Skip to comments.The Laffer Curve
Posted on 01/30/2004 7:51:52 PM PST by MegaSilver
Some of you may share the mistaken belief that the Laffer Curve, named for Dr. Arthur Laffer, was tested and found wanting during the Reagan Administration. Nothing could be farther from the truth. There are two possible causes for your error. The first is that you may simply not know what the Laffer Curve is. This, combined with a natural tendency to agree with the "conventional wisdom," may lead you to just mindlessly nod your head in agreement every time you hear some T.V. network reporter blithely dismiss the "discredited Laffer Curve."
The second possible cause for your error may be that you do not understand what results the Laffer Curve promises. This is really a part of the greater problem mentioned above, so let us begin there.
For us to gain a rudimentary understanding of the ideas incorporated into the Laffer Curve, we must understand a tiny bit about economics. Economics is really just basic human psychology as applied to money and business affairs. We assume that people will react to the realities of the world of money and business more or less like they react to any other set of stimuli. They tend to act in their own and their family and friends' best interests, as they see them. The Laffer Curve results from our assumptions about how people will react to varying rates of income taxation. Now we must put our understanding of human nature to work. We must ask ourselves two questions, the answer to the first being obvious, and the answer to the second being not so obvious, but just as certain. The first question is, "If the income tax rate is zero %, how much income tax revenue will be raised?" The answer is, of course, "None."
Now, here is where it gets a bit tougher. The second question is, "If the income tax rate is 100%, how much income tax revenue will be raised?" To answer this question, we must place ourselves in the position of an income earner who faces a tax rate of 100% on every extra dollar he earns. Will he have any reason whatsoever to earn any more money? The answer is, "No, he won't." He will refrain from any activities likely to result in taxable income. So the income tax revenue from a 100% income tax will be zero, or nearly zero. There will always be a few suckers who go ahead and earn some money, only to have it taxed away. But the number of people willing to do so must be exceedingly small. For all practical purposes, the number is zero.
Okay, now we get to the nub of the "infamous" Laffer Curve. We must take the ideas discussed above and reach some conclusions. The reasoning goes like this: If a zero % income tax rate brings in zero revenue, and if a 100% income tax rate brings in zero revenue, the tax rate which will bring in the most revenue must be somewhere between zero % and 100%. It necessarily follows that in a given economy, there is some optimal income tax rate which will bring in the most revenue possible. In that economy, a lower than optimal rate will bring less revenue, and a higher than optimal rate also will bring in less revenue. Are we all still together here? Did you get that? If not, go back and do it again. Keep doing it until you get it.
Okay, that is all the Laffer Curve claims. Let's all say this together, "In any given economy, it is possible that the income tax rates are already too high, and if the authorities wish to bring in more income tax revenue, they must lower the tax rates." Do we all understand that? Even the Democrats amongst us?
The Laffer Curve does not claim that lowering income tax rates will always bring in more revenue. It only claims that a lower income tax rate may bring in more revenue. If the tax rates are already very low, lowering the rates may not bring in more revenue. But if the rates are too high, lowering the rates will bring in more revenue.
The problem people tend to have regarding the Laffer Curve is that they confuse economics with their political considerations. Many people have political reasons to desire high income tax rates on the earnings of the rich. They wish to prevent the rich from earning more money, even if the resulting tax revenue is smaller than it would otherwise be, and the economy less productive than it would otherwise be. These people do not believe that the income tax on the rich can ever be "too high." They are willing to deprive the government of revenue and deprive the economy of the productivity of the rich, all for the sake of their politics. There really is no arguing this point, as it is merely the outward manifestation of envy.
The Laffer Curve does not address questions of envy and redistributionist politics. It only addresses the question of how to have the healthiest economy producing the highest income tax revenue.
The Laffer Curve does not claim to know exactly what tax rate is the "right" tax rate. In fact, the only way to know if the current tax rates are too high is to lower them, and see whether revenues increase or not. If the revenues increase, the rates were too high. If the revenues decrease, the rates were too low. Of course, it would be equally valid to run the experiment the other way around: raise the tax rates and observe the results. The choice is the politicians' to make, based upon whether the current rates "seem" to be high or low. In 1981, the rates seemed rather high. The Laffer Curve experiment showed that the rates were, indeed, too high.
