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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Oct '10
Re: The Laffer Curve and New Evidence that Taxes Stifle Economic Output
I suspect Romer was making a Keynesian point. Remember that supply-side economics concerns itself with the growth rate of potential output, not GDP per se. One-time falls in GDP do not reduce potential growth in the future.
May '10
Re: The Laffer Curve and New Evidence that Taxes Stifle Economic Output
Are such 'impositions' as fees and sales taxes considered in these studies/calculations?
Sep '12
Re: The Laffer Curve and New Evidence that Taxes Stifle Economic Output
drlorentz: 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.
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· 4 hours ago
Edited 4 hours ago
A fair assertion. Bear in mind, however: Very few individuals willingly pay more than required by law - and the more you have, the more leeway in finding ways to shelter your earnings from rapacious taxation.
Sep '12
Re: The Laffer Curve and New Evidence that Taxes Stifle Economic Output
I perceive a fundamental difference between conservative and progressive economic theory.
Conservative economists observe the way systems actually function, and formulate theories to explain them.
Progressive economists visualize systems as they believe they should be, and formulate theories to arrive at the desired result. Human nature, however, invariably declines to cooperate with the the best-laid theories.
May '11
Re: The Laffer Curve and New Evidence that Taxes Stifle Economic Output
Nah, the liberal response is: "You are a stupid, racist Repugnantant who got all that stuff off of Faux News and say whatever the Koch brothers tell you to say." Trust me. I live in California.
May '10
Re: The Laffer Curve and New Evidence that Taxes Stifle Economic Output
The reason Mitt, et al, pay those lower rates is that the higher rates they would otherwise be exposed to create incentives for re-structuring your sources of income to avoid taxation. Lower the rates, such as a flat rate would do, and those incentives go away....and everyone pays their "fair" share.
May '10
Re: The Laffer Curve and New Evidence that Taxes Stifle Economic Output
Larry3435
Seriously? On what planet? Only high income people who are also retiredand 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.
Not true. That is why CEOs and other high earners get a large portion of their pay in the form of stock.
May '12
Re: The Laffer Curve and New Evidence that Taxes Stifle Economic Output
Dan Hanson: 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.
I thought I was the only one that cared about this. Very well written.
Sep '12
Re: The Laffer Curve and New Evidence that Taxes Stifle Economic Output
Tom Lindholtz
The reason Mitt, et al, pay those lower rates is that the higher rates they would otherwise be exposed to create incentives for re-structuring your sources of income to avoid taxation. Lower the rates, such as a flat rate would do, and those incentives go away....and everyone pays their "fair" share. · 1 hour ago
I could be wrong on this, but normal people make a living off selling their time and skills to make a living, i.e. middle class folk. Rich people do that to a very high degree, i.e. iBankers. But for people like Romney and Buffett, their wealth comes from asset value appreciation, which is taxed long term at 15%. I don't know what you could do to make them pay more without jacking up capital gains rates.
Capital is easily moved, which is why those rates are so low to begin with; and why labor rates are so high.
Sep '12
Re: The Laffer Curve and New Evidence that Taxes Stifle Economic Output
P.S. I really wish people would stop talking about the Laffer Curve. That model doesn't shed any light on anything.
There's a rate that maximizes output on the curve. It's true -- no doubt to that -- but that doesn't mean it's helpful in any meaningful way.
Aug '12
Re: The Laffer Curve and New Evidence that Taxes Stifle Economic Output
Is there any mention in the study the Romers performed that by reducing tax rates 1% you increase tax revenue 3%?
Sep '10
Re: The Laffer Curve and New Evidence that Taxes Stifle Economic Output
CoveredUp: P.S. I really wish people would stop talking about the Laffer Curve. That model doesn't shed any light on anything.
There's a rate that maximizes output on the curve. It's true -- no doubt to that -- but that doesn't mean it's helpful in any meaningful way. · 49 minutes ago
I think a fair number of economists would disagree with you about this. I understand that you might prefer that "people would stop talking about the Laffer Curve" because it is uncomfortable for you, but not because it is not "helpful in any meaningful way."
Your assertions are supported by neither facts nor arguments. If you have either of those to offer, I'd like to hear them. It would be best if the facts were integrated into a cogent argument.
Sep '10
Re: The Laffer Curve and New Evidence that Taxes Stifle Economic Output
CoveredUp
I could be wrong on this, but normal people make a living off selling their time and skills to make a living, i.e. middle class folk. Rich people do that to a very high degree, i.e. iBankers. But for people like Romney and Buffett, their wealth comes from asset value appreciation, which is taxed long term at 15%. I don't know what you could do to make them pay more without jacking up capital gains rates.
I'm not sure what your definition of normal is. Most people who acquired assets to invest did so by providing a useful product or service through their skills. Are retirees 'normal'? How about someone who built a business? (Yes, they built that.)
I don't think Mr. Buffett inherited his wealth; it came by dint of skill and effort, just like almost everyone else. Mr. Romney may have inherited some money, but he was hardly a trust fund baby. He undoubtedly brought his considerable skills to his work. If it were easy, anyone could do it. Evidently, it's not.
Sep '12
Re: The Laffer Curve and New Evidence that Taxes Stifle Economic Output
drlorentz,
"middle class folk", i.e. wage earners.
The point of my post was to point out why wealthy people's tax rates are lower than non-wealthy people's, and why it's going to stay that way.
Sep '10
Re: The Laffer Curve and New Evidence that Taxes Stifle Economic Output
CoveredUp: drlorentz,
"middle class folk", i.e. wage earners.
The point of my post was to point out why wealthy people's tax rates are lower than non-wealthy people's, and why it's going to stay that way.
By your reasoning, capital gains rates would always have been lower, yet this is manifestly false. The reasoning is simplistic. As Einstein once observed,
Edited on September 10, 2012 at 10:02amMay '10
Re: The Laffer Curve and New Evidence that Taxes Stifle Economic Output
This is an interesting theory, but one that even our Bold-Persistent-Experimenter-in-Chief is unlikely to put to the test. Haven't the Democrats been complaining that companies are sitting on large amounts of cash instead of investing it? Is there any chance that they will implement any policies that remove penalties from investing?
And why should they when Obama is ahead in the polls? Do the people of this nation even want a growing economy?
Rush Limbaugh has argued for years that the Democrats want to make as many people as possible dependent on the Government for their livelihoods. For this opinion, Rush is often derided as a partisan demagogue. But it should be up to the Democrats to prove otherwise.
Mr. Obama, if you seek a growing economy, if you seek prosperity in your second term and beyond, then unleash investors from fear of their profits being confiscated. Cut their taxes.
Oct '10
Re: The Laffer Curve and New Evidence that Taxes Stifle Economic Output
Tim - See reference to your article from Dave Henderson at Econlog, with an incoming link to Ricochet.
http://econlog.econlib.org/archives/2012/09/friday_night_vi_5.html