Political Talking Point for Taxes: The Laffer Curve

Benjamin Franklin said it best, “In this world nothing is certain but death and taxes.” Taxes and tax rates have very large actual and psychological effects on both the  economy and investments. Not a day goes by without hearing news or issues related to taxes – especially when relating to budgets and deficits. How to get enough revenue for the government is a constant battle. Within political discussions, there seems to have emerged two distinct camps: those that propose that increasing taxes will increase revenue, and those that propose lowering taxes will increase revenue.

The battles rage daily over news networks, water cooler discussions, and internet forums. Quite often the Laffer Curve is brought up as an argument point for both sides. It is both said that the concept itself has been discredited, and that it has proven that lowering taxes increases revenues. So which is it?

The only thing that I can see is that there is a lot of misunderstanding of what the Laffer Curve really is.

The Laffer Curve, a simpler explanation

The Laffer Curve is an economic theory named after Dr. Arthur Laffer. The theory relies heavily on psychology attempting to predict how people will react to different levels of taxation. For example, at a zero tax rate, revenues will obviously be zero. At a 100% tax rate, revenues will also be zero because people will realize that all their money goes to the government, so they will just stop earning money (at least legally). There may be a few die-hards that will continue to work for free, but it will effectively bring zero revenue. This implies that there is some optimal rate between 0 and 100 that will bring in the max amount of revenue.

That’s pretty much it.

It does not say that lowering taxes will aways bring in more revenue. It also does not say that increasing taxes will always increase revenue. So what does it say? What is the answer? The answer is the same as the answer to every psychological question – it depends. (Don’t put that answer on your next psychology test!)

Assuming that we accept that there is some optimal tax rate to maximize revenues, the desired point to reach would be point A. Now, if we as a country were at point B, then the model would show that increasing the tax rate would increase government revenues. If we were at point C, lowering the tax rate would increase revenues.

So where do we currently lie on the curve?

That’s the tricky part. The curve itself has an unknown shape. Additionally, we really don’t know where we lie, and there really is no way to tell until you increase or decrease the tax rate and observe the results. There are also a myriad of other factors and variables that complicate measurements. That makes taking empirical evidence and forming conclusions much more difficult.

For example, during the 1980’s lowering the tax rate appeared to have worked to increase government revenue. But was lowering the tax rate the main factor, or were there other economic forces at work? The Bush-era tax cuts appeared to also have increased government revenues, but it was also a time when banks threw out money with large shovels. Attributing revenue gains from tax rate changes is a bit too simplistic and finding the real answers are much beyond the scope of the Laffer Curve itself.

We should look at the Laffer Curve for what it is: an economic theory and a thought experiment. It does not prove anything, and it certainly does not disprove anything as well.

As Al Gore, the inventor of the internet, said before, “It is what it is.”

Comments
2 Responses to “Political Talking Point for Taxes: The Laffer Curve”
  1. G! That’s a great article. Very articulate and informative! Too many people see economics as a black and white science, when in reality it is amazingly complex with so many differing influences. Every, or nearly every decision and action we take has externalities that cannot be exhaustively studied. At least there are patterns we can see, and heck, computers can chug data. Perhaps we will find the equation some day! Muahaaha We’ll be a utopia!

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