In the early 1980s, I had the privilege of meeting and conversing with the American economist Arthur Laffer twice. At that time, the trust company I worked for hired him as an economic advisor to speak and teach the company’s investors. We were also fortunate to receive copies of his published economic works.
Back then, Arthur Laffer was a controversial figure among some for his groundbreaking “Laffer Curve” theory. He proposed that at a tax rate of either zero or 100%, the government would not generate any additional revenue. However, there exists an optimal tax rate between these two extremes where tax revenue is maximized. In other words, there is a level of taxation where the government collects the most money, and any further increase in taxes would decrease economic activity, resulting in lower tax revenue, possibly even approaching zero.
Many considered Laffer eccentric because the logical conclusion of his economic theory was that at a certain point, raising taxes could lead to diminishing returns for the government due to suppressed economic activity, ultimately resulting in decreased tax revenue. While the government might not experience an absolute decrease in tax income, economic analysts realized that increasing the tax burden would eventually lead to much lower revenue levels than initially assumed.
For instance, if a sales tax, like increasing from 5% to 6%, resulted in the government collecting $10 billion from a total of $200 billion worth of goods purchased previously (5% of $200 billion equals $10 billion), under unchanged conditions, the revenue expected in the current period would be $12 billion (6% of $200 billion). However, due to reduced spending by individuals, the funds collected might actually be less than $12 billion. Over time, the continual increase in taxes could lead to economic activity shrinking from its original levels as people cut back on spending and find ways to avoid tax obligations. Eventually, the tax burden becomes too heavy, causing the government to reduce tax revenue in absolute terms.
The two endpoints of the Laffer Curve are logically indisputable. The debate lies in the curve’s shape, which is that of an inverse “U.” It is crucial to remember that these discussions took place in the early 1980s when the top marginal tax rate for the highest income earners was 70%. Considering that the top marginal tax rate exceeded 90% between 1944 and 1963, 70% was actually quite reasonable.
When studying the highest marginal tax rates, adjustments must be made to account for inflation and the overall standard of living. For example, at the end of World War II in 1945, the top marginal tax rate was 91% and applied from $200,000 onwards. Some argue that this justifies increasing taxes on so-called wealthy individuals to confiscatory levels. However, it’s essential to bear in mind that $200,000 then is equivalent to around $3.5 million today, and the average standard of living in 1945 was much lower. At that time, hardly anyone had incomes matching $3.5 million today, and those who did found ways to avoid the risk of having their earnings confiscated.
In 1948, the threshold was raised to $400,000 and remained in place until the mid-1960s when the U.S. government lowered the tax rate to 70%, and the threshold decreased to $200,000, which would be roughly $1.1 million today. This was during a period of significant inflation. This situation persisted until the late 1970s when adjustments were made based on inflation rates starting in 1977. Essentially, this was an automatic annual increase in taxes for the most productive members of society. The late 1960s through the Reagan era saw a series of frequent economic downturns and heightened inflation during periods of economic growth.
After Ronald Reagan took office as the 40th President of the United States in 1981, he began lowering the top marginal tax rate to 50%, effectively reducing the maximum tax burden. This sparked economic growth. In a sense, it was a form of tax increase as it reduced the starting point for taxation, while from another perspective, it was a tax cut. The economy started to grow, the cycle of frequent economic downturns and high inflation came to an end. By 1987, the top tax rate had decreased to 38.5%, with a starting threshold of around $90,000.
During Reagan’s presidency, the economy experienced a remarkably high average growth rate. The U.S. economic growth rate ranged from 3.25% to 3.5% between 1982 and 1990, which is considered excellent in today’s standards. Despite tax cuts and deregulation, tax revenues increased. Certainly, the debt-to-GDP ratio saw an uptick; however, this is still relatively low by today’s standards.
Laffer’s theory has largely been validated. An economy burdened by excessive taxes may see an increase in tax revenue even when tax rates are lowered because high taxes act as a hindrance to economic development, a lesson that Canadians are beginning to understand. Not every dollar in tax revenue necessarily translates fully into government income.
When tax rates reach absurdly high levels, further increasing taxes might paradoxically result in decreased tax revenue as economic activity stagnates. Businesses might close down or reduce investments, leading to a spike in unemployment, requiring the government to spend more on social welfare programs.
Canada may find itself in a situation where taxes continue to rise while the populace becomes increasingly impoverished. The solution is rather straightforward: reduce taxes, cut government spending, abolish outdated regulations, and reform wealth redistribution schemes. Drawing wealth and income from productive sectors into government employment creation plans and subsidies, which ultimately impoverish the nation, will help elevate Canada’s prosperity.
(Author information removed for anonymity)