Executive Summary: Margaret Thatcher is the first national political leader in the current era to be elected on the idea behind the Laffer Curve, that the law of diminishing returns can be applied to tax policy. The Tory victory May 3 may thus come to be viewed historically as one of the most important political events of this period. The immediate effect already has been to strengthen the resolve of Canadian Conservatives, who used the same issue in winning the national elections May 22. Mrs. Thatcher's success or failure will be closely watched by politicians and policymakers worldwide. The key will be the first Tory budget of June 12, with advance indications that it will be more timid than we might have expected of Mrs. Thatcher.
The boldest tax reform of the year is credited to Egypt's Anwar Sadat, which should bring a major expansion of the Egyptian economy in the 1980s. A similar reform is desperately needed in Israel, which is now suffering with business and personal tax rates appropriate conceivably only in wartime.
Aftermath of the British Elections
The Laffer Curve first appeared in print in London in the summer of 1977. Walter Eltis, a 45-year-old economist from Oxford University, had received international attention in the Commonwealth countries in 1975 with his vigorous denunciations of Keynesian economics, published serially by the Times of London. In May 1977, he was a guest speaker at the annual Bank Credit Analyst conference in Bermuda. Professor Arthur Laffer and 1 were also on the program, and because the conference moved at a leisurely pace, the three of us spent considerable time over several days discussing Laffer's wedge model and his Curve of diminishing returns on rising tax rates.
Eltis, though, immediately saw the policy implications of the Curve for the United Kingdom, and upon his return wrote his monthly bank letter about this "marvelous instrument which the Americans have devised." His essay argued on behalf of a cut to 60 percent in the top marginal tax rate on personal incomes in Britain, which then and now stands at 83 percent on wage and salary income and 98 percent on interest and dividend income, both rates applying at roughly $40,000. The Eltis arguments circulated in the group of economists advising Margaret Thatcher and before the summer was out she was publicly discussing a cut to 60 percent as a plank for the Tory Platform.
During a tour of Europe's financial centers in the summer of 1978, Laffer was invited by Gordon Pepper of the City of London's Greenwell & Co., to a series of private meetings and discussions with Mrs. Thatcher and her chief staff economist, Adam Ridley, and with the Tory economic brain trust, including Sir Keith Joseph and Sir Geoffrey Howe. Mrs. Thatcher, a tax lawyer by profession, easily understood that tax rates could be a political issue separate and apart from spending priorities, which meant she would not have to couple promised cuts in tax rates with initial cuts in social programs. The Laffer Curve became an explicit intellectual weapon in her tax-cutting political arsenal. Reporting on the intellectual influences on Mrs. Thatcher, the New York Times recently remarked on this aspect of the theory: "Mrs. Thatcher has also been influenced by Arthur Laffer, a Chicago-school economist who has argued that income-tax reductions can pay for themselves by stimulating production. Mrs. Thatcher has said things suggesting she would be cautious, even after the campaign, about proposing cuts in social programs, which could be kept largely intact if output were raised."
Last month, this was the theme of her final press conference preceding the national elections of May 3. She told the British Press Association: "What we offer is lower taxation because we believe the people are entitled to a bigger proportion of the fruits of their own efforts. If they don't get that, they won't work harder; we shall not get expansion. We shall not get a higher standard of living or the money for helping the disabled or improving the prospects for our children."
A week before the elections, the Washington Post's David Broder went to London and was surprised with the familiarity of the issue at the center of the campaign: "No one had told me that Margaret Thatcher is really Jack Kemp dressed up to look like Mrs. Miniver", said Broder, referring to Representative Kemp's (R-New York) sponsorship of the Kemp-Roth Bill, which embraced the Laffer Curve concept.
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The Tory victory of May 3, and Mrs. Thatcher's election as Prime Minister, may come to be viewed historically as one of the most important political events of this era. For the first time in a century, a Tory government has come to power in Britain on an explicit pledge to expand the domestic economy by significant reductions in marginal tax rates on personal incomes. The emphasis is on increasing economic supply by increasing individual incentives to supply, thus ending the total preoccupation with demand theory that has burdened British political parties left, right and center. Without a doubt, the event will have a profound effect on politicians around the world as they digest its implications.
