It’s not a big component of my introductory economics classes, but I always make sure my classes learn a little about the Laffer Curve. If for no other reason than it was what Ben Stein was teaching The day Ferris Bueller took the day off. This article has an interesting idea I hadn’t really thought deeply about – that the “best tax rate” might be lower than the revenue maximizing tax rate. The argument is that the lower tax rate leads to more growth. Or to put it differently, for every dollar of extra tax revenue produced, private incomes are reduced by a bigger amount. The article I’ve linked to gets a little technical, but I liked this part:
That’s the theory of the Laffer Curve. What about the evidence? Where are the revenue-maximizing and growth-maximizing points on the Laffer Curve?
Well, ask five economists and you’ll get nine answers. In part, this is because the answers vary depending on the type of tax, the country, and the time frame. In other words, there is more than one Laffer Curve.
The Laffer Curve is a graphical representation of the relationship between tax rates, tax revenue, and taxable income. It is frequently cited by people who want to explain the common-sense notion that punitive tax rates may not generate much additional revenue if people respond in ways that result in less taxable income. Unfortunately, some people misinterpret the insights of the Laffer Curve. Politicians, for instance, tend to either pretend it doesn’t exist, or they embrace it with excessive zeal and assume all tax cuts “pay for themselves.”
Another problem is that people assume that tax rates should be set at the revenue-maximizing level. Policy makers should strive to set tax rates at the growth-maximizing level. But since a growth-generating tax is about as common as a unicorn, what this really means is that tax rates should be set to produce enough revenue to finance the growth-maximizing level of government.
The conclusions are interesting and possibly disturbing:
The key factoid (assuming my late-at-night, back-of-the-envelope calculations are right) is that this study implies that the government would reduce private-sector taxable income by about $20 for every $1 of new tax revenue.
Does that seem like good public policy? Ask yourself what sort of politicians are willing to destroy so much private sector output to get their greedy paws on a bit more revenue.
What about capital taxation? According to the second chart, the government could increase the tax rate from about 40 percent to 70 percent before getting to the revenue-maximizing point.
But that 75 percent increase in the tax rate wouldn’t generate much tax revenue, not even a 10 percent increase. So the question then becomes whether it’s good public policy to destroy a large amount of private output in exchange for a small increase in tax revenue.
Once again, the loss of taxable income to the private sector would dwarf the new revenue for the political class. And the question from above bears repeating. What should we think about politicians willing to make that trade?
And that’s the real lesson of the Laffer Curve. Yes, the politicians usually can collect more revenue, but the concomitant damage to the private sector is very large and people have lower living standards. So that leaves us with one final question. Do we think government spending has a sufficiently high rate-of-return to justify that kind of burden?