The Laffer Curve and New Evidence that Taxes Stifle Economic Output
Many people may remember Christina Romer, who was the chair of President Obama’s Council of Economic Advisors from January 2009 to September 2010. She is currently an economics professor at University of California Berkeley.
Approximately three months before she left the Council of Economic Advisors, the American Economic Review– a journal which many people consider the most prestigious peer-reviewed journal in economics – published an article that she co-wrote with her husband David Romer, also an economics professor at UC Berkeley. The article, “The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks,” is in my view one of the most important economic articles of the last several years.
The Romers examined the effects of tax policy on GDP. They found that the effects are very large. Specifically, they found that for every 1% that taxes rise (as a percent of GDP), this causes GDP to fall about 3%. The authors employed some clever methods to try to find what economists call “exogenous” changes in tax rates. When they employed their methods, they found much higher effects than economists had previously found.
The article was something of a Nixon-goes-to-China phenomenon. That is, while conservatives tend to claim that taxes strongly decrease GDP, liberals tend to claim that taxes have at best a weak influence on GDP. When the Romer-Romer article reported a strong influence, one of the most interesting aspects of the finding was that it came from a very liberal quarter – namely, one of its authors was a senior member of the Obama administration.
The article, in my view, should have been big news. However, it’s now been two years since it was published, and I am aware of no mainstream news outlet that has mentioned it.
This is especially surprising given its implications for the Laffer Curve. Specifically, the Laffer Curve specifies that there exists a “hump” tax rate – a rate that maximizes revenue to the government, and if the government raises taxes above the hump rate, then its revenue actually decreases.
Academic economists generally agree that the hump rate is very high, something like 70%. However, although Romer-Romer article did not explicitly discuss the Laffer Curve, its results imply that the hump rate is much lower, something like 33%.
To see this consider the following example. Suppose a country’s GDP is $100 billion, and suppose its tax rate is 33%. Then its tax revenue will be 33% of $100 billion, or $33 billion. Now suppose it raises taxes to 34%. If the Romer-Romer result is accurate, then this will decrease GDP by 3% to $97 billion. Tax revenue will be 34% of $97 billion, or $32.98 billion. Note that this is slightly less than the revenue at the 33% rate. If you experiment with other tax rates, you’ll see that revenue is maximized when the tax rate is 33 1/3 %. Moreover, as the tax rate increases to rates higher and higher than 33 1/3 %, government revenue becomes smaller and smaller.
(Alternatively, one can show the above points more rigorously with calculus. Namely, let Y(t) be the GDP of a country, which is a function of t, the tax rate it chooses. Romer and Romer show that if a country increases its tax rate by 1%, then GDP falls by 3%. That is, the decrease in GDP, dY, is approximately .03 Y(t). Note that .03 is 3 times the change in the tax rate, .01. Thus, when we define dt as the change in the tax rate, the Romer-Romer finding suggests that dY = -3*dt*Y(t). Thus, the derivative of Y with respect to t, dY/dt, is -3Y(t).
Note that total revenue for the government is t*Y(t). To maximize revenue, we take the derivative with respect to t and set the result equal to zero. I.e. we want t to satisfy the following: t*dY/dt + Y(t) = 0. Now let us substitute the above expression for dY/dt. We get t[-3Y(t)] +Y(t) =0. Once we divide both sides of the latter equation by Y(t), we get -3t+1 = 0. Some algebra shows the solution to the latter equation is t=1/3. I.e. the tax rate that maximizes revenue is 33%.)
U.S. taxes are generally below 33%. For instance, the total amount of federal taxes is about 17 or 18% of GDP. If you add in state and local taxes, this raises the percentage to something in the low twenties, but still significantly below 33%.
However, the Romer-Romer result likely applies not just to the entire U.S. economy, but also to subsets of it – such as the subset of very rich taxpayers. They currently face a top federal income tax rate of 35%. And if you add in their state and local taxes, their rate reaches the high thirties, and the low forties in some states. The Romer-Romer result suggests that they are above the hump rate. If we increase their tax rates—as President Obama says he plans to do—then the government would actually receive less revenue. President Obama claims that he can reduce the deficit by making the rich pay their “fair share” of taxes. However, the Romer-Romer result suggests the opposite might happen – the deficit might actually increase.
As I mentioned, all this should be big news with the U.S. media, but it has not been. Although I suspect that the reason is that liberal journalists want to squelch the Romer-Romer results and hide them from the public, perhaps the true reason is more innocent: Perhaps U.S. journalists simply never learned about the Romer-Romer results.
If so, over the next several days, we will get to observe something akin to an experiment. On Monday, Prager University will post a new five-minute video to its web site describing many of the above findings. In addition, Glenn Beck’s web site, “The Blaze,” is scheduled to publish an article about these results, and the Daily Caller is scheduled to publish an op-ed by me describing the results.
