Where We Are on the Laffer Curve

By Sean Carroll | September 16, 2009 9:55 am

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:

laffer-curve

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.

CATEGORIZED UNDER: Miscellany
  • http://www.astro.multivax.de:8000/helbig/helbig.html Phillip Helbig

    It is important to distinguish political goals from hard and fast facts (to the extent that hard and fast facts exist in economics). Often, parties try to justify their tax scheme, whether it involves raising or lowering taxes, by claiming that it will increase revenue. However, many parties who want to cut taxes want to cut them whatever the effect on revenue; low taxation is a goal in itself. They should come out and say so, rather than trying to justify their tax cuts through the back door.

    I don’t know how detailed the models are. Certainly if factors such as “if the government raises taxes I’ll leave the country” are taken into account, the model would have to be different for different countries, since for various reasons citizens of some countries are more likely to leave than those of other countries. (Such arguments are largely overblown; in Europe, where there are quite different rates of taxation and where it is relatively easy to move to another country, the number of people who do so for tax reasons is very small. Note that the classic Swiss tax exile is not an example of this. Many countries require their citizens to pay tax regardless of where they live; the attraction of Switzerland was not so much the low tax rate (probably offset by the high cost of living) but the fact that it is easy to hide money so that it income generated from it (interest etc) is not taxed at all. Fortunately, pressure on Switzerland, Liechtenstein and other tax havens has increased and they have actually made it more difficult (but still too easy) to hide money.)

    It also makes a big difference WHY taxes are raised or lowered: what will be bought from the additional revenue or what will not be bought if there is less revenue (ignoring for now the possibility of increasing the debt to offset revenue decrease). The will to work will be stronger if people have the feeling that they are getting their money’s worth even if the taxes are high.

    The highest combined tax rate is in Denmark. Interestingly, the party which has been in power for years is a liberal party in the sense that such parties traditionally favour a minimal state.

  • Edd

    So we don’t buy into Martin Gardner’s criticism and his idea of the neo-Laffer curve? http://en.wikipedia.org/wiki/File:Neo-Laffer-Curve.svg
    It’s really surprising that one should plot a single curve like that and not expect complicated hysteresis that makes the whole thing quite intractable.

  • AdamK

    You can’t make a curve out of the two end points without some actual data in between.

  • Metre

    The Cato institute did a video series on the Laffer Curve:

    http://www.youtube.com/watch?v=fIqyCpCPrvU

    Personally, the idea of the maximum around 60% is scary. Last year, I paid 42% of my income in federal, state, and local taxes. Laffer curve or not, that’s just too much!

  • http://ryandickherber.com/ Ryan Dickherber

    I’m not convinced the Laffer Curve is correct. At 100% tax rate, are you sure no one would work? A lot of people actually enjoy what they do, and wouldn’t quit doing it just because they don’t get paid. Instead, people would only do the work they enjoy doing. Perhaps given such a chance, everyone would make contributions to society that they enjoy and end up more productive. Therefore there is no logical necessity in having a peak.

    Also, why just one peak? Maybe there are two. Or maybe the curve is discontinuous.

  • JD

    “But if the tax rate is 100%, nobody has any reason to work, and your total revenues will be back at zero.”

    While the argument seems plausible, this stated boundary condition is certainly wrong. In the USSR when essentially everything was state owned, and similarly in China’s recent past, the effective rate of taxation was essentially 100% but it certainly wasn’t true that those countries had no revenue; the USSR was a world power for decades, even if in the end it wasn’t sustainably so. Certainly this wasn’t a very economically efficient way of doing things, to say nothing of whether or not it was a Good Thing, but it’s hard to argue that the economic activity and government revenue in these sorts of examples are 0.00.

  • Mike

    The Laffer curve has appeared on this blog before — in a completely bogus fit to corporate tax rates vs govt revenue.

    I presume the present implementers can be better trusted?

  • Oded

    There’s a huge culture problem with this curve as well. If the culture gets accustomed to a “5%” tax, a sudden raise to even “15%” would seem enormous, and discourage a lot of people.
    So, the Laffer curve should change dramatically not only between cultures, but even over time, in a very nonlinear way…

  • Stephen P

    “I’m not convinced the Laffer Curve is correct. At 100% tax rate, are you sure no one would work? A lot of people actually enjoy what they do, and wouldn’t quit doing it just because they don’t get paid.”

    Possibly some people would still work, but at 100% tax rate no-one would bother paying them, would they? (Well, not in a manner visible to the tax-man, anyway.) So yes, the principle of the curve is certainly correct. Calculating the maximum is hard, though.

  • NewEnglandBob

    The Laffer curve is, and always has been a pile of nonsensical garbage. Just like supply side economics and Reaganomics and all the other Republican tactics to make the rich richer.

  • http://www.savory.de/blog.htm Eunoia

    It may notbe smooth, differentiable, single-peaked etc etc.

    Thus I tend to think of it as the Laugher curve ;-)

  • http://sifter.org/~aglisi Garrett

    Rather counterintuitively, changing taxes in the U.S. doesn’t actually effect upper-bracket tax revenue much. The wealthy in the U.S. are not to be Laffed at:

    http://online.wsj.com/article/SB121124460502305693.html

    And because I can’t resist a SW quote: “The more you tighten your grip, the more will slip through your fingers.”

  • http://brokenglassware.blogspot.com El Charro

    Thanks for the post Sean. I didn’t know about the Laffer curve but it is an interesting idea.

