Thursday, August 29, 2013

Lessons, if there are any, from the Laffer Curve

I have a bad habit of occasionally reading supply-side works, such as the book Return to Prosperity: How America Can Regain Its Economic Superpower Status by Arthur Laffer, Ph.D. and Stephen (please, no) Moore. Arthur Laffer is an economist best known as the originator of the Laffer Curve (more on his ideas here), which brings forth the conclusion that in certain instances, governments may be able to raise more revenue by cutting taxes, although if well-respected economists Peter Diamond and Emmanuel Saez are right, it only happens when effective marginal tax rates are above about 70%[1] (the maximum in the U.S. is about 42.5%[2]).  Stephen Moore is an obnoxious member of the editorial board of the Wall Street Journal (moore on his ideas here and here). Unfortunately, supply-siders often overstate their case, making it seem like tax cuts always increase revenue, instead of admitting that they can, in unusual circumstances, but usually don't.

Just for illustrative purposes, below you will find the Laffer Curve as it was originally represented by Art Laffer (follow this link for a photo). 

The basic principle behind the laffer curve is fairly simple. As marginal tax rates increase, each additional dollar of pre-tax income yields less disposable income, so there are declining marginal revenues. Up to a point, rising tax rates increase revenue, then revenue begins to decline. The picture above does not attempt to capture the true values where marginal tax rates maximize revenue, just to give an indication of the general form to expect.

A meme among conservative politicians is that tax rate cuts yield higher revenue, full stop. They have basically just asserted that tax rate cuts increase tax collections, even though that is only true in very limited circumstances, which is underscored by the work of Paul Diamond and Emmanuel Saez.

One of the most recent papers examining at what tax rates revenues are maximized is Diamond and Saez[2]. Among their findings, are what Paul Krugman summarized on his blog in a post on November 22, 2011:

In the first part of the paper, D&S analyze the optimal tax rate on top earners. And they argue that this should be the rate that maximizes the revenue collected from these top earners — full stop. Why? Because if you’re trying to maximize any sort of aggregate welfare measure, it’s clear that a marginal dollar of income makes very little difference to the welfare of the wealthy, as compared with the difference it makes to the welfare of the poor and middle class. So to a first approximation policy should soak the rich for the maximum amount — not out of envy or a desire to punish, but simply to raise as much money as possible for other purposes.

Now, this doesn’t imply a 100% tax rate, because there are going to be behavioral responses – high earners will generate at least somewhat less taxable income in the face of a high tax rate, either by actually working less or by pushing their earnings underground. Using parameters based on the literature, D&S suggest that the optimal tax rate on the highest earners is in the vicinity of 70%.
This implies that the Laffer Curve is actually better represented by this:

Source: Wikimedia Commons, 2011

If the findings by Diamond and Saez (or, for that matter, Mathias Trabandt and Harald Uhlig, upon whose work the above graphic is based) is correct, tax cuts in the U.S. should not increase revenue (at least in the short-run).

[1] Paul Krugman summarizes the findings of Diamond-Saez here.
[2] Peter Diamond and Saez, Emmanuel. Journal of Economic Perspectives. "The Case for a Progressive Tax: From Basic Research to Policy Recommendations." Fall 2011.

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