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Taxation and laffer effects on employment and growth.

Abstract Some dangerous short- and long-term ambiguities of fiscal policies arise from the belief that Laffer effects may be generated from deficit-financed tax cuts able to stimulate aggregate demand. However, even in a supply-side framework, fiscal illusion prevents a rational perception of the effectiveness of Laffer-oriented fiscal measures. The ambiguity of the Laffer effect led to an important series of studies of Francesco Forte, designed to disclose and empirically test its interactions with short- and long-term fiscal policies on gross domestic product (GDP) growth and on other relevant macro-economic variables. We discuss, under the Laffer perspective, some of Francesco Forte's studies related to fiscal policy effects on the labour market and GDP growth.

Keywords Laffer effect * Fiscal illusion * Fiscal policy * Tax-cut * Growth * Employment

JEL Classifications D70 * E62


The Laffer effect has been recently depicted by Francesco Forte as the situation in which:
"[T]he tax rate affects the revenues through its relationship with the
public expenditure and through its effect on the behavior of the
taxpayers. Initially an increased revenue devoted to public
expenditure gives a benefit greater than the cost of the taxes in
terms of loss of wealth and incentives. Therefore, the revenue
increases both because the rate increases and because the taxable
basis increases. Subsequently, the benefits of the cost of the tax for
the taxpayers overcomes the benefits of public expenditure and the
negative effects of the tax increase reduces the taxable basis at an
increasing rate. Therefore, the revenue increases at a reduced rate
because the reduction of the taxable basis reduces the revenue effect
of the increase of the tax rate. After a point, the taxable basis
diminishes in a proportion greater than the increase due to the rate
increase and the revenue diminishes. Thus, any amounts of revenue
except the point of maximum revenue may be achieved with two
alternative tax rates (...)" (Forte 2018).

In this paper, we discuss some of Francesco Forte's studies related to fiscal policies (Laffer) effects on the labour market and gross domestic product (GDP) growth. We begin by considering a main ambiguity generated from the incorrect belief that Laffer effects may arise in a demand-side approach and look at how, in a number of studies, Forte has tried to bring the debate back into the proper supply-side perspective. Under the latter perspective, we shall then consider some interconnected effects due to policies of tax reduction and deregulation explored in Forte's analyses. These policies, other than creating weak and/or strong Laffer effects, may, lead to a number of fiscal illusions. The reasons for these fiscal illusions arising in a supply-side fiscal policy approach are considered.

Demand-Side Approach and the Trap of Fake Laffer Effects

The ambiguity of the Laffer effect was the stimulus for an important series of Forte studies, not only to explain some hidden consequences of the Laffer effects per se, but also to empirically test the effects of short- and long-term fiscal policies in light of the "Laffer curves." These latter works studied the effect on national income and employment as well as on other relevant macroeconomic variables.

Possibly the main dangerous ambiguity or illusion, disclosed in both short- and long-term fiscal policies, derives from the expectations of Laffer effects of deficit financed tax cuts aiming to stimulate demand. The origin of such reasoning can be traced directly back to Keynes, who argued that a tax cut financed with public deficits increases national income by increasing aggregate demand, which, in turn, creates a balanced budget at a higher level of national income. As a consequence, employment also increases with a positive influence on both growth rates and welfare.

By exploring this line of research, Forte (jointly with various co-authors) has recently produced a number of empirical studies aimed at testing the short- and long-term effects of fiscal policies on the main macroeconomic variables. It is worth mentioning a few.

Long-Term Empirical Analysis of Public Deficits and Unemployment Growth

With a panel of Organisation for Economic Co-operation and Development (OECD) countries, the cointegration relationship found between unemployment rate and total public deficit to GDP supports the thesis that the effects of fiscal policies attempting to combat unemployment via deficit spending actually increase unemployment. Clearly, the persistence of unemployment may be due to rigid labor markets, excessive taxation of labour or other institutional factors. Nevertheless, distinguishing between groups of countries, with high/low public expenditures and tax burden and high/low natural rates of unemployment for the period from 1981 to 2009, clearly shows that fiscal deficits (inclusive of interest repayment) are likely to aggravate unemployment. This mainly occurs in those countries characterized by a large public sector (such as EU countries), an aging population, and rigid market structures and institutions (Fedeli and Forte 2012).

