Laffer curve

Laffer curve: t* represents the rate of taxation at which maximal revenue is generated. This is the curve as used by Laffer, but the curve need not be symmetrical nor peak at 50% in practice.

In economics, the Laffer curve is a theoretical representation of the relationship between government revenue raised by taxation and all possible rates of taxation. It is used to illustrate the concept of taxable income elasticity (that taxable income will change in response to changes in the rate of taxation). The curve is constructed by thought experiment. First, the amount of tax revenue raised at the extreme tax rates of 0% and 100% is considered. It is clear that a 0% tax rate raises no revenue, but the Laffer curve hypothesis is that a 100% tax rate will also generate no revenue because at such a rate there is no longer any incentive for a rational taxpayer to earn any income, thus the revenue raised will be 100% of nothing. If both a 0% rate and 100% rate of taxation generate no revenue, it follows that there must exist at least one rate in between where tax revenue would be a maximum. The Laffer curve is typically represented as a stylized graph which starts at 0% tax, zero revenue, rises to a maximum rate of revenue raised at an intermediate rate of taxation and then falls again to zero revenue at a 100% tax rate. However, there are infinitely many curves satisfying these boundary conditions. Little can be said without further assumptions or empirical data.

One potential result of the Laffer curve is that increasing tax rates beyond a certain point will become counterproductive for raising further tax revenue because of diminishing returns. A hypothetical Laffer curve for any given economy can only be estimated and such estimates are sometimes controversial. Estimates of revenue-maximizing tax rates have varied widely.

The Laffer curve is associated with supply-side economics, where its use in debates over rates of taxation has also been controversial. The Laffer curve was popularized by Jude Wanniski in the 1970s, with Wanniski naming the curve after the work of Arthur Laffer. Laffer later pointed out that the concept was not original, noting similar ideas in the writings of both 14th century North African polymath Ibn Khaldun – who discussed the idea in his 1377 Muqaddimah – and John Maynard Keynes. Numerous other historical precedents also exist.

Theory

Laffer explains the model in terms of two interacting effects of taxation: an "arithmetic effect" and an "economic effect". The "arithmetic effect" assumes that tax revenue raised is the tax rate multiplied by the revenue available for taxation (or tax base). At a 0% tax rate, the model assumes that no tax revenue is raised. The "economic effect" assumes that the tax rate will have an impact on the tax base itself. At the extreme of a 100% tax rate, the government theoretically collects zero revenue because taxpayers change their behavior in response to the tax rate: either they have no incentive to work or they find a way to avoid paying taxes. Thus, the "economic effect" of a 100% tax rate is to decrease the tax base to zero. If this is the case, then somewhere between 0% and 100% lies a tax rate that will maximize revenue. Graphical representations of the curve sometimes appear to put the rate at around 50%, but the optimal rate could theoretically be any percentage greater than 0% and less than 100%. Similarly, the curve is often presented as a parabolic shape, but there is no reason that this is necessarily the case.

The Laffer Curve assumes that the Government will collect no tax at a 100% tax rate because there would be no incentive to earn income. There is some question whether this assumption is correct.

Jude Wanniski noted that all economic activity would be unlikely to cease at 100% taxation, but would switch to barter from the exchange of money. He also noted that there can be special circumstances where economic activity can continue for a period at a near 100% taxation rate (for example, in war time).

Various efforts have been made to quantify the relationship between tax revenue and tax rates (for example, in the United States by the Congressional Budget Office). While the interaction between tax rates and tax revenue is generally accepted, the precise nature of this interaction is debated. In practice, the shape of a hypothetical Laffer curve for a given economy can only be estimated. The relationship between tax rate and tax revenue is likely to vary from one economy to another and depends on the elasticity of supply for labor and various other factors. Even in the same economy, the characteristics of the curve could vary over time. Complexities such as possible differences in the incentive to work for different income groups and progressive taxation complicate the task of estimation. The structure of the curve may also be changed by policy decisions. For example, if tax loopholes and off-shore tax shelters are made more readily available by legislation, the point at which revenue begins to decrease with increased taxation is likely to become lower.

Laffer presented the curve as a pedagogical device to show that, in some circumstances, a reduction in tax rates will actually increase government revenue and not need to be offset by decreased government spending or increased borrowing. For a reduction in tax rates to increase revenue, the current tax rate would need to be higher than the revenue maximizing rate. In 2007, Laffer said that the curve should not be the sole basis for raising or lowering taxes.

History

Origin of the term "Laffer Curve"

The term "Laffer curve" was reportedly coined by Jude Wanniski (a writer for The Wall Street Journal) after a 1974 afternoon meeting between Laffer, Wanniski, Dick Cheney, Donald Rumsfeld, and his deputy press secretary Grace-Marie Arnett. In this meeting, Laffer, arguing against President Gerald Ford's tax increase, reportedly sketched the curve on a napkin to illustrate the concept. Cheney did not buy the idea immediately, but it caught the imaginations of those present. Laffer 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 himself does not claim to have invented the concept, attributing it to 14th century Muslim scholar Ibn Khaldun and, more recently, to John Maynard Keynes.

