QandO

August 26, 2004

The Laffer Curve
Posted by Dale Franks

Roger Snowden objects to my characterization of the Laffer Curve below, arguing:

The Laffer Curve is valid, I believe, but must be placed in the context of time. And lots of questions remain, such is the actual growth effect of tax policy, lag times, the effects of changing levels of government spending, etc. The inevitable "all other things being equal" that does not actually happen in reality.

Well, here's the thing about the Laffer Curve. It posits, correctly, that higher rates of taxation hinder economic growth by killing incentives. But, and this is often missed, it also posits that, below the equilibrium point, the tax rate no longer impedes economic growth.

Snowdon appears to be interpreting that as meaning that lower taxes keep incentivizing economic growth, so the lower the tax rate, the greater the rate of economic growth. But that isn't the correct interpretation.

Once taxes have reached the equilibrium point, lower taxes don't encourage even greater economic growth. Once you've reached the equilibrium point, you're already at the optimum level of growth. Cutting taxes beyond that point begins to reduce revenues, because the lower tax rates no longer produce increased economic growth.

Essentially, the Laffer Curve posits that, below the EP, people are already maximizing their economic production, because they are, after all, willing to pay some taxes. It keeps the cops on the beat, and the courts open, and the roads relatively pothole free. It is only after you move to the right of the EP that economic activity begins to become constrained. Moving to the left of the EP no longer increases economic growth, it merely reduces revenue, and that's true over time, as well.

Once people are already maximizing their production, lower tax rates can't make them super-maximize.

UPDATE:

Reader Frank Castle asks:

I thought equilibium point is where govt revenue is maximized, not economic growth. Are you saying that both are maximized at equilibrium, or am I in error?

I am saying something close to that, but not exactly that. At the EP and below, economic decisions are not made with much reference to taxation. So, as long as tax rates are acceptably low, i.e., at the equilibrium point or the left of it, people make economic decisions on other factors.

Once taxes reach the equilibrium point, or move to the right of it, taxes begin to distort economic decisions because they provide disincentives. In other words, the main power of tax rates is to hinder economic activity. Once tax rates are low enough, the disincentive they provide is removed.

Now, it might very well be that very low taxes might help economic growth to some small extent, simply because more money is freed up for, say savings or investment. But in all probability, the increases in economic activity aren't enough to overcome the lost revenues.

So, you are technically correct to say the EP is the point at which revenues are maximized. But the reason revenues are maximized is because the revenue losses from tax rates at the left of the EP are greater than the marginal increases in economic activity that might be provided by the extra money in people's pockets.

It is important to remember that there are other reasons why economic growth can't increase too much. There are, for instance, physical limits on the amount of work one can do in a single day. Lowering tax rates doesn't change those physical limits.

Raising tax rates above the EP might make a person decline to work more than eight hours a day, because the benefits of doing so are hindered by high tax rates. But, if a person is willing to work 10 hours a day at the EP, he won't necessarily be willing, or even able, to work 12 or 14 hours a day if tax rates are cut even more. His output is already maximized.

That's why the true power of tax rates is to hinder economic growth, not to boost it.

UPDATE II:

Reader Oscar asks:

I wonder why it has not been generally recognised that below some cut-off point, however defined, the effect stop. Do economists not study mathematics?

But, it has been defined. The Laffer Curve is just the graphic representation of that definition. That's precisely why the curve shows tax revenues dropping on the left side of the EP.

The trouble is not that economists don't study math. The problem is that the Equilibrium Point can't be quantified. It changes over time, and in response to political or economic conditions. Indeed, the definition of the EP is remarkably imprecise: The rate at which the population consents to be taxed.

During a war, for example, the rate may be quite high, as people are more willing to sacrifice in a time of national emergency. But when peacetime comes, people no longer are as willing to do so.

I have long posited that we saw an example of this during the first term of President Clinton, when he raised the top rate to 36%.

During the previous several years, there was increasing concern about the deficit. Supply-Siders were aghast, though, at the thought of raising taxes. At the time, I spoke every week to former Reagan Administration Deputy Treasury Secretary Paul Craig Roberts on my radio show in LA. Craig was adamant that raising tax rates would slow te economy, then just coming out of recession, and would reduce tax revenues.

In fact, quite the opposite occured. The economy boomed and tax revenues rose quite sharply. More sharply, in fact, than during Reagan's term. I think the Supply-Siders were quite wrong because public fear about the deficit made people more willing to pay higher taxes in order to reduce the deficit. The EP had moved to the right, and Clinton's tax increases produced more revenues because they moved tax rates closer to the EP.

UPDATE III:

Co-blogger Jon ponders:

So, while an effective tax cut from 40% to 36% might create an additional, say, 1% GDP growth, that GDP growth would not offset the 10% reduction in effective tax percentage. Meaning, the revenue would still go down, though not quite by the full 10%.

But, as Snowden indicated, the cumulative effect over that extra 1% GDP growth would add up. Over the course of 10 years, that's quite a large increase in potential GDP, and that eventual increase in GDP would offset the lost revenue...though, it would not occur in any single year.

Well, that's true, but not very relevant. as long as there is any economic growth at all, eventually revenues will increase beyond the level they were before taxes were cut.

But that wasn't the argument the Supply-Siders were making in the late 1970s. Their argument was that cutting rates would result in an immediate increase in revenues, because tax rates were, at the time, so far to the right of the EP, with the top rate at 70%.

Sure, if you don't mind deficits for a decade, you can cut taxes 10% at any time, even if you're already on the left of the EP. If you don't mind deficits for a century, you can cut taxes by 99%, and 100 years from now, the money will be rolling in!

Once you start making the "Well, in the long run, revenues will increase" argument, you're moving the goalposts. As long as the economy keeps growing, then at some point, revenues will increase beyond where they are when you change the tax code, no matter what you do. In the long run, then, it doesn't matter if you raise taxes, lower them, or do nothing, as long as there is any economic growth at all.

Of coure, as Keynes wrote, in the long run, we're all dead.

UPDATE IV:

Reader el Seco is full of questions:

You are saying that we are presently very close to the maximum amount of revenue we can expect given how much we are willing to be taxed. Is that about right? Thus, our situation with revenue has little to do with the unemployment rate or Bush's tax cuts. Is that about right?

Yes, that's what I'm saying. The main reasons for our current revenue problems have been the massive increases in government soending over the past 4 years, the revenue-lowering effects of recession, and the implosion of the equities market that began in the spring of 2000.

There are, after all, a lot of things that affect revenues besides tax rates.

Last question: Did Bush promise that the tax cuts would increase revenue or did he promise that they would stimulate the economy?

Now that I think about it, I never remeber Bush explicitly making the revenue enhancement argument. He argued that his tax cuts would encourage economic growth, which is an indirect revenue enhancement argument, but he also argued that the 2003 tax cuts were an important stimulus tool.

I think both arguments were wrong. If we were already at the EP, then further cuts wouldn't encourage more growth to the extent that the revenues losses would be neutralized. And the tax cuts themselves weren't particularly stimulative. I know of no reputable economist who agreed with the stimulus argument at all.

No matter how good the moral arguments were and are for the 2003 tax cuts (i.e., the government has no right to be a majority shareholder in my income), the economic arguments for them were a bit weak, from both the stimulus and revenue point of view.

That's also not to say that all the economic arguments were bad. Ending taxation on dividends is quite a good idea, although I'm not sure I want to get into that whole argument now. But the basis on which Bush pushed them, the arguments were deficient. There were several good arguments for tax cuts, they just weren't the arguments that Bush made.

TrackBack