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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.

The Laffer Curve



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.
 
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Thanks for the re-cap. I like the econ posts.

A few questions or perhaps requests for clarification:

1. If a small tax cut is implemented that helps put off a recession, and keeps growth chugging along, doesn’t that still help increase revenues? I’m thinking of Bush’s tax cuts, here. Or is forestalling recessions not really included in the Laffer Curve, i.e. it’s based on ceteris paribus?

2. You’re saying Point C is "chosen" by the public and is not simply a technical maximum ala ways you can calculate the price and volume to maximize profits?

3. If so, what happens when there are different tax rates for different people? A theoretical 51% of the public that’s not paying any taxes could force up rates to a very high Point C, but since they are paid for by the 49%, wouldn’t they be hard to maximize?
 
Written By: Harun
URL: http://
The biggest flaw with the Laffer curve is that it IS only valid over short time periods. The tax rate changes future curves by affecting growth rates.

Anyway, the Laffer curves prove that libertarians should support massive tax increases- since they’ll lower government revenue. : P
 
Written By: MCprovost
URL: http://ethermind.blogspot.com
I’ll take a tact similar to some of Aldo’s posts in the last thread.

Setting aside where point C actually is, why should we target point C anyway?

For one, look at the corresponding private revenue curve that needs to exist. It would be a line that is essentially maximum near 0% taxes continuing to decrease until you reach 100% taxes.

When you add a downward sloping line to a curve with a maximum (point C), that maximum shifts Lower. So the optimum private+public revenue exists at a lower tax level than point C. And depending on the severity of the slope, point C could end up moving all the way to 0%.

For two, Big Government, seriously?

For three, if I even hinted at the idea of even modest protectionism or regulation (see point above), I’d think there would be plenty of folks going ape at the mere thought. One of the reasons is that you’re not suppose to interfere with the marketplace. When did taxes all of a sudden become stop being a source of interference?
 
Written By: jpm100
URL: http://
Thanks, Dale. I know you’ve talked about this before, but we live in an economically ignorant society and folks like me could always use a dose of precise language thrown into econ discussions to clarify things.

By the way, I’m pretty sure that this comment by Don
No, increased taxation has diminishing returns. Always, that’s the point of the Laffer Curve,
...was simply saying that the slope of the curve is always diminishing, i.e. the curve is concave down. That’s why I said that I had originally mistook his point - I thought he didn’t understand the shape of the curve, but the actual problem (as you note) is that he was missing what Megan McArdle was trying to say.
 
Written By: Wulf
URL: http://www.atlasblogged.com
Economic principles aside, it seems self-evident that if the government takes a larger share of the economy there is less available to grow the economy. That is unless you think that government spending somehow improves the economy.
 
Written By: Phil Underwood
URL: http://
It is that they perennially believe that we are on the right side of it, despite evidence to the contrary.
My problem with this statement is that I have never seen any "evidence to the contrary". I’m no economist, and have not undertaken to review the literature, but the so-called evidence that has been presented in this series of posts is non-sensical.

To me, saying an X% rise in revenue followed Reagan’s tax cut, while a Y% rise in revenue followed Clinton’s tax increase provide exactly ZERO evidence as to where on the Laffer curve we fell in those two instances.

The appropriate comparison in any given situation is the increase (or decrease, as appropriate) in revenue following the change in tax rates as compared to the amount of revenue that otherwise would have been produced had the tax rate change not occurred.

If someone says that there was an X% rise in revenue following Reagan’s tax cut, the appropriate question is: in the absence of Reagan’s tax cut we would have seen an A% rise in revenue - so what is the relationship of X to A?

Similarly, If someone says that there was an Y% rise in revenue following Clinton’s tax increase , the appropriate question is: in the absence of Clinton’s tax increase we would have seen an B% rise in revenue - so what is the relationship of Y to B?

However, to say, as has been said in these posts, "look at X and Y, this provides evidence that we are on the left side of the Laffer curve," is simply nonsensical.

