Does the Laffer Curve exist?

Commenting on this post, Speedmaster writes:

The Laffer curve is very real. You can argue shape differences, and where we might be on it. But I don’t think a sane person can deny it exists.

Speedmaster writes more the subject here.  It’s worth a read.  And here’s more from a February post with Arthur Laffer himself explaining the curve.  From that post Laffer explains what causes the bend in the curve:

Changing tax rates changed behavior, and changed behavior affected tax revenues. Reagan understood that lowering tax rates led to static revenue losses. But he also understood that lowering tax rates also increased taxable income, whether by increasing output or by causing less use of tax shelters and less tax cheating.

I’m always entertained by folks who downplay the Laffer Curve and claim that changing tax rates won’t change behavior “that much” (or enough to make tax rate changes counterproductive).

I find this to be a good example of revealed preferences.  Sometimes how we say we will behave and how we actually behave are different.

This difference isn’t caused by dishonesty.   It’s caused by not having a full appreciation of all the factors that will influence our behavior and decisions in the moment.

An example from mass transit might help illustrate.  I once read about a market research study for area considering building light rail for mass transit.  They asked residents if they would be willing to ride the train. 

Of course, they answered. It sounded like a great idea.  Trains are cool.  They can save time and money, right?

After they built the train, many fewer people actually used the train than the market research predicted.  Why, they asked?

It turns out they hadn’t considered all the factors when they answered the market research.  Sure, trains are cool and all, but my car gives me maximum flexibility in my schedule.  If I miss the 5:20 train, for example, I’m stuck until the 6:20 train, when I could have made it home faster if I just drove.

They also say things like they neglected to consider how much time it would take to get to and from the stations.  After they arrived at their destination, they still had to walk a ways or take a bus to get them where they were going and it was just a hassle.

In the end, they just didn’t realize how good they had it with their individual cars.  It turns out there were good reasons why roads and vehicles put most trolley cars and passenger trains out-of-business about 90 years ago.  It’s just that we forgot those reasons.

Same with tax rates.  It’s easy to say that raising marginal tax rates by 5% won’t change our behavior, for example, because we just can’t imagine that it will.  It seems insignificant.

But, when we’re actually faced with it, we do change our behavior in some marginal situations that we didn’t think about when we considered it from a distance.

But, when rates go up, we end up looking a little harder for those deductions and credits to help get back some of that tax money.  We put a little more money into our 401k or maybe buy a rental property.

We turn down that job offer that has a little higher pay and more responsibility because we do the math and realize that the after-tax bump in pay just isn’t high enough to compensate for the added headache.

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