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Giovanni Ganelli and Juha Tervala - page 5 / 32

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I. INTRODUCTION

The debate on whether tax cuts can pay for themselves is often associated with the idea, popularized in the 1980s, of the Laffer curve. The original Laffer argument was that there is, at any given point in time, a hump-shaped relationship between the tax rate and actual revenue collection. Later academic and policy discussions have extended this concept in a dynamic sense. While the precise meaning of a dynamic Laffer curve is open to interpretation and various definitions have been used in the literature, a minimum necessary condition for dynamic Laffer effects to happen is that a tax cut today will increase growth and, at some point in the future, deliver higher tax revenues in the absence of other policy changes.2 In reality, the idea that this might be possible pre-dates the Laffer debate and goes back at least to Keynes, who stated that: “Nor should the argument seem strange that taxation may be so high as to defeat its object, and that, given sufficient time to gather the fruits, a reduction of taxation will run a better chance than an increase of balancing the budget.” (Keynes 1933; p.5).

In more recent years, Auerbach (2005) has stressed that the methodology used by the US Joint Committee on Taxation (JCT) to forecast the revenue impact of legislation changes is a partial equilibrium one, in the sense that it takes nominal GDP and other macro aggregates as given. Auerbach (2005) argues that such practice, by ruling out the possibility of a positive response of economic activity to tax reductions, biases the legislative process against tax cuts. To overcome this problem, he suggests that the JCT should adopt a general equilibrium methodology, in which feedback effects from taxes to other macroeconomic variables are taken into account.3 Outside the US, as noted by Keen, Kim and Varsano (2006), much of the rhetoric in countries which have implemented so called “flat tax” reforms has been concerned more with the rate reduction aspect of the reform than with flatness itself. From this point of view, a main drive behind the recent wave of flat taxes has been the idea that tax cuts would provide a “free lunch” by self-financing themselves.4

Beside the question of the budgetary impact, another important aspect of tax reforms is related to their open economy dimension. In their Harry G. Johnson Lecture, Frenkel and Razin (1989) argued that, due to the increased integration of world capital markets and its

2 If this minimum necessary condition is not satisfied, none of the various definitions of dynamic Laffer effects used in the literature (see, for example, Ireland (1994), p. 563; Novales and Ruiz (2002), p. 188) can be satisfied.

3 The partial equilibrium methodology used by the JCT is also referred to as static scoring, while the alternative general equilibrium methodology is also referred to as dynamic scoring.

4 While the term “flat tax” has been used loosely and the various versions which have been adopted (most notably by Russia and by other countries in Central and Eastern Europe) vary widely, common features have often been both a reduction of the number of income tax brackets and a substantial reduction in tax rates. See Keen, Kim and Varsano (2006) for an interesting analysis of recent “flat tax” experiences.

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