The immediate effect was to strengthen the resolve of the Canadian Conservatives, with 39-year-old Tory leader Joe Clark on May 13 defending his own tax-cutting election platform against assaults by Prime Minister Trudeau and New Democratic leader Ed Broadbent. Like Mrs. Thatcher, Clark centered his campaign on the Lafferian idea that lower marginal rates would expand the economy and produce higher government revenues. Clark specifically pledged to propose legislation that would make home mortgage interest payments deductible from taxable income, a measure that would have the rough effect of reducing marginal income tax rates across the board. He also was specific in citing Jack Kemp's tax cutting arguments as having influenced him and the Conservative platform. The tax issue revived what was a moribund Progressive Conservative Party that has enjoyed power only a half dozen years out of the last forty-five. Clark's success in ending Trudeau's eleven year rule and sixteen years of Liberal control in the May 22 elections will ensure that these same economic themes will be at the center of the 1980 U.S. Presidential elections.
There can be no serious question that the issue was decisive in Britain, producing the Tory 43-seat majority in the House of Commons as well as a pre-election 25 percent rise in the Financial Times Industrial Index; this was the market's expectation not of a Tory victory but of the tax policy such a victory would mean. This suggests a steady rise in the U.S. financial markets if the tax issue indeed emerges as the central issue of 1980.
Except for this tax issue, after all, Mrs. Thatcher was uncompromising in the ''right wingedness" of her platform. She was hard, in other words, on crime, national defense, monetary policy, labor-law reform, immigration policy, denationalization, etc. These are the positions that have proven fatal to national parties when packaged with budget austerity. Nor can it be said that Mrs. Thatcher won on personal charm. The public-opinion polls clearly showed that Labour Prime Minister James Callaghan was the personal preference over Mrs. Thatcher, who comes across to some voters as stiff, snobbish, and elitist in her manner. The tax issue alone was of sufficient power to propel her and the Tories to victory. The last time there was such a clear division of right-left ideology in a national campaign was in the U.S. Presidential contest of 1964, when Lyndon Johnson smothered Barry Goldwater. In that race, though, the tax issue cut for the Democrats. LBJ had just completed the work of President Kennedy in slashing personal income-tax rates by a third, a move Senator Goldwater had aggressively opposed in the interest of budget austerity. The conventional analysis of the 1964 elections, by both conservatives and liberals, was that the voters desired more, not less, government involvement in their lives. Political parties and candidates around the world took their cues accordingly, and the liberal drift that resulted from this eccentric interpretation of 1964 was felt globally. Additionally, the Democratic Party dropped the idea of tax-rate reduction as an instrument of economic growth as quickly as it had picked it up. The GOP did not pick up the idea until 1978 when it embraced the Kemp-Roth tax-cut proposal, but doing so without real conviction in the face of Old Guard warnings that tax cuts without spending cuts would accelerate inflation.
If Mrs. Thatcher now can succeed economically with the Laffer Curve as well as she has politically, politicians will soon be eager to emulate her strategy. The result would be a wave of private-sector economic growth and a worldwide relative shift of investment resources out of real assets into financial assets that would reverse the process of the 1970s.
Unhappily, the steady slide in the FT Index in London since May 3 suggests that Mrs. Thatcher or, more likely, Sir Geoffrey Howe, the new chancellor of the exchequer, is getting cold feet. Mrs. Thatcher's basic campaign commitment is to cut income taxes "at all levels," not only at the top. She has talked about beefing up defense spending, and the domestic ministers in her Cabinet are leaning toward more rather than less domestic outlays. Throw in the fact that the fiscal 1979-80 budget handed her by the outgoing Labour chancellor, Dennis Healey, tops $17 billion in red ink, a figure that may have been fudged down by $3 billion already. The precise figure of the tax reform has not been announced. We must await posting of the first Tory budget on June 12. But the downward drift of the London stock market tells us there is increasing fiscal caution at work behind the scenes.
