Laffer curves and fiscal limits
Lately, I have been working on a fun project on the fiscal limit of the Australian tax system (project info and paper here). Without elaborating on the details, the key concept to quantify the fiscal limit is the peak of what is commonly known as the Laffer curve. The idea is that tax revenue initially increases with rising tax rates. But that increase is disproportional; double the tax rate and tax revenue increases less than two-fold. Importantly, there is a limit to raising taxes. Increase the tax rate further and revenue declines.
In macro-fiscal and public policy circles, the idea is attributed to Arthur Laffer[1]. To his credit, Laffer never claimed intellectual ownership for the idea. Laffer himself, and numerous others afterwards have rightly attributed the theory to the 14th century Arab scholar Ibn Khaldun in his Al-Muqaddimah. However, I feel that to truly acknowledge, we need to delve into Ibn Khaldun’s thought and reflect on how it relates to modern economics.
The hump shaped nature of society, tax and expenditure
Ibn Khaldun weaves a rich tapestry of economics, politics, sociology, and anthropology to explain the nature of society and social change. At the risk of oversimplification, Ibn Khaldun’s theory of social change revolves around tension between ‘Bedouins’ (tribes of the desert and steppes) and sedentary people. Sedentary people consist of cultured, enterprising artists and merchants of the city. But sedentary life eventually leads to decadence and decline, and the Bedouin tribes, full of vigour because of their outback lifestyle and strong “group feeling” (‘asabiyyah’), are then able to conquer the city. This leads to a renewal. However, a couple of generations down the track, they themselves become sedentary, and the cycle continues. (Side note: although Ibn Khaldun’s context shapes his metaphors. For the sake of my Aussie colleagues who might not know what a bedouin is… let’s call this “outback lifestyle”. Also, I think his theory explains conflict and change in modern times quite well… but that’s for others with more expertise to tell you).
What really fascinates me is the significant role that tax plays in Ibn Khaldun’s theory. Particularly, how I can visualize an intertwined hump shaped curve of growth, public expenses, and tax revenue against tax (rates). I emphasize that I am not an expert, and I would encourage anyone who loves economics to go directly to the source and read it. This note is just my reflection of snippets of the Muqaddimah on how it relates to tax and expenses. The snippets in blue a direct quotes from the Muqaddimah from Rosenthal’s 1967 tranlation (I will cite it properly later if I have time).
Initial low taxes
In the beginning of a dynasty, rulers still carry traces of their outback existence – a simple life of bare necessities. Ibn Khaldun sums this up as the ‘desert attitude’ – one of
“kindness, reverence, humility, respect for the property of other people, and disinclination to appropriate it, except in rare instances”
The result is low taxes. In the context of Ibn Khaldun’s times, he also attributes the reason for low taxes in initial periods for the dynasty following “the ways of religion”. That is, taxes stipulated under Islamic law are relatively low and “have fixed limits that cannot be overstepped”.
In our context, think of periods in history where social cohesion ensured communities took care of each other. People lived simply, and the government had a smaller role in general and social insurance in particular.
The rise in tax revenue
“When tax assessments and imposts upon the subjects are low, the latter have the energy and desire to do things. Cultural enterprises grow and increase, because the low taxes bring satisfaction. When cultural enterprises grow, the number of individual imposts and assessments mounts. In consequence, the tax revenue, which is the sum total of (the individual assessments), increases”
I really don’t need to explain more about what that means. Nor do I need to go on about how fascinating it is that this is hundreds of years before we talked about incentives.
Why taxes increase
The Laffer curve as we know it depicts what happens when tax rates increase. Ibn Khaldun, goes into elaborate details on why taxes increase. This again links back to the overarching theory.
“When the dynasty continues in power and their rulers follow each other in succession, they become sophisticated. The Bedouin attitude and simplicity lose their significance, and the Bedouin qualities of moderation and restraint disappear”
Ibn Khaldun goes on to explain the decadence that ensues. For our purposes, it is enough to relate this back to an increase in public expenditure. As a result, there arises a need to increase tax revenue.
“Their customs and needs become more varied because of the prosperity and luxury in which they are immersed. As a result, the individual imposts and assessments upon the subjects, agricultural laborers, farmers, and all the other taxpayers, increase”
Eventual decline in tax revenue
“Eventually, the taxes will weigh heavily upon the subjects and overburden them.”
“The assessments increase beyond the limits of equity. The result is that the interest of the subjects in cultural enterprises disappears, since when they compare expenditures and taxes with their income and gain and see the little profit they make, they lose all hope. Therefore, many of them refrain from all cultural activity. The result is that the total tax revenue goes down, as (the number of) the individual assessments goes down”.
The fiscal limit is the civilizational limit
“Finally, individual imposts and assessments reach their limit. It would be of no avail to increase them further. The costs of all cultural enterprise are now too high, the taxes are too heavy, and the profits anticipated fail to materialize. Thus, the total revenue continues to decrease, while the amounts of individual imposts and assessments continue to increase, because it is believed that such an increase will compensate (for the drop in revenue) in the end. Finally, civilization is destroyed, because the incentive for cultural activity is gone”.
In macroeconomic and public finance research we examine tax rates, revenues, and fiscal limits from a quantitative approach. However, to fully understand and relate it back to what it means for humanity, we really need to go back to sources such as Ibn Khaldun.
[1] You can find really interesting historical anecdotes about his meeting with Rumsfeld and Cheney in 1974 and how the Laffer curve became central to political discourse around the world and especially in the US elsewhere on the internet.