Chapter

7 Evidence on the Laffer Curve The Cases of Jamaica and India

Author(s):
Ved Gandhi, Liam Ebrill, Parthasarathi Shome, Luis Manas Anton, Jitendra Modi, Fernando Sanchez-Ugarte, and George Mackenzie
Published Date:
June 1987
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Author(s)
Liam P. Ebrill

This chapter evaluates the appropriateness of the tax reform proposals advocated by the so-called popular supply-side approach to economic policy in developing countries. The particular focus here is on the Laffer curve itself; that is, on the highly publicized proposition that it is possible for nominal tax revenue to increase when tax rates are reduced. The analysis attempts to determine whether examples of the Laffer curve exist in developing countries.

Section I of the chapter begins with a summary of the more important tenets of the popular supply-side approach as they apply to tax reform, followed by a discussion of those instances in which supply-side policies are held to have been successfully applied in developing countries. It is argued that some of the claims of the supply-side approach have yet to be demonstrated. Section II discusses in greater detail the cases of Jamaica and India, two developing countries in which, for whatever reason, tax changes (including some reforms) of relevance to the Laffer curve proposition had been implemented even before 1985 when this study was completed. An attempt is made to evaluate these (pre-1985) tax changes. Finally, in Section III, it is argued that, given the limited nature of the data available, the empirical tests lack sufficient discriminatory power to permit a definitive resolution of whether any given set of observations is consistent with the Laffer curve. If, as is likely, the quality of the data available for the two cases examined is typical of that for developing countries, the most important conclusion must be that assertions to the effect that developing countries are operating in regions of the Laffer curve, where tax rate reductions would lead to revenue increases, should be treated with caution.

I. The Supply-Side Approach

The literature on the popular supply-side approach to economic policy is by now voluminous. It is not the intent to summarize here the content of that literature and its relationship to the traditional public finance literature, since that has already been done elsewhere.1 Rather, this chapter focuses on those elements of the popular supply-side approach that bear most directly on the issue of the Laffer curve.

Summary of Theoretical Discussion

Briefly, the proposition of the Laffer curve takes as its starting point the simple notion that tax revenue is zero if the tax rate is either zero or 100 percent, with a smooth relationship between tax rates and tax revenues connecting these two polar points.2 The existence of such a relationship suggests that if tax rates are sufficiently high—that is, if tax rates are in what the supply-siders refer to as the "prohibitive range"—then a reduction in tax rates could lead to an increase in tax revenues.

On what does the existence of the Laffer curve depend? Borrowing from Blinder (1981), consider the specific example of a proportional tax on labor income. If w is the gross wage rate and w( (1 - t) the net tax wage rate, if S(w(1 - t)) is the supply of labor function, with S(0) = 0 by assumption, and if D(w) is the demand function for labor, it can be shown that, for G(t) continuous and differentiable, revenue responds to variation in the marginal tax rate as

where G is revenue and ηi = S, D, refers to the relevant elasticities of labor supply and demand. Given the assumptions, equation (1) yields the Laffer curve. It follows that the revenue-maximizing tax rate t* can be found by setting equation (1) equal to zero, yielding

where ηD < 0. As pointed out by Blinder, even if both elasticities are as high as 2, t* is still as high as two thirds.

Proponents of the supply-side approach believe that the relevant elasticity values are very high. There is considerable variation among the supply-siders, however, when it comes to defining the economic environment, and hence the relevant elasticities, in which the tax reduction is set.

Some establish a traditional neoclassical framework of a closed general equilibrium framework with flexible prices and full employment. They implicitly conduct a balanced-budget incidence exercise—whatever tax revenue is raised is reinjected back into the economic system via government expenditures. In such an environment, aggregate income effects can only occur if the pattern of government expenditures differs substantially from the pattern of expenditures that would have resulted in the absence of government intervention. Even then, the income effects are not likely to be large. The appropriate focus of tax policy analysis then becomes the examination of the magnitude of the substitution effects that are the inevitable outcome of the relative price movements induced by tax changes. For Laffer-style propositions to be correct, compensated elasticities of substitution would have to be sufficiently high. The argument of supply-siders presumably is that such is the case because many of the tax rates currently in force in many countries are very high. Even though a reduction in tax rates leads to a reduction in revenue per unit, the concomitant reduction in price (increase in net wages) leads to such an increase in the demand for the commodity (supply of labor) as to imply an increase in tax yield in the aggregate. An excellent example of work founded on such neoclassical mi-croeconomic grounds is Canto, Joines, and Laffer (1983).

Some supply-siders have argued for higher elasticity values by implicitly changing the base for the tax. This change is to counter the criticism of those who argue that the large elasticities required to generate Laffer-type effects are most unlikely to exist for broadly based taxes. For example, Blinder (1981), in his critique of the Laffer curve, argues that it would be much better to apply supply-side analysis to narrowly based taxes.3 In response, some supply-siders have emphasized the role of tax evasion. Thus it may be the case that, although labor supply in the aggregate is not very elastic, the supply of labor to the official market economy (as opposed to the underground economy) is much larger. This is precisely one of the effects advanced by Bartlett (1982) in support of tax rate reductions: marginal tax rate reductions provide an incentive for labor to exit from the underground economy, thereby increasing tax revenue.

This last argument is perfectly consistent with a neoclassical framework. Some, though by no means all, supply-side economists rely in addition on short-run macroeconomic considerations. Specifically, if an economy is experiencing excess unemployment, tax cuts stimulate the economy—presumably by the way they influence consumer expectations and liquidity—so much that revenues increase. This appears to be the characterization of the Laffer curve contained, for example, in Roberts (1984, p. 27). Note that income effects again play a role, though here they are due to changes in aggregate demand, changes that are precluded in a neoclassical framework.4 The nature of the elasticities implied by this analysis is markedly different from that envisaged by other authors.5 Representative empirical work on the possibilities for revenue-increasing tax reductions in developed countries is discussed in the Annex to this chapter.