Analysis of Cyclically Adjusted Budget Effects on Structural Unemployment

Based on a panel of OECD countries, the results clearly indicate that the non-accelerating inflation rate of unemployment (NAIRU) increases remarkably in the long run by both the underlying net lending of government as a percentage of potential GDP and the overall tax burden. In the long run, high deficits (even if cyclically adjusted) not only do not reduce NAIRU but instead aggravate it. Moreover, high tax burdens needed to finance the servicing of the debt and other public expenditure, under an invariant deficit, further increase the NAIRU. These results suggest that the assertion that the constitutional rule of balancing the budget may create unemployment is not supported by empirical evidence. On the contrary, a deficit in excess of that allowed by the cyclical budget balance would increase structural unemployment. Since high taxes appear to have the same effect, fiscal rules such as the EU fiscal compact, at least for the structural employment objective, need to be accompanied by rules that limit the tax burden (Fedeli and Forte 2014).

Effects of Government Budget Constraints on GDP Growth

A panel analysis on a dataset of OECD countries shows that both deficits and tax burden increases (both in the short- and in the long-run) reduce economic growth. Moreover, in the long term, reducing deficits through spending cuts is more effective than the same reduction through tax increases. This occurs at least in those countries where the tax burden is sufficiently high (already on the second Laffer point), whereas in those countries with a low tax burden, tax increases are shown to produce a higher economic growth stimulus. This result supports the idea that balanced budgets are not, per se, "good devices." Indeed, if not qualified or accompanied by other valid instruments, "the deficit-tax cut theorized by Keynes and many neo-Keynesians introduces a fiscal policy 'Trojan horse' that may lead to a 'democracy in deficit" (Forte 2018), where hypothetical future Laffer effects would also be invoked to justify popular budget unbalances and redistributions from consumptions to savings and from poor to rich. Eventually, in a supply-side approach, the national product would decrease (Fedeli and Forte 2014 and 2016).

Supply-Side Approach and Correct Perception of the Laffer Effects

However, the story does not end with the demand-side approach. Forte noticed that Laffer effects led some scholars, among others Wanniski (1978), to incorrect explanations even in terms of supply-side policy. The optimal tax rate (which maximizes revenues) was also considered optimal from the point of view of GDP maximization. Forte considers this assertion unreasonable, if maximum revenue does not imply maximization of output subject to taxation, as in Monissen (1999). In this respect, the policy maker, acting as a monopolist, is similar to the Leviathan-state (Brennan and Buchanan 1980; Forte 1987). In turn, this gives rise to ambiguous interpretations and actual fiscal illusions related to the Laffer effect, depending on whether the latter is considered a partial or a general equilibrium analysis.

Indeed, even maintaining a supply-side approach, the Laffer effect has at least two main ambiguities. It can be perceived as only a partial equilibrium framework, where output is given in the short term. In the long term, however, GDP can also change as a result of taxation. Therefore, the Laffer effect on revenues significantly differs from the Laffer effect on ratio of revenues to GDP both in the long- and in the short-term. This may prevent researchers from rationally perceiving the effectiveness of these policies. In this respect, Forte has worked on identifying and empirically measuring these effects in terms of fiscal illusion, pointing out the main issues in terms of both benefits and drawbacks.

For example, Fedeli and Forte (2013), following the theoretical background of the Puviani (1903) theory of fiscal illusion, point out that governments may decide to adopt a level of taxes such that, quantitatively and qualitatively, marginal cost equals the marginal benefit of public spending resulting from them. However, because of fiscal illusion on both the revenue and expenditure sides, over-taxation and overspending take place. The opposite case of under-taxation and under-spending may also occur because fiscal illusion overstates the negative effects of taxes and understates the benefits of public spending. However, these examples are quite secondary since politicians are mainly interested in increasing the size of government. Thus, they tend to promote either fiscal illusions that hide the negative effects of taxes and emphasize the positive effects of spending, or conceal the real quantity of revenue needed to balance the budget in order to gain popularity and power.

The theory of fiscal illusion (Puviani 1903) was thus discussed by Forte in order to explain why tax cuts motivated by supply-side considerations are often seen suspiciously from the standpoint of fiscal soundness. Many reasons support it. The following are some of these reasons, without pretension of being exhaustive, given the number of Forte's works on the topic (Fedeli and Forte 2009).

The first reason has to do with the existence of two "critical points" in the relationship between increases in tax burden and tax revenue. Beyond one, revenue does not increase and beyond the other, revenue decreases. Accordingly, a weak and a strong Laffer effect should be distinguished and empirically explored in order to avoid a political undervaluation of the economic and social relevance both of the Laffer effect and of the meaning of a weak Laffer effect. A typical case is that of the tax on labor in relation to unemployment.

