The Laffer Curve is a concept accredited to economist Dr. Arthur Laffer. Laffer admitted that whilst he gave it a name, it’s been around as an idea in one form or another since the 14th century, when Muslim philosopher Ibn Khaldun wrote about it. It was also referenced in John Maynard Keynes work.
In simple terms, Laffer’s theory suggests something about taxation which is fairly obvious. It states that there is a relationship between the amount of tax a government collects and the rate of taxation. If tax rates are too low, they will bring in too little revenue. However, if tax rates are too high it will change people’s behaviour and ultimately that will also reduce tax revenues. Discouraging taxed activities, like consumption, selling shares and investing money, can have a negative net impact on how much money the government receives in tax.
The Laffer Curve suggests there is an optimum ‘position’ for tax rates – not too high and not too low – which brings in enough tax revenue but doesn’t change behaviour.
It is especially pertinent when considering Capital Gains Tax, and the Chancellor’s decision to increase this particular tax to 24%. It was nothing like the increase some had expected, rumoured at one point to be as high as 39%, and is expected to generate some but not a massive amount of additional tax revenue.
Why 24%?
There is a precedent in very recent history. Jeremy Hunt changed the CGT rate for people selling their second home from 28% to 24%, as of April 2024. It was a partly a sweetener to soften the blow of additional taxes on second home owners elsewhere. The main purpose of introducing this slightly lower rate of tax was to encourage more people with second homes to sell their properties. Not only would this generate more tax revenues through sales, it would free up more homes for first time buyers in a market severely short of housing stock.
Hunt was advised by Treasury officials that 24% was the right rate of tax, hitting the sweet spot on the Laffer Curve.
Robert Peston suggested on X that the CGT change to 24% was not as radical as hoped because ‘HMRC lacked the resource to properly work through the consequences of root-and-branch change, so instead Reeves has opted for the path of least resistance’.
However, it seems unlikely that she would have been unaware of the reports from Whitehall which showed that a more fulsome increase in CGT rates would most probably see an overall reduction in tax revenues because people would change their investment behavior. 24% is the perfect rate for CGT on the Laffer Curve, she will most likely have been advised.
We will probably never know the true answer to why the change to 24% was made, but it does suggest that regardless of where the sweet spot is, most politicians and economists recognise that there is only so far tax rates can be pushed upwards before they cease to be effective.
