The Laffer Curve and Last Laughs

There’s nothing more contentious — or the topic of sound bites — than federal tax policy. Although Jude Wanniski, a writer for the Wall Street Journal, coined the term in 1974, the Laffer Curve made its way into the political lexicon with President Reagan’s championship of supply-side economics and the Kemp-Roth Tax Cut of 1981.

And now it’s back, because Authur Laffer called GOP Presidential Candidate Herman Cain’s 9-9-9 tax plan “wonderful.” Laffer was Reagan’s economic adviser.

In the original Cain proposal, the current tax system would be replaced with a 9 percent tax on income, a 9 percent business tax and a 9 percent national sales tax. The Tax Policy Center showed the 84 percent of Americans would pay more taxes under this plan, according to the SunshineStateNews.

For those who don’t remember Reagan, the Laffer Curve claims to model tax elasticity. In vernacular, the argument is that there is a tax rate that will yield the most tax revenue. Raising the tax rate beyond this point would reduce tax revenue.

Mike Kimel at TheAngryBear asks the reader: “have you ever seen [the Laffer Curve] estimated?” No, right?

Kimel writes that “someone should let non-quant people into the joke [b]ecause the only people really discussing it are those who are driven by ideology…” According to his calculations (emphasis added):

The low point in tax collections happens to be about 32%. In other words… if the top marginal tax rate is below 32%, cutting it further will raise tax revenues. On the other hand, if the top marginal tax rate is above 32%, to boost revenues you have to raise tax rates…

[I]t turns out that the optimal tax rate for growth is easy to calculate. The data cooperates very nicely. There is a relationship, an easy to estimate curve which I’ve modestly called the “Kimel curve.” And the high point in the Kimel curve is somewhere around 65%. Now, the Laffer curve analysis shows us that getting to the level of taxation that produces the fastest economic growth rates would also increase our tax collections… not a bad thing at all in an era of rapidly rising national debts.

Which brings us to the biggest Laffer curve joke of them all: ain’t no way the folks who like to talk about the Laffer curve would support that.

Although I am an economist and once-upon-a-time dealt with complex equations, it’s been decades, so I pass this along in the category of “interesting and rigorous” analysis. The comments are very worthwhile.

         

6 Comments

  1. Why is it that we can lower taxes by a flat tax but not raise them by a flat tax? I just want more tax! I’m tired of having a bankrupt government.

    So if flat taxes are so great, then I say lets raise taxes by flat tax. 9-9-9 sounds good.

    EVERYBODY PAYS 9% MORE….NOW!

    …and instead of being wimpy about tax cheats or manipulative dodgers, bring in the Singapore caning crews and publicly cane the cheats right in front of both the occupiers and Tea Baggers….along with some cell phone drivers as sort of a Potpourri concession to include insurance lobbyists…

    Sounds bipartisan. Lets do it!

  2. Allen, flat taxes are regressive. This means that they disproportionately affect people with lower incomes. This is the rationale for increasingly marginal rates and for no sales tax on food at the grocery store.

  3. An interesting argument but I think there are quite a few flaws.

    (1) Even the article admits that there are boundary issues with the model. Obviously, as tax rates increase, at some point tax receipts must decline. This is true even if we concede that there may be a dip (or double-peak) in the curve. The article does not attempt to figure out what that point is, which is the entire point of the Laffer curve concept. The article shows that it is above 32 percent (probably well above it), but then it jumps to the unfounded conclusion that it must also be above 65%.

    (2) Looking only at the top marginal rate, and comparing that with tax receipts, is missing quite a few variables from the picture. What are the income brackets? What are the other rates? What are the exemptions and deductions? Those things also impact tax receipts and change over time. Based on my understanding of the historic tax policy, looking at the top marginal tax rate is only a very small indicator of the over-all tax policy.

    Here’s why I don’t think the Laffer curve has been (or can be) estimated: because it’s not one curve. It is a general concept that would yield a different curve depending on what you are trying to measure and the conditions in which you want to measure it. The “tax code” is not one thing. It is a collection of many things and each one has its own Laffer curve. And measuring where that is at any one point of time for any one of those things is pretty close to impossible since we don’t have any economic petri dishes.

    My view: in general we have some room before we need to start worrying about the the peak of the laffer curve, but it’s not just the peak that we should avoid. We don’t really want to get anywhere close the peak because of diminishing returns and the nonproductive incentives that it would cause. So, I think we have some room but not a ton. In general I don’t think anyone should pay more than a 50% effective tax rate (including state and local taxes). I don’t have an equation that came up with that. It’s just my gut feeling.

  4. Yes Kathy, so in reverse they should be de-regressive.

    More tax please.

  5. the only people really discussing it are those who are driven by ideology

    This really shouldn’t be true since all the Laffer curve says is there is an optimal tax rate to maximize revenues. As everyone seems to be pointing out it’s very hard to actually prove where that optimal level is. The GOP misuses the curve by essentially claiming all tax cuts will improve revenue, the Democrats tend to claim it’s dumb or doesn’t exist. Neither of those approaches make much sense.

  6. The Laffer Curve isn’t rocket science. It’s basically the Law of Diminishing Returns applied to a certain problem. Sure, the Optimum tax rate is undiscovered, and is certainly unfixed due to the socio-political aspects of economics, but the concept is valid.

    The article makes it sound like the concept itself is flawed, which IMO it is not.

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