Irrespective of the precise mechanism underlying the Laffer curve, there is a consensus among the supply-side economists as to the appropriate direction of tax reform. Since reductions in marginal tax rates lead to revenue increases only if tax rates are very high, the preferred reform involves reductions in the highest marginal tax rates on income (see, for example. Canto, Joines, and Laffer (1981) and Wanniski (1983)).

Although it is clearly a supply-side concept, there is no sense in which the Laffer curve encompasses the entirety of the supply-side approach. If it did, it would imply that increasing government revenue was an important objective of supply-side economists. That objective would obviously run counter to other goals of the supply-side program, most notably a reduction in the size of the government sector. In more general perspective, concern is focused on improving the production efficiency of economic systems.6

In essence, then, the primary concern of supply-siders is to ensure that, whatever the degree of government intervention in the workings of private markets, government intervention should occur in the most efficient manner possible. The Laffer curve is important since, if Laffer effects do exist in any given economy, they are extreme examples of inefficient intervention.

Summary of Empirical Evidence

The bulk of the empirical evidence advanced by supply-siders to support their position is concerned with economic policy in the United States (for a summary of this and related material, see the Annex to this chapter). Empirical analysis considering developing countries is scarcer and such results as exist are superficial, frequently based on a simple correlation between some change in a country’s tax structure and the subsequent economic performance of that country. A supply-side writer who has devoted considerable attention to circumstances in developing countries is Wanniski (1983). He argues that many developing countries have adopted extremely progressive income tax structures where this is presumably a source of major disincentives. Leaving aside the question of how one can interpret the effective progressivity of a nominal tax structure given the plethora of deductions and exemptions as well as the low monetary income levels in many developing countries, consider how Wanniski utilizes the income tax information. In particular, consider his discussion of the effects of tax policy changes in India (Wanniski (1983, p. 258, et seq.)). He ascribes the “extraordinary quiescence” that descended on India, after a period of political turmoil, to the tax changes introduced by Finance Minister Subrama nian in 1975. These tax changes were very much in the supply-side mode in that they involved reductions in the highest marginal income tax rates (cut to 77 percent from 85 percent), corporate tax rates, and wealth tax rates. Further rate reductions and bracket changes were made in April 1976 as a result of unexpected revenue buoyancy. These in turn, it is argued, stimulated even more dramatic economic growth. As implied above, the trouble with this type of reasoning is that it is suggestive but perhaps overly simplistic.

Kwon (1984) has examined the case of Korea. Working at an aggregate level, he concluded that the behavior of tax revenues over time as tax rates were increased is not inconsistent with the existence of a Laffer curve. However, he also concluded that Korean income tax rates do not appear to be such as to have placed Korea over the Laffer “hill.”

In the remainder of this chapter a few examples of tax changes in developing countries—changes of the supply-side type—are examined. Specifically, the next section considers the effects of reductions in top marginal income tax rates on income tax revenues in Jamaica and India.

II. Supply-Side Effects and the Personal Income Tax

An obvious problem with any empirical test of the existence of Laffer curve effects in developing countries is the paucity of the data available. What are the minimal requirements that such data should satisfy, given that the approach being used here is to consider countries on a case-by-case basis?

Empirical Methodology

First, and trivially, the examples selected should be of cases in which top marginal tax rates have been changed. The tax rate reductions undertaken by Jamaica and India satisfy this criterion. Second, because attention is focused on the behavior of those facing the highest marginal tax rates, a breakdown of taxable income and taxes paid by income level both before and after the tax change is required. Data of this type are available for India, but for Jamaica all that is available is a breakdown of the number of pay-as-you-earn (PAYE) taxpayers by income level for the relevant years. Third, it is essential that any exercise of this type control for other factors that might influence the outcome. This requirement exposes the greatest weakness of the study. With the exception of the influence of inflation and growth, it proved impossible to control for these other factors. For the case of inflation, over time, as nominal incomes increase, there is a tendency for tax revenues to increase more than proportionately because of the progressive nominal structure of most income taxes (including those of Jamaica and India). This effect should be netted out of any revenue change consequent on a marginal tax change.

The significance of the interaction of inflation with the tax system depends on the underlying distribution of income. In the absence of detailed data on this distribution, it is assumed here that incomes are distributed in the form of the Pareto distribution, whose cumulative distribution is given by

where F refers to the cumulative distribution, w refers to income level, and w* represents the lowest value of w for which this distribution is relevant. The exponent is typically assumed to be greater than or equal to 2 (Atkinson (1973)). The shape of the distribution can be found in Figure 1 Although not representative of the whole distribution of income, this distribution may be an accurate representation of the upper tail of the earnings distribution. Such an argument is made by Lydall (1968). Clearly, the upper tail of the income distribution is of great concern to this study. A positive rate of inflation implies, other things being equal, that the whole distribution shifts to the right.7 What does this imply about the number of taxpayers in each given nominal income tranche? Given that the distribution is not uniform, there will be a tendency for the number of taxpayers in each income tranche to increase at a more rapid rate than the rate of inflation.

Figure 1.Pareto Distribution of Earnings

To refine this statement somewhat, note that an alternative way to measure the effect of inflation is to hold the distribution constant and to reduce the nominal income values. Thus, the elasticity of the number of taxpayers in any given income slice to the rate of inflation is the same as the elasticity of the area to the left of any given income level, w, to a reduction in that income level. Given the specification of the cumulative distribution, that area, A(w), is

from which it follows

Equation (5) is the elasticity of the relevant area for increases in w. Hence, if α = 2.5 say, a 10 percent increase in the rate of inflation will, other things being equal, cause a 25 percent increase in the number of taxpayers in each income slice in the upper tail. (The choice of a cannot be confirmed empirically here, though Lydall (1968) reports estimated values can often exceed 2.) A similar line of reasoning can be used to describe the changes in the number of taxpayers as a result of economic growth.

