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The Laffer Curve, Part I: Understanding the Theory
YouTube ^ | January 28, 2008 | Dan Mitchell

Posted on 02/03/2008 9:46:51 AM PST by LowCountryJoe

A seven and one half minute explanation of what the Laffer curve is. This is one of three parts; the remaining two have not been posted at YouTube yet. Enjoy!

http://www.youtube.com/watch?v=fIqyCpCPrvU


TOPICS: Business/Economy; Editorial; Government; Philosophy; Politics/Elections
KEYWORDS: laffer; laffercurve; taxes

1 posted on 02/03/2008 9:46:52 AM PST by LowCountryJoe
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To: LowCountryJoe

Ping for later


2 posted on 02/03/2008 9:47:51 AM PST by moderate_conservative
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To: LowCountryJoe; Tax-chick

Do I a need beeber for this? Are beebers tax deductible?


3 posted on 02/03/2008 9:54:00 AM PST by nuconvert (There are bad people in the pistachio business.)
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To: LowCountryJoe

I understood it in 1980. It will always prove true.


4 posted on 02/03/2008 9:54:03 AM PST by Larry Lucido
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To: LowCountryJoe

Why would it take seven minutes to explain:

1. People react to incentives including tax incentives.

2. Taxes on income reduce the incentive to generate income.

3. If the tax rate on income is high enough, it is possible that the loss of tax revenue from reducing the tax rate may be more than offset by the increase in income generation caused by the improved incentive to generate income due to the lower tax rate.


5 posted on 02/03/2008 9:57:33 AM PST by JLS
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To: LowCountryJoe

Thanks for the post. Good explanation.

Interesting how some politicians can’t understand or believe this.


6 posted on 02/03/2008 10:00:16 AM PST by cowtowney
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To: cowtowney

That’s ‘cause it’s supply side econ. Poison to libs.


7 posted on 02/03/2008 10:10:05 AM PST by shove_it (and have a nice day)
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To: JLS

Why has it taken 30 years to explain?


8 posted on 02/03/2008 10:22:35 AM PST by USFRIENDINVICTORIA
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To: USFRIENDINVICTORIA
I'd like to think that I made a difference as many times as I've floated my view that we [fiscal conservatives] should change the way we engage in this argument. Did I make a difference? I don't know because I would likely not get direct credit. But that's not what motivates me...what motivates me is that we're [fiscal conservatives] are now going to be talking about this.
9 posted on 02/03/2008 10:30:12 AM PST by LowCountryJoe (Do class-warfare and disdain of laissez-faire have their places in today's GOP?)
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To: LowCountryJoe

Just the first 2 minutes of it explain all a DUmmy needs to know. It should be required viewing before being allowed to vote.


10 posted on 02/03/2008 10:44:16 AM PST by papasmurf (My next POTUS vote will be un-counted. RINOS, get out or be pushed out!)
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To: JLS
“1. People react to incentives including tax incentives.

2. Taxes on income reduce the incentive to generate income.”

But there are two effects here, not one. You’re looking at the “substitution effect”, wherein people will work more because the amount they earn for the time they work has increased.

The “wealth effect” however causes people to work less because they have to work fewer hours to reach the same amount of after tax income.

People often assume the substitution effect dominates. Indeed you see this mistake made in debates over estate taxes. People assume that if you eliminate estate taxes, then people will decrease their charitable contributions because they have become relatively more expensive. However, because the elimination of the tax effectively increases the amount of money people have in their estates it could very well cause an increase in giving.

That’s not to say the taxes don’t cause damage. Any change in work, weather increasing, decreasing, or qualitative changes in work that result from taxes are inherently inefficient (excepting the case of externalities).

Further tax theory states that the economic damage caused by a tax is proportional to the square of the marginal rate. What that means in real world terms is that, while 10% or 20% taxes don’t do much harm (beyond the cost of the tax itself), higher taxes like the 70+% top bracket during the Carter administration can do a lot of damage and can, as the Laffer curve suggests, cause lower tax revenues than at a lower tax rate.

11 posted on 02/03/2008 10:44:49 AM PST by Moral Hazard (Fred Thompson/Joe Don Baker in 08, because America needs bald, beefy character actors!)
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To: LowCountryJoe
The Laffer Curve is a no brainer and simple to understand.

At 0% tax rate, no revenue is generated for obvious reasons.

At a 100% tax rate, the taxed activity is extinguished.

So somewhere between 0% and 100% is an optimum rate that will generate the maximum amount of revenue. A rate above this will produce less revenue, and a tax increase when already above this will further decrease revenue. This is called the prohibitive zone.

