The Laffer Curve Revisited — What It States, What It Doesn’t State, And It’s Implications With Some Examples

 

image

Given a recent discussion on the Laffer curve, I thought it worthwhile to give another primer on the subject.  Apparently, there is great confusion as to what the thought behind this premise actually states.  For some reason, lefties from around the world seem to think they can debunk it.  They can’t.  The Laffer curve is simply an iteration of what people have known since taxes were first imposed.  Indeed, Art Laffer, for whom the curve is named clearly states he didn’t invent the curve.  If we want to know what the Laffer curve is about, let’s go to the source.  He offers a couple of quotes from previous economists.  One of which may surprise people……  (bold is mine)

The Laffer Curve, by the way, was not invented by me. For example, Ibn Khaldun, a 14th century Muslim philosopher, wrote in his work The Muqaddimah: “It should be known that at the beginning of the dynasty, taxation yields a large revenue from small assessments. At the end of the dynasty, taxation yields a small revenue from large assessments.”

A more recent version (of incredible clarity) was written by John Maynard Keynes:

When, on the contrary, I show, a little elaborately, as in the ensuing chapter, that to create wealth will increase the national income and that a large proportion of any increase in the national income will accrue to an Exchequer, amongst whose largest outgoings is the payment of incomes to those who are unemployed and whose receipts are a proportion of the incomes of those who are occupied…

Nor should the argument seem strange that taxation may be so high as to defeat its object, and that, given sufficient time to gather the fruits, a reduction of taxation will run a better chance than an increase of balancing the budget. For to take the opposite view today is to resemble a manufacturer who, running at a loss, decides to raise his price, and when his declining sales increase the loss, wrapping himself in the rectitude of plain arithmetic, decides that prudence requires him to raise the price still more–and who, when at last his account is balanced with nought on both sides, is still found righteously declaring that it would have been the act of a gambler to reduce the price when you were already making a loss.2

Laffer gives us a simple and basic explanation of the curve…….

Theory Basics

The basic idea behind the relationship between tax rates and tax revenues is that changes in tax rates have two effects on revenues: the arithmetic effect and the economic effect. The arithmetic effect is simply that if tax rates are lowered, tax revenues (per dollar of tax base) will be lowered by the amount of the decrease in the rate. The reverse is true for an increase in tax rates. The economic effect, however, recognizes the positive impact that lower tax rates have on work, output, and employment–and thereby the tax base–by providing incentives to increase these activities. Raising tax rates has the opposite economic effect by penalizing participation in the taxed activities. The arithmetic effect always works in the opposite direction from the economic effect. Therefore, when the economic and the arithmetic effects of tax-rate changes are combined, the consequences of the change in tax rates on total tax revenues are no longer quite so obvious…….

At a tax rate of 0 percent, the government would collect no tax revenues, no matter how large the tax base. Likewise, at a tax rate of 100 percent, the government would also collect no tax revenues because no one would willingly work for an after-tax wage of zero (i.e., there would be no tax base). Between these two extremes there are two tax rates that will collect the same amount of revenue: a high tax rate on a small tax base and a low tax rate on a large tax base.

Okay, so far, so simples, right?  There is nothing controversial in what Laffer is stating.  And, none of this is hard to understand.  I’ll give a math example for further clarity.  Let’s say in one instance, total taxable monies equal $1trillion dollars, it is taxed at 30%, so the revenue realized is $300 billion.  (1,000,000,000,000 X 30% = 300,000,000,000)  In an other instance, total taxable monies equal $3 trillion but it is taxed at 10%.  So, the revenues realized is $300 billion.  So, we’ve established that the two points can exist.  We also note too burdensome taxation does, at some unknown point, affect behavior by limiting economic activity, and then the converse would also be true, that decreasing taxation, from some unknown point, would spur economic activity. 

What does the curve not say?  Pay attention here, because this seems to be the point of confusion for many.  I would remind people I’m quoting Art Laffer. 

The Laffer Curve itself does not say whether a tax cut will raise or lower revenues. Revenue responses to a tax rate change will depend upon the tax system in place, the time period being considered, the ease of movement into underground activities, the level of tax rates already in place, the prevalence of legal and accounting-driven tax loopholes, and the proclivities of the productive factors. If the existing tax rate is too high–in the “prohibitive range” shown above–then a tax-rate cut would result in increased tax revenues. The economic effect of the tax cut would outweigh the arithmetic effect of the tax cut.

Did everyone catch that?  A cut in the tax rates does not always increase revenues.  They have in some instances in the past because, the rates had become prohibitive to economic growth and revenue collection.  Laffer notes the responses to the tax cuts are dependent upon multiple variables.  I would go further and state that there is no exacting rate or rates to find.  That is to say, one can’t say the tax rate should be x for maximized growth or y for maximized revenue.  Time and government spending priorities preclude the ability to ever find exactly what taxes should be by using the thoughts behind the Laffer curve.  The rates would be dynamic dependent upon specific situations which all change with time.