Other historical precedents

There are historical precedents other than those cited directly by Laffer. For example, in 1924, Secretary of Treasury Andrew Mellon wrote: "It seems difficult for some to understand that high rates of taxation do not necessarily mean large revenue to the Government, and that more revenue may often be obtained by lower rates." Exercising his understanding that "73% of nothing is nothing", he pushed for the reduction of the top income tax bracket from 73% to an eventual 24% (as well as tax breaks for lower brackets). Personal income-tax receipts rose from US$719 million in 1921 to over $1 billion in 1929, an average increase of 4.2% per year over an 8-year period, which supporters attribute to the rate cut.

Amongst others, David Hume expressed similar arguments in his essay Of Taxes in 1756, as did fellow Scottish economist Adam Smith, twenty years later.

The Democratic party made a similar argument in the 1880s when high revenue from import tariffs raised during the Civil War (1861–1865) led to federal budget surpluses. The Republican party, which was then based in the protectionist industrial Northeast, argued that cutting rates would lower revenues. But the Democratic party, then rooted in the agricultural South, argued tariff reductions would increase revenues by increasing the number of taxable imports. A 1997 analysis concluded that the tariff rate used was lower than the revenue maximizing rate.

An argument along similar lines has also been advocated by Ali ibn Abi Talib, the first Shi'a Imam and fourth Caliph of the Islamic empire; in his letter to the Governor of Egypt, Malik al-Ashtar. He writes:

If the tax-payers complain to you of the heavy incidence to taxation, of any accidental calamity, of the vagaries of the monsoons, of the recession of the means of irrigation, of floods or destruction of their crops on account of excessive rainfall and if their complaints are true, then reduce their taxes. This reduction should be such that it provides them opportunities to improve their conditions and eases them of their troubles. Decrease in State-income due to such reasons should not depress you because the best investment for a ruler is to help his subjects at the time of their difficulties. They are the real wealth of a country and any investment on them even in the form of reduction of taxes, will be returned to the State in the shape of the prosperity of its cities and improvement of the country at large. At the same time you will be in a position to command and secure their love, respect and praises along with the revenues.

— Ali ibn Abi Talib, Nahj al-Balagha, Letter 53

Relationship with supply-side economics

Main article: Supply-side economics

Supply-side economics is a school of macroeconomic thought that argues that overall economic well-being is maximized by lowering the barriers to producing goods and services (the "Supply Side" of the economy). By lowering such barriers, consumers are thought to benefit from a greater supply of goods and services at lower prices. Typical supply-side policy would advocate generally lower income tax and capital gains tax rates (to increase the supply of labor and capital), smaller government and a lower regulatory burden on enterprises (to lower costs). Although tax policy is often mentioned in relation to supply-side economics, supply-side economists are concerned with all impediments to the supply of goods and services and not just taxation.

Both Wanniski and Laffer were prominent supply-side advocates, and as such the concepts of the Laffer curve and supply-side economics are often conflated. Further, supply-side advocates have at times argued for lower taxes on the basis of supply-side benefits while citing the Laffer curve as a reason that such cuts would also raise revenue. However, the objective of supply-side theory is to maximize the supply of goods and services, and to achieve this one should, in theory, always lower taxes. In contrast, the Laffer curve would suggest that a tax cut would raise tax revenues only if current tax rates were in the right-hand region of the curve.

Optimal taxation

Main article: Optimal tax

One of the uses of the Laffer curve is in determining the rate of taxation which will raise the maximum revenue (in other words, "optimizing" revenue collection). However, the revenue maximizing rate should not be confused with the optimal tax rate, which Economists use to describe a tax which raises a given amount of revenue with the least distortions to the economy. Taxation causes deadweight loss to an economy, and the impact of this needs to be considered in conjunction with the amount of revenue raised.

Influence on policy

In the United States

Reaganomics

Main article: Reaganomics

The Laffer curve and supply-side economics inspired Reaganomics and 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. As a successful actor, Reagan himself had been subject to marginal tax rates as high as 90% during World War II. During the Reagan presidency, the top marginal rate of tax in the US fell from 70% to 31%, while revenue continued to increase during his tenure. However tax cuts compounded by increases in government spending caused the national debt to rise, obscuring the effects of the Laffer curve. According to the CBO historical tables, income taxes as a percentage of GDP declined from 9.4% in 1981 to a range of 7.8% to 8.4% through 1989.

David Stockman, Ronald Reagan's budget director during his first administration and one of the early proponents of supply-side economics, was concerned that the administration did not pay enough attention to cutting government spending. He 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." Stockman also said that "Laffer wasn't wrong, he just didn't go far enough" (in paying attention to government spending).

Some have criticized elements of Reaganomics on the basis of equity. For example, economist John Kenneth Galbraith believed that the Reagan administration actively used the Laffer curve "to lower taxes on the affluent." Some critics point out that tax revenues almost always rise every year and during Reagan's two terms increases in tax revenue were more shallow than increases in tax revenue during presidencies where taxes top marginal tax rates were higher. Critics also point out that since the Reagan tax cuts, income has not significantly increased for the rest of the population.

