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.
I want minimal and efficient, not big corrupt and wasteful (and power hungry).
Whether or not Laffer Curve is totally accurate is not really the point. The immorality of confiscatory taxes IS! Govt has 3 purposes: an armed forces to protect our country from invaders and attack; a police force to protect us within our borders from force or fraud; a judicial system to try those arrested for force or fraud and administer justice based on OBJECTIVE law. That is it! The rest must be left up to citizens to arrange their lives, their businesses, their social circles, the care and feeding of themselves and loved ones to their own devices. As long as force or fraud is NOT used on another citizen, we can function as a dynamic, civil society!
As for high taxes, the underground economy in high tax countries is alive and well! Italy is a good example of such a country. It is human nature to KEEP what one works for, and to CHOOSE to give it to those he values. Currently, many US citizens see less and less “value” coming out of D.C., State and even local government. We are NOT getting value for our hard earned money! We are paying for “lemons” instead of lemonade! WE feel like “economic slaves”! If other countries can institute a FLAT tax, why don’t we at least consider it? Our 77,000 page Federal Tax Code is an abomination. Even the IRS counselors cannot fully understand it or “advise” us how to fill out complicated tax forms. When the Iron Curtain fell, some Eastern European countries instituted a FLAT tax. Our elected officials refuse to even consider it. They will see more “Tea Party Marches”, and ticked off citizens. However, I suspect that “some” in D.C. want that, so then they can clamp down on free speech and our right to bear arms. I believe they will find that there are millions of “us” that will NOT put up with that. We are NOT all “sheeple”, and NOT European. We ARE AMERICANS!
Interesting that Norway, Sweden, Denmark and Finland—all countries which have had high taxes for decades—always come out on top in Transparency International’s list of the least corrupt countries.
Talk about a racist comment. These countries are full of Scandinavians. Enough said.
Controlling for culture and ethnicity, the comparison of choice has to be North Korea and South Korea. Same culture and ethnicity, and in 1945, North Korea was slightly ahead of the South in per capita income.
So, to the extent that tax rates make a difference, we can see what happens with sustained taxation to the right of the Laffer curve in North Korea compared to what happens when policies further to the left on the curve are adopted as in South Korea.
That line in the graph is the AVERAGE. Almost no one is average. What matters is YOUR effective tax rate.
It also doesn’t count property and sales taxes (here in California this is well north of 10% of what you spend) and a myriad of other fees (i.e. taxes on telecom), tolls, and other taxes, etc. designed to vacuum money out of citizen’s wallets at every opportunity.
My accountant told me my taxes will be 60-70% and I’m going to quit working. So long, See ya.
As for leaving the country, there is now a “departure” tax that became effective in 2008. You’ll pay about 30+/- % of any unrealized gains you made. North Korea is the only other country in the world I’m aware of that does this.
A quick meta comment: it’s interesting that the libertarian line is presented in terms of abstract principles while the defense of limited government activity is presented in terms of historical experience and prudence–rules of thumb rather than metaphysical dogmas. The free marketeers just know that absolute laissez faire will produce a utopia while the rest of us don’t know of any general policy that can be counted on to do that and rather doubt that there are simple answers to complex economic and social problems. In this respect, the libertarians remind me of the Marxists I encountered forty years ago for whom empirical evidence and methodological modesty were irrelevant or simply evil. Under the circumstances, it’s a bit ironic that anybody who doubts the wisdom of the libertarian party line is denounced as a Marxist.
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If my tax rate were to be increased, I’d rather pay a CPA to minimize my total taxes rather than write a larger check to the government even if the total of taxes and CPA’s fees didn’t save me any cash. At least the government would get less from me and then could only tax what I paid the CPA at the CPA’s tax rate.
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The Laffer Curve is a joke and a neocon disater of a theory. Supply side demon economics is what is causing the collapse.
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It’s like figuring how hard to beat a mule to make him pull a cart faster without killing him in the process.
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Wow, I’m amazed at the number of responses that were generated by this article. Some of them are intelligent, but many are simply ignorant. Please note that ignorance is not a function of intelligence, just knowledge. Anyone who is familiar with the Laffer curve and its origins can tell you that the curve was not meant to determine the optimal rate of taxation, but merely to illustrate the concept that there are times when you can reduce tax rates and generate more revenue for the government (not to mention making people paying taxes much happier). I will demonstrate a simple scenario later in this post. The method used to draw this curve seems like a lot of hogwash to me, but maybe that’s because I’m ignorant of “marginal revolution” and constant Frisch elasticity. First, and like many above comments have mentioned, an average tax rate does not exist in practice. We could be in very different places on the Laffer curve for many different people. For instance, I’m certain that we’re far to the left of the maximum revenue generating rate for the 50% of the population that does not contribute to the income taxes of the United States–and I don’t think that any of you can argue that point. For the wealthy, it’s less clear, but maybe we are still to the left of the maximum… who knows? But whoever thinks that maximizing tax revenues should be the goal of the government probably doesn’t think that he or she has any true prospects for bettering their own circumstances in this world. They’d rather live in a nanny state. That’s fine, I just don’t feel like contributing my hard earned money so that you can do nothing.
Okay, now I want to illustrate to illustrate exactly how the Laffer curve works in the real world. But before doing this, I’d like to take a quick survey.
Question 1) Have you ever worked for a large or small company that had limited money?
Question 2) Have you ever been in a position where you were responsible for making the decision (or making a recommendation) of how that limited money was invested?
Question 3) If you answered yes to questions 1) and 2), did you consider the tax consequences when making this decision?
I have spent my career working in Finance and helping make these decisions for a Fortune 100 company. If you couldn’t already guess the answer to number 3, it should be “yes.”
Now let me illustrate. Let’s say that you have the opportunity to bet on the outcome of a coin toss. If you guess correctly, you win $120. If you guess incorrectly, you lose $100. Since the expected return is 0.5 * 120 + 0.5 * (100), or $10, a rational person would take this bet over and over until he/she was supremely wealthy. Now, let’s add taxes into this decision. If we tax the winnings at 25%, then the expected return drops to 0.5 * 120 * (1-.25) + 0.5 * (100) = (10). Now, you expect to lose $10 every time you take this bet, so you make the decision NOT to invest in this opportunity.
Now, rather than thinking of this as a coin flip, let’s think of it as the decision to expand manufacturing capacity in a region. This decision will have similar expected returns, but multiplied by $10MM–and this project is expected to create 100 new jobs if we do it. If the payouts and taxes are the same, you don’t do the project. However, if taxes are reduced to 10%, then you make the investment because your expected return is once again positive.
If you still can’t see how this illustrates the Laffer curve, then I’ll break it down even more simply so the nay sayers can understand it. If taxes are 25%, how much tax revenue is collected from this project? The answer = $0, because the project is not undertaken. If the tax rate = 0%, then you also collect $0 in taxes. However, if the tax rate is 10%, then your expected tax revenue = $10MM * (0.5*120*+0.5*-100) = $100MM * .25 = $25MM + the tax that you receive from the income on the 100 new jobs. Hey, (0%,$0), (10%, $40MM+), (25%, $0)–if you plot those coordinates on a graph, you actually get a Laffer curve.
I hate to disappoint you academics and people who have never worked in the real world, but this is actually how investment decisions are made and it supports the theory of supply side economics. This example applies to personal tax rates and corporate tax rates. High personal tax rates discourage investment by small business owners (many of whom report business income as personal income). So the next time you wonder why those 100 people are out on the street and looking for work, maybe you should think about cutting tax rates on corporations and individuals who make these decisions–because that’s how you will incentivize these people to take the risks that will create jobs.