I promised some examples.  In a couple of cases, we’ll examine what higher taxes do to economies in peril, and then we’ll revisit a favorite of mine and see what decreases in taxes can do for an economy and tax revenues!!!!

Much has been recently stated about Europe’s so called PIIGS.  These nations have economic problems which are doubled edged.  On one hand, their economies are in the tank, on the other hand, the governments have no more money.  They’re broke.  For years, they embraced deficit spending in order to prop up their economies, but, they ran out of ability to borrow.  So, even if they wanted to, they can no longer even try to spend their way out of their difficulties.  It was the spending which broke the respective governments.  And, we should note, the chronic deficit spending did not save their economies. 

For today, we’ll briefly examine Greece and Spain.  The dynamics of their problems are similar but not exactly the same.  Spain’s problems are more bank related and Greece has simply collapsed and is entirely dependent upon money from the ECB and the IMF.  Both countries have recently dropped their corporate tax rates, but, there was too few corporations to have made any immediate difference.  While they did drop the corporate tax rates, they’ve increased all else.  Here’s the recent tax increases from both, we’ll start with Spain…..

February 2010
…..The current 18% income tax rate on saving income would be raised to 19% for income up to EUR 6,000 and 21% for income exceeding this limit.
From 1.7.2010 the standard V.A.T. rate would be raised from the current 16% rate to 18%.

January 2012
Starting January 1, 2012 there is an additional 0.75%-7% tax which is imposed in additional to the regular progressive rates of 24% -45%.
The additional 0.75% tax is imposed on income of up to EUR 17,707 while the 7% tax is imposed on income exceeding EUR 300,000 resulting in a top marginal 52% rate compared to the previous 45% rate.
For saving income, e.g. interest and dividend, there is an additional 2%-6% tax which is added to the previous 19%/21% rates.  The new tax hike is a part of the Spanish austerity measures.

[edit note:  Tax hikes are not austerity, tax hikes are an effort for the government to continue it's largess.]

July 2012
The tax measures include increase of the V.A.T. rate from the current 18% rate to 21%.

Now Greece……..

January 2007
Individual income tax rates for 2007 are progressive, 15%, 29%, 39% and 40% fore income over EUR 75,001.

September 2008
Dividends paid by Greek companies, including payments to non-residents, will be subject to 10% tax withholding.
For individuals, self employed will have to pay 10% tax on the first EUR 19,500 income which is currently tax exempt.
The tax rate for the middle tax bracket would go down in the years 2010-2014, from 25% to 20%.
The finance ministry is also considering a 10% capital gain tax on sale of listed shares. Currently such gains are subject only to a flat 0.15% transaction tax.

March 2009
According to the new measures rich taxpayers will pay an additional tax levy according to their declared 2007 income.
The levy will be EUR 1,000 for income of EUR 60,000- EUR 80,000, EUR 2,000 for income of EUR 80,000- EUR 100,000, EUR 3,00 for income of EUR 100,000-EUR 150,000 and EUR 5,000 for income above EUR 150,000.


May 2010
VAT rate will increase from the current 21% rate to 23%.
In addition Greece will increase by 10% excise on alcohol, tobacco and fuel.

August 2010
The new standard V.A.T. rate is 23% compared to the previous 21% rate.The new reduced V.A.T. rates are 11% and 5.5%, compared to the previous 10% and 5%.

January 2011
Starting January 1, 2011 the reduced Greek V.A.T. rate increased by two per cent to 13%,replacing the previous 11% rate. The super reduced V.A.T. rate increased by one per cent, from the previous 5.5% rate to 6.5%.

source

So, what has been the response to these increases?  I’ll use the annual GDP growth rate for both.

image

image

source

In spite of massive infusion of capital from other sources, we see the very negative affects of the tax increases.  And, in spite of the tax increases, both nations remain broke. 

Now, for my favorite.  For reasons unknown, the left hates the prosperity the US had under the leadership of Reagan.  While it’s true he wasn’t perfect, he led this nation out of dismal economic conditions.  For those who didn’t live through it or those who have forgotten, when Reagan became president, we had high inflation, high interest rates, and high unemployment.  In fact, the inflation rate was so high that while the GDP was nominally growing, it wasn’t growing fast enough to keep pace with inflation. 

image

Again borrowing from Art Laffer……

The Reagan Tax Cuts

In August 1981, President Reagan signed into law the Economic Recovery Tax Act (ERTA, also known as the Kemp-Roth Tax Cut). The ERTA slashed marginal earned income tax rates by 25 percent across the board over a three-year period. The highest marginal tax rate on unearned income dropped to 50 percent from 70 percent (as a result of the Broadhead Amendment), and the tax rate on capital gains also fell immediately from 28 percent to 20 percent. Five percentage points of the 25 percent cut went into effect on October 1, 1981. An additional 10 percentage points of the cut then went into effect on July 1, 1982. The final 10 percentage points of the cut began on July 1, 1983.

Looking at the cumulative effects of the ERTA in terms of tax (calendar) years, the tax cut reduced tax rates by 1.25 percent through the entirety of 1981, 10 percent through 1982, 20 percent through 1983, and the full 25 percent through 1984.

