Tax Revenue Theory: From Ibn Khaldun to Arthur Laffer
Influential Economist Dr. Arthur Laffer Receives Presidential Medal of Freedom
On Wednesday, June 19, 2019, President Donald Trump bestowed the Presidential Medal of Freedom upon Arthur Laffer, one of the nation’s outstanding economists.
Laffer is known for his theoretical work involving tax cuts and their effect on promoting economic growth, as well as for his famous Laffer Curve.
A 1974 Lunch in Washington, D.C.
One afternoon in 1974, Laffer, then a young University of Chicago economist, was sitting in a Washington restaurant having lunch with Donald Rumsfeld, Dick Cheney, and Jude Wanniski.
Donald Rumsfeld was White House Chief of Staff for then-President Gerald Ford, and Dick Cheney was one of his young aides. Wanniski was a prominent conservative journalist.
Laffer explained his work on taxes, which Cheney was having trouble grasping. Taking his pen and nearby napkin, the young economist quickly sketched a graph illustrating how, at some point, government revenues tended to fall rather than continuing to rise as taxes were increased.
As they left the restaurant to go back to work, Cheney was still struggling with the concept. However, Wanniski clearly understood the theory and its potential not only for stimulating the economy but as a way for Republican lawmakers to stop tying spending cuts, which Democrats opposed, to tax cuts.
In articles and speeches Wanniski actively promoted Laffer and his theory, even going sp far as to reproduce the simple graph Laffer had sketched on a napkin at lunch (the napkin had been left behind with the dirty dishes and thrown out when the table was cleared for the next customer) and referring to it as the "Laffer Curve."
Arthur Laffer’s Theory Was Neither New nor Original
Arthur Laffer’s public fame is due to the efforts of Jude Wanniski and other conservative writers driving the modern conservative political revival. Laffer continued to promote the theory behind the suddenly famous Laffer Curve but his efforts, like the 1994 lunch, were directed at working with policy and lawmakers directly.
In his efforts, Laffer never claimed to have been the originator of the theory and was quick to give credit to the 14th century Arab scholar and philosopher named bū Zayd ‘Abdu r-Raḥman bin Muḥammad bin Khaldūn Al-Hadrami (أبو زيد عبد الرحمن بن محمد بن خلدون الحضرمي,) or, as he is more commonly known to European and American scholars, Ibn Khaldun.
Life and Times of Ibn Khaldun
Ibn Khaldun was born in Tunis, an ancient city in present-day Tunisia, on May 27, 1332, to an upper-class Andalusian Arab family that had immigrated to Tunis from Seville, Spain following the fall of Seville in 1248 to Christian forces led by King Ferdinand III of Castile.
Ibn Khaldun came from a political family, and his ancestors, including his parents, had long served as courtiers and advisers to powerful Arab rulers in Andalusia (a southwestern region of Spain) and later in North Africa.
Well educated in philosophy and law, Ibn Khaldun was also well versed in economics, sociology, history and other areas of learning that have since emerged from philosophy as separate intellectual disciplines.
Seville, the Moorish controlled City where Ibn Khaldun's parents and ancestors were advisers to the rulers when the city was ruled by the Moors
Tunis, the city in North Africa where Ibn Khaldun was born and raised
Khaldun's Career as an Adviser to Kings
While Ibn Khaldun is remembered today for his writings, especially his classic, The Muqaddimah, the bulk of his career, like that of his parents and family members before them, was as a courtier and adviser to North African rulers.
Ibn Khaldun was a smart political operator who usually chose and, when necessary, changed allegiances and employers wisely.
However, he did occasionally miscalculate and, at least once, supported the loser in a dynastic power struggle, ending up in prison for a time as a result. Once freed, he quickly bounced back and continued his career as a political adviser.
Ibn Khaldun - May 27, 1332 – March 17, 1406
Khaldun Developed His Theory of Taxes & Prosperity After Observing a Number of Kingdoms
While Ibn Khaldun is credited as the person behind the theory of increasing government revenue by reducing taxes, he is really just the first person to describe and explain the theory behind this phenomenon by which reductions in tax rates can lead to increased tax revenue.
In his travels throughout North Africa and the Eastern Mediterranean he observed both prosperous kingdoms and those in decline. Kingdoms in decline were usually impoverished due to wars and poor fiscal management including high taxes.
Increasing Tax Revenue by Reducing Taxes is Similar to Price Elasticity in Free Markets
The idea behind increasing tax revenues by reducing tax rates is essentially the same as the concept of price elasticity which is taught in most college introductory economics courses.
The concept is that, with many products, a seller can increase his total revenue by reducing the price of the product within a certain range. In these cases, reductions in price result in proportionately larger increases in total units sold which yields an increase in total revenue and overall profit.
Here, the small loss in revenue on each item sold is made up by the increase in the number of items sold. While lowering prices within a certain range will result in a proportionately greater increase in sales, raising prices within that range will result in a proportionately greater decrease in sales.