A second possible reason for illusion may be due to the fact that often scholars focus only on the level of the tax rate, whereas the value of the taxable base is crucial for the change in the tax burden in relation to a possible Laffer effect. This is related to proper consideration of an often-hidden explanatory variable consisting of an increase in the economic activity taxed due to reduction of the tax burden, as in the case of a reduction in ad valorem taxes on factors of production and products when liberalization reduces prices. In this case, the institutional setting may determine different Laffer effects (Fedeli and Forte 2008; Fedeli et al. 2008). Indeed, tax cuts combined with market deregulations (as in the case of labor market deregulation associated with a reduction in social contributions of the first Treu reform in Italy) have been shown to positively affect revenues and employment, although, it should be verified why this beneficial effect on employment did not continue over time, even if subsequent governments stressed deregulation in this same direction.

A third reason for fiscal illusions arises from the time lags of the Laffer effects with respect to the fiscal maneuver that generated them. In this regard. Forte et al. (1980) show that in the short term and in a partial equilibrium context, with a given output, the tax burden can be adversely affected and thus delayed by tax avoidance due to both tax evasion and elusion induced by the increased tax rate. A tax rate cut can increase revenues at any level of GDP. However, in the long-run, GDP can change as well as the elasticity of the tax base to GDP. However, even if delayed, Laffer effects might become a permanent phenomenon in the same legislature in which a government undertakes the Laffer maneuver, at least if the government is smart enough to undertake the maneuver at the beginning of its term. But here another trap emerges. The fourth reason for fiscal illusion may endanger appreciation of the result. Indeed, if the starting situation to which the maneuver applies is suboptimal, both from the point of view of the proper tax burden that yields a given revenue and because of the economic interventions per se, then these co-factors may display perverse effects particularly in the same difficult economic periods that they themselves generated. This may be the case of tax reduction for a given factor of production undertaken within the context of deregulation of supply that, in turn, reinforces an increase in demand for the factor affected by the tax cut (Forte 2008).

The latter situation is also related to a fifth reason, explicitly considered by Puviani, of tax illusion related to the artificial reduction of the perception of the tax burden caused either by ignorance or by imperfect perception of tax shifting. The sixth reason, also particularly important, is the difficulty of tracking Laffer effects in the presence of high tax burden and severe regulations. In this case, the revenue-to-GDP ratio could decline, but a strong Laffer effect slows down the decrease.

A seventh reason for fiscal illusion is related to the issue of Laffer effect measurement. Indeed, not even Laffer himself (Laffer 2004) has clarified how to assess whether or not a reduction of tax rates induces Laffer effects. Indeed, Laffer referred to generic high revenue increases, increases in GDP and employment, or increases in the tax revenue-to-GDP ratio. Nevertheless, Laffer effects may be present even if the ratio of tax revenue to GDP, after the rate reduction, is lower than before, as revenue can be substantially higher than that which would be observed in the absence of tax reduction under the smaller GDP (Forte 2008). Forte also noticed that, if the public sector can be considered a factor of production in the market economy, but the GDP increase requires an equal increase in public spending, then the asserted Laffer effect, deriving from the increase of revenue in comparison with the revenue obtained under smaller GDP in the absence of tax reduction would be fake. This situation, a type of Baumol disease, is also ethically dangerous because not all public expenditures can be considered factors of production nor should they grow proportionally with GDP growth. For example, expenditures related to the welfare state are not, by definition, factors of production. Most importantly, the entitlement of the beneficiaries of public spending to a given share of GDP for any type of public expenditure is ethically unsustainable (Forte 2008).

A final fiscal illusion is a taboo ("residue" in Pareto's sociological theory) about the virtuous process of balancing the budget to contain the tendency of democracies to perpetrate deficits. This taboo or "residue" determines the illogical belief ("derivation" in Pareto's terminology) that reducing taxes always means to permanently reduce revenues, which obviously is a fiscal illusion.


All the mentioned ambiguities can prevent a rational perception of the effectiveness of policy measures that determine Laffer effects, often delayed or hidden. It can be difficult to convince citizens/consumers/voters of the merits of such measures. Quite often, ideology, rather than economic reasoning, supports incorrect beliefs about fiscal policies themselves. Nevertheless,
"[I]f people shall prefer governments who promise to lower taxes to
governments who promise to increase welfare, because the first option
appears the 'right' one, even if the Laffer effect is only probable
and not necessarily immediately perceivable, then the various traps
that we have seen shall begin to vanish" (Forte 2008, p. 92).

Acknowledgments I wish to aknowldge Gordon Brady who organised the Lisbon session in honour of Francesco Forte and Katherine Virgo for the wonderful, as usual, organization of the whole conference. A particular thank you goes to Francesco Forte, who transformed me into an economist. I will always be indebted to him.


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Silvia Fedeli (1)

Published online: 21 November 2016

[c] International Atlantic Economic Society 2016

[??] Silvia Fedeli

(1) Department of Economics and Law, Sapienza - University of Rome, Via del Castro Laurenziano 9, 00161 Rome, Italy
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