We are on The Laffer Curve

Science Magazine ^ | 16 Sep 2009 | S Carroll

[Admiral_Zeon]

The Laffer Curve is a simple idea: a government can’t raise taxes forever and expect to increase revenue along the way. Eventually you’re taking so much in taxes that people don’t have any reason to earn income. The argument is simple (and correct): if you have zero tax rate you get zero tax revenue. If you raise taxes just a bit, nobody will be discouraged from working, and you will collect some amount of revenue; therefore, the curve of revenue versus tax rate starts at zero and initially rises. But if the tax rate is 100%, nobody has any reason to work, and your total revenues will be back at zero. By the wonders of math, there must therefore be a maximum of the curve somewhere in between 0% and 100% tax rate.

An important question is, where are we on the curve? The notion of the Laffer curve has been used to justify all sorts of tax cuts, under the assumption/claim that we are to the right of the maximum, so that cutting taxes will actually increase revenues. Serious economists generally don’t believe this holds true in the U.S. right now, but the lure of the idea is undeniable: lose weight by eating more ice cream!

Via Marginal Revolution, here’s a study by Mathias Trabandt and Harald Uhlig that tries to get it right. Obviously they have models that make various assumptions, and I have no idea how realistic those assumptions are. They study the U.S. and several European countries, and find that Denmark and Sweden are just a bit on the wrong side of the curve for the specific case of capital income taxation. For the most part, however, tax rates lie to the left of the maximum. In the U.S., especially, we are significantly on the left.

[CutePuppy]

Laffer curve is a classic application of minmax / minimax rule in game theory to the tax system.

Combined with Hauser's Law, it is an excellent rule to figure out when the tax rates become counterproductive and actually lead to diminishing returns, i.e. instead of growing the economy ("the pie") and tax revenues, they start shrinking the tax revenues.

Unfortunately, many economists make a mistake in calculating only federal income tax revenues in the USA, partly because it's ideologically convenient, partly due to difficulty to account for multitude of separate taxes, i.e., states and municipalities income and sales taxes (including use, "sin" and other taxes) as well as special purpose taxes, such as Social Security.

There is also no accounting to implicit "taxes" (business or personal expenses) caused by excessive regulations from federal, state and municipal regulations.

Reference to Kurt Hauser's Law :
You Can't Soak the Rich [Regardless of tax rates, federal tax revenue is always 19.5% of GDP] - FR / WSJ, 2008 May 20, by David Ranson

Comment on power of combining Hauser's Law with Laffer Curve :
You Can't Soak the Rich [Regardless of tax rates, federal tax revenue is always 19.5% of GDP] - FR / WSJ, 2008 May 20, by David Ranson

[Dr.Deth]

You can play Evony and figure out Laffer Curve. It’s pretty straighforward.

[Tenacious 1]

My problem with the Laffer curve is that it assumes revenue based on an average tax rate. The problem with our progressive system is that each tax rate collects revenue at a varied amount. The highest tax rate collects the most revenue from the fewest people. The lowest tax rate collects 0 revenue from a good amount of the population.

I actually won this debate with an econ professor in college. I also asked what is the basis of a model and forecast that predicts what consumers/tax payers will spend and what their threshold is? He could not answer this.

I argue that supply and demand drives what revenue potential taxes will produce and that the unemployment rate affects the government's take of taxes more than the average tax rate. Cutting taxes is affective because it reduces costs and puts more cash into citizen pockets. Freed up capitol in businesses and for citizens inspires consumption and drives unemployment down. I would argue that our country is to the right (over) the most efficient taxation level based on historical evidence. Since these models and history cannot be tied together, I do not put much faith in it. Our number one problem is that government spends more than American's will tolerate funding. So they borrow and steal.

[CutePuppy]

See my post #21 re Hauser’s Law, in conjunction with Laffer Curve.

[Tenacious 1]

Increased taxation provides a nice incentive to do the kind of work that pays in under-the-table ‘cashy money

You mean "supplemental income"? I have found great success in bartering these days. If you have a talent, go trade your goods and services for goods and services of others.