    I am posting on my blog a related question.

    http://brokenglassware.blogspot.com/2009/09/hours-worked-vs-taxes-paid.html

  • http://radical-moderation.blogspot.com/ TheRadicalModerate

    For all of you arguing that maybe revenues don’t go to zero at 100% taxation: Can we at least agree that they get pretty close to zero? And that the optimal taxation rate is nowhere near 100%?

    So, mod that one little proviso, is there anybody who’s really going to argue that at least one maximum does not exist in the curve?

    The Laffer curve is a useful tool for telling you that, if you’re to the right of the maximum, you should reduce taxes. However, when you’re to the left of the maximum, you’ve got other policy constraints to think about. You may be able to maximize government revenues, but economic output declines monotonically with increasing tax rates. You have to balance the government’s need for money with its need to produce a strong economy. You might be at the optimal Laffer rate and still be generating such severe inefficiency that you had an extremely fragile economy.

    I think it’s pretty clear that we’re to the left of the maximum in the US. I have to say that 60% as the maximum doesn’t pass the smell test, especially since you can’t get there without setting the top marginal rate for both individuals and corporations pretty close to 100%, or without making sure that the bottom three quartiles are paying at least (and this is a SWAG) 30% in taxes. Since the bottom quartile is effectively paying just social security and medicare taxes today and the second quartile isn’t paying a whole lot more, that doesn’t seem like it will fly.

  • tacitus

    The highest combined tax rate is in Denmark. Interestingly, the party which has been in power for years is a liberal party in the sense that such parties traditionally favour a minimal state.

    And yet Denmark often comes tops when polling the happiness, optimism, and entrepreneurial spirit of its citizens, especially its young people, who don’t see at all phased by the high tax burden.

    But then, when you don’t have a single moment’s worry about how you are going to pay for your health care, or about being made destitute by one wrong turn in your life, then I guess you’re free to dream the dream. That’s what conservatives don’t seem to get.

  • http://pleion.blogspot.com Bjørn Østman

    But if the tax rate is 100%, nobody has any reason to work, and your total revenues will be back at zero.

    This is not true. People could (and should) realize that working (thus producing something of worth) and helping to run society by giving all income to the government, is far, far better than doing nothing at all. Therefore, while revenues will go down, they won’t be zero at 100% taxation.
    [Not that I think 100% taxation is a good thing, of course.]

    find that Denmark and Sweden are just a bit on the wrong side of the curve for the specific case of capital income taxation.

    Why is that the wrong side, Sean (assuming that’s the right side of the curve [stupid language])? For revenue a little on the right side is no better or worse than a little (more) on the left side.

  • knowlessmore

    yeah 60% being the “ideal” tax rate is insane.. numbers like Me:$7680 gov:$11520 dont sit well with my poor ass self. im already paying 1/3 of my income in taxes.. at least i was when i was employed.

  • Thidwick

    Duh! Perhaps you should define the curve as revenues vs. taxable income. When the government takes away 100%, no one produces taxable income. But everyone has to eat to survive, therefore they switch to non-taxable income streams – be it under the table work, barter, etc. You may enjoy painting pictures, but if they don’t put food on the table, you have another source of income. Or you beg or die.

  • Josh

    The curve may evolve with time. For example, the longer we have a low tax rate the more the population may dislike raising taxes.

  • Suetonius

    Man, you liberals are stupid! Still having revenues at 100%? I’ll give you a hint, rubes: 100% taxation means you are a slave and the state owns you. The Soviet Union was a super-power? Yes, and its people were slaves, there were endless lines waiting for very limited supplies of extremely shoddy goods, and their country was disgustingly poor and squalid in spite of having every bit as many natural resources at its disposal is its much richer rival, the U.S.A. You’ve got centuries of failure under your belt, and still you idiots try to push socialism!

    60% is the optimal rate on the curve? Puh-lease! That doesn’t pass the laugh test anywhere but at the CPUSA. Remember how “optimal” life was during the Carter administration when taxes were so high? How “optimal” is our employment rate now, as the Democrats look to crush our already-overburdened businesses with even more tax to pay for their cockamamie social programs?

    Tell me this, you charlatans: how would you like to have all your scientific institutions taxed at 60%? The fact that you politicized quacks keep trying to impose this junk science of yours on the rest of us while always trying to exempt yourselves from it speaks volumes about its reliability. Architects should be forced to live in the buildings they design, governments should be subject to their own laws, and economists should taxed at the same rate they propose for everyone else. (Likewise, Senators and Congressmen should be subject to whatever health care scam they foist on the rest of us. The “reform” bill as it currently stands exempts them from it. Still wonder why anyone’s less than enthusiastic about socialist plans for the rest of us?)

    Of course, those studies measuring “happiness” are also pure BS, just like everything that professes to be able to measure such an unquantifiable abstraction. You’re not ALLOWED to be unhappy in a fascist and/or communist state! That you’d be trumpeting the results of opinion polls in lands where certain opinions are illegal is just one more proof that you’re political hacks and not scientists at all.

    No, you don’t worry how to pay for your health care when there isn’t any to be had anyway! Likewise, you don’t worry about going broke from taking a wrong turn when you’re already broke. What you worry about is food, shelter, and clothing while staying out of the way of your rapacious state’s enforcers, sort of like those warty, scabby, and mostly toothless East Germans we saw scuttling forth from that benighted state after the Berlin Wall collapsed. That’s what “free” programs from government will do to you: focus you too much on things like scurvy and rickets to be worried about whether your insurance will cover your kid’s epilepsy. (Chances are that kid won’t live long enough to grow up in the hellhole where you live anyway.)