Bush Tax Cuts

Main article: Bush tax cuts

See also: Economic Growth and Tax Relief Reconciliation Act of 2001 and Jobs and Growth Tax Relief Reconciliation Act of 2003

Economist Paul Krugman contended that supply-side adherents did not fully believe that the United States income tax rate was on the "backwards-sloping" side of the curve and yet they still advocated lowering taxes to encourage investment of personal savings.

Influence beyond the U.S.

Between 1979 and 2002, more than 40 other countries, including the United Kingdom, Belgium, Denmark, Finland, France, Germany, Norway, and Sweden cut their top rates of personal income tax. In an article about this, Alan Reynolds, a senior fellow with the Cato Institute, wrote, "Why did so many other countries so dramatically reduce marginal tax rates? Perhaps they were influenced by new economic analysis and evidence from... supply-side economics. But the sheer force of example may well have been more persuasive. Political authorities saw that other national governments fared better by having tax collectors claim a medium share of a rapidly growing economy (a low marginal tax) rather than trying to extract a large share of a stagnant economy (a high average tax)."

Another explanation might be that a higher tax rate also increases the risk of tax evasion towards tax havens, which leads governments to lose revenue.

Research, quantification and empirical data

A possible non-symmetric Laffer Curve with a maximum revenue point at around a 70% tax rate.

Research on revenue maximising tax rate

Economist Paul Pecorino argued in 1995 that the peak of the Laffer curve occurred at tax rates around 65%. A 1996 study by Y. Hsing of the United States economy between 1959 and 1991 placed the revenue-maximizing tax rate (the point at which another marginal tax rate increase would decrease tax revenue) between 32.67% and 35.21%. A 1981 empirical study published in the Journal of Political Economy found that the point of maximum tax revenue in Sweden in the 1970s would have been 70%.

This has been confirmed in a recent paper by Trabandt and Uhlig of the NBER.

However, a study by Teather and Young of the Adam Smith Institute using evidence from the Republic of Ireland has suggested that the optimal rate for capital gains tax, as opposed to income tax, may be around 20%, but this is at least partly due to savvy taxpayers holding onto assets in anticipation of tax rates being lowered in the future. A 2007 study by the American Enterprise Institute, a right leaning think tank, found that the revenue maximizing rate for corporate taxes in OECD countries was about 26%, down from about 34% in the 1980s.

2005 US CBO estimates on tax cuts

In 2005, the Congressional Budget Office (CBO) released a paper called "Analyzing the Economic and Budgetary Effects of a 10 Percent Cut in Income Tax Rates". This paper considered the impact of a stylized reduction of 10% in the then existing marginal rate of federal income tax in the US (for example, if those facing a 25% marginal federal income tax rate had it lowered to 22.5%). Unlike earlier research, the CBO paper estimates the budgetary impact of possible macroeconomic effects of tax policies, that is, 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). 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 the paper's analysis.

Other empirical data

Laffer has presented the examples of Russia and the Baltic states, which instituted a flat tax with rates lower than 35% and whose economies started growing soon after implementation, in support of the Laffer curve. He has similarly referred to the economic outcome of the Kemp-Roth tax act, the Kennedy tax cuts, the 1920s tax cuts, and the changes in US capital gains tax structure in 1997. Others have cited Hauser's Law, an empirical observation that US federal revenues, as a percentage of GDP, have remained stable at approximately 19.5% over the period 1950 to 2007 despite significant changes in margin tax rates over the same period, as supporting evidence.

The Adam Smith Institute stated in a 2010 report that "The 1997 Budget in Ireland halved the rate of taxation of realized capital gains from 40% to 20%. The then Minister for Finance, Charlie McCreevy, was heavily criticized on the grounds that this change would reduce revenues. He countered by predicting that revenues would rise substantially as a result of the lower tax rate. Revenues rose considerably, almost trebling in fact, and greatly exceeded official predictions." The effects of the credit bubble in the Republic of Ireland have not been included in this research, although since the bubble burst the taxes collected have proven far from adequate to continue operating the Irish state or economy.

Laffer Curve in other contexts

Outside of economics, American journalist Reihan Salam has argued in National Review Online that Laffer curve also exists with respect to incarceration rates as punishment for crimes. He stated that past a certain point in which more and more of the population have been or are currently in prison, incarceration becomes more destigmatized and crime would actually increase. He stated that the U.S. seems "to be past that point."

See also

• Arthur Laffer
• Deadweight Loss
• Hauser's Law
• Jude Wanniski
• List of economics topics
• Macroeconomics
• Optimal tax
• Reaganomics
• Supply-side economics
• Trickle-down economics

External links

• Jude Wanniski, "Taxes, Revenues, and the `Laffer Curve,'" The Public Interest, Number 50, Winter 1978
• Arthur Laffer describing the Laffer Curve
• The Laffer Curve, Part I: Understanding the Theory
• The Laffer Curve, Part II: Reviewing the Evidence
• The Laffer Curve, Part III: Dynamic Scoring