The importance of this result is that, for a given tax system, α is also the elasticity of tax revenues; that is, the elasticity of both the number of taxpayers and of tax revenue in response to uniform increases in nominal income is, for a given tax structure, equal. The analysis draws on Hutton and Lambert (1979).

To see this relationship, define Y to be total income and R(Y) to be total tax revenue. The definition of the tax elasticity is then given by η = Y ⋅ R′(Y)/R(Y). Let t(w) be the tax payable on income level w, with (0 ≤ w ≤ ∞), and let f(w) be the frequency density of that income for a population level. Then the elasticity can be re-expressed as

Substituting for the Pareto distribution, it follows by differentiating equation (3) that

from which it follows

From integrating the numerator by parts, it follows that

which is also the elasticity of the number of taxpayers. Hence, for α = 2.5, a 10 percent increase in the rate of inflation will, other things being equal, yield a 25 percent increase in tax revenue in each income slice in the upper tail of the distribution. Discrepancies are, of course, possible. In particular, contrary to assumption, nominal incomes for the relevant income groups might not rise in line with inflation. Finally, note that the result that η = α greatly alleviates any problems that might arise because the distribution data available for Jamaica are in numbers of taxpayers.

The value of a is determined by the distribution of income based on cross-section data. Presumably, this value, therefore, already reflects the decisions of income earners in response to the given tax structure. On the assumption that all individuals have the same preferences concerning the work-leisure trade-off, the value of α then incorporates the disincentive effects that individual taxpayers face as they move into higher tax brackets in response to nominal increases in income.

The analysis has to be modified to account for the fact that the tax structure has changed. In particular, top marginal tax rates have been reduced. One way of accommodating this reduction is to interpret α as the elasticity of the tax base. The product of the change in the tax base and the average change in tax rates can then be used to calculate the approximate change in tax revenue and, hence, to evaluate the Laffer curve hypothesis.

With the preceding subsection as background, we now consider the specifics of the two cases selected.

Jamaica

The structure of the progressive Jamaican personal income tax is presented in Table 1 This structure has been subject to a number of changes, which can be classified into two types. First, the Jamaican authorities made some attempt to adjust the income tranches for inflation—this was the primary motivation for the changes that became effective January 1, 1975. It is clear, however, that the effects of inflation were not fully accommodated by these changes. Thus, nominal per capita gross domestic product (GDP) increased from J$626 in 1970 to J$2,195 in 1980, a period of negligible real growth which indicates a high rate of nominal income growth. Second, the highest marginal tax on incomes was increased from 60 percent to 80 percent. This presumably represents a deliberate attempt to increase tax revenues by raising the tax rates faced by wealthier individuals in Jamaica.

The above is purely descriptive. Before examining the disincentive effects implied by this tax structure, or indeed whether this tax system might imply that Jamaica is operating in the prohibitive region of its Laffer curve, it is important to determine the effective tax rates implied by Table 1 To do so, one first might ask what is the economic incidence of an income tax on earned income. This paper adopts the traditional assumption that the tax is borne by labor, a view consistent with the incidence analysis of a general factor tax in a closed economy framework with fixed aggregate supplies. Use of this assumption, however, may not be entirely appropriate. It is not correct if aggregate factor supplies are endogenous, as they would be in the long run (Feldstein (1974a, 1974b)) or if the economy is open. The latter consideration could be important for Jamaica and should, therefore, be kept in mind. For example, if the net impact of a progressive income tax is for skilled labor to emigrate, some of the burden of the tax may well be shifted to other factors. (This might be particularly true if labor is heterogeneous with specific skills and if some of the commodities consumed in the country are nontraded commodities. For example, consider the impact of the emigration of doctors on the quality of the health care of those who remain.)

Table 1.Jamaica: Rates of Income Taxation
Before January 1, 1975On January 1, 1975Before January 1,1980After January 1, 1980
Taxable incomeTax rateTaxable incomeTax rateTaxable incomeTax rateTaxable incomeTax rate
(In Jamaica dollars)(In percent)(In Jamaica dollars)(In percent)(In Jamaica dollars)(In percent)(In Jamaica dollars)(In percent)
1-50015
501-1,000201-100020
1,101-1,500261,001-2,00025
1,501-3,50032½2,001-3,50030
3,501-4,500353,501-5,500350-5,00030
4,501-7,00037½-455,501-7,50042½5,001-7,000350-7,00030
7,001-8,000507,501-9,500507,001-10,000407,001-10.00040
8,001-11,00056½9,501-12,50057½10,001-12,00045½10,001-12,00045
Above 11,00060Above 12,5006012,001-14,0005712,001-14,00050
14,001-20,00060Above 14,00057½
20,001-30,00070
Above 30,0008O
Sources: Jamaica, Ministry of Finance and Planning, budget speeches (Kingston), various issues; and Report of the Commissioner of Income Tax (Kingston), various issues.
Sources: Jamaica, Ministry of Finance and Planning, budget speeches (Kingston), various issues; and Report of the Commissioner of Income Tax (Kingston), various issues.

The issue of the effective burden of an income tax raises some practical questions as well. For example, how burdensome is a tax system such as that delineated above, given that per capita GDP in 1980 was only J$2,195 (at an official exchange rate of J$1.7814 per U.S. dollar this equals US$1,232). Further, the tax schedule applies only to reported income after deductions, exemptions, and allowances. Given that it is generally conceded that tax evasion is widespread and that, further, tax administration has been weak in Jamaica, the disincentive effects are by that token substantially altered.8 This topic will be discussed further below.

The Jamaican personal income tax system is of particular interest to this study because of the tax reforms that became effective January 1, 1980. As can be seen from Table 1, the highest marginal tax rates were significantly reduced, from 80 percent to 57½ percent. This reduction is precisely the type of rate realignment recommended by supply-siders. Did it have the predicted supply-side effect, namely, an increase in tax revenues? Consider Table 2, which presents the data for the partial test outlined in the previous section. The table documents the recent trend in the number of PAYE taxpayers by income class.9 While this does not provide direct evidence on income tax revenue, the analytical results presented above suggest that the trends in the number of taxpayers in each income class can be illuminating.