When in this area, a tax rate reduction will INCREASE revenue.

However, if the rate is already below the optimum rate, a tax rate increase will increase revenue.

12 posted on 02/03/2008 10:55:08 AM PST by Phantom Lord (Fall on to your knees for the Phantom Lord)
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To: Phantom Lord
You must not forget about the payroll tax, which, because it is spent on the current budget rather than the surplus invested in non-federal government issued assets, has a distorting effect on taxation schemes — taxation schemes that lower or raise income and capital gains taxes only.
13 posted on 02/03/2008 11:02:19 AM PST by LowCountryJoe (Do class-warfare and disdain of laissez-faire have their places in today's GOP?)
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To: Phantom Lord

“The Laffer Curve is a no brainer and simple to understand.”

I agree with the above, but you have to remember how dumb most politicians are, especially democrats (to be fair there are plenty of dumb republican politicians as well; the rate is merely a little lower).

I think the best discussion of economic theory and economic history, including the Laffer Curve, is the 1977 book, “The Way the World Works”, by Jude Wanniski. I’ve made numerous copies of the book gifts over the years.

Wanniski went off the deep end in his last years, but he was one of the architects of the Reagan/supply side revolution that’s swept the world by being acolyte and “propangandist” for the supply-side ideas, as enumerated by Laffer.


14 posted on 02/03/2008 11:07:52 AM PST by KamperKen
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To: KamperKen

Never underestimate the smarts of Democrats politicians. They are not dumb. They may not be wise or they may be deliberately advocating stuff just for their own personal gain/satisfaction, but they are not dumb. Their supporters are. We’ve got the same problem [only the issues are different] on the Right as well even if we choose to ignore it.


15 posted on 02/03/2008 11:16:58 AM PST by LowCountryJoe (Do class-warfare and disdain of laissez-faire have their places in today's GOP?)
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To: Phantom Lord

That’s a good way to explain it. And being on the “wrong side” of the curve is amazingly stupid because nobody wins. Even the big-government liberals and socialists lose because they have less to spend on their favorite welfare programs.

The only “winners” on the back side of the Laffer curve are people that just want to maximize misery so they can take over the government and save us (i.e., communists).


16 posted on 02/03/2008 11:48:07 AM PST by RussP
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To: LowCountryJoe

As many have noted here, the theory is not that hard. The hard part is determining where the optimal (at least in terms of revenue maximization) occurs. At any point in time, which side of the optimal rate are we? Clinton passed the largest tax increase in US history and revenues went up. Bush passed the tax cuts of 2001 and 2003 and revenues went up. Perhaps we are just bouncing back and forth a litle bit around what is the optimum.


17 posted on 02/03/2008 11:48:53 AM PST by NC28203
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To: NC28203
Please visit the link I left in post #9.
18 posted on 02/03/2008 12:31:39 PM PST by LowCountryJoe (Do class-warfare and disdain of laissez-faire have their places in today's GOP?)
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To: nuconvert

You need a highly technical number-beeber. The best ones have a ray-gun attachment.


19 posted on 02/03/2008 12:33:42 PM PST by Tax-chick ("Political zombies need brains, but they hunger only for taxes." ~ NicknamedBob)
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To: NC28203

The ‘optimal’ you are discussing is the rate that maximizes government revenue. A better ‘optimal’ is the one that maximizes growth.


20 posted on 02/03/2008 12:39:04 PM PST by sobieski
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To: NC28203
Clinton passed the largest tax increase in US history and revenues went up.

You cannot ignore the short-term and long-term effects of taxes. Even above the optimal point, revenues can go up short-term. They can raise rates faster then people can adjust their work and lifestyles. Effects can take several years to fully kick in. (i.e. Raised rates make it less optimal for me to work long hours, but I already have a mortgage that assumes I will be working those hours. I cannot adjust immediately, but I will adjust.)

21 posted on 02/03/2008 12:45:29 PM PST by Onelifetogive (Member of the Right-Wing Conspiracy before it was Vast.)
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To: JLS

Higher taxes also raises incentives to cheat....


22 posted on 02/03/2008 1:03:02 PM PST by misterrob (Mitt Romney-My Favorite 3rd Choice!!!)
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To: Moral Hazard

Are you an economist? We just covered the substitution/income effects in my macro theory class. It was a little tough to wrap my head around until my prof. explained that both effects occurred at the same time.


23 posted on 02/03/2008 1:12:28 PM PST by 31R1O ("Science is organized knowledge. Wisdom is organized life."- Immanuel Kant)
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To: 31R1O
You must be discussing Engles Curves about now.
24 posted on 02/03/2008 1:15:36 PM PST by LowCountryJoe (Do class-warfare and disdain of laissez-faire have their places in today's GOP?)
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To: LowCountryJoe

John McCain doesn’t understand economics, so he will hire someone else to read this thread for him.


