Where We Are on the Laffer Curve

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:

laffer-curve

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.

90 Comments

90 thoughts on “Where We Are on the Laffer Curve”

  1. How about just 10%, no fancy ever-changing rules, loopholes and credits – no retaining records for over 1/2 decade, just 10%.

    That’s what tithing is, and biblical references centuries apart don’t vary – 10% of one’s increase. Of course Churches can’t enforce the 10% – but some seem to operate well with that simple guideline (consider the Mormon Church). The issue is simply “Don’t spend more than you have”, which Government just won’t do (especially since they found that Money can have a mere ‘FIAT’ basis).

    Of course, there may still be issues when Fed takes 10%, State takes 10%, County takes 10%, City Takes 10%, etc.

    It does make sense that at some point taxation would be collecting from tax-based Jobs to a point that the economy would just start inflating faster and faster.

    Inflation and ‘Tax the “Rich”‘ work together, initially USA Income Tax ‘top bracket’ was for those earning just over $7,000 annually (but back then a loaf of bread might be under 5 cents). Just ‘draw the line’ to ‘single out those “Rich” people’ and wait for inflation to make everyone rich (even if bread could be $100 a loaf by then…).

  2. Tell me again–how many fairies can dance on the head of a pin?

    Well, it turns out that’s the ideal tax rate for maximum revenue, too. Perhaps it might be better to tax as needed rather than for maximum revenue?

    Of course, determining “need” would then be the question, and we can’t have that, can we?

  3. It was my understanding that when Bush lowered the tax rate, that the government got a lot more revenue than at the higher tax rate?
    Rebuttals?

  4. The problem with the Laffer curve is that it assumes a constant tax rate for all incomes. Trabandt and Uhlig appear to be falling prey to this oversimplification. In the US, we have an extremely progressive tax rate. The bottom 20% pay a negative tax (that is, they get a tax “refund” that is more than what they paid in). The next 20% pay no tax at all, while the top 1%, pay more than the bottom 95%. Simply making the tax rate flat would allow Laffer curve effects to be seen. As it is now, the top of the economy is well to the right of the peak, everyone below the middle is at the extreme left and the upper middle is probably near the peak. The problem is that whenever taxes are raised in the US, they are raised on the upper middle and above payers. It’s far too easy for politicians to target that group, since it cannot singlehandedly vote them out of office. Unfortunately, it is also the part of the economy that employs the rest of us. When you ask where on the Laffer curve are we, you have to specify who “we” are.

  5. Joe:

    Things are different in the US. Republicans are *not* conservatives, and Democrats are *not* liberals. Yes liberals are left-wing and conservative are right-wing, but those two words have specific meanings, and are only 2 of the many, many different political viewpoints in the right and left wings. Just because someone is left-wing doesn’t make them a follower of the liberal philosophy (eco-nuts are left-wing, and they aren’t liberal), and just because someone is right-wing doesn’t make them a follower of the conservative philosophy (Iran’s theocratic government, US Republicans, and Zimbabwe’s dictatorship are all right-wing, but none of them are conservative).

    This is why a lot of the *real* conservatives in the US hate the Republican party with a passion (ditto real liberals and the Democrats… although the democrats are actually a center-right party, not left-wing. US politics are weird. They ave a center-right party and a far-right party. Heh. That *points up* is why a two party system is a really stupid idea. Multi-party systems have their problems, but getting stuck with 2 useless, corrupt political parties isn’t one of them:)).

  6. The modern Republican party is not in favor of individual freedom. It has constantly worked to erode civil rights, unshackle the cops, and even defend torture. It, not the Democrats, wants to control your sex life and harass people who don’t belong to approved churches. There is nothing surprising in this since increasing the disparity of income and wealth between the minority at the top and the rest of the population is only possible if there is enough police power to keep the plebs in line. You can only have limited government in a country with a large and relatively content middle class. The paradox is that you can’t achieve the requisite level of equality without some mechanism of redistribution such as a strongly progressive income tax.

  7. ah, the Americans! love to spend their money on war rather than public welfare. it’s always interesting to see just how much emotional pseudoarguments are brought up once the state controlled money stream from the poor to the rich is in danger of getting just a little bit reversed.