To draw on the earlier analysis, any evaluation of the relevance of the Laffer curve to Jamaican circumstances, which are characterized on the basis of trends in the numbers of taxpayers, depends on the interaction of a number of factors; the underlying rates of inflation and real growth, the underlying distribution of incomes, and the changes in tax rates. Inflation, in Jamaica, as measured by changes in the consumer price index, was 27 percent in 1980 and 12.5 percent in 1981 (calendar years). The corresponding growth rates in real GDP were—5.4 percent and 2.0 percent, respectively.10

Table 2.Jamaica: PAYE Employees Classified by Income Groups
Income Groups

(In Jamaica dollars)
Number of

PAYE Employees
Number of

PAYE Employees,

1981
Percentage ChangePercentage Change
19791980
2,300-2,5004,5883,384-262,535-25
2,501-3,50022,60220,399-1012,040-41
3,501-5,00026,79931,4091724,326-23
5,001-7,00023,55726,0081041,05756
7,001-9,00015,10916,8961216,291-4
9,001-11,0008,8699,8301110,0412
11,001-12,0002,9203,09463,2144
12,001-16,0006,1937,175167,5415
16,001-20,0001,9563,043563,49515
20,001-30,0009171,682832,00319
30,001-50,00021238783376-3
Above 50,0014311727293-21
Total113,765123,4249123,0120
Sources: Jamaica, Report of the Commissioner of Income Tax for Years Ended 31st March. 1981 and 31st March. 1982 (Kingston, 1982).
Sources: Jamaica, Report of the Commissioner of Income Tax for Years Ended 31st March. 1981 and 31st March. 1982 (Kingston, 1982).

The actual income categories for which the Laffer curve hypothesis can be most readily evaluated are those in which income exceeds J$20,000. Thus, for incomes in the range of J$ 16,000-20,000, marginal tax rates were reduced by 2½ percentage points, whereas for the income ranges J$20,000-30,000 and above J$30,000, the reductions were 12½ and 22½ percentage points, respectively. If the hypothesis is correct, a significant proportion of the increase in the number of taxpayers (hence in the tax base) earning above J$20,000 may be credited to the income tax changes, which presumably provided a sufficient incentive to induce a sharp increase in the supply of work effort to the organized market. For the Laffer curve to apply, however, this increase would have to exceed the increase that would normally be expected because of fiscal drag. For incomes in excess of J$20,000, it can be calculated that the tax base increased by 87 percent between 1979 and 1980.11 This increase, however, has to be seen in light of an inflation rate of 27 percent in that year. If nominal incomes in those income categories increased by a like amount, and if the Pareto distribution is a correct characterization of the underlying income distribution, then a value of α = 2.5 would result in an increase in the tax base of 67.5 percent owing solely to the effects of fiscal drag.12

The evidence to this point suggests that the Jamaican tax base responded buoyantly to the tax rate reductions. Assuming α = 2.5, the base grew by approximately 29 percent more than would have been anticipated. Further, this occurred in a year of negative GDP growth. What happened to tax revenue, the primary concern of the Laffer curve? Using 1979 weights, the average reduction in marginal tax rates for the relevant income groups was approximately 20 percent, indicating that tax revenue did increase relative to what collections would have been had the tax system remained unchanged and tax revenues had increased only as a result of the effects of fiscal drag.

Although these data are consistent with the existence of a Laffer curve in Jamaica, the reservations about such an interpretation should be kept in mind. It is based on little evidence and on just one year’s observation. Indeed, referring back to Table 2, it is clear that the buoyancy of the tax base in the following year, a year of 12½ percent inflation, fell below what would have been predicted by the framework developed here. More important, the exercise above is cast as if the tax reductions occurred in a vacuum, which, of course, was not the case. The increase in the number of taxpayers in the target year may have been due to other factors, such as a simultaneous drive to enhance tax administration and a coincidental growth in government employment. The 1980 Economic and Social Survey notes that a significant part of the larger-than-expected tax collections from individuals on the PAYE system represented payments of arrears in income tax (Jamaica, National Planning Agency (1980)).

A further reason for caution in interpreting these results as evidence of the Laffer curve is that PAYE taxpayers are not the most suitable group to consider when looking for Laffer curve effects. Thus, as pointed out earlier, the significant factor may not be the aggregate elasticity of labor supply but rather the elasticity of labor supply to organized markets. Elaborating, reductions in marginal tax rates might not result in increased work effort. Instead, they might yield increased tax revenue because of reduced tax evasion.13 This effect, which enhances the observed elasticity of labor supply to organized markets, is less likely to be relevant in the case of PAYE taxpayers. Those paying income taxes under PAYE schemes typically have little control either over the income they report or over the hours they work. If Laffer-type effects exist in Jamaica, these effects are more likely to be observed when other taxpayers are included. As noted in the Report of the Commissioner of Income Tax for 1981 and 1982, delinquency and tax evasion are so extensive that in excess of 80 percent of the self-employed are assumed to be “dodging their responsibilities” (Jamaica (1982, p. 18)).

