For years, supply-side economists have been arguing that lower tax rates often bring in more revenue than higher rates. Immortalized in the Laffer Curve, the idea is that tax-rate reductions can sometimes expand the tax base by more than rates are cut, causing net revenue to rise.
I have never understood why the basic notion of the Laffer Curve is so controversial. Every day, businesses everywhere mark down prices in hopes that higher sales will yield a greater total profit. Obviously, it works -- or they wouldn't continue doing it year after year.
The same principle applies to tax rates, which alter important relative prices. Among these are the decision to work overtime or not, invest one's earnings or consume them, buy tax-free municipal bonds or taxable corporate securities, start a business or continue working for someone else, and pay all the taxes one owes or take the risk of evasion. When tax rates rise, people shift their work, saving and investment choices in ways that lower the government's revenue. Hence, lower tax rates can cause people to shift back, thereby raising revenue.
For these reasons, economists have long recognized that at some point high tax rates become counterproductive in terms of raising revenue. More than 200 years ago, Adam Smith had this to say, "High taxes, sometimes by diminishing the consumption of the taxed commodities, and sometimes by encouraging smuggling, frequently afford a smaller revenue to government than what might be drawn from more moderate taxes."
In recent years, Russia, of all places, has been a virtual laboratory for the Laffer Curve. When communism collapsed there a decade ago, the country really had only a rudimentary tax system. Although the old Soviet Union had taxes, they didn't serve the same purpose that taxes do in market economies. Since the government owned everything, it could get all the revenue it needed just by raising prices. And since everyone worked for the state, it could alter the distribution of income as it saw fit simply by changing wage rates. Taxes in the Soviet Union appear to have been used mainly to adjust the money supply, as Federal Reserve open market operations do here.
The tax system Russia adopted after the fall of communism was very inappropriate for its stage of economic development. It thought it was more developed than it really was. Consequently, its tax rates were too high, especially on businesses and entrepreneurs; the tax administration system was inadequate and unworkable; and opportunities for evasion too easy. The result was a government starved for revenue, despite high tax rates, forcing it to print money to pay its bills, leading to hyperinflation.
The International Monetary Fund correctly recognized that tax revenue needed to rise in Russia to control inflation. But it erred in encouraging it to enact new taxes and crack down on evaders, which only exacerbated the flaws of the existing tax system. The result was that Russian tax revenue fell from 11.1 percent of GDP in 1995 to 8.6 percent in 1998.
Finally, the Russians figured out for themselves that their tax system needed to be overhauled. Against the IMF's advice, taxes were cut, leading to increased revenue as evasion became less profitable. Two years ago, Russia initiated a major tax reform that instituted a 13 percent flat-rate tax system. It became fully effective last year, with the result that tax revenue jumped more than 50 percent, rising to 16.1 percent of GDP in 2001.
In recent days, Russian President Vladimir Putin has announced further plans to cut tax rates on small businesses precisely in order to reduce evasion and raise revenue. As The Wall Street Journal reported on April 4, "Russia's small business community could finally come out of hiding if sweeping reforms to the corporate tax system make it onto the statute book."
Even The New York Times, normally hostile to anything that smacks of supply-side economics, has noticed. A March 23 news story said that Russia has had "stellar first results from a bold experiment, a 13 percent flat-rate income tax." And two years ago, the Times even editorialized in favor of Russia's flat tax, noting that the previous system was "the worst of all tax worlds: high rates and little revenue."
George W. Bush has also taken note of Russia's flat tax. In a meeting at his Texas ranch with Putin last November, he specifically praised Russia's flat tax. All he needs to do now is take the next logical step and propose something similar for us. Maybe Putin will come back some time and show him how to do it. It could make future April 15ths less taxing for all Americans.