When does the Laffer Curve kick in, if at all?

[SenorBeef]

Rather than hijack this thread, I’m opening a seperate discussion on the Laffer curve here.

The Laffer Curve is the idea, typically associated with supply side economics, that at some point your tax rate becomes high enough as to disincentivize work (or certain kinds of taxed income), therefore less work is done, less revenue is generated, and even with your higher tax rate you actually take in less revenue. This is obviously disastrous - you get less productive work and less tax revenue, and everyone is worse off.

But the only empirical analysis I’ve ever read on the subject came from an obvious biased source. The concept seems logical enough - but is it something we have to worry about when discussing taking the top marginal income rates from the low 30s to the high 30s, or is it something that only takes effect at much higher rates?

Dick Dastardly asserted:

@Dick_Dastardly

Well, we had 90% tax rates in the 1950s, that mythical time for conservatives when America was the real America, the way things should be and that they’d like to return to. So it couldn’t have been that bad back then. The 1950s did also feature 5-8% yearly GDP growth too so clearly high tax rates didn’t affect economic growth negatively compared with tax rates/GDP gropwth over the last thirty years.

If we put the marginal rate up to 50%, back to where it was under Reagan, we’d get much greater revenues and it would help reduce the deficit. Tax cuts especially since 2000 have been catastrophic for revenues, long term-deficits, national debt etc.

and:

Clinton raised the marginal rate to just under 40% in 1992. The entire GOP voted against it and we were warned of economic catastrophe, huge drops in GDP, tax revenues etc. Instead we got the best economic growth for decades, record investment and balanced the budget.

Bush cut the top rate in 2001 and we were told the usual supply-side snake oil about how well it would work. Instead tax revenues fell catastrophically causing huge long term problems and the weak economic growth petered out very quickly, creating the need for something to give us economic growth to hide the failure of the tax cuts. And lo and behold we got the biggest asset bubble in history.

What did the rich do in the 50s? Keep working as they were and accept their taxation rate as a patriotic duty? Find different sources of income that wouldn’t be taxed at that rate? Was investment down across the board? What harm did the extreme tax rate cause?

So in the 50s, when we had a very oppressive 90% top marginal tax rate, the economy still very quickly. In the 90s the marginal rate was higher than it was now, and our tax revenues and general economic growth were far better than they are currently.

So, is the Laffer curve BS? Or at least something that doesn’t take effect until rates far above what we’re currently at? I’m willing to be convinced. This seems like a subject that can be cleanly solved by economic analysis.

[SenorBeef]

To add: Other countries have higher top marginal tax rates than us. Do they experience reduced revenue based on that? It seems to me that government is interested in maximizing their income far more than punitively attacking the rich - if raising their tax rates actually did decrease their revenue, they’d move away from it immediately. After all how would they benefit from the situation?

[Gangster_Octopus]

It’s not the Laffer Curve is BS, it is that the Laffer Curve is laughably simplistic. The desing of a full tax code menas you simiply cannot equate a “tax rate” with an amount of income as it relates to our current tax situation. Now, if you has a simple tax code, where income was easily measured and tax rates were simply applied, then it is undeniably true, although where that sweet spot is exactly, who knows.

[Maeglin]

@SenorBeef

So, is the Laffer curve BS? Or at least something that doesn’t take effect until rates far above what we’re currently at? I’m willing to be convinced. This seems like a subject that can be cleanly solved by economic analysis.

It is actually not so clean. The important question in policy is whether the taxation deadweight loss parabola (fine, ok, Laffer curve) can be used to justify any one of a number of tax rate decisions. The intuition is very simple and requires a little algebra. But one of the real problems empirically is that it is not smooth. Most of the time, we have no good way of knowing where we actually are on the curve. So unless you are already at one of the extremes, this idea is a very poor guide to setting tax policy.

[Voyager]

When Kennedy cut the marginal tax rate, there was an economic upturn, but I don’t know if the increased revenue matched the loss of taxes. I never read about a deficit issue, so it couldn’t have been too bad.

There are negative consequences. When England had a high marginal rate, there were many tax exiles, who’d rather live in Switzerland than pay 90%. This was only slightly offset by the song about it, Taxman.

The Laffer curve is just a trivial application of the mean value theorem. If you get no tax revenue at 0 tax, and none at 100% (since no one would work) and you get tax revenue between these points, there must be an optimal tax rate, above which you don’t get optimal revenue. If you are above this, cutting will increase revenues. It appears that to Republicans this point is always slightly lower than where we are today.

Given all the other factors involved in a tax cut, I’m not sure you can figure it out. If I remember, the market response to the Clinton tax increase was increased investor confidence since Washington finally seemed to know what it was doing. I don’t think factors like this are included in the Laffer Curve calculation.

So, the answer to the question seems to be somewhere over where we are and under where we were in the '50s.

