Do Conservatives Understand the Laffer Curve?
I was listening to the fantastic Radio Free Delingpole podcast, when Mr. Delingpole (if memory serves me right) made the assertion that cutting taxes will generate more tax revenue. The basis for this statement was the "Laffer Curve." I have heard this sentiment expressed by many conservatives and Republican politicians. The iron clad mantra of the GOP is that lowering taxes will generate more revenue. Like Mr. Delingpole, they will all cite the Laffer Curve as the basis of their belief. But does the Laffer Curve actually support the claim that lowering taxes will generate more government revenue?
Here is an idealized version of the Laffer Curve:
Simply looking at the graph will let any one who knows how to read graphs see right away that the statement, "Lowering tax rates will always yield more revenue," is false. Clearly the implications of the Laffer Curve are twofold.
First, government revenue and tax rates do not have a linear relationship. Second, there is an optimal tax rate at which the government can generate maximum revenue. Conservatives and GOP politicians always seem to ignore the fact that the Laffer curve is a curve. They will point to Thatcher and Reagan and Kennedy and say, "They lowered tax rates and revenues went up," and then they will point to California or Illinois and say they raised tax rates and failed to draw in extra revenue. All of these being true, they are nevertheless still missing the point of the Laffer Curve.
To understand what government tax increases or decreases will do, you have to know what the actual Laffer curve for your particular government (federal or state) looks like and where you are on that curve. The GOP always seems to think we are on the right side of the optimum, and the Democrats don't even understand what the Laffer curve is.
Why am I harping on this? Well, if, like me, you believe that that our national debt problem is real and serious and must be confronted, knowing what the Laffer Curve is and how to read it is vital to fixing the mess we are in. Our government is running serious deficits. To handle these, we will surely have to not only cut programs and spending but also look to maximizing tax revenue. What I hear regularly from the GOP is a blatant ignorance of their own economic theories. How are they supposed to solve this problem when all they seem to know is a political chant, rather than actual theory?
So I pose these questions to the Ricochet audience at large. What does the US federal government's Laffer Curve look like, and where are we now on that curve? If we are below the optimum should we then not consider raising taxes, or at the very least drop the notion that lowering them will yield us more revenue?
PS: Mr. Delingpole and his guest did later make mention that the Laffer Curve has an optimum. They just seemed rather disappointed that the optimum places at 48% for the UK, and seemed rather inclined to doubt that figure as true. I think that if we are to be rational and empirical we must accept that the optimum may be higher than we would philosophically like it to be.
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Comments:
Aug '10
Re: Do Conservatives Understand the Laffer Curve?
Hang On
James Delingpole, the real stimulus package!
Wow. Now I need to scrub my filthy brain.
May '10
Re: Do Conservatives Understand the Laffer Curve?
Something looks wrong with the Corporate Tax Rate Graph. The values for Norway, France, and the US seem odd. Drawing the curve through Norway ignores the clear clustering in the middle of the chart. That suggests that Norway is an outlier for some reason. And clearly the curve can allow for outliers because both France and the US are " outside" the curve. Without the data I can't tell, but it looks suspicious. And certainly the variation in goods received for taxes paid is a huge variable. The US gets a lot more soldiers for its taxes paid than any other country. I suspect Norway gets a lot more doctors for its taxes paid, for example.
Feb '11
Re: Do Conservatives Understand the Laffer Curve?
One of the reasons I have such high regard for Milton Friedman is that he always brought a sense of reality to discussions on economics. You can't really know where the optimum point on the Laffer Curve is. You can be pretty sure that when your top marginal rate is 95% and you've cut it to 70% that you're closer though still on the right. You can be pretty sure that when your top marginal rate is 70% and you cut it to 35% that you're closer. When you begin fighting over whether it's 39.6% or 31%, I'm not so sure.
Feb '11
Re: Do Conservatives Understand the Laffer Curve?
Midget Faded Rattlesnake
Hang On
James Delingpole, the real stimulus package!
Wow. Now I need to scrub my filthy brain. · 5 minutes ago
Whatever you do, don't read Rob's post in conjunction with this one.
Apr '11
Re: Do Conservatives Understand the Laffer Curve?
Hey its your government who said it. In my heart though I hope you are right because I find it disturbing to ask for half of somebodies income. I always liked the idea of 10%.
May '10
Re: Do Conservatives Understand the Laffer Curve?
