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. Here is the graph for labor taxes:
The vertical line is our average tax rate; the curves represent different model assumptions. They estimate the U.S. could increase revenues by about 36% by raising taxes. That obviously doesn’t necessarily imply that we should — but we could.
It is important to distinguish political goals from hard and fast facts (to the extent that hard and fast facts exist in economics). Often, parties try to justify their tax scheme, whether it involves raising or lowering taxes, by claiming that it will increase revenue. However, many parties who want to cut taxes want to cut them whatever the effect on revenue; low taxation is a goal in itself. They should come out and say so, rather than trying to justify their tax cuts through the back door.
I don’t know how detailed the models are. Certainly if factors such as “if the government raises taxes I’ll leave the country” are taken into account, the model would have to be different for different countries, since for various reasons citizens of some countries are more likely to leave than those of other countries. (Such arguments are largely overblown; in Europe, where there are quite different rates of taxation and where it is relatively easy to move to another country, the number of people who do so for tax reasons is very small. Note that the classic Swiss tax exile is not an example of this. Many countries require their citizens to pay tax regardless of where they live; the attraction of Switzerland was not so much the low tax rate (probably offset by the high cost of living) but the fact that it is easy to hide money so that it income generated from it (interest etc) is not taxed at all. Fortunately, pressure on Switzerland, Liechtenstein and other tax havens has increased and they have actually made it more difficult (but still too easy) to hide money.)
It also makes a big difference WHY taxes are raised or lowered: what will be bought from the additional revenue or what will not be bought if there is less revenue (ignoring for now the possibility of increasing the debt to offset revenue decrease). The will to work will be stronger if people have the feeling that they are getting their money’s worth even if the taxes are high.
The highest combined tax rate is in Denmark. Interestingly, the party which has been in power for years is a liberal party in the sense that such parties traditionally favour a minimal state.
So we don’t buy into Martin Gardner’s criticism and his idea of the neo-Laffer curve? http://en.wikipedia.org/wiki/File:Neo-Laffer-Curve.svg
It’s really surprising that one should plot a single curve like that and not expect complicated hysteresis that makes the whole thing quite intractable.
You can’t make a curve out of the two end points without some actual data in between.
The Cato institute did a video series on the Laffer Curve:
http://www.youtube.com/watch?v=fIqyCpCPrvU
Personally, the idea of the maximum around 60% is scary. Last year, I paid 42% of my income in federal, state, and local taxes. Laffer curve or not, that’s just too much!
I’m not convinced the Laffer Curve is correct. At 100% tax rate, are you sure no one would work? A lot of people actually enjoy what they do, and wouldn’t quit doing it just because they don’t get paid. Instead, people would only do the work they enjoy doing. Perhaps given such a chance, everyone would make contributions to society that they enjoy and end up more productive. Therefore there is no logical necessity in having a peak.
Also, why just one peak? Maybe there are two. Or maybe the curve is discontinuous.
“But if the tax rate is 100%, nobody has any reason to work, and your total revenues will be back at zero.”
While the argument seems plausible, this stated boundary condition is certainly wrong. In the USSR when essentially everything was state owned, and similarly in China’s recent past, the effective rate of taxation was essentially 100% but it certainly wasn’t true that those countries had no revenue; the USSR was a world power for decades, even if in the end it wasn’t sustainably so. Certainly this wasn’t a very economically efficient way of doing things, to say nothing of whether or not it was a Good Thing, but it’s hard to argue that the economic activity and government revenue in these sorts of examples are 0.00.
The Laffer curve has appeared on this blog before — in a completely bogus fit to corporate tax rates vs govt revenue.
I presume the present implementers can be better trusted?
There’s a huge culture problem with this curve as well. If the culture gets accustomed to a “5%” tax, a sudden raise to even “15%” would seem enormous, and discourage a lot of people.
So, the Laffer curve should change dramatically not only between cultures, but even over time, in a very nonlinear way…
“I’m not convinced the Laffer Curve is correct. At 100% tax rate, are you sure no one would work? A lot of people actually enjoy what they do, and wouldn’t quit doing it just because they don’t get paid.”
Possibly some people would still work, but at 100% tax rate no-one would bother paying them, would they? (Well, not in a manner visible to the tax-man, anyway.) So yes, the principle of the curve is certainly correct. Calculating the maximum is hard, though.
