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The Laffer Curve: Myths and Realities
Posted by: Dale Franks on Thursday, October 18, 2007

Looking over the comments in Jon's post below, there seems to be some misinterpretation of the Laffer Curve on the part of some. Although I learned long ago that econ posts tend not to draw any great interest, and though I've written on this several times before (and am too lazy to look up the specific links at the moment), I'll give it another shot.

The curve itself is pretty simple, and there's hardly an economist in the world that doesn't believe that the Laffer Curve, or something quite like it, doesn't exist.

Generally stated, the point of the Curve is that there are two rates—with one exception—at which the government collects the same revenue. In the example above, at both Point A and Point B, the government collects the same revenue. Point C is the single exception, in that, at Point C, you have the rate at which revenues are maximized.

If the rate is higher than the rate at Point C, then you are said to be on the right sid of the curve. If the rate is less than the rte at point C, you are on the left side of the Curve.

If tax rates are on the right side of the curve, a decrease in rates will cause both economic output and revenue to rise. An increase in rates will result in a decrease in both output and revenue.

If tax rates are on the left side of the curve, an increase in rates will result in an increase in revenues, but a drop in production. A decrease in rates will result in an increase in production, but a decrease in revenues.

Some important factors to keep in mind:
1. There are no specific rates on the Laffer Curve, other than 0% and 100%. The rates at Points A, B, and C are notional, not fixed with any precision.
2. The variations between production and revenues as rates change are not symmetrical.
3. The curve itself is not symmetrical. Since all of the rates between 0% and 100% are notional, the curve itself is not symmetrical. the shape of the curve will change according to the wishes of the electorate. In general, however, there is ample reason to assume that Point C resides much closer to 0% than it does to 100%
4. Jude Wanninski, in his book, The Way the World Works—the book that essentially served as the underpinnings for the "Reagan Revolution"—defines Point C as "the rate at which the electorate desires to be taxed. (p.98)" This rate will change—often quite quickly—with circumstances, which leads Wanninski to conclude, that "it is the task of the political leader to determine point [C] and to follow it through its variations as closely as possible." (pp.98-99)
5. There may not, in fact, be a "Point" C. C may in fact be a range of tax rates at which the electorate will not object. That implies that changes to tax rates within this range will not have any measurable effect on incentives or output.
So, with this in mind, let us turn to some of the comments.
The Curve doesn’t preclude other factors on revenue. So revenues changing in absence of a tax cut is not disproof of the Laffer curve and "GOP" popular thought.

A handful of times that it has been tried to stimulate an economy its appeared to work. Its possible its a coincidence because there are multiple factors, but the empirical evidence is growing. All to slowly though.
The Curve, in fact, doesn't address other factors, nor is it meant to. Where the Curve has worked, is at points in history where high tax rates were lowered dramatically. For instance, the tax cuts implemented in the Harding Administration after WWI, the Kennedy tax cuts of the early 1960s, and the Reagan tax cuts of the 1980s.

At smaller increments, the record is, at best mixed. During the Clinton Administration, the top tax rate was increased from 28% to 36%, which was followed by an economic boom, despite all the negative predictions of the doomsayers.

Again, I would refer you to factor #4, above. My memory of the time is that a majority of the population responded to polls that taxes needed to be increased to get away from the \$400 billion deficits of the Bush 1 years. That implies a shifting of Point C to the right due to fiscal concerns. Whether the electorate was correct in thinking tht is immaterial. Point C is a reflection of the electorates desires, right or wrong.

At very small tax changes when the rates are already in the neighborhood of Point C, it is difficult, if not impossible, o bifurcate out the results of tax rate changes from other economic factors, such as productivity increases. Moreover, it is probably not possible to tell, with any certainty, whether you are a) on the right or left side of the Curve, or b) to predict whether the wishes of the electorate will shift Point C to the left or right of the new, incremental change in tax rates. Since point C is merely a reflection of changing wishes among the electorate, the effects of small incremental changes around it are not amenable to definitive predictions.

Also, the fact that "revenues changing in absence of a tax cut is not disproof of the Laffer curve and "GOP" popular thought", then it also cannot be used as proof of the contrary. If you are already conceding that other factors may impact revenues, then you are left, really, without a point.
...spiked a book review because I said that the Laffer Curve didn’t apply at American levels of taxation,
What does he mean the Laffer Curve doesn’t apply?

It always applies, regardless of which side of the inflextion point you are on. Increasing taxes always results in diminishing returns (assuming all else is equal).

If I was an editor and someone wrote that Laffer didn’t apply to tax cuts, I’d probably drop his piece too.
I think there's more than enough imprecision of language on both sides here, although, the commenter seems to willfully ignore what the actual quote represents.