Okay, so what happened to our GDP prior to 1984 and after 1984?

image

Or, to put it in easier view…….

image

source

So far, I’ve only concentrated on Laffer’s description of how taxes affect the economy, but, that’s only part of what he was stating.  The other part of what he was stating was it’s possible effects on government revenues.  To the point, that taxes were so high, that by lowering taxes we could see an increase in revenues.  Did this happen?

image

source

Wooooaaa!!!!  OMG!!!!  Look at the correlation between GDP growth and revenue growth after the tax cuts got implemented!!  Surprised smile  Surprised smile  Surprised smile

So let’s review the Reagan era.  When he took office we had high inflation, high interest rates, and high unemployment.  Inflation was so high that the gains to GDP and direct revenue to the government couldn’t keep up with what inflation was taking.  Inflation dropped to less than 1/3 of what it was.  Tax cuts got fully implemented in 1984.  Nominal GDP grew as well as direct revenue to the federal government.   Unemployment, BTW, was nearly halved by the time he left office from 9.7% in 1982 to 5.3% in 1988. 

For additional laughs for the Laffer haters, I’ll even throw in this favorite punching bag of the left.  BUSH TAX CUTS!!!  How much revenue did the Bush tax cuts cost?

image

Hard telling, federal revenues increased after the taxes were implemented.  Can anyone argue that the tax cuts didn’t spur growth and thereby increase the revenues? 

About these ads
This entry was posted in Economics. Bookmark the permalink.

14 Responses to The Laffer Curve Revisited — What It States, What It Doesn’t State, And It’s Implications With Some Examples

  1. DirkH says:

    The Muslim reference is great. Saw a talk given by a Turkish entrepreneur at a Mises.org convention a few days ago. He pointed out that Mohammed was amongst other things a merchant and that the longest Sura in the Quran describes how to write a proper wage contract.

    Muslims understood the importance of free trade (and their most effective warfare was piracy; destroying the trade in the Roman Empire which used the mediterranean as its transportation hub.)

  2. DirkH says:

    “For reasons unknown, the left hates the prosperity the US had under the leadership of Reagan. While it’s true he wasn’t perfect, he led this nation out of dismal economic conditions.”

    No; they hate that he killed the USSR, their utopia.

    • suyts says:

      There’s probably a lot to that. I still see some with butthurt about him calling the USSR the “evil empire”. :)

    • philjourdan says:

      You are probably accurate with that. But most of all, liberals hate Reagan because their propaganda wing had no effect on him. He spoke the truth, and when they tried to “politifact” him, he would just do an “Awe Shucks, there you go again” and destroy the libeler.

  3. Pingback: National Income Tax Turns 100, But No One Seems To Be Celebrating

  4. tckev says:

    The other great (and IMO as important) element that President Reagan changed, was to simplify the tax regime. ( http://en.wikipedia.org/wiki/Tax_Reform_Act_of_1986 )

    The tax system today is far too complex allowing the very wealthy, multinational companies, and the tax experts, to legally avoid much of their tax burden. Simplifying taxes, as Reagan did, would cut down on these loop-holes and allow proper rationalization, and reductions to the whole system. Currently the many tens of thousands of pages of tax law and this is testament to the lack of clarity and incorrect application of tax generally.
    Tax reformation and reduction must start with a rationalization.

    • suyts says:

      I agree. We do need our tax laws simplified. I was going to add that in there, but the post was already rather lengthy. It may be possible sometime in the future to extent the function of the Laffer curve to pinpoint some idealized tax rates, but that could only be possible if we had one tax, and one rate.

      • tckev says:

        Your explanation of the Laffer curve is excellent, and it should be better understood by everyone.
        I just think that with the federal tax code now over 70,000 pages, (was 400 pages long in 1913) something needs to be done.

      • suyts says:

        I think the laws are deliberately so, not just the tax laws. No one can say they fully understand them. It makes all of us criminals at the leisure of our government.

  5. Bruce says:

    I had to dig down more than a few posts to add this comment here, but the following article is so relevant its creepy:

    Greek Tax Hikes Backfire As Tax Revenues Plunge 16%

    the Greek Finance Ministry just reported that despite big tax hikes demanded as part of austerity measures by international lenders, tax revenues fell precipitously in January, with the Greek Finance Ministry reporting a 16 percent decrease from a year earlier, and a loss of 775 million euros, or $1.05 billion in one month.

    Looks to me that ordinary Greeks are so fed up that they are actively finding ways to not pay VAT or income tax, just so that the weenies in the Government don’t get the money. Fiscal guerilla warfare.

    And the left laffs at Laffer…LOL!

    • suyts says:

      Great find Bruce!! I was looking for something like that! Laffer having the last laughs at the left! :D

    • DirkH says:

      You could reduce tax rates to 1% in greece and they still wouldn’t pay. They see their state as prey for eons. Ancient Athens went broke because they built the Acropolis (it never got finished due to lack of finances).

      Before the Euro, the Greek state solved that problem by simply printing itself money.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s