India

Because the case of India was cited by Wanniski (1983), it is appropriate to consider the example of the marginal income tax reductions introduced in that country in 1975.14 As rationalized in the hudget speech for 1974/75, the reductions in marginal income tax rates were a response to recommendations made by the Direct Taxes Enquiry Committee. The existing high rates were held to be a major cause of tax evasion. The magnitude of the reductions can be gauged from Table 3. As for the revenue loss implied by these reductions, the Minister for Finance argued

The reduction in the rates of income-tax on personal income would ordinarily have resulted in a loss of about Rs. 60 crores in a full year and Rs. 36 crores in the financial year 1974-75. I am, however, not taking any loss into account for budgetary purposes as I expect that the reduction in the rates of taxes will lead to better tax compliance, and full disclosures of incomes by all taxpayers.15

At face value, the Minister's optimism appears to have been justified the yield of the income and corporation taxes was later revised from Rs 1,370 crores to Rs 1,460 crores (India (1976, p. 5)). This upward revision is only evidence, however, of buoyancy at the aggregate level. As was the case with Jamaica, a more disaggregated approach is necessary. Such a breakdown of income tax receipts by income class for fiscal years 1972/73 and 1975/76 (unfortunately, these were the only two years for which data were available) is presented in Table 4. Applying the framework developed above for Jamaica, nominal national income (a proxy for the tax base) increased by 55 percent between fiscal year 1972/73 and fiscal year 1975/76. During the same period, as can be seen from Table 4, total income assessed increased by 30 percent, whereas the tax payable increased by only 27 percent. At this level, it would appear that the supply-side view was not vindicated.

Table 3.India: Rates of Income Taxation, 1473/74 and 1974/75
1973/741974/75
Income (In rupees)Tax rateIncome (In rupees)Tax rate
Below 5,0000Below 6,0000
5,001-10,00011.006,001-10,00013.2
10,001-15,00018.7010,001-15,00016.5
15,001-20,00026.1515,001 -20,00022.0
20,001-25,00034.5020,001-25,00033.0
25,001-30,00046.0025,001-30,00044.0
30,001-40,00057.5030,001-50,00055.0
40,001-60,00069.0050,001-70,00066.0
60,001-80,00080.50Above 70,00077.0
80,001-100,00086.26
100,001-200,00092.00
Above 200,00097.75
Sources: Data for 1973/74 were obtained from Anupam Gupta, Impact of the Personal Income Tax (New Delhi: National Institute of Public Finance and Policy, 1978); and data fur 1974/75 were obtained from KailashC. Khanna, “India: The Finance Bill. 1974,” Bulletin,. Internaiinnal Bureau of Fiscal Documentation (Amsterdam). Vol. 28 (April 1974), pp. 143-46. The surcharge has been included.
Sources: Data for 1973/74 were obtained from Anupam Gupta, Impact of the Personal Income Tax (New Delhi: National Institute of Public Finance and Policy, 1978); and data fur 1974/75 were obtained from KailashC. Khanna, “India: The Finance Bill. 1974,” Bulletin,. Internaiinnal Bureau of Fiscal Documentation (Amsterdam). Vol. 28 (April 1974), pp. 143-46. The surcharge has been included.

When one considers the breakdown in greater detail, a clearer picture emerges. First, a sharp drop in tax revenue occurred in the lowest income classes where this may be ascribed to the increase in the basic exemption. Second, the increase in the basic exemption also implies tax revenue reductions in the higher gross income tranches. Note that this may well be an inframarginal tax reduction for many taxpayers—taxpayers may find their taxes reduced and yet face the same marginal tax rates. (This is not to deny that there are grounds, based on equity considerations, for introducing this type of tax reduction—grounds that may be all the more relevant in an inflationary environment.)

Table 4.India: Classification of the Tax Payable by Assessees According to Income Class
Income (In rupees)Number of AssesseesPercentage ChangeTotal Income Assessed

(In thousands of rupees)
Percentage changeTotal Tax Payable

(In thousands of rupees)
Percentage Change
1972/731975/761972/731975/761972/731975/76
Below 5,000193,54755,144-72838,614188,990-7714,17213,652-4
5,001-7,500775,715661,569-154,723,7724,206.137-11128,27495,920-25
7,501-10,000368,500529,829443,172,9754,547,48243185,861192,8944
10,001-15,000367,666514,001404,458,5806,236,16940370,121437,44018
15,001-20,000158,879237,186492,730,2304,075,96149303,047426,49541
20,001-25,00087,227127,322461,913,0902,835,62948262,710371,17941
25,001-30,00052,84474,094401,439,5332,026,97041246,417319,7703O
30,001-40,00057,48981,957431,979,2652,817,78842373,008531,79843
40,001-50,00030,62144,381451,364,9701,979,74945284,655408,82244
50,001-60,00017,40325,50747949,8981,394,37247210,898308,59246
60,001-70,00011,66816,99946753,3101,097,82446176,365249,84242
70,001-100,00018,10927,094501,498,0322,245,85950378,420535,44641
100,001-200,00013,05722,685741,752,7923.030.83473526,964843,82960
Above 200,0006,2458,554378,506,04810,351,019224,673,4535,608,90820
Total2,158,9702,426,3221236,111,11047,061,783308,134,36510,344,58727
Sources: India. Cencral Statistical Organization, Statistical Abstract (New Delhi), various issues.
Sources: India. Cencral Statistical Organization, Statistical Abstract (New Delhi), various issues.

Third, as can be seen from Table 5, which presents summary data based on Table 4, the increase in total tax payable tends to decline as income levels increase. More important, average assessed income per assessee and average tax payable per assessee both decline in absolute terms for incomes in excess of Rs 50,000. These declines were even more pronounced for incomes in excess of Rs 100,000. A comparison of Tables 4 and 5 reveals the source of this behavior: income and revenue growth rates of the highest income group (those with incomes above Rs 200,000) were sluggish, both in comparison with the corresponding growth rates registered in most other income classes and with the underlying growth in national income. If in addition it is assumed that income is Pareto distributed, with α = 2.5, one would expect above-average increases in these categories.

The data on India, at least for the years selected, therefore, do not support the Laffer curve hypothesis.16 The “revenue performance” of the highest income group was quite poor. This is, of course, the income group that might be expected to exhibit the most pronounced Laffer-type effects because taxpayers in this bracket experienced the greatest reduction in marginal tax rates (20.75 percentage points).