In re Valiuth's question, I think any particular tax would have only one peak. But in an environment with federal income, state income, payroll, Medicare, etc., all using different brackets and exclusions, the result for the whole would undoubtedly have something other than a smooth, curved, single-peaked surface.
Mar '11
Re: Do Conservatives Understand the Laffer Curve?
Valiuth:
I would also like to ask if we are certain that the Laffer Curve has only one peak? It could be more complicated where there are local peaks in certain ranges but maybe only one overall maximum. This would create really confusing situations, where one tax cut generated revenue, but a further tax cut just lost us revenue.
According to this paper written by a University of Chicago economist (found through the link in Midge's comment #13), in the US we are solidly on the left side of the Laffer peak for income ("labor") taxes, and could potentially generate 30% more revenue by increasing income taxes. However, the same paper argues that if we cut our income tax by 32% it would be self-financing. I guess this supports the multiple-optima scenario, but in reality I have no idea.
Aug '10
Re: Do Conservatives Understand the Laffer Curve?
Well, the folks who made the 2-D Laffer hill based their model on steady-state conditions, that is, the state that you're supposed to get to after transitional effects of a new tax policy have died down.
But they note that transitional effect do matter. Quite a bit.
They say, for instance, that a "permanent surprise increase" in capital taxes always increases revenue, by which I suppose they mean that a capital tax increase that is permanently surprising can never be planned for in advance, and so no one has the chance to rearrange their affairs to minimize the tax burden.
But I don't know how you'd make tax increases permanently surprising. People catch on quick to a pattern of raising taxes, financially, if not politically.
Feb '11
Re: Do Conservatives Understand the Laffer Curve?
Valiuth: Right so if the curve is always shifting then all tax rates could be a crap shoot. This though would argue for having a much simpler tax system with very few exceptions, as it would make it easier for the government to know where on the Laffer Curve its taxes fall.
I would also like to ask if we are certain that the Laffer Curve has only one peak? It could be more complicated where there are local peaks in certain ranges but maybe only one overall maximum. This would create really confusing situations, where one tax cut generated revenue, but a further tax cut just lost us revenue. · 9 minutes ago
I'm always impressed by how much the economy is like ecosystems and modeling ecosystems you more often than not have multiple viable equilibria. I think I would be surprised if the economy were not in a situation very close to how you describe it in the second paragraph: Multiple local optima.
Oct '10
Re: Do Conservatives Understand the Laffer Curve?
Misthiocracy
Note that I wrote bestavailablemethodology.
I will now define that to mean available to mylittle brain, at this particular moment, and at my currentparticular blood-alcohol level. · 2 hours ago
What is the optimum blood-alcohol level for your brain-size, Misth? As charted on a Laugher Curve.
Dec '10
Re: Do Conservatives Understand the Laffer Curve?
The Laffer Curve is illustrative of human nature. I’m reminded me of what my Accountant always says concerning tax deductions: “Pigs get fed and hogs get slaughtered.” It is when the Government vacillates between being a pig and a hog that sends the tax lobbyists to Washington to create loopholes or leads average people to dump tea into the Boston harbor.
The staying power and impact (the Reagan tax cuts, etc.) of this simple napkin drawing is pretty amazing. We are still talking about it and many of us have never even studied the data. Even more interesting are the cast of characters present in that bar with Dr. Laffer when he drew this drawing.
May '10
Re: Do Conservatives Understand the Laffer Curve?
Midget Faded Rattlesnake
Well, since different forms of taxation create differing incentives, the best model may not be a curve at all, but a surface with more dimensions, such as this pretty-looking Laffer hill in two dimensions:
Be still, my beating heart.
Apr '11
Re: Do Conservatives Understand the Laffer Curve?
Midget Faded Rattlesnake
They say, for instance, that a "permanent surprise increase" in capital taxes always increases revenue, by which I suppose they mean that a capital tax increase that is permanently surprising can never be planned for in advance, and so no one has the chance to rearrange their affairs to minimize the tax burden.
But I don't know how you'd make tax increases permanently surprising. People catch on quick to a pattern of raising taxes, financially, if not politically. · 2 minutes ago
Well one way may be to have a tax policy that is due to change every 2 years and only gets settled 5 hours before the dead line. I mean dose anyone know what the tax rates will be in 3 years? I don't. Maybe this is showing Obama's inadvertent brilliance.
Edited on March 23, 2012 at 9:26pmMar '12
Re: Do Conservatives Understand the Laffer Curve?
