The story of the Laffer curve and three points about Ethiopia’s tax revenue
In economics, the Laffer curve is one possible representation of the relationship between rates of taxation and the resulting levels of government revenue. It postulates that no tax revenue will be raised at the extreme tax rates of 0Pct and 100Pct and that there must be at least one rate that maximises government taxation revenue. The curve is typically represented as a graph (see the figure on the following page), which starts at 0Pct tax with zero revenue, rises to a maximum rate of revenue at an intermediate rate of taxation, and then falls again to zero revenue at a 100Pct tax rate.The Laffer curve earned its name from a 1978 article by the late Jude Wanniski (then-associate editor of the Wall Street Journal). Wanniski recounted a 1974 dinner he attended with Arthur Laffer (a professor at the University of Chicago, pictured below), Donald Rumsfeld (then Chief of Staff to President Gerald Ford), and Dick Cheney (Rumsfeld’s deputy and a former classmate of Laffer’s). When their dinner discussion turned to President Ford’s “WIN” (Whip Inflation Now) proposal for tax increases, Laffer is said to have grabbed his napkin to sketch the curve as an illustration of the trade-off between tax rates and tax revenues. Wanniski dubbed the trade-off as the ‘Laffer curve’.
Although it bears his name, the ideas behind the curve were not new nor his alone; Laffer himself noted, for example, the philosopher Ibn Khaldun alluded to the concept in his 14th century work, The Muqaddimah: “It should be known that at the beginning of the dynasty, taxation yields a large revenue from small assessments. At the end of the dynasty, taxation yields small revenue from large assessments.”
In the September 2015 issue of EBR (No. 33), the editorial noted the serious problems related to tax avoidance in Ethiopia that are being carried out in front of tax officials, whereas registered companies and individuals are mercilessly treated. This may well relate to the aforementioned Laffer issue. Here, I’d like to note three more points related to taxing in Ethiopia.
First, over the course of five years (2009/10 -2013/14), public revenue doubled and that of expenditures nearly tripled. While the substantial increase in revenue is mainly attributed to the increase in direct and indirect taxes, the threefold increase in expenditures is mainly related to the high growth in public investment and related spending. Due to this significant increase in total expenditure over revenues, the overall balance of the fiscal account has been persistently negative and gives the impression that taxes are low.
Yet this is misleading. As the former US President Bill Clinton said in his 1992 campaign, “it’s the economy stupid!” – Ethiopian leaders may say “it is the expenditure!” that is causing this imbalance in the country’s fiscal accounting.
Second, when the government plans to collect more taxes it usually cites the performance of other African countries. It says, for instance, that Ethiopian tax revenue as percentage of GDP (National Income) is about 13Pct while the African average is about 18Pct, so Ethiopia has to do a lot more to match its African peers. However, it is known that taxes are generally accurately recorded while GDP is not. A simple illustration of this is the IMF’s forecast for Ethiopia’s economic growth, which is about 7 to 8Pct, which differs from the government’s figure of about 11Pct. If the IMF is right, the GDP, which is the denominator in the tax-to-GDP ratio, will be lower; hence, the share of Ethiopian tax revenue in GDP could be even larger than the African average of 18Pct, perhaps even more than 20Pct. So Ethiopia may already be taxing too much and need to consider the Laffer curve.
Finally, the tax revenue has increased from 65 to 84.5Pct of total revenue in the last five years. This improvement in domestic resource mobilisation has helped the government to finance about 80Pct of its public spending domestically (with taxes alone financing about 70Pct). This is an excellent achievement. However, this tax revenue growth is primarily driven by the growth in indirect taxes, which require relatively less effort to collect. Moreover, the fact that the growth of ordinary revenue has been erratic – having grown by nearly 50Pct in 2009/10 but dropping to 22Pct in 2013/14 – suggests that the domestic resource mobilisation endeavours might not be established on a firm and informed basis.
5th Year • September 2017 • No. 54