High taxes, sometimes by diminishing the consumption of the taxed commodities, and sometimes by encouraging smuggling, frequently afford a smaller revenue to government than what might be drawn from more moderate taxes.
From Adam Smith, The Wealth of Nations.
Notice that there are two “leakages” due to the high tax. The first is simply a move up the demand curve for the taxed item. The second is a reduction in the quantity purchased legally.
When I gave my recent OLLI talk on The Wealth of Nations, I noted that there appeared to be such a case in Canada in the early 1990s. I noticed it at the time and found the following, from testimony by a GAO official before a House subcommittee:
According to the Canadian government, sharp increases in Canadian federal and provincial cigarette taxes in the late 1980s and early 1990s led to large-scale smuggling between the United States and Canada conducted almost entirely by organized crime. Violence increased, merchants suffered, and in one year alone, Canada and its provinces lost over $2 billion (in Canadian dollars) in tax revenues. Canada responded in 1994 by sharply reducing federal and provincial cigarette taxes and increasing its enforcement efforts, among other steps. Since then, smuggling has declined considerably.
In his testimony, the official pointed out that from 1984 to 1993, Canada’s federal cigarette taxes rose from 42 cents per pack to $1.93; Ontario’s rose from 63 cents to $1.66; and Quebec’s rose from 46 cents to $1.78. Those two provinces alone accounted for well over 50 percent, and close to 60 percent, of Canada’s population. The result of all these tax increases was that the price of a pack rose from $2.64 in 1984 to $5.65 in 1993, all in 1994 dollars.
How did the illegal flow occur? The official stated:
During most of this period, cigarettes made in Canada were exported tax-free to the United States. Organized criminal groups purchased Canadian cigarettes that had been exported to the United States and smuggled them back into Canada. This resulted in more than an 11-fold increase in United States cigarette imports from Canada from 1990 to 1993 (see fig. 1). The 1994 study found that an Indian reserve that straddles the U.S.-Canadian border between Cornwall, Ontario, and Massena, New York, had become the primary conduit for smuggling cigarettes into Canada.
I had grown up in Canada thinking of us Canadians as relatively law-abiding and I think that was true. But change the incentives, and behavior changes. Adam Smith would not have been surprised.
READER COMMENTS
Brent Buckner
Dec 26 2023 at 8:38am
Somewhat aside: there’s indication that one reason that the Mohawk Warrior Society was so heavily armed in the Oka Crisis was that they had previously armed up in support of their position in cigarette smuggling.
steve
Dec 26 2023 at 10:13am
In Ontario the tax was $3.70/pack in 2018 and now it is going to $4.5o in 2023. Has smuggling increased again? Reading articles on the issue it sounds like the purpose of the tax increase was not so much raising revenue but trying to discourage smoking.
https://montreal.ctvnews.ca/cigarettes-to-cost-quebecers-more-as-province-raises-tax-on-tobacco-products-1.6266131
Steve
Mark Brady
Dec 26 2023 at 12:41pm
John Maynard Keynes recognized the truth behind the so-called Laffer curve decades before Arthur Betz Laffer, who did not claim originality for his insight.
“Nor should the argument seem strange that taxation may be so high as to defeat its object, and that, given sufficient time to gather the fruits, a reduction of taxation will run a better chance, than an increase, of balancing the Budget. For to take the opposite view to-day is to resemble a manufacturer who, running at a loss, decides to raise his price, and when his declining sales increase the loss, wrapping himself in the rectitude of plain arithmetic, decides that prudence requires him to raise the price still more;—and who, when at last his account is balanced with nought on both sides, is still found righteously declaring that it would have been the act of a gambler to reduce the price when you were already making a loss.”
—John Maynard Keynes, The Means to Prosperity (London: Macmillan & Co., 1933), Chapter I, The Nature of the Problem, p. 7. (This pamphlet is an enlarged version of four articles printed in The Times in March 1933.)
And we can go back much further to Arsène-Jules-Emile Juvenal Dupuit.
“If a tax is gradually increased from zero up to the point where it becomes prohibitive, its yield is at first nil, then increases by small stages until it reaches a maximum, after which it gradually declines until it becomes zero again. It follows that when the state requires to raise a given sum by means of taxation, there are always two rates of tax which will fulfil the requirement, one above and one below that which would yield the maximum.”
—Arsène-Jules-Emile Juvenal Dupuit (1804-66), a French engineer and economic theorist (pioneering cost-benefit analysis), in “De la mesure de l’utilité des travaux publics,” Annales des ponts et chaussées, Second series, 8 (1844), p. 104. Translated by R.H. Barback as “On the measurement of the utility of public works,” International Economic Papers, 2 (1952): 83–110.
Enough of the Laffer curve! It should be called the Dupuit curve!
Ahmed Fares
Dec 26 2023 at 1:29pm
https://en.wikipedia.org/wiki/Laffer_curve
Also, this:
https://capx.co/why-the-laffer-curve-should-really-be-called-the-khaldun-curve/
Ahmed Fares
Dec 26 2023 at 1:40pm
Ibn Khaldun quoted by U S President Ronald Reagan
A short 35-second video with that quote mentioned in my previous comment:
https://www.youtube.com/watch?v=KETIOgYu5uc
David Henderson
Dec 27 2023 at 10:06am
Your point seems to be that one should name the idea after the person who first discovered it. But then why not apply it consistently? Adam Smith discovered it long before Dupuit.
Mark Brady
Dec 26 2023 at 4:00pm
Indeed.
I hesitated to cite Ibn Khaldun, who is more cryptic than Dupuit’s very clear statement. And we should recall John Maynard Keynes, from whom many supporters of Laffer would recoil and who acknowledged the underlying truth behind what forty years later became known in the United States as the Laffer curve.
Andrew_FL
Dec 26 2023 at 4:05pm
Keynes’ supports would as likely recoil from the implications of his words as Laffer’s from association with Keynes
Mark Brady
Dec 27 2023 at 12:49am
Which Keynesians do you have in mind?
Richard W Fulmer
Dec 27 2023 at 11:21pm
Andrew Mellon also talked about the diminishing returns of higher tax rates in his book, “Taxation: The People’s Business”:
His book was published in 1924, so he beat Keynes and Laffer to the punch, but lagged well behind Ibn Khaldun, Smith, and Dupuit.
Of course, the problem with the curve is knowing where we are on it. While there are indicators (e.g., are people investing in tax shelters or stocks?), we can only really know after the fact and we see what happens to revenues once the tax rates have been changed.
Kurt Schuler
Dec 28 2023 at 9:36pm
See here for Bruce Bartlett’s three-part history of the Laffer curve through history. (Don’t worry, each part is just a few pages.)
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2155974
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2155978
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2155979
Comments are closed.