Now, let us consider whether the Laffer Curve "failed" to deliver on its promises during the Reagan administration. Remember, the Laffer Curve does not promise to balance the budget. The Laffer Curve does not promise to solve social problems. The Laffer Curve does not promise to force elected representatives to propose and enact lower spending programs. The Laffer Curve only promises that, if the tax rates are too high and they get lowered, revenues will increase. Income taxes were lowered (and "flattened") during the Reagan administration. Income tax revenues increased. In fact, they increased a great deal. Unfortunately, neither the Republican Reagan administration nor the Democrat-controlled Congress were interested in lowering the rate of growth in federal spending. While the income tax revenues increased substantially, federal spending increased even more. The result was that the federal government ran up a staggering national debt. But please, let's not blame it on the Laffer Curve!
This is why the ruling Marxists in our current intelligensia have resorted to different tactics now-- they are determined to push their version of free trade and open borders until the middle class disappears and only a multi-cultural ruling elite are left at the top of the pyramid to manage the rest of us livestock.
By the way, for purposes of full disclosure, Laffer was once a professor of mine. When he was, I had almost as much hair as he did. No longer. Recently, his cousin, was a hostile expert witness in a trial in which I was called upon to litigate. I quite enjoyed shredding cousin Laffer. The subject was check kiting. The opposing counsel "assumed" I also sported a CPA in his closing brief. The assumption was erroneous, but I took it as a compliment. And so it goes.
They should stick to just reporting the fact and let us do the intrepreting.
Of couse, that's just wishful thinking. Oh, well!
Nobody knows the shape, even the approximate shape, although the shape obviously varies over time based on a whole host of factors, macro, micro, and cultural. The data is two "noisy" because there are too many variables. Awareness of the unknown is a key step to good judgment, and the pursuit of knowledge.
I'm sure it did, since it's all about maximizing revenue, something all businesses and governments seek to do. The difference between the two, however, is that the government has the legitimate threat of force on its side--they can just stick a gun in our faces and say, "pay up, sucka". I think it was Madison that said the power to tax is the power to destroy, and today taxation is as much a tool used to destroy the opposition (and conversely reward the loyal) as it is a revenue-raising tool.
Laffer may have been a bit dumb (and frankly he was never a leading intellect in economics ever; he got by with his connections and charm, both of which were considerable), but he is not stupid. As I said before, nobody knows, in part because it is a moving target, and in part because there are so many variables, that it is next to impossible either to verify the hypothesis, or falsify it, within the reasonable range of public policy choices. Hypotheses that cannot be verified or falsified are worthless.
That's precisely the argument that Democrats use to rationalize higher taxes. We'll just work harder and there won't be negative economic effects.
I recall hearing 15%, I don't know from where or from who, but 15% keeps sticking in my mind.
What is this "awareness of the unknown?" Some kind of lawyer's algebra? If it is unknown, then who could possibly be aware of it? Who, exactly are the elite that are posessed of this special awareness that no one knows a danged thing about, huh? Please reply immediately!!!
I guess the French Revolution din't behead 'em all.
"Fascinating!" God only knows!!!
No. Electron mass = 9.10938188 × 10-31 kilograms. That's not zero, practically or theoretically.
yet has "spin?"
They spin because electrons have intrinsic angular momentum. Moreover, photons have no mass, but they have a lot of interesting properties, don't they?
Proton mass = 1.67262158 × 10-27 kilograms.
Electron mass = 9.10938188 × 10-31 kilograms.
One thing Rush doesn't get right is Reaganomics. You'd be much better served by reading what Reagan's economists have written, than to take Rush's accounts seriously. He's often 180 degrees out from what they have to say. I sometimes wonder where he gets his information, as it's certainly not from the economists who worked for President Reagan.
How about the take that the liberal website Economist.com takes on the Laffer Curve . . .