  8. The Laffer curve is way too simplistic a model. Also, you can’t compare different countries. It would be like comparing two different cars to determine what the optimal speed for maximum miles per gallon is. Also, in the very short term, and small tax increase will increase revenues, and likewise any small tax decrease will decrease revenues. However, there are many tax rates, not just income, capital gains, and corporate. If there are significant swings in capital gains, often times companies and individuals will post gains in favorable years. This curve is laughable at best.

  9. Anonymous Snowboarder

    Left unsaid is why government should EVER consider maximizing revenues. Or do you all work for the state, comrades?

  10. “# 16. Bjørn Østman Says:
    September 16th, 2009 at 2:06 pm

    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.”

    Bjorn – What you are recommending is slavery to the state. Its shocking that some desire to become slaves and think freedom is for the evil or greedy. When you would like to work for me for free please let me know.

  11. Also just because a government can raise more revenue doesn’t mean it should. Since when is funding our government to the maximum something to desire. America was founded on the principle that the least amount of government was the most desirable. Our goal should always be on trying to minimize the influence and power of the government. Government growth always comes at the expense of individual freedom.

  12. Bjorn – What you are recommending is slavery to the state. Its shocking that some desire to become slaves and think freedom is for the evil or greedy. When you would like to work for me for free please let me know.

    Bingo! How much can the massa extract from his slaves before they balk at working is the only question in his mind! Big Gobmint Massa – we can all live on the Big Rock Candy Mountain if only we pay enough taxes to the Massa! LOL

  13. Jim Harrison Says:

    “You can only have limited government in a country with a large and relatively content middle class. The paradox is that you can’t achieve the requisite level of equality without some mechanism of redistribution such as a strongly progressive income tax.”

    Your saying you can’t have a strong middle class without taking from the rich and creating the “middle class” by giving them money? This is absurd. Redistribution is a nice word for stealing.

    Government monetary policy, taxation, and government run education are the prime external causes of impoverishment/class division in this country. Cut corporate & income taxes to zero or near zero, maintain a strong currency through fiscal restraint, and concentrate on better education for the citizenry and the flood of new business and employment opportunity will do more than any redistibution ever could. Rather than spreading the existing wealth around we could create a much greater amount of new wealth. This of course does nothing for those like you who want the government to control more of our lives in a way that seems “fair” to you.

  14. The Laffer curve presented here does not include the full range of taxes on the public. The way it compares US taxes to those of a few European Countries is deceptive. Corporate taxes for example are lower in Europe. I’m not sure any conclusions can be drawn from this simplistic analysis. Besides, as I point out earlier our goal should not be to maximize the size of government. Also, a Laffer Curve is only useful in concept to explain that incremental increases in tax rates do not achieve always achieve incremental increases in tax revenue. As many point out here, the Laffer Curve endpoint of 0 revenue at 100% tax does not work in a Communist State where the people and all their labor belong to the State. You will find however that productivity in a Communist State is much lower than in a free one. There is a reason the Chinese have allowed reforms.

  15. “AB Says:
    September 17th, 2009 at 5:19 pm

    The problem with the Laffer curve is that it assumes a constant tax rate for all incomes. Trabandt and Uhlig appear to be falling prey to this oversimplification. In the US, we have an extremely progressive tax rate. The bottom 20% pay a negative tax (that is, they get a tax “refund” that is more than what they paid in). The next 20% pay no tax at all, while the top 1%, pay more than the bottom 95%. Simply making the tax rate flat would allow Laffer curve effects to be seen. As it is now, the top of the economy is well to the right of the peak, everyone below the middle is at the extreme left and the upper middle is probably near the peak. The problem is that whenever taxes are raised in the US, they are raised on the upper middle and above payers. It’s far too easy for politicians to target that group, since it cannot singlehandedly vote them out of office. Unfortunately, it is also the part of the economy that employs the rest of us. When you ask where on the Laffer curve are we, you have to specify who “we” are.”

    This post deserves to be read and read again. Great post AB.

  16. Phillip Helbig Says:
    September 17th, 2009 at 6:35 am

    ““Even if the graph shows that the US could charge higher taxes, it would be political suicide for any lawmaker to suggest a thing. It would also hurt the economy, which is based mainly on consumer spending, to take money away from the consumer and place it in the pocket of the government.”

    Of course, the government spends the money it gets. Some countries have 30% of the population working in the civil service. So, your statement is a non sequitur.”

