Laffer curve
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Image:Laffer.png The Laffer curve, popularized and promoted by economist Arthur Laffer and often used to justify tax cuts, is intended to show that government can maximize tax revenue by setting a tax rate at the peak of this curve and that raising tax rates further actually decreases revenue. The idea is clearest at both extremes of 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, where there is a 100% tax rate, the government collects zero revenue because (in a "rational" economic model) taxpayers have no incentive to work or they avoid taxes, and 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 the next and is subject to much theoretical speculation. Another contentious issue is whether a government should try to maximize its revenue in the first place. Such debate about the Laffer curve tends to be centred on the point at which public goods and services are maximised rather than the point at which total goods and services are maximised (ie public goods plus private goods).
The Laffer-curve concept is central to the supply side economics theory, 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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Context in US 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 revenue because government was operating on the right-hand side of the curve.
David Stockman, 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.
Critiques of the Laffer Curve
Conventional economic paradigms acknowledge the basic notion of the Laffer curve, but 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 Ronald 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.
Supporting Examples
Laffer himself has pointed to Russia and the Baltic states that have recently instituted a flat tax with rates lower than 35%, and their economies started growing right 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 raise revenue.
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, one would 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.
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. For instance, in the United States, some claimed that both tax cuts and government spending policies of the 1980s were the cause of large budget deficits.
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.
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 examines the budgetary impact of any possible macroeconomic effects of tax policies, i.e., it attempts to account for how tax cuts affect the overall size of the economy, and therefore influence future government tax revenues; and ultimately, 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 the lost revenue). Even in the paper's most generous scenario, only 28% of lost tax revenue is recouped over a 10-year period after a 10% tax-rate cut. The paper points out that these 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. The 10% tax cut would result in a 1% increase in gross national product. 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).
Precedents to the Laffer Curve
The idea inherent in the Laffer curve has been described many times prior to Laffer, including:
- The 19th century French economist Frédéric Bastiat
- The 14th century Islamic scholar Ibn Khaldun
- The 20th century economist John Maynard Keynes
- The 18th century politician Alexander Hamilton
- The 19th century constitution of the Confederate States of America
Note that Laffer himself does not claim credit for the idea [3], although he does seem to be responsible for popularizing the concept and its implications to policy makers.
See also
Inflation driven revenue
References
- Jude Wanniski, "Sketching the Laffer Curve," The Yorktown Patriot (14 June 2005).
- Arthur B. Laffer, "The Laffer Curve: Past, Present, and Future," Heritage Foundation Backgrounder #1765 (1 June 2004).
- Paul Pecorino, "Tax rates and tax revenues in a model of growth through human capital accumulation," J. Monetary Economics 36, 527-539 (1995).
- Victor A. Canto, Douglas H. Joines, and Arthur B. Laffer, Foundations of Supply-Side Economics—Theory and Evidence (New York: Academic Press, 1982).
- Robert E. Kaleher and William P. Orzechowski, "Supply-Side Fiscal Policy: An Historical Analysis of a Rejuvenated Idea." In Richard H. Fink, ed., Supply-Side Economics: A Critical Appraisal (Frederick, MD: University Publication of America, Inc., 1982).
- Robert McGuire and T. Norman Van Cott. "The Confederate constitution, tariffs, and the Laffer relationship", Economic Inquiry, Vol. 40, No. 3 - 2002Template:Link FA
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