Perhaps the latter outlets, in addition to this Ricochet post, will help spread the word about the importance of the Romer-Romer result. I suspect that it will but only to a small group of conservative intellectuals.
On the other hand, maybe word will spread more widely, and the Romer-Romer result will receive the attention it deserves. I will be watching with much interest.
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Sep '10
Re: The Laffer Curve and New Evidence that Taxes Stifle Economic Output
Could we add to that, tax revenues to GDP regardless of tax rate fall at or around 19% of GDP?
Apr '12
Re: The Laffer Curve and New Evidence that Taxes Stifle Economic Output
Most high income people pay lower rates than middle/upper middle income people. That's why the buffet rule has such appeal. Mitt claims to have paid at least 13 percent , a long way from laffer curve influence.
Oct '10
Re: The Laffer Curve and New Evidence that Taxes Stifle Economic Output
What has taxation got to do with revenue. Its purpose is to manage behavior. We are awash in money. We can get all we need by mortgaging our future in bonds. Taxation is now superfluous to spending, and by any measure not very important to the financial equation.
But, as Maggie the Great said; Socialism will collapse as soon as they run out of other people's money.
The major difference between the US and Greece is order of magnitude, and an historic reputation for fiscal honesty. How long before that cow runs dry?
Apr '12
Re: The Laffer Curve and New Evidence that Taxes Stifle Economic Output
I disagree raycom, It's not spending per se that is the main problem. It's spending what you don't have that caused the Greece fiasco and will eventually cause financial issues in the u.s. If it continues.
Sep '10
Re: The Laffer Curve and New Evidence that Taxes Stifle Economic Output
Much as I would like to agree with the conclusions, one important distinction is glossed over:
This simple analysis only works when there is a perfectly flat tax with no deductions or exemptions. Beyond this, I question whether the curve is necessarily constant over time. The location of the maximum likely changes as a society becomes wealthier: the less you have, the more painful a 33% rate is. We have, on the average, become significantly wealthier over the last 30 years. The curve may also have hysteresis; the shape might depend on whether the tax rate is rising or falling. I suspect it does.
One last concern: if this applies to effective federal tax rates, aren't we below 33%? If so, then isn't this an argument for raising taxes?
I'm sure these thoughts aren't original, but they deserve responses.
Dec '11
Re: The Laffer Curve and New Evidence that Taxes Stifle Economic Output
The importance of the "tax as percentage of GDP" is that it gets at the layering of taxes. ( This is like fat within the muscle tissue, not just under the skin. ) It demonstrates the drag affect of taxes as a cumulation of millions of transactions. Converting that to the expected behavior of any individual taxpayer is problematic. The question is when is a taxpayer group large enough that a "hump" can be calculated for that group alone?
The argument against raising taxes is that taxpayers have feet. The GDP measurement reflects that the country as a whole does not have feet. Similarly individual taxpayers only have feet if, considering all other factors, they have someplace to go.
May '12
Re: The Laffer Curve and New Evidence that Taxes Stifle Economic Output
Great post.
I think the idea that taxes are below 33% should be re-visited. Federal rates are below that, but add on state income taxes, sales tax, property tax, utility/communication/fees, gasoline taxes, assorted fees and levies and the ultimate tax rate is probably north of 50% depending on where you live.
Academics do agree that the hump point in the Laffer curve is high, but those of us in the real world earning a living know that it is much lower.
Sep '10
Re: The Laffer Curve and New Evidence that Taxes Stifle Economic Output
The weak link in the argument is the extrapolation of effective rate to marginal rates for individuals at various income levels. Though I'm no friend of 'progressive' tax rates, I do recognize that the more you have the less of a sacrifice a 33% rate is. Taxes are like a luxury good, except that they're compulsory.
To make this case, you'd have to analyze the effect of marginal tax rates on taxpayers in various brackets. I'd be surprised if this hasn't already been done. Mr. Groseclose, what is the state of knowledge about this?
Edit: The argument also presupposes that the only reason people work is for money. If you like your work, you'd be inclined to work more at a higher marginal tax rate than a person who hates his job. As jobs have become less arduous and more satisfying, the hump of the curve shifts up. In short, the disutility of work is not constant.
Edited on September 9, 2012 at 7:20pmJul '11
Re: The Laffer Curve and New Evidence that Taxes Stifle Economic Output
The purpose of government is not to maximize its tax revenues. The purpose of government is to maximize the prosperity of its citizens.
Sep '10
Re: The Laffer Curve and New Evidence that Taxes Stifle Economic Output
Agreed. The Laffer Curve argument is a pragmatic, not a moral one. The economic conservative view is better served by moral defenses of capitalism.
