Voodoo economics? Can tax cuts boost revenue

With the Federal election finally out of the way and with Mr. Martin's "mini-- budget" back on the parliamentary order books, we finally have a supply-side event to contemplate in the Canadian context. Supply-side policies are those associated with tax cuts that so increase economic activity and tax compliance that they actually generate more tax revenue. President Reagan was the White House resident who waved the supply-side flag, hence the 198os label, "Reagonomics", but it was Arthur Laffer who graphed the connection between tax rates and tax revenue that now bears his name. Laffer made the now rather obvious claim that tax revenue is zero at both a zero tax rate and a loo percent tax rate. This means that there must be a number between zero and loo percent at which tax revenue is optimized (see Figure 1). Here then is the billion-dollar question: Where in that loo percent wide interval is the tax rate that maximizes government revenue?

As with many economic ideas, especially those associated with the political right, most of the discussion of the possible benefits of tax cuts for tax revenue has taken place in the United States. This discussion has focussed on two different routes by which tax rates may influence tax revenue. The first of these follows the effect of high tax rates on the incentive to generate taxable income or to shelter income by legitimate means - tax avoidance. The second route follows the effect of high tax rates on the incentive to declare income - tax evasion.

Both tax avoidance and tax evasion increase with the tax rate. Tax avoidance can involve unwillingness to work more hours because it's not considered worth the effort on an after tax basis. Avoidance can also involve unwillingness to invest because the expected payoff, after tax, is not worth the risk taken. The latter effect is likely to have more serious long-term consequences because investment is essential to economic growth, whether that investment is in physical capital such as plant and equipment, or in human capital ("brain-ware"). Why should somebody spend years working towards degrees and professional qualifications if the payoff is truncated by extremely high rates of taxation?

In discussions of the connection between tax rates and tax revenue in the United States, people are very unlikely to mention a third route by which tax revenues might decline, namely that of the migration of businesses and people to lower tax rate jurisdictions. In fact, there seems to have been little or no discussion of the matter, even at a local (i.e. state or municipal) tax jurisdiction level. People and businesses can move from state to state or city to city in response to varying tax rates, but US discussions of the Laffer curve have not factored this mobility into the equation.

CANADA's LAFFER CURVE

In Canada, the possible effect of migration on the tax revenue-tax rate connection is discussed at the national level. But in this country, discussions of the "brain drain" often cast the problem only in terms of people leaving the country to avoid high tax rates. Clearly there are other factors at work in the flow of talent and entrepreneurship to the United States. The weak Canadian dollar is exporting our people, as well as our goods and services, and is also helping Canadians sell their

businesses to foreign buyers at bargain-basement prices. Canadians also move to expand their opportunities and improve access to the giant US capital market - a market much more accessible to those living within the United States. In addition to tax avoidance and tax evasion, this mobility of capital and labour is the third force influencing the slope of Canada's Laffer curve.

What then does mobility mean fog the shape and height of the Laffer curve in Canada? When we add migration to the mix of influences on the tax rate-tax revenue relationship, how potentially serious are the consequences?

THE MOBILITY FACTOR

The mobility factor operating at the national level is of only minor significance when compared to this same factor operating provincially. The more local and open the domain over which the Laffer curve is constructed, the greater its curvature. Businesses and people can move between provinces without green cards and work visas. This mobility is more of an issue today than in the past because so many businesses today are knowledge-based and depend mainly on human capital. The old bricks and mortar industries that used to be the backbone of our economy are being replaced by industries that require little more than an office and some fibre cables.

When labour and business mobility are added to the Laffer curve, they shift the entire curve downwards; this means that less money is collected at every tax rate. However, mobility does not affect the entire length of the Laffer curve in the same way. The effect is likely to be more pronounced at higher tax rates. Canadians are relatively tolerant people and will pay reasonable tax rates, especially if they believe the money is being spent wisely. Therefore, the effect of mobility on the height of the curve is greater at higher tax rates, as shown in Figure 1: the curve with labour and capital mobility is lower at all tax rates, but particularly so at high tax rates.

Changes in tax rates shift the Laffer curves of competing tax jurisdictions. Alberta's move to a lower, flat provincial tax rate means that BC will collect a smaller amount of tax revenue at all tax rates. With the effect larger at higher rates, the optimum BC income tax rate will be shifted to the left, as in Figure 2. Open economic jurisdictions must keep looking over their shoulders. Just as Canada cannot sit idly by while the US lowers taxes, BC cannot sit idly by while Alberta and nearby US states lower their rates.

A RACE FOR THE BOTTOM?

The issue of tax competition leads immediately to the question of whether we can expect a "race for the bottom" Will tax rate reductions, once begun, cause a cycle of catch-up and leap-frogging? Will low tax rates mean a low quality of services provided? Such fears overlook an important point: residency is a determinant of tax, but residency is also a qualification for collecting government provided or supported services. People might want to stay in Canada, or BC - even if this means paying higher taxes - if the health care or education is better. As much as people care about tax, they also care about what they receive in return for their taxes. If people could collect the best services regardless of where they lived and paid taxes, there would be a problem. This is not true of health care, although it may be true of higher education (a province might be tempted to save money by having limited university seats, knowing that local children can go to another province or country for their education, but hopefully come back home afterwards).

With the quantity and quality of government-provided or funded services being as important as tax rates, what does this imply about the optimal tax rate? The key is whether or not people think they're receiving value for their money Higher tax rates won't guarantee brain drain or corporate drain, if people and businesses believe they're receiving good value for their taxes. That is the more people value the services they receive, the higher the Laffer curve will be. Of course, there are limits; people won't tolerate extremely high tax rates for superb services if these services aren't wanted.

With perceived value for money such an important part of the tax rate-tax revenue connection, governments should think very hard about how to give people the right level of services, and how to do this in a cost effective manner. How do you decide what people want? The market does this by seeing if people are willing to pay. Of course, it is hard to collect user fees for some government services, and the goal is, after all, to deliver public goods. However, there are services that lend themselves to user fees, perhaps with special provisions or assistance for those with limited ability to pay. How then do we satisfy the other aspect of receiving value, namely provision, in a cost-effective manner?

With some services, peoples' perception of efficiency is likely to be improved when the services are contracted out to private sector providers. The perception is likely to be correct, since in a competitive bidding process the low cost provider is likely to win. Of course, levels of service must be specified and service provision monitored. We must also remember that not all services provided by government lend themselves to market-- based mechanisms.

The pendulum seems to be swinging back to the recognition that people want to be rewarded for their work and for taking risks. Income tax rates and capital gains rates reflect this. The possibility of moving to locations where value is received for what we pay is forcing open economic jurisdictions to take action, like it or not. Those governments that do not respond, thinking their Laffer curves are just the way they used to be, uninfluenced by outside forces, are in for a big shock. Mobility, which has been enhanced by the shift to service industries, particularly those that are knowledge-based, means that it is no longer business as usual for governments.

BY MAURICE D. LEVI

BANK OF MONTREAL PROFESSOR OF INTERNATIONAL FINANCE

UNIVERSITY OF BRITISH COLUMBIA

Copyright Institute of Chartered Accountants of British Columbia Jan 2001
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