Either the curve is generated by an equation or the data points on the graph are used to draw the curve.
If the former, we need to know what variables are used and the values they are set to and what constants constants are used. My guess is that any equation is highly complex and the assumptions made are highly subjective. Kind of like the Global Warming graphs.
If the data points are used, are we comparing apples to oranges. Norway, Italy and the US have different economic and cultural systems. Can we make a valid comparison?
Bottom line, any Laffer curve is most likely highly subjective and useful more for political talking points than for accurately determining optimal tax rates.
Oct '10
Re: Do Conservatives Understand the Laffer Curve?
Valiuth
.... I always liked the idea of 10%. · 30 minutes ago
So does God, coincidentally.
Jun '10
Re: Do Conservatives Understand the Laffer Curve?
Relying mainly on income tax revenue is inherently a crap shoot. This is a major problem here in California where the state relies on income taxes for a larger percentage of the budget than most other states. Incomes vary a lot from year to year with the economy, so when the economy booms state revenue shoots up and the fools in Sacramento quickly spend away the surplus. Then when the next recession hits state revenues plummet and we face yet another entirely predictable budget crisis.
Aug '10
Re: Do Conservatives Understand the Laffer Curve?
Severely Ltd.
Misthiocracy: Note that I wrote best available methodology.
I will now define that to mean available to mylittle brain, at this particular moment, and at my currentparticular blood-alcohol level.
Whatisthe optimum blood-alcohol level for your brain-size, Misth? As charted on a Laugher Curve.
As mentioned in many previous posts, it depends entirely on where you are on the graph, what assumptions you make, and how you define "optimal".
If I plan to get behind the wheel of a car in the near future, then clearly the answer is "below 0.08%".
However, the answer will be different if our goal is:
In short, the variables are so numerous that one can only even attempt to measure them at a quantum level.
(I repeat, the correct short-form is Misthios.)
Apr '11
Re: Do Conservatives Understand the Laffer Curve?
Joseph Stanko
Relying mainly on income tax revenue is inherently a crap shoot. This is a major problem here in California where the state relies on income taxes for a larger percentage of the budget than most other states. Incomes vary a lot from year to year with the economy, so when the economy booms state revenue shoots up and the fools in Sacramento quickly spend away the surplus. Then when the next recession hits state revenues plummet and we face yet another entirely predictable budget crisis. · 8 minutes ago
I thought that was the problem not of income tax but a highly progressive income tax. Since the rich have some of the most variable incomes in the population and their yearly earning are greatly effected by the markets because of their reliance on investing. A broad regressive income tax I thought was very stable.
Aug '10
Re: Do Conservatives Understand the Laffer Curve?
When conservatives try to reduce something as complex as the economy down to a simple curve, they are engaging in the same fallacy that Keynesians engage in when they reduce the myriad complexities of production down into simple aggregates.
The economy is a complex adaptive system. How it will respond to a tax cut today may not be the same as how it responds tomorrow. We do not have a good understanding of all the dependencies and variables that affect the response of the economy to tax changes.
As for the Laffer curve itself, it really needs a time dimension to be understood. If the mechanism for revenue growth is a supply-side stimulus caused by lower taxes, then it takes time for that stimulus to result in increased GDP and therefore increased revenue. In the meantime, you're likely to take a short-term revenue hit.
When Bush reduced taxes in 2001, revenue dropped by 300 billion dollars. It did not recover to its pre-tax cut level until the middle of 2003. As a percentage of GDP, it took even longer - until the middle of 2005.
Aug '10
Re: Do Conservatives Understand the Laffer Curve?
Continuing... You also have to consider the effect of the monstrous deficit. If you hold spending constant, then cutting taxes will, in the short term, cause an increase in the deficit. In times when the deficit was small and manageable and real fiscal crises were in the distant future, an increase in the deficit might not have a large negative effect on growth. Today, the story is completely different. There is evidence that the economy is now responding to deficit increases as if they were tax increases. If that's the case, then cutting taxes further might just drive up the deficit, which will then inhibit the growth you thought you were going to get from the stimulative effect of the tax cut. The result would be that all you've done is defer taxes into the future, which is not a particularly conservative way to govern.
Finally, I totally reject the 'starve the beast' argument. I used to believe in it, but I don't know how anyone can still buy into that argument in an era when the government is borrowing more than 40% of all the money it spends. It has an endless appetite.