Thoughts on the Laffer Curve


I am not an economist, so feel free to take these comments with a grain or two of salt. But I have a background in physics, and think I have a good enough grasp of calculus to make some observations about a graph.

Description

NotLaffer

Laffer curve is a qualitative description of government revenues as a function of tax rates. Wikipedia suggests that there are some sophisticated economists that doubt its existence. I, being less sophisticated, regard it as self evident. At zero tax rates, the revenues would be nearly zero – except for tariffs (which are taxes on trade) and legal fines and maybe some other fees (taxes) such as liquor stamps.  100% tax rates result in essentially a slave state or barter society.  Revenues would also be low as there in no incentive to generate an income.  Citizens are completely dependent on government for basic needs.  In between revenues will be higher, and there will be [at least] one maximum. Laffer skirts the issue of the maximum, noting that reducing taxes reduces income less than expected, and presumably, raising taxes produces less income.  Since there is no quantitative formulation of the Laffer Curve, any conclusions can only be qualitative.

Past Experiments with tax Revenue

Carnegie argued in the 1920’s that the the high income tax rates, which were only on the rich, provided incentive to divert, hide, or reduce income subject to the tax. He got a reduction in rates, which still provided enough government revenues to balance the budget and reduce the debt. He claimed the lower rate provided less incentive to hide revenue.  Its not clear to me that the revenues increased with the changing value of the dollar.  But it is clear the government was able to make ends meet during a time of prosperity.

In the 1970’s the perks of company officers, (cars, travel, entertainment, etc) were publicized as an important component of compensation. The Reagan tax reforms, while lowering rates, sought to bring this compensation into the tax system. My impression is that given the choice of income or perquisites, executives opted for higher salaries. The Bush tax reforms, by lowering capital gains rates, shifted some of the stock holder compensation from strictly stock value, to adding and increasing dividend payments.  We saw something similar last December when many companies advanced their dividend payments to avoid anticipated tax increases.

“Peak” of the curve

Bypassing the fearful Angels, I’d like to propose some hypotheses about the peak. I assume the peak[s] is relatively flat, instead of sharp. This seems reasonable for an ill defined curve.  Small changes in tax rates, near the peak[s] won’t change revenues much.  Small changes may try to increase or decrease revenues, but will be compensated for by changes in behavior, and/or the economy. This is evident from the definition of “peak”. Small reductions in rates will likely cause the economy to expand somewhat, creating more jobs?  Conversely, small increases will cause the economy to contract somewhat. But revenues will hardly be affected.

Levels of government services may also push the curve higher (and maybe peak at higher tax rates) or lower (to lower tax rates?). I suspect that if these services are “cost effective”, whatever that means, it will tend to push the curve up, and when they are “over priced” the curve will fall.

Where are we?

It is not really possible to try to map out the Laffer Curve. We can’t hold regulations constant, stop tinkering with the economy. We won’t make small changes to the tax rates, and wait a few years to see how revenues stabilize. One can argue the curve depends on individuals. People who live within their means, will behave differently from those who don’t. There will always be people willing to tolerate high taxes, for the same reason (and perhaps the same people) there are always people willing to work for the government. Once you break through the red tape barriers, there are tremendous opportunities. These days government is where the money is.

We presently have 50 Laffer experiments going on as each state adds its own taxes onto the Federal and payroll taxes. Which states are doing better? High tax big government states, generally appear to do worse than low tax small government states. Though this is often hard to tell as states try to balance sales, property and income taxes.  I know that years ago when I lived near a border, in a high sales tax state, I tended to shop in the high property tax state.  I think that a survey of the states suggests we tend to be in the diminishing returns part of the curve.  Even if revenues increase a little with higher taxes, a price is paid in jobs (especially low end, beginning jobs) and freedoms.  It will be interesting to see if those states raising taxes this year experience revenue increases.

According to 10in21id.xls, in 2010, $5.8B were claimed in tax preparation fees as deductions (about 1/3 of NASA’s expenditures). I expect actual tax preparation costs are higher since many, like me, do not/cannot, claim our tax preparation fees.  While not large in the scheme of federal revenue things, it documents a minimum amount of money that is paid to comply with tax regulations.

For me, nearing retirement, I’m deciding when to shift from a relatively high paying job, to a lower income , less responsibility, more subsidized, life style. Higher taxes and and reduced take-home pay make that decision easier, and it will be sooner rater than later.

Conclusions

When I started this exposition I figured we are near the peak of the Laffer Curve, possibly on the diminishing revenue side. Now I am not so sure, but don’t think it matters.  We may be on the increasing revenue side. However, there are two important implications near the peak. 1) Increasing rates, result only in minimal increases in receipts, if any.  2) Increasing tax rates hinder the economy significantly. The peak is created by the damage to the economy beginning to overpower the alleged increase in revenue of the higher rate. Near the peak the economy is being damaged, and prosperity inhibited. I don’t think we should be trying to survive near that peak with high unemployment rates. Instead we should target the low tax, growing economy part of the Laffer Curve.

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