The Laffer curve is, and always has been a pile of nonsensical garbage. Just like supply side economics and Reaganomics and all the other Republican tactics to make the rich richer.
It may notbe smooth, differentiable, single-peaked etc etc.
Thus I tend to think of it as the Laugher curve 😉
Rather counterintuitively, changing taxes in the U.S. doesn’t actually effect upper-bracket tax revenue much. The wealthy in the U.S. are not to be Laffed at:
http://online.wsj.com/article/SB121124460502305693.html
And because I can’t resist a SW quote: “The more you tighten your grip, the more will slip through your fingers.”
Thanks for the post Sean. I didn’t know about the Laffer curve but it is an interesting idea.
I am posting on my blog a related question.
http://brokenglassware.blogspot.com/2009/09/hours-worked-vs-taxes-paid.html
For all of you arguing that maybe revenues don’t go to zero at 100% taxation: Can we at least agree that they get pretty close to zero? And that the optimal taxation rate is nowhere near 100%?
So, mod that one little proviso, is there anybody who’s really going to argue that at least one maximum does not exist in the curve?
The Laffer curve is a useful tool for telling you that, if you’re to the right of the maximum, you should reduce taxes. However, when you’re to the left of the maximum, you’ve got other policy constraints to think about. You may be able to maximize government revenues, but economic output declines monotonically with increasing tax rates. You have to balance the government’s need for money with its need to produce a strong economy. You might be at the optimal Laffer rate and still be generating such severe inefficiency that you had an extremely fragile economy.
I think it’s pretty clear that we’re to the left of the maximum in the US. I have to say that 60% as the maximum doesn’t pass the smell test, especially since you can’t get there without setting the top marginal rate for both individuals and corporations pretty close to 100%, or without making sure that the bottom three quartiles are paying at least (and this is a SWAG) 30% in taxes. Since the bottom quartile is effectively paying just social security and medicare taxes today and the second quartile isn’t paying a whole lot more, that doesn’t seem like it will fly.
And yet Denmark often comes tops when polling the happiness, optimism, and entrepreneurial spirit of its citizens, especially its young people, who don’t see at all phased by the high tax burden.
But then, when you don’t have a single moment’s worry about how you are going to pay for your health care, or about being made destitute by one wrong turn in your life, then I guess you’re free to dream the dream. That’s what conservatives don’t seem to get.
But if the tax rate is 100%, nobody has any reason to work, and your total revenues will be back at zero.
This is not true. People could (and should) realize that working (thus producing something of worth) and helping to run society by giving all income to the government, is far, far better than doing nothing at all. Therefore, while revenues will go down, they won’t be zero at 100% taxation.
[Not that I think 100% taxation is a good thing, of course.]
find that Denmark and Sweden are just a bit on the wrong side of the curve for the specific case of capital income taxation.
Why is that the wrong side, Sean (assuming that’s the right side of the curve [stupid language])? For revenue a little on the right side is no better or worse than a little (more) on the left side.
yeah 60% being the “ideal” tax rate is insane.. numbers like Me:$7680 gov:$11520 dont sit well with my poor ass self. im already paying 1/3 of my income in taxes.. at least i was when i was employed.
Duh! Perhaps you should define the curve as revenues vs. taxable income. When the government takes away 100%, no one produces taxable income. But everyone has to eat to survive, therefore they switch to non-taxable income streams – be it under the table work, barter, etc. You may enjoy painting pictures, but if they don’t put food on the table, you have another source of income. Or you beg or die.
The curve may evolve with time. For example, the longer we have a low tax rate the more the population may dislike raising taxes.
Man, you liberals are stupid! Still having revenues at 100%? I’ll give you a hint, rubes: 100% taxation means you are a slave and the state owns you. The Soviet Union was a super-power? Yes, and its people were slaves, there were endless lines waiting for very limited supplies of extremely shoddy goods, and their country was disgustingly poor and squalid in spite of having every bit as many natural resources at its disposal is its much richer rival, the U.S.A. You’ve got centuries of failure under your belt, and still you idiots try to push socialism!
60% is the optimal rate on the curve? Puh-lease! That doesn’t pass the laugh test anywhere but at the CPUSA. Remember how “optimal” life was during the Carter administration when taxes were so high? How “optimal” is our employment rate now, as the Democrats look to crush our already-overburdened businesses with even more tax to pay for their cockamamie social programs?