    By the way, that ice cream analogy is more an indictment of your own socialist twaddle than anything else. Maximizing revenues for our porker of a state is supposed to be a GOOD thing? Here, Uncle Sam, have some more ice cream; you’ll be slimmer and less oppressive in no time! Honestly, how have you tax-loving liberals managed to go so long without accidentally ingesting something from a bottle with a yucky face sticker on it? What’s keeping an angry mob of taxpayers from dispatching all of you thieving scum with their shotguns? For some of life’s mysteries, evidently, no adequate scientific explanation exists, at least not from what is so euphemistically referred to as our scientific community.

  • Some guy

    Now someone needs to do a pretty little curve correlating the amount of money the government could potentially receive with the probability that such money will be either wasted or end up in the pockets of the politicians (and their friends and family).

    Put that curve alongside this one and then we can talk about where the taxes should be.

  • Gsquared

    Um…to hell with maximum possible. Maximum necessary sound right? I mean, what is the Federal Government’s true purpose? I assure you they’ve outstripped the original intent and scope of what was to be…even adjusted for 200 years of change. The government does SO LITTLE well….

  • Kev

    To Bjorn Ostman: The reason the right side of the maximum is the “wrong side” to be on is simple. Take the blue curve in the above plot, the government receives roughly the same revenue taxing at 70% or at 45% (eyeballed). For this to be true, the taxable income per capita at 70% tax rate must be significantly less than at 45%. To the left of the maximum, however, the total revenue vs tax % appears to be roughly linear (below about 40%), which would imply to me that the tax rate in this range has marginal effects on the total taxable income generated by the populace.

  • John R Ramsden

    It’s not just a question of revenue – The higher taxes become, the more an economy is degraded and corrupted long term as politicians have more money to fritter away on idealistic unworkable misguided schemes (and intrusive and totalitarian ones), bribing voters with welfare and health spending, and hampering private enterprise.

    In the UK we’ve been progressively finding this out the hard way for the last ten years of having to endure a villainous socialist government, who are only now being rumbled.

    Wasn’t it J K Galbraith who said “recessions catch what the auditors miss”? One might equally say “depressions catch what stupid gullible voters miss”!

    Unfortunately, our state broadcaster, the BBC, has hitherto managed to foster a culture where paying higher taxes is seen as somehow virtuous, and all too many suggestible sheeple, pitifully anxious not to seem out of step with this naive idea, have been willing to believe it. But at last it seems a change in attitudes is underway, as it becomes clear what a colossal amount of money has been wasted.

  • http://www.milwaukeepain.com grumpygresh

    This Laffer curve appears to be significantly shifted to the right. I seriously doubt that revenue will increase up to a 60% marginal income tax rate. We also have to include state and local income taxes that moves the vertical line substantially to the right. Add property taxes, sales taxes and user fees, indeed many higher income persons may be paying something approaching 60% of their income already. Other factors reducing the ability of earning income include intangibles such as political instability (which reduces risk taking), regulation (driving up costs of doing business).
    I would bet that the highest tax yield would be at a lower rate of around 20% and flat across all incomes.

  • Kay

    Obviously Sean has no clue that Mathias Trabandt and Harald Uhlig have no clue what they are talking about. (Findings based on assumption are not scientific… they are conjecture.) Is it too much to ask that our stories not be contingent only upon supposition?

  • tacitus

    It’s funny how conservatives cannot bring themselves to believe that liberals have rational reasons for believing that government-funded services have their place in a well-ordered and free civil society. We must all have been brainwashed by some invisible bogeyman to which they are somehow immune.

    Face it, John Ramsden, Brits love having the BBC and their National Health Service, and woe betide any government that seeks to do away with them (not that any would dare).

    As for Suetonius’s barely comprehensible rant. Maybe you should try visiting Denmark and find out for youself how they live, breathe, and yes, think for themselves. East Germany it is not, and never will be. As for American freedoms, why not ask the millions of incarcerated American citizens (more than 10 times as many, per capita, than Denmark — ten times!) how much freer they feel living in America.

  • http://www.facebook.com/benedict.at.large Benedict@Large

    It is amazing that anyone takes the Laffer Curve seriously anymore. It should have been left on the cocktail napkin in that bar. The idea that anyone can chart out a graph when its ends are undefinable is silly. I can recurve it and shift it left and right to say anything I want, and not a single economist can dispute me.

    Pure junk.

  • Just Learning

    Sean

    When you say that no one has a reason to work, does that mean they choose to starve to death or die of exposure?

    Just out of curiosity, where does all that revenue go anyway? Into a big hole?

  • Jason

    Suetonius’ ravings cite the Carter years as an example of how bad things were when tax rates were higher. In so doing he demonstrates his historical illiteracy and lack of critical thinking skills. Why? 1)The economy wasn’t in the toilet then because of high marginal tax rates, but because of other factors;
    2) Marginal rates had been far higher before, and the economy was pretty good – the early 1960s comes to mind, when the top marginal rate was **91 percent**.

  • Pope Maledict XVI

    I’m sure that Sean gives away 60% of his income to worthy causes. After tax I mean.

    Too bad about the Jaguar.

  • http://thekinkyeconomist.blogspot.com/ Mark

    A few points to make. 1. The average tax rate is irrelevant because people have widely different tax rates. If some people are to the right of the curve but the average is to the left, then revenues could be increased by lowering those top rates. 2. If you include Federal, State, Local, Social Security, and Sales or Capital Gains taxes, the average rate is much higher. 3. There is a different maximum point for different people. The rate that maximizes your taxes may be 80% and mine may be 25%. Further the revenue maximizing rate for high income individuals is probably lower than the rate for low income individuals (who can’t afford to stop working). 4. While the economy may have been fine when marginal rates were higher, the increase in income inequality helps to prove the Laffer Curve. When tax rates on high income individuals was reduced, their incomes (before taxes) increased at a faster rate.