Just as caution was required in interpreting the data for Jamaica, so it is required in this case. For example, the low income growth registered by the highest income group might be due to income and price (e.g., rent control) policies. This possibility raises the obvious point that, for the Laffer curve to exist, individuals must be able to earn more income. Nonetheless, the conclusion of this section must be that strong supply-side effects are not readily observable in India. Again, one should remember that such a conclusion concentrates on the revenue implications of cuts in marginal tax rates to the exclusion of any consideration of efficiency or equity effects.

III. Overview and Conclusions

This chapter represents an attempt to evaluate empirically whether Laffer curve effects are to be found in developing countries. Jamaica and India, which have reduced their top marginal tax rates, were selected for the exercise. Empirical tests rarely afford definitive resolutions of intellectual disputes, but the prospects of their doing so in this instance appearparticularly poor. The data are hardly adequate. Although there was some evidence of tax revenue buoyancy in Jamaica, the opposite was found in India. Because the testing techniques used depended on a number of critical assumptions and lacked discriminatory power, however, in both cases the results could easily be rationalized using non-Laffer curve explanations. For Jamaica, one could appeal to the possibility of a once-and-for-all gain from improved tax administration; for India, the existence of other market imperfections might have played a role.

Table 5.India: Trends in Tax Base and Taxes Paid, 1972/73 and 1975/76(In thousands of rupees, unless otherwise stated)
AssessesAverage
Number

(In thousands)
Percent

Total
Total

Income

Assessed
Total

Tax

Payable
Assessed

Income/

Assessee
Average

Tax/

Assessee
All income levels
1972/732,159100.036,1118,13416.83.76
1975/762,426100.047,06110,34519.44.26
Percentage change12.430.327.215.513.40
Income levels above Rs 50.000
1972/73663.013,4605,966203.990.4
1975/761004.118,1207,547181.274.6
Percentage change52.034.626.5-11.1-17.5
Income levels above Rs 100,000
1972/73190.910,2595,200539.9273.7
1975/76311.313,3826,453431.7208.2
Percentage change63.130.424.1-20.0-23.9
Sources: India. Central Statistical Organization. Statistical Abstract (New Delhi), various issues.
Sources: India. Central Statistical Organization. Statistical Abstract (New Delhi), various issues.

A paper such as this, which considers the Laffer curve as it applies to marginal income tax reductions, focuses on a narrow aspect of supply-side economics. Taking a broader perspective, the supply-side approach is concerned with the disincentive effects of tax distortions irrespective of their source (cf., Chapter 9). This broader concern was touched on when it was argued that the effects of the marginal tax rate reductions extend beyond the revenue effects. Even if Laffer-type effects are not in evidence, removal of tax distortions may nonetheless induce significant supply responses.

Moreover, although the reduction of top marginal tax rates may yield some revenue increase or, at least, a negligible revenue decline, the real significance of the result most likely lies in its implications for economic efficiency and equity. Thus, for Jamaica, the 387 taxpayers in the income group of J$30,001-50,000 (Table 2) might have been expected to pay approximately J$7 million in taxes in fiscal year 1980/81. This amount must be seen in the context of total individual income tax payments in the year of J$7 million (Jamaica, Ministry of Finance and Planning (1981)). The J$7 million refers to total revenue, which implies that any change in revenue associated with marginal tax changes will be correspondingly smaller. (A caveat is that the revenue implications for the highest income group cannot be derived because of the open-ended nature of the income levels in that group; although this group is certain to have “outliers,” particularly if the analysis is extended to non-PAYE taxpayers, the force of the point in this paragraph is unlikely to be altered.)

ANNEX Summary of Empirical Evidence: Developed Countries

The bulk of the empirical evidence advanced by supply-side economists to support their position is concerned with economic policy in the United States. Much of this work concerns the revenue effects associated with the Kennedy tax cuts implemented in 1962 and 1964. These tax cuts are felt to be particularly suitable as a test of the supply-side approach, since they involved reductions in the highest marginal tax rates on earned income as well as reductions in the corporate profits tax. Much of the evidence cited in support of the supply-side position is anecdotal. Most argue that the tax cut was stimulative and that the resultant surge in economic activity resulted in significant revenue buoyancy.17 However, to the extent that the revenue increase was due to a surge in macroeconomic activity it does not necessarily sustain the argument that the Kennedy tax cuts led to the large gains in microeco-nomic efficiency sought by some supply-side economists.18

There have been more rigorous attempts to evaluate the Kennedy tax cuts. Consider, for example, the research by Canto, Joines, and Laffer (1981). On the assumption that the exogenous policy variables bear a constant relationship to the endogenous variables and that the structure of the complete model is stable, they used univariate time-series analysis to identify the stochastic process generating, for example, the income tax revenue series. The forecast errors that result when these univariate models are applied to the post-sample period (i.e., the period after the Kennedy tax cuts became effective) may then be regarded as estimates of the revenue changes resulting from those tax cuts. There are a number of conclusions. In particular, the authors found that their time-series estimates showed smaller revenue losses than those predicted at the time by the U.S. Treasury. This result is of interest since, given that the Treasury utilized a Keynesian framework for its revenue loss projections, the time-series discrepancy may be due to relative price effects. However, this interpretation is predicated on the Treasury model having exhaustively captured all effects associated with the tax cuts other than the relative price changes.19

Taking an alternative approach to the evaluation of actual tax changes such as the Kennedy tax cuts, Fullerton (1982) used an empirical U.S. general equilibrium model to plot the Laffer curve for various elasticity values of factor supply in the United States. He concluded that, although Laffer effects were conceivable in the context of the U.S. income tax system, they were unlikely given the conventional wisdom concerning the relevant elasticities of labor supply. Mackenzie (Chapter 2) has modeled the effects of a tax reduction on aggregate supply within the context of a simple macroeconomic model and found the aggregate demand effects to be more pronounced than the aggregate supply effects. Grieson and others (1977) reported a more positive result. They found the possibility of an inverse relationship between tax rates and tax revenue for local government in New York. This finding lends support to the hypothesis that Laffer effects are likely to be most pronounced where the tax base is narrowly defined, and substitution possibilities are thus increased. As a final example of research on the extent of Laffer effects in developed countries, consider Stuart’s (1981) study of Sweden. Using a two-sector model with parameter values to fit Sweden, he found that the peak of the Laffer curve occurs at a marginal tax rate of approximately 70 percent. This result can be contrasted with actual marginal tax rates in force in Sweden—rates as high as 80 percent—and he concluded that tax rate reductions were in order. (A weakness of this latter study is that the parameterization was done within a Cobb-Douglas framework. This not only imposes the strong restriction that labor-supply elasticities be constant but it may also imply larger labor-supply elasticities than actually occur.)

