This post was inspired by a caller on Thursday’s (5/20/10) Wilkow Majority who claimed that few economists accept the Laffer curve as valid. I hear this half truth from time to time, and it follows a left wing pattern of discrediting an idea by citing “experts” instead of developing a well crafted argument. Let’s go through the facts.
The Laffer curve illustrates what economists call taxable income elasticity, the idea that not all increases in the tax rate affect tax revenues in the same way. Tax rates of 0% and 100% generate no government revenues, so the key is to locate the point in between where increasing the rate becomes counterproductive, and NOT raise taxes beyond that point. If you’re not familiar with Laffer’s work, take a few minutes to visit the Heritage Foundation cite for a more detailed explanation and a picture of the curve:
Like supply and demand curves, the Laffer curve considers the relationship between two variables (that is, the influence of tax rate on tax revenue). The beauty of the curve is its simplicity, but it doesn’t consider other factors—wars, the price of oil, or developments in China, to name just a few—that also influence economic activity and ultimately tax revenue. The Laffer curve does not take into account the type of tax either, such as income, sales, or VAT. All tax hikes reduce personal or business activity to some degree, but some do more harm than others. Rudy Giuliani actually pointed this out in a 2008 presidential primary debate, but it went largely unnoticed.
Few economists question the basic premise of the curve. What some debate is the shape of the curve and our current position on it. Those who say they are “for the curve” believe we are at a point where increasing the tax rate will not significantly increase tax revenue. Those who are “against the curve” are really arguing that we are still at a point where tax increases will increase tax revenue with little or no lost economic activity.
Most liberals and economists are Keynesians (more or less) and discredit the curve because it challenges the role of government intervention in the economy in the first place. Some actually contend that if tax rates are hiked considerably, most people will work as hard or even harder to make up the difference, and government tax receipts will increase anyway.
The best economic case for the curve is historical evidence (especially the Reagan years), the current crisis in Europe where high taxes have reduced economic activity and government revenues, and human nature, as people tend to work more when they have more incentive to do so. The case against the curve cites the so-called Clinton budget surplus, but ignores changes in capital gains taxes and a massive artificial Internet stock bubble that sparked the economy for a short time before bursting.
Overall, the hard evidence suggests that Laffer has a point, but neither proving nor disproving the curve is possible anyway. The take home point is this: Beware of unintended consequences associated with tax hikes. The best way to deal with revenue shortfalls is to cut government spending.
In the end, I have found that most who attempt to debunk the Laffer curve seem to be less interested in economic reality and more interested in advancing a socialist worldview. When debating Keynesians on the curve, I am willing to assume that they are right to a point, for the sake of the argument. What if increasing the tax rate by 10% would increase tax revenues by 6% instead of the full 10%? That would still mean a 4% loss due to reduced economic activity. Do we really need to endure this economic pain just to finance more social programs and entitlements? At this point they usually digress to Marxists clichés about the rich not paying their fair share or the need for shared sacrifice. Even Obama admitted during the campaign that higher taxes that reduce revenues might be acceptable as a matter of fairness.