  • Kaleberg

    We know for a fact that taxes could be much higher and that this would lead to much higher revenues and much higher economic growth, at least in the United States. We had 90% marginal tax rates in the 1950s through the 1970s and we had much higher growth rates, and much more tax revenue, than we have now. We just have a lot of unpatriotic people who benefit greatly from our system who don’t like paying for what they get.

  • Paul

    Suetonius: I don’t make nearly enough working as an academic scientist to fall into the highest tax bracket. Since you are so bent out of shape about taxes, I’m guessing that you do?

    As a matter of fact, I am “taxed” at 56% by my university when I apply for grants. This amount is called “overhead” or “indirect costs” and is supposed to cover things like electricity, building maintenance, grant administrators, etc. So if I need $50k/year to pay a couple of graduate research assistants, I actually have to ask for $50k * 1.56 = $78k. This has a direct effect on my chances of being funded, both because my institution may have higher overhead rates than others and because the extra amount comes out of the total available for the program I am applying to, reducing the number of grants that can be made. Do I mind? Not too much, as long as the money seems to be spent reasonably. It’s only when the university tries to ask me to pay for, eg., electricity directly out of grant funds that I push back, since it should be covered by overhead.

    You express a lot of disgust for people who argue that taxes should be set at a level that allows for the adequate delivery of government services. Let me assure you that the disgust is mutual. When I was growing up, I was taught to clear my plates after dinner, clean up my room, etc. — boring things for a kid, but contributing to the overall work load of the household. Those of you who bitch and moan about every cent of taxes and every government program must not have been raised that way. I suppose I should feel sorry for you instead, but I guess that’s _my_ character flaw.

  • http://thekinkyeconomist.blogspot.com/ Mark

    Paul, your “tax rate” would actually be 28/78 = 36%, not 56%.

  • Jason Dick

    As for the 100% bound being zero, that stems from the assumption of rationality. Obviously the real world is more complex, so it’s not quite that simple. But it does seem to indicate that we could stand to increase taxes quite a bit. That shouldn’t be surprising considering that the last time we had a balanced budget, the taxes were much higher.

    I’d also like to mention that with a progressive tax, the curve is likely to be substantially different for different income brackets.

  • http://davidalananderson@hotmail.com David

    The Laffer curve is incredibly complex, as is the US tax code. This chart does not reflect the true tax on GDP, federal tax, state tax, SDI, FICA, coorperate tax, sales tax, property tax, the double tax of inheritance and business tax, or medical costs. Many of these are not in this chart. Another huge factor in the laffer curve is the debt level of society, which in the US is at an all time high. There is no single number for the laffer curve, to pretend so is to misrepresent the theory. The true number varies by country by laws and tax structure, and by the current events within that country so that it changes constantly.

  • http://davidalananderson@hotmail.com David

    The US rate including medical costs is well north of 50%.

  • http://davidalananderson@hotmail.com David

    And with the current private debt structure any increase will kill the so called recovery.

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  • Ernest A.

    There are some obvious fallacies in both the curve presented and in many of the comments. First of all the “U. S. Average” tax line is gee whiz meaningless factoid. The reason is simple, that 95% of the tax revenue paid to the IRS is paid by less than 5% of the tax payers. Because of this the only group that has a significant impact on tax revenues is this 5%, not the “U. S. Average”. If the top 5% significantly shift if and how they generate dollars for themselves they can significantly change how much tax they pay. They don’t have to quit making money. They, by virtue of their wealth have more options than the rest of us and they can and will use those options to their own best self interest, no matter what silly restrictive laws are written by the socialists. If that 5% change their financial activity in a way that has a major reduction in their tax liability they can (in theory) take their contribution to tax revenue to near zero which would effectively reduce tax revenues to the IRS to near zero, regardless of what the other 95% of income earners do.

    One more comment regarding the tripe about people liking what they do so they would do it regardless. That is more in tune with hobbies than jobs. However, this to is easily demonstrated as a bunch of feel good bunk. In order to understand this it only requires superimposing the political ideologies onto the curve that are associated with higher and lower taxes. That is freedom and liberty on the left side (0% tax rate) and Marxist socialism on the right side. As a practical matter and as demonstrated by history the only way to get to the 100% tax (government ownership of all labor and property) is by way of a totalitarian state. This type of government is not characterized by a tolerance for people doing their own thing, i.e. doing what you love to do. In all of the cases I can think of where a government owns all the property and labor, which is what a 100% tax nation is, there is no free choice as to what vocation a person does. They are told what they will do to benefit the government the most. This is decided by some government official who is far removed from the individual and has no interest in what the individual wants. This is where the utopians theory always breaks down – when it meets the harsh realities of actual implementation.

    On the other end of the spectrum is zero tax thus no government, just complete freedom and liberty. Of course the argument against that is that it leads to anarchy. Although the preachers of crisis and fear who say that freedom is to dangerous to be given to the common man are overstating their case it seems plausible that some government is necessary, which brings us back to the discussions taking place during that long summer when the U. S. Constitution was written. None of the arguments being presented had anything to do with “how much can we tax the people to get the most out of them”. Taxation was a means to an end, and end which we collectively have lost sight of. The States created the Federal government, via the U. S. Constitution, and gave it certain powers (Article I, Section 8) to provide basic security for the states so that all other matters may be attended to within each State.