My assumption is that we are on the left side of the curve. But thes so-called evidence presented in these posts do not provide any reason to believe that my assumption is correct.
 
Written By: A.S.
URL: http://
Nicely written, Dale. I have one nitpick:
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.
The boom was already starting before Clinton was even elected. The last negative growth GDP quarter before Clinton took office was 1991Q1. That means that the economy had been growing for 2 solid years before Clinton’s tax increase was enacted.

And, as A.S. pointed out, there would have been an increase in revenue with or without the tax increase.
 
Written By: Steverino
URL: http://
I have really enjoyed Dale’s and Jon’s posts on the laffer curve. Aside from the economic concept, which I believe cannot be disputed, one’s political views drives one’s interpretation of the curve and the perception of where we are at on the curve. In my view, small govt conservatives, big government onservatives, and liberals/progressives all view the curve differently. A small govt conservative is not trying to find point C where govt revenues and power are maximized. This individual would use the curve by first trying to determine the minimum amount of revenues govt needs to do its job and then trying to determine the tax rate that will yield that level of revenue. For example, if the amount of tax revenue is the level that corresponds with points A and B on the curve, the small govt conservative will strive to set the tax rate at point A. A small govt conservative who advocates further tax cuts is not overly concerned if we are on the left side of the curve because they have the view that fewer tax revenues will require govt to shrink or at least slow its growth rate. If we are on the right side of the curve and tax revenues increase from a tax cut, they will advocate still more tax cuts because they want us to be on the left side of the curve. A large govt conservative (which is what is in power today), seeks to set taxes to arrive at point C, in order to maximize govt revenues and to expand the role of govt. (albeit expanding govt spending in a far different manner than desired by liberals). A liberal/progressive is most likely to deny the existence of the curve, but to the extent that they do ackonowledge it, they would view us as being on the left side of the curve such that an increase in tax rates will yield higher tax revenues and thus enable them to implement govt programs that they want to implement. If we are, in fact, at point C, the liberal/progressive will still believe we are on the left side and want to raise taxes, because they would really like to spend more than C. And just like the small government conservative would err such that we are on the left side of the curve, the liberal/progressive would err such that we are on the right side of the curve - where govt controls a larger share of the economy.

As Dale pointed out, past events in the economy have been very dynamic and fluid with many other factors changing other than just tax rates and this masks the true effect of the tax cuts/increases at any point in time, not to mention there is likely a lagged effect on the economy from any change in tax rates.

One last thing on this last point form Jons’s post:

I’ll give the last word to Alan Viard, an economist who worked at the White House before joining AEI. Last year, the Washington Post quoted him: "Federal revenue is lower today than it would have been without the tax cuts. There’s really no dispute among economists about that."

This really reminds me of Al Gore claiming there is no dissent on global warming. This is even more preposterous when discussing economists. I find it hard to believe that it is impossible to find an economist who disputes the notion that revenue is lower today than it would have been without the tax cuts. I have never known economists to be in 100% agreement on anything.
 
Written By: Greg Abbott
URL: http://
1. If a small tax cut is implemented that helps put off a recession, and keeps growth chugging along, doesn’t that still help increase revenues? I’m thinking of Bush’s tax cuts, here. Or is forestalling recessions not really included in the Laffer Curve, i.e. it’s based on ceteris paribus?
The Laffer cure has no direct application to anything other than the relationship between tax rates and tax revenue.
2. You’re saying Point C is "chosen" by the public and is not simply a technical maximum ala ways you can calculate the price and volume to maximize profits?
That is correct. Point C changes according to the mood of the electorate.
If so, what happens when there are different tax rates for different people?
It complicates the anlysis. Wsually, you use a proxy such as the average effective tax rate to try and see what Point C is at a given time, based on a comparison to historical conditions.
To me, saying an X% rise in revenue followed Reagan’s tax cut, while a Y% rise in revenue followed Clinton’s tax increase provide exactly ZERO evidence as to where on the Laffer curve we fell in those two instances.