    True, but an argument can be made that the government is less able to make productive use of the money it spends. Your disagreement with the previous poster’s idea that the government somehow removes the money is of course correct. I also appreciate your discussion of political terminology. I would be a classical liberal but vote primarily for Republicans. It is too bad they do not support individual freedom and limited government to the degree I do, but they are the lesser of two evils in my mind and at this time.

  17. “Slavery to the state.” “Redistribution is a nice word for stealing.”

    Sigh. All this political cant is very depressing.

    I have a question for you – can you name a place where the State has failed that you would want to live?

    In fact, if you made a list of places you wanted to live, they’d all be countries with Big Government – but Big Effective Government.

    Acting as if “government is evil bad bad” is childish. Government is a tool of humans to achieve better, more stable lives, where individuals can flourish and progress.

    Instead of trying to break your government, you should trying to make it work properly – stop wasting huge amounts on the military, which has shown extremely poor results considering that more money has been spend on the US military than any other project on Earth; prevent it from taking money from the middle classes and giving it to the ultra-rich (we’ve seen a trillion dollar+ giveaway from the Treasury to Wall St in the last year, all going to the ultra-rich); stop farming out work that used to be competently performed by the government but has gone to no-bid contractors who charge many times the original price for shoddy work.

  18. Paul doesn’t mind being “taxed”at 56% on the money he gets from the taxpayers and students, and doesn’t get to keep for himself, since he can just ask for more. How nice.

    That, and the assumption that more government revenue is automatically a good thing. Yes, the Church must get its tithe, even if it’s the Church of Marx.

    I’m willing to bet all the leftist idiots posting here believe in the myth of “corporate income tax,” too. No, no corporation would EVER funnel the cost of those taxes to the consumer.

    Then, as a an ex-pat Brit now in the US, I’ve been offering similar comments for years: http://news.yahoo.com/s/weeklystandard/20090916/cm_weeklystandard/anunnecessaryoperation_1;_ylt=AtY.WLDVSL.8ihFa7utCQO.7e8UF;_ylu=X3oDMTE2OGQxczZuBHBvcwMyBHNlYwN5bi1yLWItbGVmdARzbGsDZXYtYW51bm5lY2Vz

    I’m aware the socialists will insist the article is “biased.” Yes, so are yours. You couldn’t pay me to move back to the UK or any similar third world country. My poorest American friends are better off than my British middle class relatives. Crime is lower here. Food is cheaper. Medical care is better (and I’ve had British National Health Care, American VA care, and private sector care, so unless you’ve had the same experiences, you have no basis for comparison or argument).

    Socialism has failed everywhere it has been tried on a mass scale, for the simple fact that without profit, there is no incentive. In a wonderful Star Trek Next Generation socialist utopia, there’s no crime, war, money or dissent…but in reality, there would be no incentive. If you foresee everyone working “for the greater good,” please put down the hash pipe and go see a psychiatrist.

    You might go read a little history, such as how the American colonies developed in the first place–by providing goods and services tax free to businesses, that were not available as cheaply in England. This was apparently intolerable enough to ultimately lead to taxes and revolution.

    Perhaps it’s time for a new one.

    Oh, and Tom–that military you hate? You can thank it for computers, automated manufacture, advanced surgical techniques, space travel, advanced mapping…so please turn off your computer, GPS and never visit a trauma center until you learn to appreciate your moral betters a little more. And it was your socialist buddy 0bama who gave those trillions to Wall Street–more money than Bush spent in 8 years. It must be hard for you to be betrayed by your Savior.

    Incidentally, the contractors I served with were doing support tasks the military was not prepared to do, cheaper and more efficiently. It’s nice that your propaganda says otherwise, though.

    Government is a necessary evil, but liberals focus on ‘necessary’ while conservatives focus on ‘evil.’

  19. Who’s trying to break it? Minimizing is not breaking. It is childish to make them your master and caregiver. I agree military spending needs to be brought under control and bailing out the banks was a disgrace. Both of these were actions of big government. The government is out of control and growing it will not solve the problems. BTW the giveaway from Treasury to Wall St saved many a retirement savings account and union pensions were saved by the giveaways. More than the ultra rich were served, but this does not fit your view that the ultra rich get everything at the expense of the poor.

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