In his extensive travels Ibn Khaldun advised and conferred with many rulers and probably also interacted with many merchants in the bazaars who probably enlightened him with the fact that in some cases lowering prices led to more sales and greater profit.
Khaldun Focused on Giving People Incentive to Work & Produce
Ibn Khaldun’s argument was that, by decreasing the tax burden, people are given the incentive to work and produce more, thereby generating a surplus or profit over and above what they needed in order to obtain the basic food, clothing and shelter needed to keep them alive.
This surplus or profit would then be spent on either buying other things needed to make their lives better or investing it in more land or capital.
Additional purchases of what Ibn Khaldun called luxury items (things not essential to survival) will increase demand thereby providing jobs for more people as well as adding to the division of labor which helps to make an economy more efficient.
Of course, having more people working and earning money also results in more people paying taxes.
Investing in additional land to cultivate or capital to increase production would also lead to an increase in output as well as creating more jobs.
Ibn Khaldun's Classic Work - The Muqaddimah
An Abridged version of Khaldun's classic work entitled "The Muqaddimah" which has been translated and reprinted in numerous languages for scholars and students during the past six centuries.
Government Revenues Increased After Each of the 20th Century American Tax Cuts
Whenever governments have followed Ibn Khaldun’s advice on taxes, economic growth has surged. In the United States we have seen this most recently with the Trump tax cut as well as tax cuts enacted by the Regan administration in the 1980s, the Kennedy-Johnson administration in the 1960s and the Coolidge administration in the 1920s.
In the three of these twentieth century American examples, where federal income tax rates were cut, the U.S. government saw its revenues from income taxes increase. At the same time, unemployment decreased and working Americans saw their discretionary income increase.
Criticisms of Khaldun and Laffer
While not a household name, Ibn Khaldun and his works, especially his classic work, The Muqaddimah, covering Philosophy, History, Economics and other topics, have been known to and studied by scholars for the past six centuries.
The Muqaddimah has been translated into numerous languages, including English, and is available from publishers like Amazon as well as in digital format on the web and in University libraries.
Throughout the past 6 centuries numerous scholars and advisors to kings, presidents, prime ministers and other high government officials have encouraged political leaders to follow the advice of Ibn Khaldun in their governing.
Static Economic Models used by Progressives Distort Effect of Tax Cuts
While most people today have not heard of Ibn Khaldun, they probably have heard of Arthur Laffer, or at least the Laffer Curve, of which progressives and other left wing politicians love to mock.
Progressives and others on the left continually dismiss the theory behind tax cuts claiming they don’t work. It is true that tax cuts don’t always work as planned.
This is partly due to the fact that the economy is a dynamic and ever changing thing while theories used by progressives and other left wing politicians and policy makers rely on static models in which everything is constant except for one variable. This makes for an easier but unrealistic model.
As mentioned above increasing government revenue by cutting taxes is similar to the concept of price elasticity in the market. In both cases there is no single optimal point to cut on the graph and this is complicated in both instances by the fact that both operate in a dynamic environment in which things are constantly changing.
Sellers in a market are able to quickly react to changes in the market by changing their prices to meet the change. If the price they set turns out to be too high or too low they change it.
Taxes, on the other hand, are set by the government which, in most cases, involves action by a legislature which usually results in long delays as members debate extensively before reaching a consensus. The can be months after the motion to adjust tax rates was put forward.
Individuals and members of a legislature react differently to the revenue increase resulting from their actions. Individuals use the extra money to improve their standard of living or invest it in expanding their business.
In contrast to individuals in the market, politicians in focus on spending the higher revenues from the tax cuts on new ongoing programs rather than using the increased revenues to pay down public debt or shore up underfunded programs like Social Security and Medicare. This is especially true of lawmaking bodies dominated by progressives, socialist and other left wing parties.
Optimal Point for Cutting Taxes Changes as Economy Changes
The biggest problem with the Laffer Curve is that it is simply an illustrative sketch and, as such only indicates that at a certain point increasing taxes results in less revenue collected.
However, the optimal point at which taxes should be cut is not marked on the graph and can’t be marked because, in a complex and constantly changing economic environment, the exact point at which to cut taxes is difficult to determine. Further, given the long time lag between determining a tax cut is needed and the final passage of the cut the optimal point will move and change its position on the graph.
Even When Weakened by the Political Process Tax Cuts Can Still Benefit Taxpayers and the Economy
While finding the precise point and time to increase tax revenue by cutting taxes is impossible, it is usually obvious that a tax cut is needed when the economy is stagnating or declining and government revenues from current taxes are declining as well.
In this situation a tax cut can still result in an increase in government tax revenue and economic growth, even if the magnitude is less than optimal due to delays resulting from the months of legislative debate.
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© 2019 Chuck Nugent