    The Laffer Curve is an interesting exercise that demonstrates the fallacy of the tax and spend mindset but it was probably never intended to be the center of discussion about how much tax should be levied in a nation such as the united States of America, a nation that is unique among all others in its founding principles. To focus on how much can we tax to get the most money misses the point. The real point is what is the proper activity of the Federal Government and how can that be done most efficiently so as to reduce the taxes to a minimum that a free and sovereign people will allow to be levied upon themselves in order to secure the natural rights they were given before the founding of this nation.

  • http://www.astro.multivax.de:8000/helbig/helbig.html Phillip Helbig

    ” The highest combined tax rate is in Denmark. Interestingly, the party which has been in power for years is a liberal party in the sense that such parties traditionally favour a minimal state.

    And yet Denmark often comes tops when polling the happiness, optimism, and entrepreneurial spirit of its citizens, especially its young people, who don’t see at all phased by the high tax burden.”

    Why the “yet”? One could just as well, or even better, say: BECAUSE OF THIS, Denmark often comes tops…

    “But then, when you don’t have a single moment’s worry about how you are going to pay for your health care, or about being made destitute by one wrong turn in your life, then I guess you’re free to dream the dream. That’s what conservatives don’t seem to get.”

    Indeed.

  • http://www.astro.multivax.de:8000/helbig/helbig.html Phillip Helbig

    “The higher taxes become, the more an economy is degraded and corrupted long term as politicians have more money to fritter away on idealistic unworkable misguided schemes (and intrusive and totalitarian ones), bribing voters with welfare and health spending, and hampering private enterprise.”

    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.

  • http://www.astro.multivax.de:8000/helbig/helbig.html Phillip Helbig

    Saab, Volvo, IKEA, ABBA, ABB, Ericsson, Marabou,… not bad for a country of about 8 million people. Doesn’t look like the high taxes stifled private enterprise. Yes, Volvo and Saab are not what they once were—at least the automobile divisions of these companies (they have others). That’s because US automakers now own those automobile divisions.

  • Joe

    Even if the graph shows that the US could charge higher taxes, it would be political suicide for any lawmaker to suggest a thing. It would also hurt the economy, which is based mainly on consumer spending, to take money away from the consumer and place it in the pocket of the government. The reduction in consumer spending that would result would mean a loss of jobs which would then result in a loss of income and payroll tax revenue as well as a loss of other tax revenues as the newly unemployed stop consuming, which would lead to even further job loss and reduce consumption even further. Raising taxes will only increase revenue in a society that does not depend so heavily on the consumer having plenty of discretionary income to spend.

  • Joe

    “Interestingly, the party which has been in power for years is a liberal party in the sense that such parties traditionally favour a minimal state.”

    Can you please tell me where you got this information, because here in the US the Democrats (liberals) are the party of big government and maximum interference in the lives of the people. It is the Republicans (conservatives) that want to shrink government and remove it from the lives of the people to the extent that it is possible to do so.

  • http://www.astro.multivax.de:8000/helbig/helbig.html Phillip Helbig

    “Even if the graph shows that the US could charge higher taxes, it would be political suicide for any lawmaker to suggest a thing. It would also hurt the economy, which is based mainly on consumer spending, to take money away from the consumer and place it in the pocket of the government.”

    Of course, the government spends the money it gets. Some countries have 30% of the population working in the civil service. So, your statement is a non sequitur.

    ““Interestingly, the party which has been in power for years is a liberal party in the sense that such parties traditionally favour a minimal state.”

    Can you please tell me where you got this information, because here in the US the Democrats (liberals) are the party of big government and maximum interference in the lives of the people. It is the Republicans (conservatives) that want to shrink government and remove it from the lives of the people to the extent that it is possible to do so.”

    [Big sigh]

    Time to explain some terms. Yes, your definitions apply in the States. Note that one really needs two dimensions to describe political parties: left and right, liberal and conservative aren’t enough. One axis is “individual freedom vs. state-defined morals” and the other is “free-market economy vs. more state control of the economy”. In the US, with the two-party system (only slightly better than a one-party system, but I digress), you don’t see the full picture. Look at a typical European country, Germany for example. Grossly simplified: The Social Democrats are for personal freedom and for state control of the economy. The Christian democrats are for the state defining how people should behave and for free-market economy. The Free Democrats (roughly corresponding to the Liberal Democrats in England) are for personal freedom and for free-market economy. (The fourth combination: the state controls the economy and, as far as it can, your thoughts, is typical of dictatorships.) It varies from country to country, and from time to time within a country, which aspect of “freedom” the Free Democrats emphasise. (“Liberal”, in a European context, usually applies to such parties.) The Danish Liberal party (which for historical reasons is called “Venster”, “Left”, though this doesn’t refer to a left-wing party today, but rather the name comes from when left-wing meant “opposed to the monarchy” and conservative was in support of the monarchy; the name has stuck and the party gets along fine with the Queen these days) has historically emphasised free-market economics and little government intervention in the economy, in contrast to the Social Democrats and Communists, who hold/held power for a long time in Sweden and Norway.

    In the States, the Democrats are called liberals due to their stance on civil rights etc and the Republicans are conservatives because they favour more “traditional family values” etc. So this is just one axis. As far as the other axis goes, the Republicans might be considered more liberal (think free as in free enterprise, not free as in free love) in the European sense, but in practice both are very free-market orientated compared with European parties (in almost no European country would a conservative party question state-run healthcare, for example). (Also on the other axis, personal freedom, both are quite conservative compared to European standards. In some states in the US, certain sexual practices are actually illegal between married heterosexual consenting adults behind closed doors. OK, they might not be enforced, but the laws are still on the books. And other laws which apply when one or more of the five constraints above are dropped ARE enforced; people get ten years in prison for things which in other countries are expected behaviour. But I digress.)