The Economist of London, which remains a redoubt of hard and fast conservative Keynesianism, has been pointing the way. The May 12-18 issue recommends going slow on ''untaxing the economy" in order not to upset the bankers. This means putting off serious reduction in the basic 33 percent rate that everyone pays until next April's budget. This, says the Economist, allows time for a' "full public expenditure review." As for cutting the top rate to 60 percent, the Economist recommends a three year phase in, starting with the first cut to.75 percent. The argument is if the bottom and middle rates are cut only a little, it doesn't look nice to cut the top by a lot (even though the top rates produce little revenues and stifle economic expansion). However, the ideal course would be for Mrs. Thatcher to immediately cut the top rate to 50 percent. Even at that level the first order revenue loss would be trifling, the second order revenue gain enormous.
Mrs. Thatcher did discuss the possibility, during the campaign, of offsetting reduction in income-tax rates with increases in consumer-tax rates. A specific mention was made of financing across-the-board reductions in income tax with a 2 percent rise to 10 percent in the Value Added Tax (VAT). The net effect would be positive, because the high personal rates produce such little revenue; a small increase in proportional tax can finance dramatic reductions in progressivity. But here, too, Mrs. Thatcher is being warned to go easy, because VAT is counted in the consumer price index while the income tax rate is not. Thus, offsetting one with the other will mean "an unsightly bulge in the retail price index," says the Economist, which the unions will use to inflate their wage demands in the new pay round starting in August.
This is no time for timidity on Mrs. Thatcher's part. The less aggressive she is in her June 12 budget/tax reform, the less expansion the economy will feel through increased output in the private sector; the more demands her government will feel for social spending; and the more aggressive the labor unions will be in demanding after-tax wage increases that require steep pre-tax wage increases, which translate into unsightly bulges in the retail price index. A reasonably aggressive course that could be inferred from her campaign would be to immediately drop the top rate to 60 percent, cut the basic rate to 30 percent and adjust thresholds throughout accordingly. To get the full benefit of a program to "untax the economy," Mrs. Thatcher should lay out simultaneously her intentions for 1980 and beyond to further reduce income-tax and VAT rates as the tax base expands. The national tax base and revenues would undergo an additional expansion in anticipation of the outlined effective dates. Implementation would be made that much easier.
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To unwind the negative effects on inflation/tax progressivity in the last decade, the 1980s will bring a worldwide adjustment in income-tax progressivity and a shift toward proportional rates. The greater the success politicians have in following this track, the faster they will pick up imitators and competitors at home and abroad. Rapid changes can be expected in the Third World countries, especially those which originally designed tax systems off the British model. Now that global attention is being focused on the unnecessary burdens placed on an economy by steep tax progressions, the unwinding may take place in a rush of country-by-country reforms.
Both Egypt and Israel are in the category of troubled economies with tax systems designed in London. The conventional wisdom is that peace in the Middle East will depend on economic expansion of the Israeli and Egyptian economies. Anwar Sadat in particular counts on Egyptian prosperity providing him with political support necessary to maintain the Israeli peace accords, and he believes that such prosperity will require massive doses of foreign aid from the U.S. to offset the loss of aid from Saudi Arabia. Israel, too, counts on continued injections of resources from the U.S. The answer for both countries, though, lies in internal tax reform.
Egypt, thanks to the genius of Sadat, is already on the way toward economic revival that could bring major advances in living standards to the country's 40 million people in a few years. Since 1961, when "strongman" Gamal Abdel Nasser decreed a series of socialist experiments, the tax rates on personal incomes have been confiscatory above the level of small shopkeepers. Since 1971, Sadat has been inching the domestic economy back in the direction of market capitalism. In January, the long-debated tax reform on personal income took effect. Here is the tax schedule, before and after:
The Egyptian Tax Cut
Tax Schedule 1967-1978 Tax Schedule 1979
taxable income marginal tax rate taxable income marginal tax rate
(Egyptian pounds) (Egyptian pounds*)
1,000 exempt 1,200 exempt
1,500 8% 2,000 8%
2,000 10 3,000 9
3,000 15 4,000 10
4,000 25 5,000 11
5,000 40 6,000 12
6,000 50 7,000 13
7,000 60 8,000 20
8,000 70 9,000 25
9,000 80 10,000 30
10,000 95 15,000 35
over 10,000 95 20,000 40
over 100,000 80
*The market rate for the Egyptian pound is 1 E£ = $1.44 Source: International Bureau of Fiscal Documentation.
