Tuesday, January 29, 2008

Laffer Curve, Part I: Understanding the Theory

The Laffer Curve charts a relationship between tax rates and tax revenue. While the theory behind the Laffer Curve is widely accepted, the concept has become very controversial because politicians on both sides of the debate exaggerate. This video, featuring Cato Institute Senior Fellow Dan Mitchell, shows the middle ground between those who claim "all tax cuts pay for themselves" and those who claim tax policy has no impact on economic performance.

This is Part I of a three-part video series, and focuses on the theory of the Laffer Curve. Part II reviews historical evidence of Laffer-Curve responses. Part III discusses how the revenue-estimating process in Washington can be improved.


At 1/30/2008 4:34 AM, Anonymous Anonymous said...

A lot of misinformation here. I don't think anybody disputes that there a small grain of truth to the Laffer myth. But the illustration of the shape of the curve is completely unrealistic, and probably at the heart of the supply-side delusions.

First, the curve doesn't go down to zero on the right hand side. 1) In the heyday of communism, Soviet and Chinese marginal taxes were effectively 100%, yet people still worked. 2) Today we have lots of people who do volunteer work. 3) It's unlikely that highly driven and extremely wealthy business people are really working for the money once they have more than anybody can spend.

That's not to say that 100% taxation is a good idea or at all efficient, but lets be clear that the curve never goes down to zero, and that's perhaps one reason why the supply-siders have such a strange conception of what the curve might look like.

Now the concept behind the Laffer curve can be applied elsewhere too. For example, there are diminishing, and then negative returns to extra hours worked. Fatigue sets in and you start to make mistakes. So you might think that incentivising somebody to work 130 hours a week is a great thing, but they're probably getting less done than if they took a little time to rest and recuperate. Thus, once you've got a certain amount of productivity out of a wealthy person, there's not much point in incentivising them further.

I see no evidence of rich people choosing to work only 20 hours per week because their marginal tax rate is too high. But if high taxes cause them to cut their working hours from 100 hours/week to 90 hours/week, it's quite likely that the actual productivity lost from that 10 hours is very small. In fact, it's possible that this results in a productivity increase.

This suggests there a large part of the curve, perhaps covering most of the chart, is actually close to linear. Revenue increases in proportion to the tax rate with very little of the Laffer effect. The fact is that most people work about 40 hours per week regardless of the tax rate, and those that work 60 hours per week probably are thinking of career advancement rather than immediate monetary rewards.

So the real Laffer curve probably slopes up fairly linearly up to maybe 70 or 80%, then levels off a bit, dropping down on the right but never hitting 0 revenue, even when taxes are 100%.

Finally, the video fails to mention other ways of stopping tax avoidance. You don't reward other criminals by simply making their behaviour legal, it seems rather odd that you would suggest doing this with tax dodgers. If you think that a large number of people are evading taxes, then increase enforcement and penalties until the number of criminals drops.

At 1/30/2008 10:07 AM, Anonymous Anonymous said...

If tax rates don't affect tax receipts, then why not adopt a flat tax? Everyone pays the same rate. That's as fair as it can possibly get.

Oh wait. "Progressives" think they know how to spend other peoples money better than the people themselves.

Society is so fortunate to have such smart people taking my money and spending it for me. Where would I be without these benevolent bureaucrats?

At 1/30/2008 11:42 AM, Anonymous Anonymous said...

ami ganguli said:

1) In the heyday of communism, Soviet and Chinese marginal taxes were effectively 100%, yet people still worked.

Right. It was either work or be shot.
That sounds like a great idea.

Have you read about the Soviet farmers who would only plant crops on the perimeter of a field?

No wonder Russia and the USSR were exporting so much grain during their heyday! People were working so hard - NOT!

These hard working Communists couldn't even feed themselves.

No disincentive there.

At 1/30/2008 1:53 PM, Blogger Cobb said...

I agree with Ami on one thing:

The way the curve was drawn looks biased. I think the curve probably does look like that, but it would have been more convincing to those like Ami if it had been a normal bell-shaped curve.

When trying to convince the non-believers, I think it's important to look as unbiased as possible.


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