The appropriate comparison in any given situation is the increase (or decrease, as appropriate) in revenue following the change in tax rates as compared to the amount of revenue that otherwise would have been produced had the tax rate change not occurred.
Well, you’re correct, technically, but it’s immaterial to the case at hand. The claim being made in 1993 by Supply-Siders in re the Clinton tax increase was that output would be reduced along with tax revenues. I know that was the claim because I was talking to, among other people, Paul Craig Roberts every thursday on my radio show in LA. And the supply-siders, Larry Kudlow, Roger Robinson, et al. made the claim repeatedly.

They were completely wrong.

So, the evidence given is, in fact, a refutation of the claims Supply-siders were making at the time, and, are making now.

Moreover, your methodology is rather difficult to implement, in that it is essentially a comparison between two counter-factuals.
And, as A.S. pointed out, there would have been an increase in revenue with or without the tax increase.
Well, again, that wasn’t the claim Roger, Craig, et al. were making at the time. They were predicting a recession caused by the tax increases. That did not occur.
 
Written By: Dale Franks
URL: http://www.qando.net
A couple of things:

First, this is a very solid explanation of how the Laffer Curve works and how it doesn’t work. I’d like to add that even looking back at changes in marginal rates and average rates and receipts you still cannot say exactly where you were on the Curve. The Curve exists as a helpful conceptual model and is little help in actual forecasting. I haven’t seen any compelling case that it’s much help historically either. Why? Too many extraneous factors. The economy is simply too complex to attribute huge trends like growth or recession to any single factor.

Also, and this is just my own musing, but when we try to decide how people will respond to incentives, we kind of assume an average amount of effort required to produce X income, and we tend to measure it in hours. I suggest it might be a little more complicated given that at least I would be more likely to work another hour underwriting and allocating myself shares in startup dotcoms than, say, mining zinc. Even if both were equally lucrative per hour worked. FWTW.

Finally, the "really no dispute" quote the Lefties are passing around is next to meaningless and should be treated as such. Nobody’s claiming that tax cuts begin making up the revenue loss the very next year. Without knowing the time frame these economists are willing to guarantee that statement for, it means nothing. Long term economic growth is the goal anyway, not maximization of receipts.

 
Written By: spongeworthy
URL: http://
Well, you’re correct, technically, but it’s immaterial to the case at hand. The claim being made in 1993 by Supply-Siders in re the Clinton tax increase was that output would be reduced along with tax revenues. I know that was the claim because I was talking to, among other people, Paul Craig Roberts every thursday on my radio show in LA. And the supply-siders, Larry Kudlow, Roger Robinson, et al. made the claim repeatedly.

They were completely wrong.

So, the evidence given is, in fact, a refutation of the claims Supply-siders were making at the time, and, are making now.
The fact that Larry Kudlow made a claim in 1993 that was wrong is completely irrelevant to your claim that there is "evidence to the contrary" that we are on the right side of the Curve. As far as I can tell, there is no reputable evidence that we are on the left side of the Curve (although, as I said, I assume we are). The so-called evidence you have provided is nothing of the sort.

It is not Larry Kudlow’s statements I am disputing - I am disputing your statement.
Moreover, your methodology is rather difficult to implement, in that it is essentially a comparison between two counter-factuals.
So? I don’t think it is appropriate to say that, because evidence supporting an assertion is difficult to obtain, no evidence need be provided.
 
Written By: A.S.
URL: http://
Thing is, there is "evidence" that we are on the left side, but it isn’t even close to conclusive. I don’t want to horn in on anybody else’s argument here, but this is kind of my point in my own post above.

If receipts went up when rates went up and then went down when rates went down, then that is "evidence". But there are too many other factors. I don’t have the numbers in hand but I would suggest that when FDR raised taxes to pay for WWII, he was on the right side of the curve already, but nobody was knocking off early from the bomber plant. You can’t make hard-and-fast rules about how people will respond to a single incentive, only generalizations about how they should respond. Or something.