    Liberal originally meant free in the sense of freedom from the state, an absolute monarchy being the opposing viewpoint. The meaning then evolved into open for change in the political system, whereas conservative meant “keep things as they are”. (One could add “radical” for those in favour of quick change (etymologically, it means addressing the root of a problem) and “reactionary” for those for whom keeping things as they are isn’t good enough; they want to turn the clock back to the good old days.) Liberal then took on both meanings “personal freedom” and “free enterprise”. However, what if the change you want happens and you want to keep it that way—are you then conservative or liberal? The problem occurs because labels which were appropriate in the past might not be appropriate now. In Russia, communists are often described as conservative or, these days, reactionary, not in the sense of right-wing but in the sense of keeping things as they are (as opposed to moving towards a free-market economy) or, these days, turning the clock back.

  • 907ie

    Well, the government thinks that it’s their money anyway, after all they created it even if they didn’t earn it.

    The future is “gaming the system”.

    Everywhere, as here in the US, we have individuals that are experts at it.

  • Xenophge

    If you earned a 4.0 in a course you are only entitled to a 2.5. Just as with income tax, 37.5% will be surrendered to the Internal Scholarship Service, then to be redistributed to the Officially Sad.

    No, wait! According to Cosmic Variance social activism, 60% confiscation is optimum. You earn a 4.0, you get a 1.6, and only the deserving graduate magna cum laude. Fair is fair.

  • hanfordgradstudent

    Couldn’t help but pass along an old (two years) blog post from Brad DeLong concerning the lengths the Wall Street Journal Editorial Page will go to keep the Laffer Curve alive. This should serve as an exercise in how to NOT do curve fitting.

    http://delong.typepad.com/sdj/2007/07/most-dishonest-.html

  • Tom Bowman

    How about just 10%, no fancy ever-changing rules, loopholes and credits – no retaining records for over 1/2 decade, just 10%.

    That’s what tithing is, and biblical references centuries apart don’t vary – 10% of one’s increase. Of course Churches can’t enforce the 10% – but some seem to operate well with that simple guideline (consider the Mormon Church). The issue is simply “Don’t spend more than you have”, which Government just won’t do (especially since they found that Money can have a mere ‘FIAT’ basis).

    Of course, there may still be issues when Fed takes 10%, State takes 10%, County takes 10%, City Takes 10%, etc.

    It does make sense that at some point taxation would be collecting from tax-based Jobs to a point that the economy would just start inflating faster and faster.

    Inflation and ‘Tax the “Rich”‘ work together, initially USA Income Tax ‘top bracket’ was for those earning just over $7,000 annually (but back then a loaf of bread might be under 5 cents). Just ‘draw the line’ to ‘single out those “Rich” people’ and wait for inflation to make everyone rich (even if bread could be $100 a loaf by then…).

  • MedallionOfFerret

    Tell me again–how many fairies can dance on the head of a pin?

    Well, it turns out that’s the ideal tax rate for maximum revenue, too. Perhaps it might be better to tax as needed rather than for maximum revenue?

    Of course, determining “need” would then be the question, and we can’t have that, can we?

  • AL Koppen

    It was my understanding that when Bush lowered the tax rate, that the government got a lot more revenue than at the higher tax rate?
    Rebuttals?

  • AB

    The problem with the Laffer curve is that it assumes a constant tax rate for all incomes. Trabandt and Uhlig appear to be falling prey to this oversimplification. In the US, we have an extremely progressive tax rate. The bottom 20% pay a negative tax (that is, they get a tax “refund” that is more than what they paid in). The next 20% pay no tax at all, while the top 1%, pay more than the bottom 95%. Simply making the tax rate flat would allow Laffer curve effects to be seen. As it is now, the top of the economy is well to the right of the peak, everyone below the middle is at the extreme left and the upper middle is probably near the peak. The problem is that whenever taxes are raised in the US, they are raised on the upper middle and above payers. It’s far too easy for politicians to target that group, since it cannot singlehandedly vote them out of office. Unfortunately, it is also the part of the economy that employs the rest of us. When you ask where on the Laffer curve are we, you have to specify who “we” are.

  • gopher65

    Joe:

    Things are different in the US. Republicans are *not* conservatives, and Democrats are *not* liberals. Yes liberals are left-wing and conservative are right-wing, but those two words have specific meanings, and are only 2 of the many, many different political viewpoints in the right and left wings. Just because someone is left-wing doesn’t make them a follower of the liberal philosophy (eco-nuts are left-wing, and they aren’t liberal), and just because someone is right-wing doesn’t make them a follower of the conservative philosophy (Iran’s theocratic government, US Republicans, and Zimbabwe’s dictatorship are all right-wing, but none of them are conservative).

    This is why a lot of the *real* conservatives in the US hate the Republican party with a passion (ditto real liberals and the Democrats… although the democrats are actually a center-right party, not left-wing. US politics are weird. They ave a center-right party and a far-right party. Heh. That *points up* is why a two party system is a really stupid idea. Multi-party systems have their problems, but getting stuck with 2 useless, corrupt political parties isn’t one of them:)).

  • http://Information.Architecture.Abacurial.com tOM Trottier

    This must be the first time the US has been to the left of average!

    tOM

  • boreds

    “lose weight by eating more ice cream!”

    ha, because the guilt makes you exercise harder ;)

  • http://vacua.blogspot.com Jim Harrison

    The modern Republican party is not in favor of individual freedom. It has constantly worked to erode civil rights, unshackle the cops, and even defend torture. It, not the Democrats, wants to control your sex life and harass people who don’t belong to approved churches. There is nothing surprising in this since increasing the disparity of income and wealth between the minority at the top and the rest of the population is only possible if there is enough police power to keep the plebs in line. You can only have limited government in a country with a large and relatively content middle class. The paradox is that you can’t achieve the requisite level of equality without some mechanism of redistribution such as a strongly progressive income tax.