Tell me this, you charlatans: how would you like to have all your scientific institutions taxed at 60%? The fact that you politicized quacks keep trying to impose this junk science of yours on the rest of us while always trying to exempt yourselves from it speaks volumes about its reliability. Architects should be forced to live in the buildings they design, governments should be subject to their own laws, and economists should taxed at the same rate they propose for everyone else. (Likewise, Senators and Congressmen should be subject to whatever health care scam they foist on the rest of us. The “reform” bill as it currently stands exempts them from it. Still wonder why anyone’s less than enthusiastic about socialist plans for the rest of us?)
Of course, those studies measuring “happiness” are also pure BS, just like everything that professes to be able to measure such an unquantifiable abstraction. You’re not ALLOWED to be unhappy in a fascist and/or communist state! That you’d be trumpeting the results of opinion polls in lands where certain opinions are illegal is just one more proof that you’re political hacks and not scientists at all.
No, you don’t worry how to pay for your health care when there isn’t any to be had anyway! Likewise, you don’t worry about going broke from taking a wrong turn when you’re already broke. What you worry about is food, shelter, and clothing while staying out of the way of your rapacious state’s enforcers, sort of like those warty, scabby, and mostly toothless East Germans we saw scuttling forth from that benighted state after the Berlin Wall collapsed. That’s what “free” programs from government will do to you: focus you too much on things like scurvy and rickets to be worried about whether your insurance will cover your kid’s epilepsy. (Chances are that kid won’t live long enough to grow up in the hellhole where you live anyway.)
By the way, that ice cream analogy is more an indictment of your own socialist twaddle than anything else. Maximizing revenues for our porker of a state is supposed to be a GOOD thing? Here, Uncle Sam, have some more ice cream; you’ll be slimmer and less oppressive in no time! Honestly, how have you tax-loving liberals managed to go so long without accidentally ingesting something from a bottle with a yucky face sticker on it? What’s keeping an angry mob of taxpayers from dispatching all of you thieving scum with their shotguns? For some of life’s mysteries, evidently, no adequate scientific explanation exists, at least not from what is so euphemistically referred to as our scientific community.
Now someone needs to do a pretty little curve correlating the amount of money the government could potentially receive with the probability that such money will be either wasted or end up in the pockets of the politicians (and their friends and family).
Put that curve alongside this one and then we can talk about where the taxes should be.
Um…to hell with maximum possible. Maximum necessary sound right? I mean, what is the Federal Government’s true purpose? I assure you they’ve outstripped the original intent and scope of what was to be…even adjusted for 200 years of change. The government does SO LITTLE well….
To Bjorn Ostman: The reason the right side of the maximum is the “wrong side” to be on is simple. Take the blue curve in the above plot, the government receives roughly the same revenue taxing at 70% or at 45% (eyeballed). For this to be true, the taxable income per capita at 70% tax rate must be significantly less than at 45%. To the left of the maximum, however, the total revenue vs tax % appears to be roughly linear (below about 40%), which would imply to me that the tax rate in this range has marginal effects on the total taxable income generated by the populace.
It’s not just a question of revenue – The higher taxes become, the more an economy is degraded and corrupted long term as politicians have more money to fritter away on idealistic unworkable misguided schemes (and intrusive and totalitarian ones), bribing voters with welfare and health spending, and hampering private enterprise.
In the UK we’ve been progressively finding this out the hard way for the last ten years of having to endure a villainous socialist government, who are only now being rumbled.
Wasn’t it J K Galbraith who said “recessions catch what the auditors miss”? One might equally say “depressions catch what stupid gullible voters miss”!
Unfortunately, our state broadcaster, the BBC, has hitherto managed to foster a culture where paying higher taxes is seen as somehow virtuous, and all too many suggestible sheeple, pitifully anxious not to seem out of step with this naive idea, have been willing to believe it. But at last it seems a change in attitudes is underway, as it becomes clear what a colossal amount of money has been wasted.
This Laffer curve appears to be significantly shifted to the right. I seriously doubt that revenue will increase up to a 60% marginal income tax rate. We also have to include state and local income taxes that moves the vertical line substantially to the right. Add property taxes, sales taxes and user fees, indeed many higher income persons may be paying something approaching 60% of their income already. Other factors reducing the ability of earning income include intangibles such as political instability (which reduces risk taking), regulation (driving up costs of doing business).
I would bet that the highest tax yield would be at a lower rate of around 20% and flat across all incomes.