Laffer curve
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The Laffer curve is used to illustrate the concept of Taxable income elasticity, the idea that government can maximize tax revenue by setting tax rates at an optimum point. The curve, popularized by Arthur Laffer though widely known among economists long before that, is primarily used by advocates who want government to reduce tax rates (such as those on capital gains) whenever it appears they exceed this "optimum" level.
Lowering the tax rate too much, they argue, will produce less revenue; the non-intuitive aspect of this idea is that setting the tax rate too high can actually decrease revenue as well.
The idea is clearest at both extremes of income taxation—zero percent and one-hundred percent—where the government collects no revenue. At one extreme, a 0% tax rate means the government's revenue is, of course, zero. At the other extreme, where there is a 100% tax rate, the government collects zero revenue because (in a "rational" economic model) taxpayers change their behavior in response to the tax rate: either they have no incentive to work or they avoid paying taxes, so the government collects 100% of nothing. Somewhere between 0% and 100%, therefore, lies a tax rate percentage that will maximize revenue.
The point at which the curve achieves its maximum will vary from one economy to another and depends on elasticities of demand and supply and is subject to much theoretical speculation. Another contentious issue is whether a government should try to maximize its revenue in the first place.
The Laffer-curve concept is central to supply side economics, and the term was reportedly coined by Jude Wanniski (a writer for The Wall Street Journal) after a 1974 afternoon meeting between Laffer, Wanniski, Dick Cheney, and his deputy press secretary Grace-Marie Arnett (Wanninski, 2005; Laffer, 2004). In this meeting, Laffer reportedly sketched the curve on a napkin to illustrate the concept, which immediately caught the imaginations of those present. Laffer himself professes no recollection of this napkin, but writes, "I used the so-called Laffer Curve all the time in my classes and with anyone else who would listen to me" (Laffer, 2004). Laffer also does not claim to have invented the concept, attributing it to 14th century Islamic scholar Ibn Khaldun and, more recently, to John Maynard Keynes.
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[edit] Context in U.S. history
The Laffer curve and supply side economics inspired the Kemp-Roth Tax Cut of 1981. Supply-side advocates of tax cuts claimed that lower tax rates would generate more tax revenue because the United States government's marginal income tax rates prior to the legislation were on the right-hand side of the curve.
David Stockman, President Ronald Reagan's budget director during his first administration and one of the early proponents of supply-side economics, maintained that the Laffer curve was not to be taken literally — at least not in the economic environment of the 1980s United States. In The Triumph of Politics, he writes:
- [T]he whole California gang had taken [the Laffer curve] literally (and primitively). The way they talked, they seemed to expect that once the supply-side tax cut was in effect, additional revenue would start to fall, manna-like, from the heavens. Since January, I had been explaining that there is no literal Laffer curve.
[edit] Critiques of the Laffer curve
Conventional economic paradigms acknowledge the basic notion of the Laffer curve, but they argue that government was operating on the left-hand side of the curve, so a tax cut would thus lower revenue. The central question is the elasticity of work with respect to tax rates. For example, Pecorino (1995) argued that the peak occurred at tax rates around 65%, and summarized the controversy as:
- Just about everyone can agree that if an increase in tax rates leads to a decrease in tax revenues, then taxes are too high. It is also generally agreed that at some level of taxation, revenues will turn down. Determining the level of taxation where revenues are maximized is more controversial.
At least one empirical study, looking at actual historical data on tax rates, GDP, and revenue, placed the 'optimal' tax rate (the point at which another marginal tax rate increase would decrease tax revenue) as high as 80%. Paul Samuelson argues in his popular economic textbook that Reagan was correct in a very limited sense to view the intuition underlying the Laffer curve as accurate, because as a successful actor, Reagan was subject to marginal tax rates as high as 90% during World War II. The point is that in a progressive tax system, any given person's perspective on the validity of the Laffer curve will be influenced by the marginal tax rate to which that person's income is subject.
[edit] Supporting examples
Laffer himself has pointed to Russia and the Baltic states who have recently instituted a flat tax with rates lower than 35%, and whose economies started growing soon after implementation.[1]
He has also referred to the economic success following the Kemp-Roth tax act, the Kennedy tax cuts, the 1920s tax cuts, and the changes in US capital gains tax structure in 1997 as examples of how tax cuts can cause the economy to grow and thus increase tax revenue.
In 2006, the US Treasury reported that monthly tax receipts in April reached their second-highest point in the history of the nation, totalling $315.1 billion, second only to April 2001's mark of $332 billion prior to the burst of the Internet stock bubble. These results could be interpreted as suggesting that the US was still on the right half of the Laffer Curve, contradicting some predictions in the wake of enactment of the Jobs and Growth Tax Relief Reconciliation Act of 2003, . On the other hand the higher tax revenues could simply be the result of a strong economy with low unemployment, unrelated to the tax cuts.