I shovel a drive way all winter for my taxes (usually about 3 times). I change one guys oil and he treats my lawn. I built a loft for another guy and he repaired our computer and added some software for free. I installed a ceiling fan for babysitting. Who is John Galt?

[Stosh]

“This assumes that we want the govt to get the most money it can. Only a population of willing slaves thinks that increasing govt revenue is a good thing.”

Exactly correct.

The further problem with this analysis is that it’s one-dimensional.

From a purely economic standpoint, government might be able to extract more money from us without discouraging productivity.

But a second dimesion is freedom. If we give zero dollars to the state, we have maximum freedom, at least in an economic sense. If we give all of our income to the state, we’re slaves. The curve relating those extremes does not rise, then fall like the Laffer curve, it moves only in one direction: greater tax rate, less freedom.

The government’s job should not be to maximize tax revenues, but to find the a balance which provides adequate funding while maximizing the personal economic freedom of the taxpayers.

But when you have a political party, an entrenched bureaucracy, and a compliant media which operates on the principal that everything belongs to government, and government needs to find the minimum it can let us keep, then personal economic freedom falls to the wayside.

[the anti-liberal]

I’m building a two floor balcony for cashy money. Shh, don’t tell the IRS though, please.

[Citizen Tom Paine]

Is it the total tax burden, Federal, state, and local. It has been my experience that the homeowner ultimately carries the freight with real estate and school taxes increasing when ever any other taxes are cut.

The tax people are very creative when it comes to extracting money from a property owner. The studies rarely comment on the inefficiencies and graft inherent in the present system.

[Uncle Miltie]

My recollection is that all U.S. governments spend 35% of GDP, sourced from all varieties of taxes and debt.

Next, about 10% of the U.S. economy is subject to coercive regulation that amounts to a pure government encumbrance of productivity, i.e. a tax equivalent.

So, I think the true total “tax” take is around 45%.

Therefore, we could cut taxes in half (towards the 22%) and the economy and Treasury receipts would boom!

But Democrats would get fewer “envy” votes, so it’s a non-starter.

Proving Democrats care about power, not ameliorating any actual problem with the increased revenues that would result.

[Recovering_Democrat]

Preparing to shrug...

[Two Kids' Dad]

“Lose revenue by eating up more of a person’s income in taxation.”

The inappropriate ice cream analogy actually works if we’re on the right side of the curve and arguing for a need to lower tax rates. But I agree with you that it doesn’t work for the author’s intended purpose.

[LTCJ]

Self ping for later. Good comments.

[JasonC]

It's a line. The legal rates bounce all over the place, the revenue line stays entirely flat, with slight undulations of a few percent of GDP, driven entirely by the economic cycle and not reacting at all to the tax code.

[tom h]

The peak or “inflection point” is actually less about fact and more about perception. Meaning, when citizens perceive their tax money is spent wisely, and the need is real, then they will tolerate a higher peak. When citizens perceive waste, the peak is lower. Hence, in WWII citizens not only tolerated high tax rates but they bought war bonds (e.g., more financing of government) and worked harder in spite of the higher government collections. But when citizens perceive waste they will do anything to avoid taxes including investing in non-productive investments, just for the satisfaction of thwarting the government. Others will go so far as to hide income and risk tax fraud.

So the peak is not a fixed number but will vary depending on the party in power, the cultural and economic conditions, and citizens’ general perception of fairness.

Politicians are the worst in this regard. I like the story from Massachusetts, where liberal members voted in a higher tax on alchohol so as to fund their pet projects, and ignored pleas that it would hurt business and not raise revenue. A few months later, one of the key Dem legislators was caught avoiding state taxes bringing a trunkful of booze across the state line from New Hampshire. Touche.

Readers Digest did a survey years ago as to what a “fair” tax rate might be. The answer, from all income brackets, was about 20%. I think that the starting point for Laffer curve inflection point discussions should be there.

[TopQuark]

You appear to misunderstand the point. Nobody questions whether a maximum exists; the question is whether our tax rates are below or above that maximum.

If it is obvious to you, you should publish your findings in a peer-review journal.