25 posted on 02/03/2008 1:16:29 PM PST by Hoodat (The whole point of the Conservative Movement is to gain converts, not demonize them.)
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To: KamperKen
you have to remember how dumb most politicians are

The eternal question is, "Are they stupid or are they evil?" If they aren't dumb but they are evil then the only explanation for their increasing taxation is to destroy America's economy.

26 posted on 02/03/2008 1:45:14 PM PST by Dan Evans
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To: LowCountryJoe

No, we havn’t covered that yet. We just finished up Consumption, Savings and Investment and next it is on to Savings and Investment in the Open Economy.


27 posted on 02/03/2008 1:45:15 PM PST by 31R1O ("Science is organized knowledge. Wisdom is organized life."- Immanuel Kant)
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To: Phantom Lord
The Laffer Curve is a no brainer and simple to understand.

At 0% tax rate, no revenue is generated for obvious reasons.

At a 100% tax rate, the taxed activity is extinguished.

That is correct only for an income tax - a point which flummoxed Arlen Specter once in a televised hearing when he was trying to be a good guy by forcing the General Accounting Office (as the congressional bean counters were then called) into a reductio ad absurdum I forget what the taxable item being discussed was exactly, but let's say it was cigarettes: That was a blunder. The correct follow-on line would have been:

28 posted on 02/03/2008 2:54:45 PM PST by conservatism_IS_compassion (The Democratic Party is only a front for the political establishment in America - Big Journalism.)
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To: 31R1O

My undergraduate degree was in Economics (My MS is Computer Science). If you keep going in Economics you’ll eventually run into the term “moral hazard”. Fun!


29 posted on 02/03/2008 3:29:59 PM PST by Moral Hazard (Fred Thompson/Joe Don Baker in 08, because America needs bald, beefy character actors!)
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To: USFRIENDINVICTORIA

More like 45.

The first to follow the philosophy was Kennedy.

Don’t tell the Democrats.


30 posted on 02/03/2008 5:24:01 PM PST by SlapHappyPappy
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To: NC28203

If memory serves me right, the biggest grow in federal tax dollars was capital gains tax receipts. The Cap Gains tax was cut.


31 posted on 02/04/2008 7:13:02 AM PST by Phantom Lord (Fall on to your knees for the Phantom Lord)
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To: conservatism_IS_compassion
That is correct only for an income tax

Not true. It works as well for products and activities.

If product A has a zero tax on it today and tomorrow it has a 100% tax, that products sales would plummet and flourish underground. Reduce that tax and its legitimate sale would return.

32 posted on 02/04/2008 7:16:20 AM PST by Phantom Lord (Fall on to your knees for the Phantom Lord)
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To: Moral Hazard; USFRIENDINVICTORIA
Sorry to all I forgot to come back and reply to this over the weekend:

1. USFRIENDINVICTORIA: It has not taken 30 years to explain. It is belittled by some. It is ignored by others. Usually these are members of the political class who despite understanding the Laffer curve just want higher taxes and are happy to say global warming demands higher taxes or the budget deficit demands higher taxes. Higher taxes are what they really want and more government, the rationale is irrelevant. It is empirically challenged by others who understand it but wonder at what is the revenue maximizing tax rate.

2. Moral Hazard: Of course there are income and substitutions effects associated with the effect of income tax rates on income and thus income tax receipts. The people raising your point are the people I said above were empirically challenging the Laffer relationship. Implicit is many policy debates is that the aggregate labor supply curve is upward sloping not backward bending. To me, that is a point for economics class, but in policy discussions just leads to not making ones point if one wants to explain the Laffer curve. You may believe a more complete explannation that heads of future criticism is more effective with the US public. I don't and thus I would not take 7+ min to explain the Laffer curve.

3. misterrob: You are correct that a probably smaller incentive that lower rates provide is to more fully report and pay taxes on previously unreported income. To me this is more of a side issue too. The unreported income is still part of GDP, so it is not growth from the lower tax rates, it is just one additional source of tax receipts.
33 posted on 02/04/2008 12:11:11 PM PST by JLS
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To: JLS
"1. USFRIENDINVICTORIA: It has not taken 30 years to explain. It is belittled by some. It is ignored by others. Usually these are members of the political class who despite understanding the Laffer curve just want higher taxes and are happy to say global warming demands higher taxes or the budget deficit demands higher taxes. Higher taxes are what they really want and more government, the rationale is irrelevant. It is empirically challenged by others who understand it but wonder at what is the revenue maximizing tax rate."

