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.