January 15, 2008 10:17PM

IMF Concludes Lower Tax Rates Can Yield More Tax Revenue

A new study from the International Monetary Fund looks at what happened in Russia after the 13 percent flat tax was implemented and concludes that there was a Laffer Curve effect. Indeed, the increase in taxable income was so large that it completely offset the impact of the lower tax rate. In other words, this was one of the rare cases of a tax cut “paying for itself” (in the vast majority of cases, lower tax rates generate revenue feedback, but the net result is still less money for government).

Interestingly, the study finds that the additional revenue materialized because people are more willing to obey the law when the tax rate is low, as theory would predict, but did not find an increase in labor supply, which theory also would predict This anomaly aside, it is still good news that the IMF recognizes that there is a Laffer Curve and that high tax rates are needlessly destructive:

Can tax rate cuts increase revenues?

…The Russian flat tax experiment is particularly interesting: after the introduction of flat taxes, and effective personal income tax rate cuts, tax revenues increased substantially and almost immediately. Furthermore, they increased much faster than labor supply and output. The paper explains how tax rate cuts can increase tax revenues through tax compliance spillovers in such a manner.

…This paper shows that endogenous tax compliance responses can be responsible for the massive increase in tax revenues. The key intuition is that tax regimes are prone to spillovers, as the aggregate behavior of taxpayers determines how much time the tax authority can dedicate to the individual taxpayer. In a way, tax evaders protect each other by tying down the tax authority’s limited capacity. Hence, small cuts in the tax rates can lead to much larger changes in the behavior of taxpayers — most importantly, it can make them much more likely to declare their incomes honestly. These spillovers can lead to increasing tax revenues.

…taxpayers evade less tax payments when the tax rate is lower… evasion increases with the tax rate.

…Three cases could be highlighted. First, countries with high official tax rates and relatively weaker tax authorities, such as some of the transition economies, might benefit from tax rate cuts and improving compliance. Second, the model might be also relevant for countries with high tax rates, even if tax enforcement seems to be strong in absolute terms. Third, low tax countries which have particularly weak tax enforcement could also think about improving tax compliance via tax rate cuts.