  • Thomas Larsson

    The Pomperipossa effect: marginal tax rate exceeding 100%.

  • chris

    ah, the Americans! love to spend their money on war rather than public welfare. it’s always interesting to see just how much emotional pseudoarguments are brought up once the state controlled money stream from the poor to the rich is in danger of getting just a little bit reversed.

  • Noreen
  • Ramanan

    Why be obessed with government debt ? Modern governments are revenue constrained like households and taxes go directly into the dustbin ;) . The purpose of Tax is to reduce aggregate demand. http://bilbo.economicoutlook.net/blog/?p=381

  • Joshua Grigonis

    The Laffer curve is way too simplistic a model. Also, you can’t compare different countries. It would be like comparing two different cars to determine what the optimal speed for maximum miles per gallon is. Also, in the very short term, and small tax increase will increase revenues, and likewise any small tax decrease will decrease revenues. However, there are many tax rates, not just income, capital gains, and corporate. If there are significant swings in capital gains, often times companies and individuals will post gains in favorable years. This curve is laughable at best.

  • Anonymous Snowboarder

    Left unsaid is why government should EVER consider maximizing revenues. Or do you all work for the state, comrades?

  • S

    “# 16. Bjørn Østman Says:
    September 16th, 2009 at 2:06 pm

    But if the tax rate is 100%, nobody has any reason to work, and your total revenues will be back at zero.

    This is not true. People could (and should) realize that working (thus producing something of worth) and helping to run society by giving all income to the government, is far, far better than doing nothing at all. Therefore, while revenues will go down, they won’t be zero at 100% taxation.
    [Not that I think 100% taxation is a good thing, of course.]

    find that Denmark and Sweden are just a bit on the wrong side of the curve for the specific case of capital income taxation.

    Why is that the wrong side, Sean (assuming that’s the right side of the curve [stupid language])? For revenue a little on the right side is no better or worse than a little (more) on the left side.”

    Bjorn – What you are recommending is slavery to the state. Its shocking that some desire to become slaves and think freedom is for the evil or greedy. When you would like to work for me for free please let me know.

  • S

    Also just because a government can raise more revenue doesn’t mean it should. Since when is funding our government to the maximum something to desire. America was founded on the principle that the least amount of government was the most desirable. Our goal should always be on trying to minimize the influence and power of the government. Government growth always comes at the expense of individual freedom.

  • WL

    Bjorn – What you are recommending is slavery to the state. Its shocking that some desire to become slaves and think freedom is for the evil or greedy. When you would like to work for me for free please let me know.

    Bingo! How much can the massa extract from his slaves before they balk at working is the only question in his mind! Big Gobmint Massa – we can all live on the Big Rock Candy Mountain if only we pay enough taxes to the Massa! LOL

  • S

    Jim Harrison Says:

    “You can only have limited government in a country with a large and relatively content middle class. The paradox is that you can’t achieve the requisite level of equality without some mechanism of redistribution such as a strongly progressive income tax.”

    Your saying you can’t have a strong middle class without taking from the rich and creating the “middle class” by giving them money? This is absurd. Redistribution is a nice word for stealing.

    Government monetary policy, taxation, and government run education are the prime external causes of impoverishment/class division in this country. Cut corporate & income taxes to zero or near zero, maintain a strong currency through fiscal restraint, and concentrate on better education for the citizenry and the flood of new business and employment opportunity will do more than any redistibution ever could. Rather than spreading the existing wealth around we could create a much greater amount of new wealth. This of course does nothing for those like you who want the government to control more of our lives in a way that seems “fair” to you.

  • S

    The Laffer curve presented here does not include the full range of taxes on the public. The way it compares US taxes to those of a few European Countries is deceptive. Corporate taxes for example are lower in Europe. I’m not sure any conclusions can be drawn from this simplistic analysis. Besides, as I point out earlier our goal should not be to maximize the size of government. Also, a Laffer Curve is only useful in concept to explain that incremental increases in tax rates do not achieve always achieve incremental increases in tax revenue. As many point out here, the Laffer Curve endpoint of 0 revenue at 100% tax does not work in a Communist State where the people and all their labor belong to the State. You will find however that productivity in a Communist State is much lower than in a free one. There is a reason the Chinese have allowed reforms.

  • S

    For those interested in actual tax information:

    http://en.wikipedia.org/wiki/Tax_rates_around_the_world

  • S

    “AB Says:
    September 17th, 2009 at 5:19 pm

    The problem with the Laffer curve is that it assumes a constant tax rate for all incomes. Trabandt and Uhlig appear to be falling prey to this oversimplification. In the US, we have an extremely progressive tax rate. The bottom 20% pay a negative tax (that is, they get a tax “refund” that is more than what they paid in). The next 20% pay no tax at all, while the top 1%, pay more than the bottom 95%. Simply making the tax rate flat would allow Laffer curve effects to be seen. As it is now, the top of the economy is well to the right of the peak, everyone below the middle is at the extreme left and the upper middle is probably near the peak. The problem is that whenever taxes are raised in the US, they are raised on the upper middle and above payers. It’s far too easy for politicians to target that group, since it cannot singlehandedly vote them out of office. Unfortunately, it is also the part of the economy that employs the rest of us. When you ask where on the Laffer curve are we, you have to specify who “we” are.”