My point about underwriting dotcoms versus mining zinc reflects upon a single reason I might offer to claim Clinton’s tax cuts don’t mean what we think they must mean. If it’s that eay to make money, we may not respond to higher marginal rates as we would if we were doing grueling work. So producers may not have responded to higher rates the way we would predict due to changes in conditions that affect productivity.

I’m inclined to believe we were and are on the left side, but the Curve does not prove that we were, and cannot.
 
Written By: spongeworthy
URL: http://
1. Why isn’t the discussion of total taxation? Federal tax, state and local, payroll including those paid by the employer, property taxes, etc

2. As I mentioned last time this came up here, the Laffer curve doesn’t say raising taxes will lead to decreased revenue than before or cause a recession so the fact that the economy boomed while Clinton was President isn’t evidence of anything.
 
Written By: abw
URL: http://abw.mee.nu
Dale & Jon — Thanks for the posts on supply side issues and income taxes. I also enjoyed the comments. It is great to have an economic discussion in which most everyone sticks to the point at hand and avoids partisan debates.

The one issue that was not explicitly addressed is taxation and economic growth. That is, what is the relationship between a given tax structure and growth—does the structure encourage growth. I realize it is outside the scope of the Laffer curve itself, but it’s impossible to address what structure will encourage growth of tax revenues without taking into account its impact on economic growth.

The overall rate of taxation is very important in this regard, but an equally important issue has to do with how predictable and permanent our tax structure is. Let’s assume the current tax structure and then consider two alternative futures. One, in which the current tax structure was made permanent and another in which the tax structure could change at any given time. I think a permanent tax structure would have significant advantages in that uncertainty would be reduced and the ability to plan ahead would be enhanced. This would contribute to economic growth in my opinion because long-term investments would be more attractive in a scenario in which tax rates would be predictable out into the future.
 
Written By: Kurt Brouwer
URL: http://fundmasteryblog.com
I had some time to kill so I threw together this Laffer and growth chart.

Disclaimer: These numbers are over-generalized and far-removed from the real world. Also some of them are very blurry but since the actual values are meaningless I didn’t bother to cleanup.


Column A is an effective tax rate of 22%, leading to Column B’s economic growth of 10% per year.

Column C is an effective tax rate of 25%, leading to Column D’s economic growth of 9% per year.

Column E is an effective tax rate of 20%, leading to Column F’s economic growth of 11% per year.

Note that it takes 20 years in this hypothetical for the total tax revenue of the 20% rate to surpass the total tax revenue of the 25% rate.

Also, the increase to 25% doesn’t stop economic growth but if you look at the ‘total economy’ column, after 10 years the increase in growth becomes significantly in favor of the 20% rate.


So sure, if you are looking at the Bush tax cuts from the last few years you are looking at a loss in revenue in the first decade. But remember that government budgets have to consider long-term obligations that project out 50 years.

(Of course if someone wants to argue increasing taxes will increase economic growth that’s a whole nother story, but I don’t think I’ve ever heard that - Dems always say taxation is needed to provide services and stop income disparity)
 
Written By: abw
URL: http://abw.mee.nu
Another point about the Laffer curve is that, despite the usual depiction as a simple curve with one maximum, there may in fact be several points C, with several maxima and minima between 0% and 100%. The various C points of course would not necessarily be equal on a multiple-inflexioned curve. The problem would then become one of determining which C point is C-prime—that is, the global maximum for the entire curve—as well as determining whether we are on the right or left sides of a local C point.

And since there’s no real data to identify any point on the curve in historical time, we can indulge ourselves with as many pinhead-dancing angels as we want.
 
Written By: kishnevi
URL: http://
That is unless you think that government spending somehow improves the economy.

But that’s impossible!!!!!!! Tear down those interstate highways! Paid for by government, they must be the source of our recessions!
 
Written By: glasnost
URL: http://

 
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