BTW, the prosperity in the '50s could be attributed in no small part to lack of competition, and selling to a world in need of products which was just ramping up industrial production after much of it was destroyed in WW II. The reason for the big tax was to repay the massive debt accumulated during WW II, much bigger than anything we see now, even after the stimulus package - so maybe patriotism had something to do with it.

[DanBlather]

The Laffer curve is not just about the dis-insentibe to work, it also take into account that money paid in taxes is not available for re-investment. Still, it’s a bunch of crap and so over-simplified as to be useless.

[Dick_Dastardly]

Some more numbers from the other thread to help us understand this issue better :

US Federal Tax Revenues Since 1990 :

These numbers are all in hundreds of billions :

1990
1,032.1

1991
1055.1

1992
1,091.3

Clinton tax increase

1993
1154.5

1994
1,258.7

1995
1,351.9

1996
1,453.2

1997
1579.4

1998
1,722.0

1999
1,827.6
2000
2,025.5

So you can see the 35% increase over the Bush year in the thing you linked is totally disastrous. Historically tax revenues roughly double every ten years, something you can see at the link below. Clinton’s would have increased another 30+% had he not cut taxes for the middle/lower earners to (slightly) make up for the redistribution of wealth from them to high eaners over the previous decade.

Anyway Bush took office in 2001 and enacted tax cuts which were backdated to the start of that financial year. If the Laffer curve and increased-revenues-when-the-top-rate-is-cut-under-50% is correct then tax revenues should be on target to roughly double plus we see some of that Laffer increase on top of the doubling, right? Here are the numbers, again in hundreds of billions$ :

2000: 2025.5

Bush tax cut

2001 : 1991.4

2002 : 1853.4

Bush tax cut

2003 : 1782.5

2004 : 1880.3

2005 : 2153.9

2006 : 2407.3

2007 : 2568.2

And the official 2008 number isn’t out yet but it’ll obviously be below the 2007 number due to the recession, financial meltdown etc.
http://209.85.229.132/search?q=cache...es&hl=en&gl=uk
From the actual evidence over the past twenty years it’s clear that if there is any merit to the Laffer idea, the ideal marginal rate is definitely north of 40%, and certainly 50% won’t cause any harm to economic growth but would evenrually balance even the current budget.

[Der_Trihs]

@Voyager

The Laffer curve is just a trivial application of the mean value theorem. If you get no tax revenue at 0 tax, and none at 100% (since no one would work) and you get tax revenue between these points, there must be an optimal tax rate, above which you don’t get optimal revenue. If you are above this, cutting will increase revenues. It appears that to Republicans this point is always slightly lower than where we are today.

Exactly; it’s a talking point not a useful model for where taxes should be. It doesn’t offer any numbers; without a means of knowing where on the curve the ideal spot is, or even of knowing the shape of the curve it’s useless.

[MOIDALIZE]

@Voyager

The reason for the big tax was to repay the massive debt accumulated during WW II, much bigger than anything we see now, even after the stimulus package - so maybe patriotism had something to do with it.

That seems to be a dead concept among many people in this country, unless it involves wrapping pointless moralizing in the American flag.

[Shodan]

@Voyager

When Kennedy cut the marginal tax rate, there was an economic upturn, but I don’t know if the increased revenue matched the loss of taxes. I never read about a deficit issue, so it couldn’t have been too bad.

The US budget deficit roughly doubled 1961-1962 (as a percent of GDP). There was a small surplus in 1960, but the US budget was in deficit thru out the Kennedy administration (cite).

Regards,
Shodan

[billfish678]

The real problem is IMO is any data we currently have would be useless. Every economic era is different.

Now, maybe in the future, when our technology and economy have been similiar and stable for long periods of time, you could actually experiment with taxation to define the curve. Right now, IMO anybody could probably spin the data we have any way they wanted.

[brickbacon]

@Voyager

The Laffer curve is just a trivial application of the mean value theorem. If you get no tax revenue at 0 tax, and none at 100% (since no one would work)

This may be a stupid question, but is there any evidence that the latter part of this is true? People work for free all the time. In fact, people often pay for unpaid internships in some situations. People in the suburbs often pay to pick their own fruit, etc. I get why few would work (on a macro level), but is there any reason to think nobody would work, thus resulting in zero tax revenue.

@Voyager

…and you get tax revenue between these points, there must be an optimal tax rate, above which you don’t get optimal revenue.

Do you think the rate is based on the actual number, or what people feel is fair, and reasonable? Seems to me like that optimal rate is a moving target that depends on what they can wrap their heads around, and who taking the money.

[begbert2]

@brickbacon

This may be a stupid question, but is there any evidence that the latter part of this is true? People work for free all the time. In fact, people often pay for unpaid internships in some situations. People in the suburbs often pay to pick their own fruit, etc. I get why few would work (on a macro level), but is there any reason to think nobody would work, thus resulting in zero tax revenue.

If you felt a desire to work for free, you could just actually work for free - rather than having your employer hand your wages to the government. I’m sure your employer would prefer that arrangement as well.

