Where does the Laffer Curve bend?

Laffer Curve

What is t*?

Thomas Sowell says that when tax rates are raised on high-income individuals, they respond to incentives by arranging their financial affairs differently to minimize those taxes.

Folks, like blogger Megan McArdle, lecture/patronize opponents of tax increases that current marginal tax rates are not near the bend in the Laffer Curve (the point where increasing tax rates would reduce revenue).

This is from Mark Perry’s blog, Carpe Diem:

The U.K. government is learning about the economic lesson that “if you tax something, you get less of it.”  Following an increase in the top marginal income tax rate to 50%, tax revenues from high-income taxpayers are falling, and are not going up, as the Treasury somehow expected by ignoring the economic lesson that “people respond to incentives.” A U.K. Treasury official explained the disappointing drop in tax revenues by saying it “was partly due to highly-paid individuals arranging their affairs to avoid paying the 50% rate.”  Duh.

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.

Incentives Matter

Courbe de Laffer

Image via Wikipedia

Arthur Laffer writing a piece called Reaganomics: What We Learned in the Wall Street Journal today, plainly explains the Laffer Curve:

The key to Reaganomics was to change people’s behavior with respect to working, investing and producing.

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.

Moreover, Reagan knew from personal experience in making movies that once he was in the highest tax bracket, he’d stop making movies for the rest of the year. In other words, a lower tax rate could increase revenues. And so it was with his tax cuts. The highest 1% of income earners paid more in taxes as a share of GDP in 1988 at lower tax rates than they had in 1980 at higher tax rates.

I always appreciate humility:

To Reagan, what’s been called the “Laffer Curve” (a concept that originated centuries ago and which I had been using without the name in my classes at the University of Chicago) was pure common sense.


It Doesn’t Matter

There’s been a buzz in blogland lately about the Laffer Curve.  For those of you who don’t know, the Laffer Curve is napkin sketch made by economist Arthur Laffer that illustrates that there is a diminishing return to government revenue after raising tax rates beyond a certain optimal rate.  The idea being that as the government share of productivity rises beyond that level, people do less and work harder to find loopholes.

For example, if I were to choose between working an extra job at night and spending time at home, how much I take home from that extra job matters.  If the government taxes my income on that extra job so that I take only 25% – 50% of what I make, I’ll be more likely to skip the extra job.

Laffer himself points out the concept was not original and has been around since at least the 14th century.

Recently, Washington Post columnist Ezra Klein asked a group of economists where the Laffer Curve bends, which sparked quite a discussion the blogosphere.

First, the discussion pleasantly surprised me.  It seems like just a short while ago, the left didn’t want to admit the Laffer Curve existed.  In fact, I had discussions  where I was treated as a moron for believing in such nonsense.  So, it was pleasantly surprising to Continue reading