The Laffer Curve
You may have heard the proposition that cutting taxes will actually increase the revenue flowing to the government.
The concept cited is known as the Laffer Curve. Arthur Laffer concedes it’s an idea that was way long before his time but has been attributed to him since a published article in National Affairs in 1978.
The Laffer curve illustrates a theoretical relationship between rates of taxation and the resulting levels of the government’s tax revenue.
The Laffer curve assumes that no tax revenue is raised at the extreme tax rates of 0% and 100%, therefore assuming that there is a tax rate between 0% and 100% that maximizes government tax revenue.
When plotted, the curve looks similar to a bell curve.
In 1924, Secretary of Treasury Andrew Mellon wrote: “It seems difficult for some to understand that high rates of taxation do not necessarily mean large revenue to the government, and that more revenue may often be obtained by lower rates”. Exercising his understanding that “73% of nothing is nothing”, he pushed for the reduction of the top income tax bracket from 73% to an eventual 24% (as well as tax breaks for lower brackets). Mellon was one of the wealthiest people in the United States, the third-highest income-tax payer in the mid-1920s, behind John D. Rockefeller and Henry Ford. While he served as Secretary of the U.S. Treasury Department his wealth peaked at around $300–400 million. Personal income tax receipts rose from $719 million in 1921 to over $1 billion in 1929, an average increase of 4.2% per year over an 8-year period, which supporters attribute to the rate cut.
Writing in 2010, Australian economist John Quiggin said, “To the extent that there was an economic response to the Reagan tax cuts, and to those of George W. Bush twenty years later, it seems largely to have been a Keynesian demand-side response, to be expected when governments provide households with additional net income in the context of a depressed economy.”
A 1999 study by University of Chicago economist Austan Goolsbee, which examined major changes in high income tax rates in the United States from the 1920s onwards found no evidence that the United States was to the right of the peak of the Laffer curve. He postulated taxes were not so high as to negatively affect government revenue.
If you’re still with me, you’re getting the idea that the point on the Laffer curve which maximizes government revenue is not one that is set or permanent. Government revenue is dependent on whether an economy needs a boost and/or whether the attitude or plight of the consumer needs to be brightened.
If is true that there is a point where higher income tax rates reduce government revenue, it must be true if you are a capitalist and the government takes so much of your income it affects your ability to consume and/or make capital investments.
I might add here that Keynesian economics, or demand-side economics, is different from classic or supply side economics.
Without writing a textbook on the differences, suffice to say demand-side lovers champion the theory of government spending more in an economic downturn while supply-siders say lower the taxes to put more in citizen pocketbooks when that occurs.
Tax revenues were $599 Billion in the 1981 fiscal year, the last fiscal year before Reagan’s tax cuts began to be phased in. When Reagan retired in 1989 the take was $991B – a $392B increase. On an inflation-adjusted basis this represents a 22% increase in tax revenue. The rapidly increasing prosperity of the American people during this period allowed the government to collect more money despite, or perhaps because of, the lower tax rates. However, despite his efforts to reduce spending, federal spending grew along with the revenue.
As an aside here, let’s get off the proposition that raising the tax rates on the so-called ‘rich’ will result in more government revenue. Historically, raising the rates on the ‘rich’ has have little impact on government revenue. When everyone realizes that the 7,000 pages of U.S. tax code is written to allow ‘the rich’ to avoid taxes by what they do with their incomes. (I add here, most of the tax code is bipartisan) There is a plethora of deductions and credits for capital investment. Lowering the tax rates for the rich could have the effect of more capital investment and economic stimulus.
The point is both the rich and the not so rich exhibit behaviors which are perfectly consistent with the economic logic that underlies the Laffer curve. As you increase the tax burden on people, they have a larger incentive to avoid taxes. As you decrease tax burdens, compliance increases. That was exhibited recently in a city in Argentina where increased taxes on the rich significantly raised noncompliance and had little effect on taxes paid by the rich.
So, the current administration’s bent to lower tax rates is worth a try to stimulate our economy and potentially even increase revenue – and plot a new point on the Laffer curve.
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Have a great and prosperous week.
Hug somebody.
References:
https://historyhalf.com/the-reagan-deficits/
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