References

    AcharyaShankar N. and others Aspects of the Black Economy in IndiaReport of a Study by the National Institute of Public Finance and Policy (New Delhi: Ministry of Finance1985).

    AtkinsonA.B.“How Progressive Should Income Tax Be?”inEssays in Modern Economics: The Proceedings of the Association of University Teachers of Economics Aberystwyth 1972ed. by MichaelParkin and A.R.Nobay (London: Longman1973).

    BartlettBruce R.Reaganomics: Supply Side Economics in Action (New York: Quill, updateded.,1982).

    BlinderAlan S.“Thoughts on the Laffer Curve,”inThe Supply-Side Effects of Economic Policyed. by Laurence H.Meyer (Boston, Massachusetts: Kluwer Nijhoff1981).

    CantoVictor A.Douglas H.Joines and Arthur B.Laffer“Tax Rates, Factor Employment, and Market Production,”inThe Supply-Side Effects of Economic Policyed. by LaurenceH.Meyer (Boston, Massachusetts: Kluwer Nijhoff1981).

    CantoVictor A.Douglas H.Joines and Arthur B.LafferFoundations of Supply-Side Economics: Theory and Evidence (New York: Academic Press1983).

    Federal Reserve Bank of Atlanta and Emory University Law and Economics CenterSupply-Side Economics in the 1980s: Conference Proceedings (Westport, Connecticut: Quorum Books1982).

    FeldsteinMartin S.(1974a) “Incidence of a Capital Income Tax in a Growing Economy with Variable Savings Rates,”Review of Economic Studies (Edinburgh) Vol. 41 (October1974) pp. 50513.

    FeldsteinMartin S.(1974b) “Tax Incidence in a Growing Economy with Variable Factor Supply,”Quarterly Journal of Economics (Cambridge, Massachusetts) Vol. 88 (November1974) pp. 55173.

    FinkRichard H.ed.,Supply-Side Economics: A Critical Appraisal (Frederick, Maryland: University Publications of America1982).

    FullertonDon“On the Possibility of an Inverse Relationship Between Tax Rates and Government Revenues,”Journal of Public Economics (Amsterdam) Vol. 19 (October1982) pp. 322.

    GriesonRonald E.WilliamHamovitchAlbert M.Levenson and Richard D.Morgenstern“The Effect of Business Taxation on the Location of Industry,”Journal of Urban Economics (New York) Vol. 4 (April1977) pp. 17085.

    GuptaAnupams Impact of the Personal Income Tax (New Delhi: National Institute of Public Finance and Policy1978).

    HailstonesThomas J. (1982a)A Guide to Supply-Side Economics (Richmond, Virginia: Robert F. Dame, Inc.1982).

    HailstonesThomas J. (1982b) ed.,Viewpoints on Supply-Side Economics (Richmond, Virginia: Robert F. Dame, Inc.1982).

    HuttonJohn P. and Peter J.Lambert“Income Tax Progressivity and Revenue Growth,”Economics Letters (Amsterdam) Vol. 3No. 4 (1979) pp. 37780.

    India Ministry of FinanceBudget for 1974/75 (New Delhi1975).

    India Ministry of FinanceBudget for 1975/76 (New Delhi1976).

    International Monetary FundInternational Financial Statistics Yearbook 1983 (Washington1983).

    JamaicaReport of the Commissioner of Income Tax for Years Ended 31st March 1981 and 31st March 1982 (Kingston: Government Publications1982).

    Jamaica Ministry of Finance and PlanningFinancial Statements and Revenue Estimates for 1981/82 (Kingston1981).

    Jamaica National Planning AgencyEconomic and Social Survey: Jamaica 1980 (Kingston: Government Publications1980).

    KhannaKailash C.“India: The Finance Bill, 1974,”BulletinInternational Bureau of Fiscal Documentation (Amsterdam) Vol. 28 (April1974) pp. 14346.

    KwonOhchul“Taxes, Tax Revenues, and the Laffer Curve for a Developing Country Like Korea,”International Tax Journal (New York) Vol. 10No. 4 (May1984) pp. 26972.

    LydallH.F.The Structure of Earnings (Oxford: Clarendon Press1968).

    MeyerLaurence H.ed.,The Supply-Side Effects of Economic Policy (Boston, Massachusetts: Kluwer-Nijhoff1981).

    RaboyDavid G.ed.,Essays in Supply Side Economics (Washington: Institute for Research on the Economics of Taxation1982).

    RobertsPaul C.The Supply-Side Revolution: An Insider’s Account of Policymaking in Washington (Cambridge, Massachusetts: Harvard University Press u 1984).

    StuartCharles E.“Swedish Tax Rates, Labor Supply, and Tax Revenues,”Journal of Political Economy (Chicago) Vol. 89 (October1981) pp. 102038.

    TanziVito and Thomas P.Hart“The Effect of the 1964 Revenue Act on the Sensitivity of the Federal Income Tax,”Review of Economics and Statistics (Cambridge, Massachusetts) Vol. 54 (August1972) pp. 32628.

    U.S.CongressHouseCommittee on the BudgetSupply-Side Economics: Hearing Before the Task Force on Tax Policy of the Committee on the Budget House of Representatives97th Congress 1st SessionMarch101981 (Washington: Government Printing Office1981).

