The government raises taxes but rather than bringing in more money to its accounts this actually reduces its revenues. Conversely, cutting taxes brings in more cash. Economic logic has been turned on its head. But this is no black magic; it is instead the main tenet of supply-side economics.

Supply-side economics is among the most controversial of economic theories. The debate over it encapsulates the divide between those who believe in greater government distribution of wealth and those who believe, above all, in individual liberty and a free market.

The term concerns more than just tax rates. Most broadly, supply-side economics refers to the reform of the supply side of the economy -- meaning the institutions and companies that produce the goods people consume. In this traditional sense, supply-siders are those who would like these companies to be freer and more efficient; they support the privatization of utilities (such as water and energy companies), cuts in subsidies to struggling sectors (such as farming and mining), and the abolition of monopolies (such as telecommunications companies). There are, in fact, few economists who would argue with aims like these.

However, since the 1980s, 'supply-side economies' has tended to refer more specifically to arguments in favor of cutting high tax rates, an idea most notably propounded by American economist Arthur Laffer in the late 1970s. The more people have to pay in taxes, he argued, the greater will be people's incentive to avoid paying them or to work less hard.

The Laffer Curve Laffer argued that if a government levied no taxes it would (logically) receive no revenue; neither would any money pour into its coffers if it imposed 100 per cent taxes (because no one would have any incentive to work). He then sketched out (on the back of a napkin, so legend has it) a bell-shaped curve which showed that there was a point somewhere between 0 and 100 per cent where a government could get maximum potential revenues. The argument -- that lower taxes could actually increase government revenues -- found admirers in Ronald Reagan and Margaret Thatcher.

The theory focuses particularly on the margined tax rate -- the rate one pays on every extra hour of work one does. Many of the biggest economies, including the US and the UK, had marginal rates of around 70 per cent. Since workers will take home only 30 per cent of every extra pound or dollar they earn, this clearly affects the incentive people have to work longer hours.

The problem is not only that people will find ways to avoid paying extra tax by, for example, decamping to tax havens such as Monaco or the Cayman Islands, but also that higher marginal tax rates can damage the overall economy. Discouraging the workers who generate the most money (usually those on higher wages) will drive them out of the country or away from their jobs, reducing an economy's overall wealth creation. If this happens, it is a sign that the country's government should either consider cutting taxes or find other incentives for encouraging businesses to stay.

By contrast, when tax rates are low, it encourages people to work longer hours, although the respective share the government takes of every extra dollar earned is less. The Laffer Curve illustrates that the government must strike a balance between the two, expressing scientifically the truth of the dictum of Louis XIV's finance minister, Jean-Baptiste Colbert, that taxation is the art of 'so plucking the goose as to get the most feathers with the least hissing'.

How High is Too High?

The big question -- given the Laffer Curve's indication that beyond a certain point tax rates bring in less and less revenue -- is where that cut-off point lies. Certainly not at the 90 per cent marginal rates paid by some in the 1960s, nor at a rate of 15 per cent, which could leave the government unable to finance its welfare state and social spending.

The debate continues to rage today, with many left-leaning economists proposing that the ceiling should be over 50 per cent, while those at the other end of the political spectrum suggest it should be below 40.
Throughout the world the consensus has been towards lower marginal rates. The number of countries with a top tax rate of 60 per cent or above had dropped from 49 in 1980 to just 3 by the turn of the millennium - Belgium, Cameroon and the Democratic Republic of Congo.

Laffer Problems

While it is difficult to dispute the elegant logic of the Laffer hypothesis, there remain major questions as to whether it actually works in practice. Indeed, in the early 1980s Reagan's tax cuts were derided by George H. W. Bush as 'voodoo economies'. According to Harvard professor Jeffrey Frankel the theory, "while theoretically possible under certain conditions, does not apply to US income tax rates: a cut in those rates reduces revenue, precisely as common sense would indicate".

Indeed, evidence shows that the Reagan tax cuts and the George W. Bush cuts in 2001-2003 reduced government revenues and pushed the budget deficit higher. In other words, they were unfunded, and would have to be paid back eventually. Supply-siders maintain that what the administration got wrong was the choice of particular taxes to cut, rather than the decision to reduce the overall level of taxation.

Although the hypothesis remains extremely popular to this day (perhaps because it promises politicians something for nothing), study after study has disproved its effectiveness. Only in extreme cases -- with rates being massively high, for instance -- can cuts in taxes bring in higher revenues.

That said, there is little doubt that excessively high taxes can hold back economic growth. By highlighting this argument, supply-side economics has been responsible for a wholesale overhaul in the way taxes are perceived and constructed throughout the world.