Is it possible for a government to increase its total tax receipt by cutting taxes?
Italy’s government believes this is the case and they risked incurring a EUR 3 billion fine from the EU last Tuesday for pursuing it. In the end, the EU abandoned the fine but it remains sceptical of Italy’s approach.
The issue is that Italy’s debt-to-GDP ratio is 132% and this is an infringement of the EU’s 60% limit. As well as this, the EU projects Italy’s 2.1% budget deficit to surpass its 3% limit thus exacerbating the debt problem.
With Italy’s economy at near recessionary levels (for example it edged into recession in the last half of 2018 and had a limp 0.1% growth in the first quarter of 2019) it is very difficult for Italy to generate the tax receipts needed to reduce its debt. The Italian government argues a fresh, dynamic approach is needed.
Italy is run by the coalition of Northern League (Lega Nord) and the Five Star Movement. The government advocates a flat income tax rate of 15% for those earning less than EUR 50,000. As reported by the Daily Telegraph, the Lega leader, Matteo Salvini, said ‘If Italians had more money in their pockets to spend, the economy would receive a kick-start and the national debt would be reduced.’
In 1974 the economist Arthur Laffer proposed that it is possible for income tax rates to be reduced and still increase overall tax revenue. He suggested that reducing income tax rates to an optimal level incentivises spending and investment, creates more jobs and taxpayers and thus increases total tax revenue. It has worked before, for example the UK government in the 1980s adopted this proposal and slashed income tax rates and total tax revenue grew.
The most important thing though is the optimal rate as cutting tax rates below the optimal rate will have the undesired effect of decreasing total tax revenue. It will be extremely interesting to see if cutting income tax rates to 15% for the masses works for Italy.