May '11
Re: The Laffer Curve and New Evidence that Taxes Stifle Economic Output
"As I mentioned, all this should be big news with the U.S. media, but it has not been. Although I suspect that the reason is that liberal journalists want to squelch the Romer-Romer results and hide them from the public, perhaps the true reason is more innocent: Perhaps U.S. journalists simply never learned about the Romer-Romer results."
Perhaps the true reason is more innocent yet. Perhaps U.S. journalists simply never learned about economics.
May '11
Re: The Laffer Curve and New Evidence that Taxes Stifle Economic Output
Seriously? On what planet? Only high income people who are also retired and living on capital gains off their savings pay lower rates. Of course, they already paid top rates on that money when they saved it in the first place.
Oct '10
Re: The Laffer Curve and New Evidence that Taxes Stifle Economic Output
On what basis do we disagree????
Jun '12
Re: The Laffer Curve and New Evidence that Taxes Stifle Economic Output
I think the idea that taxes are below 33% should be re-visited. Federal rates are below that, but add on state income taxes, sales tax, property tax, utility/communication/fees, gasoline taxes, assorted fees and levies and the ultimate tax rate is probably north of 50% depending on where you live.
The ancient Israelites set the tax rate (tithe) at 10%. Recent surveys (Reader’s Digest) say that the maximum rate should be 25% in all (Federal, State, and Local) taxes. Even at 19%, Fed taxes are still too high. To get to an average 19% in a progressive system, the upper marginal rate needs to be at least 33% with a base rate near 12%, which is close to the present social security (both halves) tax. Until Fed spending gets below 15%, you cannot approach a fair tax system.
Aug '10
Re: The Laffer Curve and New Evidence that Taxes Stifle Economic Output
drlorentz: Much as I would like to agree with the conclusions, one important distinction is glossed over:
This seems to be focusing purely on incentive effects, but there's another big effect of higher taxes - a diversion of capital from private sources to public. This has nothing to do with marginal rate increases. If you assume that the private market is a more efficient allocator of funds than is the government, then every additional dollar taxed out of the private economy and spent in the public sector will reduce economic growth.
Aug '10
Re: The Laffer Curve and New Evidence that Taxes Stifle Economic Output
Thanks for posting this, Tim. I've been blogging and posting about this paper since it came out, and can't seem to get many people to pay attention to it. We need more voices out there pushing this - especially since the effects were so large, and the conclusions were described as being extremely robust.
There's another aspect to this paper worth calling attention to - Romer and Romer found one exception to the growth-reducing effect of taxes - the effect vanished when the taxes were used to pay down the debt. The implication here is that additional debt has roughly the same effect on the economy now as does a tax increase of equivalent size.
This is devastating to Keynesian economics, at least in high debt situations, as it means that borrowing money to apply fiscal stimulus will have no effect because any positive effect from the spending will be offset by the anti-stimulative effect of the higher debt.
Aug '10
Re: The Laffer Curve and New Evidence that Taxes Stifle Economic Output
Another paper that should be more widely exposed is the Rogoff/Reinhardt paper Growth in a Time of Debt.
From the paper:
U.S. debt is now over this 90% threshold, and therefore the debt itself partially explains the low growth the U.S. currently finds itself in.
This paper makes total sense, and complements the Romer/Romer paper if you consider what's really going on: When the cost of repaying the debt is so far in the future that it's outside the planning window of business, additional debt would have little effect. But if businesses come to believe that the debt levels are unsustainable within the planning window, then that debt will start to be priced into business decisions. i.e. it will be seen as an upcoming tax increase, and will therefore affect behavior today.
Both papers suggest Keynesian stimulus will not work at this time.
May '10
Re: The Laffer Curve and New Evidence that Taxes Stifle Economic Output
This argument is laced with with one part arrogance and one part cognitive dissidence. When advocating higher taxes for gasoline liberals acknowledge high taxes discourage economic activity. Yet they believe taxing business and hiring will not have a deleterious effect.
The arrogance comes in when when people say, "Well, if I made that much money I certainly wouldn't mind paying more." What bunkum! What you make and what your obligations are can be two different things. Closing that gap is what counts and no one should have the right to pronounce "fairness" on another individual's life.
Edited on September 9, 2012 at 10:38pmSep '10
Re: The Laffer Curve and New Evidence that Taxes Stifle Economic Output
Dan Hanson
This seems to be focusing purely on incentive effects, but there's another big effect of higher taxes - a diversion of capital from private sources to public. This has nothing to do with marginal rate increases. If you assume that the private market is a more efficient allocator of funds than is the government, then every additional dollar taxed out of the private economy and spent in the public sector will reduce economic growth. · 20 minutes ago
Good point. However, the Laffer Curve argument does revolve around incentives:
Mr. Groseclose can correct me if I'm wrong, but I think this is what economists have in mind when they discuss the Laffer Curve.
Apr '11
Re: The Laffer Curve and New Evidence that Taxes Stifle Economic Output
Liberal response: Are you attempting to confuse us with facts?