Skip to comments.The Laffer Curve, Part I: Understanding the Theory
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!
Ping for later
Do I a need beeber for this? Are beebers tax deductible?
I understood it in 1980. It will always prove true.
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.
Thanks for the post. Good explanation.
Interesting how some politicians can’t understand or believe this.
That’s ‘cause it’s supply side econ. Poison to libs.
Why has it taken 30 years to explain?
Just the first 2 minutes of it explain all a DUmmy needs to know. It should be required viewing before being allowed to vote.
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.
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.
“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.
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.
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).
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.
You need a highly technical number-beeber. The best ones have a ray-gun attachment.
The ‘optimal’ you are discussing is the rate that maximizes government revenue. A better ‘optimal’ is the one that maximizes growth.
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