The Lower Half of the Laffer Curve

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As an idea, the Laffer Curve is simple and elegant. Raising taxes along a continuum from 0% to 100% will discourage legal economic activity by changing the cost/benefit analysis. Logically, if a 10% tax rate would raise X amount of revenue, then a 20% rate will raise somewhat less than the expected 2X because of the dampening effects of taxation. At a certain point, higher taxes will actually decrease revenues; at the margin, one may expect zero revenue for a 100% tax rate.

The tricky part when determining budget policy is figuring where exactly we are on the Laffer Curve.

The argument given by supply-siders is that when we cut taxes, we will actually achieve a net increase in tax revenues. Yet this is only true if the current tax rate is above the maximizing point T on the linked graph. Similarly, while any reasonable tax cut will stimulate the economy to a degree, a cut from 5% to 4% will have much less effect that a cut from 50% to 40%. The converse is that raising taxes will indeed increase tax revenue, so long as you remain below point T (though the increase may not be worth the long-term damage to the economy, depending on the tax rate).

At a presentation I saw over the summer by a member of the Heritage Foundation, he admitted that Heritage has not actually tried plotting specific taxation rates to specific points on the Laffer Curve. It seems to me that we have enough data on changes in tax policy, not only here but around the world, to at least make a rudimentary attempt at it; that Heritage has not done so makes me suspect that our present rates are indeed below point T, and that the nonspecific idea of the Laffer Curve is thus more powerful than hard data as a way to advance tax cuts.

Indeed, Congress's Joint Committee on Taxation published a report on the effects of the recent tax cuts on the economy and Federal revenues. They found that between 5% and 25% of the "cost" of the tax cut would be recouped by increased economic activity, nowhere close to a net gain.

That is not to say necessarily that we should not be cutting taxes, but that we need to be more judicious about which taxes we cut. We need to look for anomalous taxation rates that truly stand in the way of economic growth, such as our absurd corporate tax rates, rather than slashing the personal rates. Given our increasing debt, right now we should be focusing on balancing the budget. Yes, that means cutting spending, but we can no longer pretend that cutting taxes is cost-free.


Anonymous said...

no offense but this is kinda gay but im only 11 so what do i know right?

Anonymous said...

What if we all made those tax-deductible donations to the Fed deficit that you had suggested in a November blog entry? Would that then leave more room for efficient tax cuts? I'll send in my $10 dollars if you send in yours.

Mastiff said...

As it happens, I've been giving a lot of thought to that idea. Once the semester is over, I'm planning on setting up a campaign to push debt donations. I've talked to a few people who want to get in on this; now, we just need a website that can act as a central hub and scorekeeper. As you say, a lot of people will give as long as they know others are giving as well.

Stick around, we may see big things from this…