Hollande and Laffer

Source: François Hollande

The socialist hopeful to the French presidency, Francois Hollande, declared last week that once president, he would implement a 75% income tax to one million euro+ earners. What he thought would earn him some credit from the many anti-system in France quickly turned into a demagogic and unrealistic promise. Criticism poured, and Sarkozy’s proponents called up some economic common sense to the situation. The Laffer Curve theory is probably one of the most relevant theory to tax policy, or at least in its political setting. Arthur Laffer was effective in implementing Reagan fiscal policies in his two-term Economic Policy Advisor Board, while incarnating one of the academic proponents to supply-side economics. The Laffer curve tells us that total revenue is not necessarily achieved by implementing a higher maximum tax rate, but by adopting the tax rate corresponding to the maxima of the curve in the relationship between total revenue and maximum tax rate. Long-term, many scholars made the case of choosing a point even before the maxima on the curve, which fosters most of the modern debate around the theory. The argument surfacing from Laffer’s theory in connection to the matter at hand is that 75% maximum income tax rate would obviously scare off one million+ earners rather than earn more tax revenue.

In the context of a changing labour market, I make the case that the practicality of Hollande’s 75% plan is flawed.

The theoretical Laffer curve for France has been affected in the last 50 years by political and institutional changes. The main one was the Treaty of Rome in 1957, which planned the free movement of goods, services, capital and people. The movement of workers was even accelerated by the establishment of the Schengen space in 1985, which obliterated borders and eased the transfer of labour to and from European neighbours. The European Union doesn’t have a common tax code to every member, which makes the Laffer curve much more sensitive than it was before 1985. States are competing against each other in what is not quite the full extent of supranationality.

Compared to other Schengen members, France has a rather welcoming climate for million+ earners, focusing instead on corporate tax which is at an average 33.3%, the third highest in the EU. The consequences of a top corporate tax, and top maximum income rate would have the effect of scaring off banks, corporate headquarters, and innovative technologies altogether. Behind the frantic desperation of the socialist party for attaining office after 25 years lies the idea of rallying a large proportion of the poor and the unemployed behind anti-rich measures harboured under the scapegoat of a populist vision of fraternity. Doing so, it failed to consider the range of middle and upper educated classes that saw in the policy a clear threat to them. Additionally, the effects expected of Hollande’s reform would encompass much more than this.

The gap effect would also shock tremendously the one million+ earners, whether it concerns notables already installed in France or entrepreneurs and skilled labour planning to move in. The maximum income tax rate in France is 41%. That’s 34 points of difference from Hollande’s proposal. This is such a large number that it would prove revolutionary for the status of the upper class in France. In addition, it would most likely result in a loss of human capital and of an entrepreneurial basis for business activity (hence spill-over effects). It is predictable that once the legislation passes in, most million+ will move to countries with a more welcoming fiscal policy, such as Switzerland, Luxembourg or most Eastern European countries. A 75% maximum income tax rate would place France as the most taxed country in Europe by 20 points, a huge incentive to move out.

When Sarkozy attempted to pass a legislation that would tax excess profits from the banking industry earlier this year, David Cameron mocked him quite bluntly, arguing that banks would be welcome in London if they find Paris too expensive. I can’t imagine how much of a laugh he had when he heard Hollande’s proposal.