3.2.4.6 Constraints on the Amount of Tax that can be Levied

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Increased government spending can dampen an economy, as previously mentioned (3.2.3), but it is hard to judge whether an increase in spend (and therefore in total taxation) would reduce economic growth in practice.  Individualists and collectivists use different economic arguments, as described later in this chapter (3.5.2), but the decision is ultimately political (6.7.1).

There is also a theoretical limit on how much tax can be levied, as illustrated by the ‘Laffer curve’.[1]  This shows how 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.[2]  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,[3] and 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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[1] A simple and amusing explanation of the Laffer curve was available at http://www.youtube.com/watch?v=fIqyCpCPrvU in March 2018.

[2] 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.

[3] Keynes’s theory on the impact of demand on economic growth is briefly described in Samuelson and Nordhaus’s book Economics, p.  603.