Imagine that we had an income tax rate of 10% (wishful thinking!), and we reduced the rate to 5%. Chances are tax revenues would fall by roughly half. But what if we had a starting rate of 60% and reduced it to 30%? Your first thought might be that revenues would also halve. After all, you’ve cut the rate by half. Yet all the pragmatic experience, over and over again in many countries over several decades, suggests the opposite. Revenues might well double. It’s wholly counter-intuitive. When Reagan announced major tax reductions, commentators called it “Voodoo Economics”. But Reagan was right, and the commentators were wrong. When Russia recently reduced tax rates from 80% to 16%, revenues increased by 150%.
The fact is that if people feel taxes are onerous or excessive, they find ways of avoiding or evading them. They may work less, or move investments off-shore, or hire fancy accountants, or opt for the black market. Low-income people may decide that welfare is a better deal than work. Foreign investors vote with their feet, and go elsewhere.
But reduce taxes, and the reverse happens. People in the black economy will switch to the mainstream and go legit. The marginally unemployed will look for work. Higher up the income scale, expatriated investments may come home. There’ll be less creative accounting, but more capital formation to back entrepreneurs, more inward investment, higher growth, increased prosperity. And there’ll be more revenues for government to spend on social goods. (For a more technical explanation, Google the Laffer Curve).
On May 27th, I had the privilege of co-hosting a seminar on the flat tax in the European parliament, with the European Enterprise Institute and the Adriatic Institute. In the Chair, we had Edward Lucas, a Deputy Editor of The Economist. Our two main protagonists were my old friend Dan Mitchell of the Cato Institute in Washington, a supply-side tax reform expert, who made the case for a pure flat tax, and Robert Batinovich, a successful entrepreneur and former government official, who argued for a slightly less austere version designed to answer the criticism that the pure flat tax, while it would clearly work, would tend to favour those with unearned income, and therefore be seen as favouring the rich.
Both speakers made a powerful case for lower and simpler taxes, and highlighted the dangers of the EU’s implacable hostility to what it calls “unfair tax competition”. I argued that no tax competition is unfair: rather that the EU’s efforts at harmonisation are a cartel operated by governments against the interests of the people. The EU’s opposition to low tax rates could come back to haunt it in Ireland on June 12th, since fear of pressure to increase Ireland’s hugely successful 12.5% corporate tax rate is a powerful weapon for the NO campaign.
The debate was very well-attended and successful, and I was pleased that we managed to bring together such a distinguished panel. I am also delighted that back at home the Conservative Party is starting to respond to public demand for lower taxes, and to feel its way, however tentatively, towards lower and simpler taxes, if not the full nine yards of a pure flat tax. If we follow this route, then (as someone used to say) “things can only get better”. I am determined to fight Labour’s great fallacy. Whenever we talk about lower tax rates, Labour politicians ask “Which schools and hospitals will you close?”. But they are the ones closing hospitals. The proper question for Labour is this: “If you fail to reduce taxes, if you fail to use lower taxes to increase revenues and prosperity, what public services will you have to cut?”.