    WanniskiJudeThe Way the World Works (New York: Simon and Schuster, rev. and updateded.,1983).

See Gandhi (Chapter 1). Readers interested in examining some of the original sources are referred to Meyer (1981); Bartlett (1982); Federal Reserve Bank of Atlanta (1982); Fink (1982); Hailstones (1982a. 1982b); Raboy(1982); Canto. Joines. and Laffer (1983); Wanniski (1983); and Roberts (1984); and also to the other publications listed in the Selected Bibliography in Appendix II.

We leave aside here the issue of whether this concept should be credited to Laffer. Current conventional wisdom maintains that the basic concept has many antecedents. Bartlett (1982) accords the honor of first discovery of the Laffer curve to Ibn Khaldun. a fourteenth century Arabic philosopher.

An example of a Laffer-type effect is the case of New Hampshire liquor taxes. It is argued that a reduction in that state’s liquor tax rate eould well lead to an increase in lax revenue because an incentive would then be provided to consumers to come in from out of state, notably from Massachusetts, to purchase alcohol. The essence of this argument is that New Hampshire alcohol and out-of-state alcohol are close substitutes, implying highly elastic behavior on the part of purchasers. More generally, this example suggests that, the smaller geographically is the taxing jurisdiction, the greater are the possibilities for Laffer curve effects associated with changes in the level of taxation of a mobile factor. This eould be important in a developing country context.

A similar, though more neoclassical, characterization of the Laffer curve can be found in Bartlett (1982). With reference to the economy of Hong Kong, he argues that a reduction in tax rates led to an acceleration in growth rates and, thus, to revenue increases (an income effect).

further potential short-run macroeconomic effect has been pointed out to me. To the extent that a tax cut stimulates economic activity, the resultant increase in the transactions demand for money could allow the government to finance some of its expenditures through money creation. As an aside, one might also note a particular supply-side perspective that applies to those at lower income levels. It is argued that the various unemployment and social security compensation schemes in many developed countries have tended to make it unprofitable for the unemployed to seek work. At the microeconomic level, accordingly, this line of reasoning says that the discrete decision to work or not to work is influenced by tax-induced or unemployment-compensation-induccd income effects. Given the low level, both relative and absolute, of social welfare payments in most developing countries, however, it is unlikely that these effects would be important in the context of this chapter. They are therefore not treated in what follows.

To quote Wanniski from evidence he presented before the U.S. Congress Task Force on Tax Policy (U.S. Congress (1981, p. 41)):

“To the supply-sider, the producer is the active participant…. The government… regulates the marketplace in the interests of all producers…. The supply-sider is not per se a tax cutter. If the supply-sider believes the efficiency of production will be enhanced over time by more public roads… he will urge that they be financed by borrowing or taxing away a greater share of the producer’s production.”.

The analysis could as easily consider Lhc case of real growth. Note that the implicit assumption is being made at this stage that, whatever the source of nominal income grouth, it is affecting all income levels uniformly. This assumption is dictated by data inadequacies.

As evidence of the extent of the tax administration problem, the Report of the Commissioner of Income Tux for Years Ended 31st March. 1981 and 31st March, 1982 notes that the prospects for remedying the tax evasion situation were unlikely to improve as long as resources for the task continued to be inadequate and sanctions against evasion remained weak (Jamaica (1982)).

PAYE data are easy to use because tax collections and tax liabilities tend to be contemporaneous. Further, for Jamaica, they arc a pre-eminent source of individual income tax revenue. The Report of the Commissioner of Income Tax for 1981 and 1982 notes that in 1982 PAYE was responsible for 92 percent of gross individual income tax receipts (Jamaica (1982)).

These estimates were obtained from International Monetary Fund (1983).

Note that there are absolute decreases in the number of taxpayers in the lowest income classes in both years. This confirms the view that inflation and/or growth combined with changes in basic allowances, tends to shift the whole distribution. Of course, the Pareto distribution cannot be applied to the whole income distribution. For that task, a log-normal distribution would be more appropriate.

ldeally, one would lest the validity of assuming that the upper tail of the income distribution conforms to the Pareto distribution by using a χ2 test. Unfortunately, there arc insufficient observations for such a test. Note also that lack of data precludes an independent verification of the magnitude of α for Jamaica, or, indeed, for India below, though in both cases the true value of α would have to differ significantly from that assumed here to alter the interpretation of the data.

In this context, the tax cuts might also have enhanced revenue by reducing the incentives for tax avoidance techniques in the form of awarding nontaxable perquisites.

Major income tax reforms, including a substantial reduction of top marginal income tax rates, were introduced in the 1985/86 budget, and the early indications arc of substantial increase in income tax collections. However, an analysis of the reasons underlying these revenue trends remains to be carried out. It has not been undertaken in this chapter either.

See India (1975, pp. 187-88). A crore is a unit of ten million. There are some discrepancies between Wanniski’s account and the measures proposed by the budget speech. Specifically, Wanniski refers to reductions in annual taxes on large holdings, whereas the Minister proposed wealth tax increases in general.

This assessment receives support in Acharya and others (1985). Their report cites work by Bagchi and Rao (Economic and Political Weekly. Bombay, September 4, 1982) in which they concluded that the tax compliance effects of rate reductions were much lower than had been presumed in the budgets (sec above). Bagchi and Rao’s methodology relies on obtaining independent estimates of assessable income in years after tax reduction and their results further belie the optimism generated by the aggregate data discussed earlier.

For a summary of the opinions of various authorities on the impact of the Kennedy tax cuts, see BartJett (1982).

An important related point is that the nature of the income lax change was such that it resulted in an increase in the elasticity of that tax. This point is discussed further in Tanzi and Hart (1972).

The interpretation is also predicated on the accuracy of the assumptions required for the application of the univariate lime-series analysts.

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