Laffer Curve

Laffer-curve

With the Laffer Curve, Laffer attempts to show that the relationship between taxes and revenues looks like a curve rather than a straight line. In other words, tax revenues don’t rise consistently like tax rates do (which would look like a straight, positive correlation). Laffer’s curve shows that when tax rates are at zero, revenues are zero as well — the government makes no money when it taxes nothing. But it’s the same result if the tax rate were 100 percent. Think about what would happen if the government demanded every cent in your paycheck. Why work — or why tell the government what you’re making? The government would bring in no money because there’d be no incentive to work or to report earnings.

So tax revenues are zero when the tax rates are at zero and 100 percent — most agree about that. The question is, what does it look like between these extremes? The Laffer Curve postulates that once the rates get too high, the steep taxes discourage work to an extent that the revenues themselves suffer. Take another scenario: By June, you’ve already made a million dollars, and the progressive tax system promised to tax that income 50 percent. However, anything you make over a million will be taxed 90 percent. Why work the rest of the year when you know you can only keep 10 percent of your income? You’d probably take your half a million and retire to your beach house until next year. At this point, the taxes are discouraging work and tax revenue.

The range in which taxes are too high for maximum revenues is called the prohibitive range. When taxes are in the prohibitive range, a tax cut would produce an increase in tax revenues, according to Laffer. But the ideal tax isn’t necessarily 50 percent; rather, it depends on the taxpayers.

The Laffer’s Curve suggests that  tax rates could discourage people from producing, which results in fewer jobs and a hurting economy. On the flip side, lowering taxes at the right time can reverse these effects. Laffer points to examples in U.S. history where lowering high tax rates increased not only government revenue, but also increased gross domestic product (GDP) growth and lowered the unemployment rate.

lafferb

Not everyone agrees with the premise of the Laffer Curve. Supporters tend to be found in people who identify with conservatives and republican ideas.  Opponents generally are found in people who identify with liberal or democratic ideas.

One of the main points in opposition to the Laffer Curve is with the “revenue maximizing point”. In the graph above it is located at 50%.  But how do we know if 50% is when tax revenues start their decline? Many people believe the true area of decline begins at 70%.

For conservatives who support the Laffer Curve, no debate over the location of Point A is  tolerated, because cutting tax rates is said to ALWAYS generate more government revenue. In effect, Region B, the part of the curve in which lower tax rates produce sharply lower government revenue, has simply been banished from the discussion.

One point from the Laffer Curve is that if tax rates are high it will create a disincentive to work. But is this always the case?  After the WW II, the United states highest tax rate was 91%, yet America went through an unprecedented economic boom. the Laffer Curve presumes that some will not bother earning 100 million is they can only keep 50 million of it. Why would the supposedly most imaginative, innovative, hard-working and entrepreneurial people give up so easily? It ignores other motivators such as fame, respect and the thrill of success itself. Most millionaires have more money then they could ever spend, yet they don’t retire.

The Laffer Curve also famous for its argument that a tax cut could increase revenue. There is little or no evidence to support this claim. Historical evidence indicates that cutting taxes does not increase revenue. Most economists believe the Laffer Curve isn’t accurate. An IGM survey of economists found that not a single one of them agreed that a tax cut will increase revenue.

 

So how do we gauge the effectiveness of supply-side theory and the Laffer Curve in practice? Let’s look at three specific measures:

  • The core claim of supply-siders is that tax cuts spur investment, so we’ll look at growth in private investment;
  • Supply-side theory also claims that tax cuts increase government revenue, so we’ll look at whether that actually occurred;
  • And since growth in gross domestic product is the ultimate aim of any economic policy, we’ll include that in the analysis as well.

(Note: All data below have been adjusted to account for inflation.)

Private investment:

After the ‘81 Reagan tax cuts, private nonresidential investment over the next seven years grew at an annual rate of 2.8 percent.
After the ‘93 Clinton tax hike, private investment over the next seven years grew annually at 10.2 percent.
After the 2001 Bush tax cut, private investment grew annually at 2.7 percent.
(Data source: CAP/EPI study, Sept. 2008,, based on Bureau of Economic Analysis data.)

Federal revenue:

From 1981-1993, federal revenue increased by 20.7 percent over 12 years.
From 1993-2001, federal revenue grew by 46.6 percent over 8 years.
From 2001-2009, federal revenue decreased by 13.9 percent. (Even if you don’t include the deep recession year of 2009 revenue increased just 3.3 percent over the eight years of Bush’s presidency.

 

(Source: OMB Historical Table 1.2)

GDP growth

From 1981-1993, real GDP grew by an annual average of 2.97 percent.
From 1993-2001, real GDP grew by an annual average of 3.56 percent.
From 2001-2009, real GDP grew by an annual average of 1.56 percent.
(Source: U.S. Bureau of Economic Analysis)

 

In conclusion, in all three categories central to the claim of supply-side proponents, the economy performed significantly better in the wake of tax increases than it did in the wake of major tax cuts. If most economists are opposed to the Laffer Curve and to supply-side economics, who supports them?  Politicians and the wealthy who write checks to support political campaigns.


 

 

Bibliography

 

1.  http://money.howstuffworks.com/trickle-down-economics2.htm

2.  http://robertnielsen21.wordpress.com/2012/09/07/the-mythical-laffer-curve/

3.  http://blogs.ajc.com/jay-bookman-blog/2010/09/15/the-laffer-curve-in-real-life/

 

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