    This post deserves to be read and read again. Great post AB.

  • S

    Phillip Helbig Says:
    September 17th, 2009 at 6:35 am

    ““Even if the graph shows that the US could charge higher taxes, it would be political suicide for any lawmaker to suggest a thing. It would also hurt the economy, which is based mainly on consumer spending, to take money away from the consumer and place it in the pocket of the government.”

    Of course, the government spends the money it gets. Some countries have 30% of the population working in the civil service. So, your statement is a non sequitur.”

    True, but an argument can be made that the government is less able to make productive use of the money it spends. Your disagreement with the previous poster’s idea that the government somehow removes the money is of course correct. I also appreciate your discussion of political terminology. I would be a classical liberal but vote primarily for Republicans. It is too bad they do not support individual freedom and limited government to the degree I do, but they are the lesser of two evils in my mind and at this time.

  • Tom Human

    “Slavery to the state.” “Redistribution is a nice word for stealing.”

    Sigh. All this political cant is very depressing.

    I have a question for you – can you name a place where the State has failed that you would want to live?

    In fact, if you made a list of places you wanted to live, they’d all be countries with Big Government – but Big Effective Government.

    Acting as if “government is evil bad bad” is childish. Government is a tool of humans to achieve better, more stable lives, where individuals can flourish and progress.

    Instead of trying to break your government, you should trying to make it work properly – stop wasting huge amounts on the military, which has shown extremely poor results considering that more money has been spend on the US military than any other project on Earth; prevent it from taking money from the middle classes and giving it to the ultra-rich (we’ve seen a trillion dollar+ giveaway from the Treasury to Wall St in the last year, all going to the ultra-rich); stop farming out work that used to be competently performed by the government but has gone to no-bid contractors who charge many times the original price for shoddy work.

  • http://www.MichaelZWilliamson.com Michael Z. Williamson

    Paul doesn’t mind being “taxed”at 56% on the money he gets from the taxpayers and students, and doesn’t get to keep for himself, since he can just ask for more. How nice.

    That, and the assumption that more government revenue is automatically a good thing. Yes, the Church must get its tithe, even if it’s the Church of Marx.

    I’m willing to bet all the leftist idiots posting here believe in the myth of “corporate income tax,” too. No, no corporation would EVER funnel the cost of those taxes to the consumer.

    Then, as a an ex-pat Brit now in the US, I’ve been offering similar comments for years: http://news.yahoo.com/s/weeklystandard/20090916/cm_weeklystandard/anunnecessaryoperation_1;_ylt=AtY.WLDVSL.8ihFa7utCQO.7e8UF;_ylu=X3oDMTE2OGQxczZuBHBvcwMyBHNlYwN5bi1yLWItbGVmdARzbGsDZXYtYW51bm5lY2Vz

    I’m aware the socialists will insist the article is “biased.” Yes, so are yours. You couldn’t pay me to move back to the UK or any similar third world country. My poorest American friends are better off than my British middle class relatives. Crime is lower here. Food is cheaper. Medical care is better (and I’ve had British National Health Care, American VA care, and private sector care, so unless you’ve had the same experiences, you have no basis for comparison or argument).

    Socialism has failed everywhere it has been tried on a mass scale, for the simple fact that without profit, there is no incentive. In a wonderful Star Trek Next Generation socialist utopia, there’s no crime, war, money or dissent…but in reality, there would be no incentive. If you foresee everyone working “for the greater good,” please put down the hash pipe and go see a psychiatrist.

    You might go read a little history, such as how the American colonies developed in the first place–by providing goods and services tax free to businesses, that were not available as cheaply in England. This was apparently intolerable enough to ultimately lead to taxes and revolution.

    Perhaps it’s time for a new one.

    Oh, and Tom–that military you hate? You can thank it for computers, automated manufacture, advanced surgical techniques, space travel, advanced mapping…so please turn off your computer, GPS and never visit a trauma center until you learn to appreciate your moral betters a little more. And it was your socialist buddy 0bama who gave those trillions to Wall Street–more money than Bush spent in 8 years. It must be hard for you to be betrayed by your Savior.

    Incidentally, the contractors I served with were doing support tasks the military was not prepared to do, cheaper and more efficiently. It’s nice that your propaganda says otherwise, though.

    Government is a necessary evil, but liberals focus on ‘necessary’ while conservatives focus on ‘evil.’

  • S

    Who’s trying to break it? Minimizing is not breaking. It is childish to make them your master and caregiver. I agree military spending needs to be brought under control and bailing out the banks was a disgrace. Both of these were actions of big government. The government is out of control and growing it will not solve the problems. BTW the giveaway from Treasury to Wall St saved many a retirement savings account and union pensions were saved by the giveaways. More than the ultra rich were served, but this does not fit your view that the ultra rich get everything at the expense of the poor.

  • S

    I want minimal and efficient, not big corrupt and wasteful (and power hungry).

  • julius spencer

    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!

  • Cleanthesbrule

    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.

  • Concerned Citizen

    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.

  • http://vacua.blogspot.com Jim Harrison

    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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  • Scott

    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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  • corin

    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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  • bytejockey

    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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  • Mike B

    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.

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Cosmic Variance

Random samplings from a universe of ideas.

About Sean Carroll

Sean Carroll is a Senior Research Associate in the Department of Physics at the California Institute of Technology. His research interests include theoretical aspects of cosmology, field theory, and gravitation. His most recent book is The Particle at the End of the Universe, about the Large Hadron Collider and the search for the Higgs boson. Here are some of his favorite blog posts, home page, and email: carroll [at] cosmicvariance.com .

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