What Ms. McArdle was saying is that, at current levels of taxation in the United States, it is incorrectly dogmatic to assume that a reduction in tax rates will result in an increase in revenues. Her argument is, essentially, that we are already at Point C (or the range of tax rates that make up Point C) or to the left of it, so further reductions in taxes will not result in an increase in revenues. If her her argument is correct, then she is correctly interpreting the Laffer Curve. Her problem is that Conservatives don't want to believe that we are already at Point C or to the left of it.

As for the commenter, the actual argument is difficult to trace. What does "Increasing taxes always results in diminishing returns", mean? The briefest glance at the Laffer Curve disproves this, if by "returns" you are referring to tax revenues, since, at all points on the left of Point C, increases in taxes do, in fact, result in an increase in revenues.

If the commenter is referring to economic output, well, he's not really correct either. At least not in any measurable way. If tax rates were at 1%, and were increased to 2%, would that result in a decrease in output? I suppose it's theoretically possible, but I have no idea how such a change in output could even be measured.

By the same token, I suspect the economic effect of reductions of tax rates below a certain point would be similarly immune to measurement. At the end of the day, at any given point in time, there are only X number of workers, and Y hours it is physically possible to work. At some point, tax rates are low enough that workers would prefer to spend time with their families, or at leisure, rather than working, no matter how low tax rates got. Even if they didn't, it simply wouldn't be physically possible to work more than Y hours. If they are already working Y hours at tax rate X, reducing tax rates to rate Z will not result in an increase in output. Again, I refer you to factor #2, above.

What is theoretically true is a useful framework for thinking about the issue. It is not, however, true in that it is what people actually do, hence, the fundamental difficulty of economics as a whole.
No, increased taxation has diminishing returns. Always, that’s the point of the Laffer Curve.

For example, if you are currently taxed at 1% and we doulbe [sic] it to 2%, the tax revenue will increase but it will not double, assuming we are on the left side of the peak.
Actually, that isn't the point of the Laffer Curve. The Laffer Curve measures tax rates and revenues. And it does that without making any suggestions about the actual rate of revenues to tax rates except in the most general of terms. It contains no hints that a rise in tax rates from 1% to 2% will double, or triple, or half. The shape of the curve is shown as a symmetrical parabola for purely instructive purposes. The actual shape of the curve is unknown. There are, except for the two tax rates on the horizontal scale, no known data points on the curve at all. Since this is so, it is impossible for the curve to make predictions about revenue increases except in the most general terms.

Moreover, I don't think that you can assume that the economy is that sensitive to tax rates that a 1% change from a negligible rate to another negligible rate will result in a measurable difference from a doubling of revenues. At that point, you're really arguing about how many angels can dance on the head of a pin.

There is, after all, enough elasticity in human behavior that I think tax rate changes have to be gross enough to produce measurable changes in behavior, before output diminishes in response. I don't think you can assume a linear response to minor changes, but rather a stepped response to certain threshold changes.
I always thought the peak was somewhere around 15-25%, but I guess now I’m learning from Jon and Megan it’s more like 50 or 60% to maximize revenues?
I'm not sure how you came up with that. It might be fair to say that, in peacetime, we historically can see that Point C appears to be somewhere between a range of a 20%-25% effective tax rate, i.e., the proportion of income people actually pay. Whatever the statutory rate may be, it is the rate that people actually pay that affects their behavior.

According to the CBO, the current Federal effective tax rate runs about 22%, putting us inside the range where Point C has historically hovered. If so, then Ms. McArdle would appear to be substantially correct.

Recent history also provides some evidence, in that, during the Clinton Administration, effective tax rates increased from 21.5% to a high of 23%, during which time we experienced an extraordinarily long economic boom, and saw revenue increases substantially larger than even the Reagan ones.

Again, this supports the argument that we simply aren't on the right side of the Laffer Curve.

One commenter posted an article from Cal Thomas about the Irish economic rebound from tax cuts at the end of the 1990s, and asked:
How can their experience be so similar to our own if Supply side doesn’t work, Jon?
The answer, of course, is that, in the 1990s, Irish politicians—and the Irish public—tired of the confiscatory tax rates imposed under Fenian socialism, and implemented massive tax cuts. No one, including Jon, is arguing that couldn't happen.

What is being argued is that, in the US, having already gone through 2 rounds of Irish-style tax cuts in the 1960s and 1980s, further minor tax cutting will simply not have an outsized effect on the economy, or result in vastly increased revenues, or any increases in revenues at all. We've already had the benefits of Irish tax cuts. Twice.

So, what you're really asking is, "Since Ireland cut their effective tax rates from 50% to 20% and had an economic boom and massive budget surplus, why won't the same thing happen here by cutting effective rates from 22% to 20.8%?" The answer is, I think quite obvious.

The trouble with the Supply-Siders isn't that they believe the Laffer Curve exists. It is that they perennially believe that we are on the right side of it, despite evidence to the contrary.