The old rates were so steeply progressive, and tax collectors so poorly paid at roughly E£ 40 per month, that the income tax was efficiently evaded by most of the population and only about 2 percent of total government revenues flowed from the tax. Of course, in general, capital intensive enterprises have not been assembled, being too visible to tax collectors, so the economy has functioned almost entirely on the barter level Since the reform, I am told by officials of the Egyptian Embassy in Washington that capital markets already are developing at the curbstone level to support incipient enterprises. Sadat has effectively halted Egypt's "brain drain", and Egyptians who left in earlier years now are repatriating earnings at the rate of $600-to-$700 million annually, with expectations this will rise to $1 billion in calendar 1980. It is once again possible to accumulate capital in Egypt, and the only wonder is that Sadat left nominal rates as high as he did, except that he has left room for further rate reductions into the 1980s.
Both the London Economist and The New York Times in recent weeks have featured hand-wringing portraits of the supposedly beleaguered Sadat, as if the Egyptian prosperity depends on the flow of Saudi aid now cut off. It is my guess that Sadat's tax reform, plus Egyptian recovery of the Sinai oilfields, will be more than sufficient to offset the loss of Saudi aid, and that Egypt is indeed headed toward a major expansion. As far as I can tell, the Egyptian tax reform has not yet been reported in the popular press of either the U.S. or the U.K.
Israel, on the other hand, is in the merciless upper reaches of the Laffer Curve, and its economic prospects are exceedingly bleak no matter how much foreign aid it can squeeze out of the U.S. The problem is that Israeli external debt, at $3,200 per capita, is the highest in the world, and there is no one outside Israel who is arguing that the debt can be more easily paid off if the internal tax rate is lowered. The Prime Minister of Israel, Menachem Begin, is a true "conservative" in the Goldwater, not Thatcher, sense, in that he relentlessly presses austerity on the electorate. The last "tax reform" in Israel was in 1975, when the Israeli equivalents of the McGovernites ran amok closing loopholes, including the Israeli equivalent of the "three-martini lunch". True, the top marginal rate on personal income was cut to 60 percent. But in contrast to Sadat, who left the rates high but pushed the thresholds ten times higher, the Israeli tax reform left the thresholds intact. The schedule for tax year 1977 illustrates the punishing wedge the Israelis face on incomes alone.
Israeli Personal Income Tax Schedule (1977 dollars)
Taxable Income Marginal tax rate
over 12,460 60%
Converted to U.S. dollars at the average 1977 rate of $1.00=10.1 1 1£. Source: Kessleman & Kesselman, Jersualem.
Although the Israeli rate of inflation was 50 percent in 1978, and in two years the Israeli pound has plummeted from eleven to the dollar to twenty three to the dollar, these income-tax rates presumably have been adjusted fully by an indexing system. Still, the above rates are roughly comparable to the progressive schedules in India and Pakistan. It is one thing to exact such heavy taxation during war conditions, but another to attempt to exact them without war. By attempting to squeeze the population of 3,700,000 in order to pay interest on the $12 billion external debt, the government has gone well past the point of diminishing returns. Much of the economy now operates on the barter level, with an estimated $2 to $3 billion in income unreported, roughly a quarter to a third of the gross domestic product. The inflation rate will easily exceed 60 percent in 1979; the one-month consumer price index rise in April was at an annual rate of 100 percent. Like his conservative counterparts in the United States, Israeli Finance Minister Simcha Ehrlich can only think of proposing cuts in government spending, but two thirds of the budget is chewed up by defense outlays and debt service. To combat inflation, Ehrlich talks about increasing indirect taxation to take purchasing power out of the people's hands! In my view, the correct economic strategy is to convert the tax structure to a peacetime footing: Knock 15 points off the corporate tax rate of 61 percent; drop the top rate on personal income to 35 percent which might immediately bring in a third of the unreported income and at the same time push the level of national productivity to a higher plateau.
The chances that the Begin government would be so adventurous with fiscal policy are not very high, unfortunately, which suggests that the economy will remain troubled. Chances for economic reforms pushing the Israeli as well as the U.S. economy toward incentive fueled expansion would improve though, if Mrs. Thatcher shows the way in the June 12 budget with a spirit of daring and adventure, betting as many chips on the Laffer Curve after her election as she did before it.