The Laffer Curve

Marginally Useful Material Launcher ^ | 30 January 2004 | Robert Sturgeon

[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!

[MegaSilver]

Bueller?

"This is very controversial. Does anyone know what Vice President Bush called this in 1980? Class, anyone? Something... d-o-o economics... voodoo economics."

[MegaSilver]

It is a testament to effective self-publicity that a simple Elasticity Curve, when applied to tax rates, received the name of "Laffer Curve". Laffer hardly "invented" the curve, but because most people have no reason to study academic economics they are easily buffaloed into believing that nonsense.

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?

[tort_feasor]

The real problem is marginal rates. For example: a couple a nurse and a lawyer one child under 17,are married the nurse makes $70,000, the lawyer $50,000.

Now if only nurse works, after child tax credit, standard deduction and exemptions, the federal income tax is about 10 percent ($7,000).
However if the lawyer works each dollar he earns the 27 percent rate applies. For $120,000 combined gross income the FICA due is $21,000, the effective rate is 17.5%
Now lets add in state and Social Security and Medicare.

SS and Medicare are 7.5%, assume 2.5% state income tax = 10%
The nurse alone pays $7,000 in FICA and $7,000 in state & ss and medicare. $14,000 is 20% of the nurse's gross income.
If the lawyer is added.
The lawyer pays $5,000 state, ss & medicare, and the couple pays $14,000 in additional federal income tax. $19,000 is 38% of the lawyer's income. Together they would pay $33,000 in FICA, State, SS & Medicare which is 27.5%

This is why the middle class is getting F***ed by the system

[Freebird Forever]

bump for later read

[stylin_geek]

Wow, I really crashed and burned on that one. Obviously I have the wrong particle. I will have to dig up my book and get the correct answer. That's what I get when I try going from memory, and not checking my facts. Of course, this is why I am interested in politics, 'cause as a politician, I would never let the facts get in the way.

[Nevermore]

Even these percentages leave out the hidden taxes payed by employers for the privilege of paying someone. They are essentially a hidden withholding that doesn't even seen by the average worker. Unfortunately, I myself don't really know what those percentages are. My expectation is that they add at least another 10%.

[expatpat]

Yeah, the Laffer curve is valid. But this article is based on a bad assumption: that it is right for the government to take in the highest revenues it can.

[teeman8r]

i do not find the laffer curve funny at all...

and yet, its smile seems to mock me wherever i go...

[MegaSilver]

You can also argue that those European countries, with all their entitlement programs and high tax rates, have done fairly well too. They have maintained fairly high standard of living for their citizens.

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.

[Tribune7]

Save Ferris.

[Pelham]

Yep; remember, the media has a conservative bias. ;)

In this case it did, as the media in question was mainly the Wall St Journal editorial page. Robert Bartley, Jude Wanniski, George Gilder, Paul Craig Roberts.

Wanniski was a great fan of Art Laffer and probably invented the napkin story. Wanniski and Gilder were a bit too enthusiastic about promoting the virtues of tax cuts, and helped create the idea that they generate enough new revenue to prevent deficits. None of the Reagan economists claimed this, nor believed it, and the results bore out their actual prediction, which is that tax cuts would not lose as much revenue as one might expect. The real goal of the tax cuts wasn't to generate more revenue for the Treasury, but to try to get the American economy to grow after the years of stagnation that we had endured in the 70s.

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 Laffer curve does have some value as a didactic device, but there is no way to assign quantities to it. The problem is that there is no way to know what the shape of this curve is. There is one tax cut that actually did generate more revenue at the lowered rate, and that was the capital gains tax cut. Oddly enough I think that passed under Jimmy Carter.

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?

There are charts in Lindsey's "The Growth Experiment" that should give you that information. There were two Reagan tax reforms, with the '86 bill being the 'flatter' of the two. Personally I liked some of the features of the earlier bill, which had investment tax credits to encourage domestic investment. And I'm not sure that stripping out the write-offs benefited the average taxpayer.

[Pelham]

The only tax cut that resulted in higher revenues at the lower rate was the capital gains tax cut. All the others brought in lower revenue, but not nearly as low as static analysis predicted. The goal of the Reagan program was to break the stagflation of the '70s and grow the economy, not to generate new revenues for the Treasury. Reagan's program included matching spending cuts which Tip O'Neill agreed to, and then reneged on.