from working by the high taxes. Both zero and 100% tax rates collect zero revenue. A single most-efficient tax rate produces the maximum revenue.

Punitive US corporate tax rates collect relatively little revenue. According to the University of Oxford’s Said Business School, in 2015 the US had the highest statutory corporate tax rate (40.5%) of the G20 member countries. After Ireland, the UK (20%) had the second lowest. Yet among members of the Organisation for Economic Co-operation and Development, the US comes close to the bottom of the revenue table. If Donald Trump lowers the high rates, this is likely to boost tax revenue.

Global tax competition is of equal importance. US multinationals reduce their domestic tax bills by locating in tax havens, outsourcing, investing in offshore activities and retaining profits abroad to avoid tax on repatriated earnings. This directly reduces US tax revenue and indirectly impacts the tax base by lowering domestic investment, growth and productivity.

Several G20 nations, including the UK, Indonesia, Italy, India, Japan and France, intend to cut corporate tax rates before the end of the decade. America has hitherto stood aside. Trump plans to retaliate.

On trade, Trump’s border adjustment tax proposal can be seen as a reprisal. It exposes a defect in World Trade Organisation rules. Direct subsidies to exporters and taxes on imports are banned. But indirect taxation, such as value added and sales taxes, have the same effect and are allowed.

In these cases, the US is the losing party. Corporate tax competition distorts tax systems. While government deficits support demand, too much leaks into corporate savings, causing cash to be hoarded. Companies won’t invest in the light of anaemic demand, and the failure to invest causes demand deficiency. Instead, companies buy back shares and exploit record low interest rates to leverage balance sheets.

In 1981 Congress slashed personal taxes through Reagan’s Economic Recovery Tax Act. The fiscal stimulus was offset by monetary stringency. Paul Volcker, then chair of the US Federal Reserve, raised interest rates to record levels. The dollar soared and much of the stimulus and tax revenue leaked abroad through a record current account deficit. Reagan did the rest of the world a favour. If Laffer is right, Trump’s corporate tax cuts can do the opposite. The dollar may again soar as it did in the 1980s – this would only encourage further US trade protectionism.

Brian Reading was an Economic Adviser to Prime Minister Edward Heath and is a Member of the OMFIF Advisory Board.

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