The Laffer Curve, Part I: Understanding the Theory

YouTube ^ | January 28, 2008 | Dan Mitchell

[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

[Onelifetogive]

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.)

[misterrob]

Higher taxes also raises incentives to cheat....

[31R1O]

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.

[LowCountryJoe]

You must be discussing Engles Curves about now.

[Hoodat]

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

[Dan Evans]

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.

[31R1O]

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.

[conservatism_IS_compassion]

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:

• Spector: What is the tax revenue from the cigarette tax?

• Democratic GAO Aparatchik: $1 billion (or whatever it was).

• Spector: And what is the tax rate on cigarette?

• Democratic GAO Aparatchik:10% (or whatever it was).

• Spector: What would the revenue be from that tax if the rate were set to 20% ?

• Democratic GAO Aparatchik: $2 billion.

• Spector: What would the revenue be from that tax if the rate were set to 30% ?

• Democratic GAO Aparatchik: $3 billion.

• Spector: What would the revenue be from that tax if the rate were set to 40% ?

• Democratic GAO Aparatchik: $4 billion.

• Spector: What would the revenue be from that tax if the rate were set to 50% ?

• Democratic GAO Aparatchik: $5 billion.

• Spector: What would the revenue be from that tax if the rate were set to 60% ?

• Democratic GAO Aparatchik: $6 billion.

• Spector: What would the revenue be from that tax if the rate were set to 70% ?

• Democratic GAO Aparatchik: $7 billion.

• Spector: What would the revenue be from that tax if the rate were set to 80% ?

• Democratic GAO Aparatchik: $8 billion.

• Spector: What would the revenue be from that tax if the rate were set to 90% ?

• Democratic GAO Aparatchik: $9 billion.

• Spector: What would the revenue be from that tax if the rate were set to 100% ?

• Democratic GAO Aparatchik: $10 billion.

• Spector: I give up.

That was a blunder. The correct follow-on line would have been:

• Spector: What would the revenue be from that tax if the rate were set to 200% ?

• Democratic GAO Aparatchik: $20 billion.

• Spector: What would the revenue be from that tax if the rate were set to 400% ?

• Democratic GAO Aparatchik: $40 billion.

• Spector: What would the revenue be from that tax if the rate were set to 800% ?

• Democratic GAO Aparatchik: $80 billion.

• Spector: What would the revenue be from that tax if the rate were set to 160% ?

• Democratic GAO Aparatchik: $160 billion.

• Spector: What would the revenue be from that tax if the rate were set to 320% ?

• Democratic GAO Aparatchik: $320 billion.

• Spector: What you are saying, then, is that the entire federal budget can be funded by the cigarette tax. That is absurd. Mr. Chairman, I have no further questions of this witness.

[Moral Hazard]

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!

[SlapHappyPappy]

More like 45.

The first to follow the philosophy was Kennedy.

Don’t tell the Democrats.

[Phantom Lord]

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

[Phantom Lord]

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.

[JLS]

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.

[USFRIENDINVICTORIA]

"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.

[The Pack Knight]

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.

[MrB]

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.

[MrB]

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.

[TChris]

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.

[The Pack Knight]

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

[Teacher317]

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.