[Gangster_Octopus]

@brickbacon

This may be a stupid question, but is there any evidence that the latter part of this is true? People work for free all the time. In fact, people often pay for unpaid internships in some situations. People in the suburbs often pay to pick their own fruit, etc. I get why few would work (on a macro level), but is there any reason to think nobody would work, thus resulting in zero tax revenue.

Well, people might work, but what’s the point of getting paid?

[Fotheringay-Phipps]

@SenorBeef

The concept seems logical enough - but is it something we have to worry about when discussing taking the top marginal income rates from the low 30s to the high 30s, or is it something that only takes effect at much higher rates?

One thing you need to consider is that you can’t focus on the federal income tax rate and ignore state (& city, in some cases) income taxes as well as withholding taxes, since these are as much a part of a person’s decision to work as the federal rate is.

This is particularly significant when comparing to other countries or other time periods.

[smiling_bandit]

Interestingly, the point of the laffer Curve is that you DON’T want to maximize government revenue. At least not for the long-run. Hear me out. At low ends of the curve, you get increased investment, although it doesn’t actually make up (to the government anyway) the loss in revenue. However, it does mean that in the short run you can raise taxes for specific, large projects. Like World War II or creating moon colonies.

On the other end of the scale, crushing taxes force people to slave away in terror lest something bad happen. They don’t work much, and they aren’t very productive or interested, but they have too many worries to spend time trying to overthrow the government. (In Soviet Russia, Economy work in You!)

[brickbacon]

@begbert2

If you felt a desire to work for free, you could just actually work for free - rather than having your employer hand your wages to the government. I’m sure your employer would prefer that arrangement as well.

I do work for free. Not exclusively, of course, but a few people I know do. I’m not saying 100% taxation would be a fair or practical situation, just that I think the analogy may be false in an absolute sense. If that is indeed true, doesn’t that introduce a wrinkle to the underlying assumption.

@Gangster_Octopus

Well, people might work, but what’s the point of getting paid?

True. But when I hear people making the Laffer curve speech, it seems that the underlying assumption is that people only work for money, thus if there is no monetary gain, people will not work. This seems demonstrably false.

Since supreme court justices are guaranteed their salary, even after retirement, why do they continue working? My point is that if money is not the central reason most people work, then maybe tax rates are not as important as they seem in terms of incentives.

[begbert2]

@brickbacon

I do work for free. Not exclusively, of course, but a few people I know do. I’m not saying 100% taxation would be a fair or practical situation, just that I think the analogy may be false in an absolute sense. If that is indeed true, doesn’t that introduce a wrinkle to the underlying assumption.

Naah, the issue isn’t that people won’t work for free, it’s that they won’t pay the government while they work for free. There is no incentive for the employee to ask for a wage if they won’t get any of it, and there is incentive against the employer offering a wage, since it costs them money and won’t incentivize employment. So logically, at 100% taxation, while work may continue, wages will not, resulting in the 0% tax income at the extreme end of the curve.

[smiling_bandit]

@brickbacon

True. But when I hear people making the Laffer curve speech, it seems that the underlying assumption is that people only work for money, thus if there is no monetary gain, people will not work. This seems demonstrably false.

Since supreme court justices are guaranteed their salary, even after retirement, why do they continue working? My point is that if money is not the central reason most people work, then maybe tax rates are not as important as they seem in terms of incentives.

How do I put this? You are either deliberately or accidentally being obtuse. Nearly everyone on earth must work to survive. As in, we do not eat if we do not work, and our entire livelihood is dependant on that. The fact that a tiny handful of people are lucky enough to avoid this is irrelevant. And it is well-established that tax rates heavily influence investment and labor markets, because we have studies which specifically analyze this over time.

[Voyager]

@brickbacon

This may be a stupid question, but is there any evidence that the latter part of this is true? People work for free all the time. In fact, people often pay for unpaid internships in some situations. People in the suburbs often pay to pick their own fruit, etc. I get why few would work (on a macro level), but is there any reason to think nobody would work, thus resulting in zero tax revenue.

It’s an absurd extreme, but I suspect that in a 99.9% tax rate situation most economic activity would be bartering or black market - so the revenue would be fairly close to 0.

Do you think the rate is based on the actual number, or what people feel is fair, and reasonable? Seems to me like that optimal rate is a moving target that depends on what they can wrap their heads around, and who taking the money.

Optimal only in the sense of revenue generation. Fairness has nothing to do with it. Where the optimal point is might depend on that, but not its existence.

BTW here is a table of income tax revenue as a percentage of GDP. from 1941 - 1999. The Kennedy cut doesn’t seem to have changed anything much. The decline in 1958 - 1959 was due to the recession, no doubt. You can see the decline after the Reagan cuts, and the increase after the Clinton increase.

I stand corrected about the Kennedy deficit. Still, I don’t remember lots of angst about it, and can’t imagine where the spending increases came from. Apollo? The run up to Vietnam? Closing the missile gap? (Yes, I know that didn’t exist.)