You've made a lot of good points -- I don't disagree with any of them.

However, I do disagree with your assertion that it shouldn't take 7 minutes or more to explain the Laffer Curve. Certainly, a definition could be supplied in under a minute -- but, what does your audience need? If you're trying to reach the general population; you have to take time to explain some economic concepts, and you have to make them believe you. As far as lectures go, this was quite concise and effective.
34 posted on 02/04/2008 1:26:04 PM PST by USFRIENDINVICTORIA
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To: LowCountryJoe
For someone arguing that a proposed tax cut will increase revenue, demonstrating the existence of the Laffer curve is only half the argument. One also has to demonstrate that the tax burden before the cut is on the "right" side of the optimal revenue point. That's not quite so clear, and even Mr. Mitchell says that we're on the "left" side of the peak point most of the time.

That's not to say the Laffer curve is not helpful in a policy debate; it's a very important concept. I'm saying that politicians in particular should show some restraint in arguing that their tax cuts will "pay for themselves", and educate themselves on everything the Laffer curve does, and does not, represent. Particularly, they should think twice when they plan for their tax cuts to not only pay for themselves, but also to pay for increased spending.
35 posted on 02/04/2008 2:03:49 PM PST by The Pack Knight (Duty, Honor, Country.)
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To: Moral Hazard
The “wealth effect” however causes people to work less because they have to work fewer hours to reach the same amount of after tax income.

Liberals use this argument in the reverse - tax someone more and they'll work harder to get their income back to where it was.

It's an evil theory. Seriously evil. It's like whipping slaves in the field to get more work out of them. It comes from an authoritarian mentality inherent to liberals.

36 posted on 02/04/2008 2:06:34 PM PST by MrB (You can't reason people out of a position that they didn't use reason to get into in the first place)
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To: Phantom Lord

Hillary has DEMONSTRATED her economic ignorance on many occasions.

I think she has a mental wall up in order to not understand it. That mental wall has communism written all over it.


37 posted on 02/04/2008 2:07:58 PM PST by MrB (You can't reason people out of a position that they didn't use reason to get into in the first place)
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To: sobieski
The ‘optimal’ you are discussing is the rate that maximizes government revenue. A better ‘optimal’ is the one that maximizes growth.

Agreed.

Most politicians, from small-town city councils all the way to Washington DC, truly believe that their primary function is to maximize government revenue.

Oddly enough, I can't find that particular goal described, much less emphasized, in the Constitution.

38 posted on 02/04/2008 2:13:39 PM PST by TChris ("if somebody agrees with me 70% of the time, rather than 100%, that doesn’t make him my enemy." -RR)
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To: TChris

I always cringe when I hear a candidate for mayor or town council state as a policy objective “increasing the tax base”.


39 posted on 02/04/2008 2:15:16 PM PST by The Pack Knight (Duty, Honor, Country.)
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To: TChris

I call it the CEO mentality. Most pols are lawyers / business-owners, and their focus in those arenas, properly, is revenue maximization. Unfortunately, they think such a mindset is also the optimal position to take as a political representative, and nothing could be further from the truth.


40 posted on 02/04/2008 3:13:48 PM PST by Teacher317 (Eta kuram na smekh)
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To: MrB
” Liberals use this argument in the reverse - tax someone more and they’ll work harder to get their income back to where it was.

It’s an evil theory. Seriously evil. It’s like whipping slaves in the field to get more work out of them. It comes from an authoritarian mentality inherent to liberals.”

Both the income effects and substitution effects have an..umm....effect. What liberals always miss and conservatives often miss even though it strengthens their case is that both effects lead to a loss of economic efficiency.

After all, if you have to spend extra hours working to support your family under higher taxes, when you could work less and spend more time with your family under lower taxes isn’t that an efficiency loss too? And shouldn’t liberals oppose it (even though they obviously don’t) just as much as conservatives?

41 posted on 02/04/2008 4:31:55 PM PST by Moral Hazard (Fred Thompson/Joe Don Baker in 08, because America needs bald, beefy character actors!)
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To: Moral Hazard
you could work less and spend more time with your family under lower taxes isn’t that an efficiency loss too? And shouldn’t liberals oppose it (even though they obviously don’t) just as much as conservatives?

"Liberals" don't support you spending more time with your family. If you spend more time with your family, you'll be instilling YOUR values in them instead of THEIR values.

42 posted on 02/05/2008 5:42:00 AM PST by MrB (You can't reason people out of a position that they didn't use reason to get into in the first place)
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