[edit] Difficulties of measurement
The Laffer curve is a static model, in that it models an economy with identical productive capacity under two different sets of tax rules. In a dynamic economic model, economic growth is a relatively general phenomenon, and one would therefore expect tax revenue to increase over time even if the tax regime remains identical. This leads many to suggest that the common comparisons stated to support the Laffer Curve are an unfair test.
Others respond that, even if the Laffer Curve itself is a static model, a programme of tax cuts nevertheless provides incentives for innovation and investment, which will increase the rate of economic growth, as predicted by endogenous growth theory.
Also, the Laffer Curve is clearly a model assuming uniform tax rates across all income ranges. Since most governments do not have a flat tax rate the Laffer curve would not hold for them, although similar effects may apply, and so it is a useful simplification to think about.
[edit] Keynesian critique
Some economists argue that while tax cuts are beneficial to the economy, they are beneficial for different reasons. Keynesian economics suggests that an increased government deficit - for instance, resulting from a tax cut - will stimulate economic output. This leads some to identify instances of the 'Laffer curve' as periods of Keynesian demand stimulation.
[edit] The wrong incentives?
Some economists argue that, while it is correct to focus on the problems of incentives in the economy, the problem is not the general level of taxation. The inelasticity of labor supply means that tax rates will have little effect on labor. The focus of analysis should be on the effective use of the labor already available. These economists point to, for instance, principal-agent problems in ensuring staff have appropriate incentives for performance, rather than the level of tax the staff face.
[edit] The Neo-Laffer Curve
A harsher critique of the Laffer Curve can be seen with Martin Gardner's satirical construct, the so-called neo-Laffer Curve. The neo-Laffer curve matches the original curve near the two extremes of 0% and 100%, but rapidly collapses into an incomprehensible snarl of chaos at the middle. Gardner based his curve on actual US economic data collected in a fifty year period by statistician Persi Diaconis.
The satire illustrates the major fallacy commonly committed with the Laffer curve, namely the assumption that the middle is a smooth, concave function merely because the two extreme endpoints are well-defined. A realistic tax curve would most certainly not resemble a smooth parabola or even any other simple function, but rather a very complex curve with many peaks, valleys, and multiple local maxima. Inside the middle, a wide range of various economic factors confound any simplistic attempt at this interpolation.
As a pedagogical tool, a Laffer curve helps illustrate a specific application of the law of diminishing returns, where the inhibitory cost of taxes may eventually outweigh the increased rate of taxation, and thus led to a counterintuitive lower realization of tax revenue. However the Laffer curve should not be taken as a literal model for a tax revenue curve, especially in debates between relatively moderate amounts of taxation. It is in this context that the Laffer curve is often abused, taken as a serious model for tax revenue when it has little to no predictive value in debates between intermediary rates of taxation
[edit] Estimates of the effectiveness of the Laffer curve
In 2005, the Congressional Budget Office released a paper called "Analyzing the Economic and Budgetary Effects of a 10 Percent Cut in Income Tax Rates" [2] that casts doubt on the idea that tax cuts ultimately improve the government's fiscal situation. Unlike earlier research, the CBO paper estimates the budgetary impact of possible macroeconomic effects of tax policies, i.e., it attempts to account for how reductions in individual income tax rates might affect the overall future growth of the economy, and therefore influence future government tax revenues; and ultimately, impact deficits or surpluses. The paper's author forecasts the effects using various assumptions (e.g., people's foresight, the mobility of capital, and the ways in which the federal government might make up for a lower percentage revenue). Even in the paper's most generous estimated growth scenario, only 28% of the projected lower tax revenue would be recouped over a 10-year period after a 10% across-the-board reduction in all individual income tax rates. The paper points out that these projected shortfalls in revenue would have to be made up by federal borrowing: the paper estimates that the federal government would pay an extra $200 billion in interest over the decade covered by his analysis. To support these calculations, the paper assumes that the 10% reduction in individual tax rates would only result in a 1% increase in gross national product, a figure some economists consider too low for current marginal tax rates in the United States. [3][4] The paper appears to focus on Federal government revenue only and does not look at the total public sector revenue (i.e., it does not include increases in local and state government revenue).
[edit] Precedents to the Laffer curve
The idea inherent in the Laffer curve has been described many times prior to Laffer, including:
- The 14th century Islamic scholar Ibn Khaldun
- The 18th century politician Alexander Hamilton
- The 19th century French economist Frédéric Bastiat
- The 19th century constitution of the Confederate States of America
- The 20th century economist John Maynard Keynes
Note that Laffer himself does not claim credit for the idea,[1] although he does seem to be responsible for popularizing the concept and its implications to policy makers.
[edit] See also
- Trickle-down economics
- Supply-side economics
- Inflation-driven revenue
- Reaganomics
- Macroeconomics
- List of economics topics
- Lawrence Kudlow
[edit] External links
[edit] Footnotes