The Laffer Curve
Legend has it that in November 1974 Arthur Laffer, a young economist, drew a curve on a napkin in a Washington bar, linking AVERAGE tax rates to total tax revenue. Initially, higher tax rates would increase revenue, but at some point further increases in tax rates would cause revenue to fall, for instance by discouraging people from working. The curve became an icon of supply-side ECONOMICS. Some economists said that it proved that most governments could raise more revenue by cutting tax rates, an argument that was often cited in the 1980s by the tax-cutting governments of Ronald Reagan and Margaret Thatcher. Other economists reckoned that most countries were still at a point on the curve at which raising tax rates would increase revenue. The lack of empirical evidence meant that nobody could really be sure where the United States and other countries were on the Laffer curve. However, after the Reagan administration cut tax rates revenue fell. American tax rates were already low compared with some countries, especially in continental Europe, and it remains possible that these countries are at a point on the Laffer curve where cutting tax rates would pay.
If the truth is inconvenient for your world view... LIE.
All of this obfuscates the REAL point of the Laffer Curve.
On the graph above, the Y axis represents Tax Revenues and the X axis represents Tax Rates (0-100%), "T" is the optimal revenue return to the government and the point of beginning discouragement by the public to working more to produce more. Although it may look like a 50% tax rate, it is not necessarily so, that is merely an artifact of the drawing.
Finding "T" is not the point of the Laffer Curve nor was it Laffer's observation that he was illustrating on that napkin. If that were the case the graph would be merely a reverse price/demand curve that any economist would recognize.
The point that Laffer was illustrating is that for ANY given revenue, there are TWO tax rates that will produce the same revenue for the taxing agency. Draw a horizontal line across the curve from the revenue axis and you will see that the line intersects the curve both on the increasing and on the decreasing arcs of the curve. In other words a return of 100 units of revenue can be received from a 25% and a 75% tax rate (just examples, we really don't know what the rates for equal return are... sort of an economic Uncertainty Principle).
The liberal economists at Economics.com fail to realize the other effect of selecting the lower of the two equal revenue return tax rates. Supply siders noticed the duality of the curve and, being greedy capitalists that they are, not to mention hardheaded business oriented people, realized that the LOWER tax rate left more money in the hands of said greedy capitalistss while STILL giving the government the same revenues. They knew that money left in private hands could and WOULD be invested in making more income, which also could be taxed, resulting in HIGHER revenues to the taxing agency. It was this phenomenon that DID, in fact, increase government revenues in the Reagan years, despite drastically lower tax rates!
I seem to recall some very recent studies that put it right around the 5% range, plus or minus a couple percent, for the general case that we have now. Interestingly this pretty much describes the US up into the 20th century before taxation became all the rage.
There are some additional factors in the model that make the specifics more complicated but as a ballpark rule, the optimal number is ALWAYS less than 10%. At least in theoretical literature.
"This is very controversial. Does anyone know what Vice President Bush called this in 1980? Class, anyone? Something... d-o-o economics... voodoo economics."
Yep; remember, the media has a conservative bias. ;)
The Laffer Curve doesn't provide any useful predictive information, because there is no way to apply numbers to the curve, or in fact know what its shape is. You have two problems: you have no way of knowing where you are on a curve whose shape you also can't draw.
That doesn't mean the concept itself is useless; in mathematics, when you have the shape of a curve, you at least know whether or not you have a bleeding chance at recouping revenue if you significantly lower taxes.
The closest thing to an actual "Laffer Curve" is the study of the effect the Reagan tax cuts, an exhaustive regression analysis done by Larry Lindsey, Dubya's first economic advisor. The finding of Lindsey's study is that the Reagan tax cuts generated enough growth to recoup 2/3 of each dollar cut. The tax cuts didn't pay for themselves, as many supply-side journalists like to claim, but they also only cost the Treasury one-third of the amount that static analysis predicted.
Just how much, if at all, did the income tax rate "flatten out" under Reagan? Is there a table of income tax brackets in various years last century?
Don't they have, like, double-digit unemployment rates? And their efficiency's pretty low, too... not to mention that prescription drug programs like Canada's are leeching off of U.S. consumers.