[jnsun]

The further problem with this analysis is that it’s one-dimensional.

Thank You. Thank You.

The reason this article, or Economics 101, even discusses the Laffer Curve is it is simple enough for the simple minded to believe they actually "understand" economics.

As many posters here have commented there are many many other factors in the creative, productive energy of a society; and taking the so-called Laffer curve as anything near a serious way to look at government intervention in that creative synergy, is an exercise out of the fourth grade. Which, as we are seeing, indicates about the level of understanding of most "economists."

Giving Barack Obama, and the people behind him, the most overly generous benefit of the doubt, the best that can be described for them is a sad inept bunch of academics, with no experience (or grace), but certainly with one hell of a bigoted agenda.

Wasn't Pol Pot a graduate of the Sorbonne?

[nascarnation]

Business has already shrugged.

no kidding

small business is the real engine of job creation

small business is scared to death

that's why the MSM/SCM is trying to portray 10% unemployment as the "new normal"

[CutePuppy]

Not counting the impact of regulations, these are somewhat conservative and outdated numbers of total taxation. I've read recently that the latest number of total spending is closer to 43%-45% of GDP, due to so-called "The Obama effect" though George W. Bush and Congress were no angels when it came to government spending. So, including regulations, the total average impact will be easily over 50% of GDP now.

Yes, it's all about power, which is the ultimate aphrodisiac of politicians.

From Heritage Foundation / WSJ Freedom Index (calculated mostly for the last year, not yet accounting for financial crisis and "The Obama effect," e.g., Unemployment = 4.6% etc) :
Country rankings for trade, business, fiscal, monetary, financial, labor and investment freedom - United States

World Rank: 6
Regional Rank: 1 of 3
Ten Economic Freedoms of United States
91.9 Business Freedom Avg. 64.3
80.0 Investment Freedom Avg 48.8
86.8 Trade Freedom Avg. 73.2
80.0 Financial Freedom Avg 49.1
67.5 Fiscal Freedom Avg. 74.9
90.0 Property Rights Avg 44.0
59.6 Government Size Avg. 65.0
72.0 Fdm. from Corruption Avg 40.3
84.0 Monetary Freedom Avg. 74.0
95.1 Labor Freedom Avg 61.3


The United States' economic freedom score is 80.7, making its economy the 6th freest in the 2009 Index. Its score is 0.3 point lower than last year, reflecting declines in five of the 10 economic freedoms. The United States is ranked 1st out of three countries in the North America region, and its overall score is much higher than the world average.

The U.S. scores above the world average in business freedom, investment freedom, financial freedom, property rights, freedom from corruption, and labor freedom. The regulatory and legal framework supports entrepreneurial activity. Foreign investment and domestic capital are subject to the same rules. Financial markets remain open to foreign competition and are among the world's most dynamic and modern. The judiciary is independent and of high quality.

Weaknesses remain in fiscal freedom and government size. Total government spending equals more than a third of GDP. Corporate and personal taxes are high and increasingly uncompetitive. In 2008, the sub-prime mortgage crisis had far-reaching effects, and the government's unprecedented interventionist measures could severely undermine economic freedom in the future. .....

Ranking the Countries - complete Freedom Index table, sorted by score

Another index, more widely used because of longer time span coverage, is Economic Freedom of the World by Fraser Institute

One point of note, however - these indices are generally relative to other countries, not to the previous surveys of the same country, so the erosion of freedom in the country may not always be seen due to higher or faster deterioration of freedoms elsewhere.

[Uncle Miltie]

Could you imagine what a powerhouse a country would be if it really reduced its total governmental take to 20%?

They’d be masters of the world.

[CutePuppy]

I'd like to hear "The era of big government is over!" again, after 2010 elections.

I'd hope that it not be just a forced empty phrase and that GOP leadership would understand how to start dismantling the Big Government and stifling taxes and regulations. That new generation of people would once again see the power of supply-side economics and incentives of the "invisible hand", and to ply their trade mostly unburdened and free from the heavy hand of Big Brother.

Ah... perchance to dream.