Thoughts on the Laffer curve

I was out with some friends a bit ago discussing the state of things, when one of them suggested that the economic problems we are having were mostly inherited and not brought about by our president. The business cycle has more to do with where we are than his policies. I mentioned that while generally I agree, in particular cutting taxes during a time of huge deficit and enormous debt is a mistake. He asked if I had heard of the Laffer curve, hence this diatribe.

The Laffer curve plots tax revenue against tax rate. The initial inspiration was that there are two boundary conditions that help define the curve. At 0% tax rate, no revenue is collected - pretty obvious. The insight is that at 100% tax rate the revenue is also 0. While both boundaries are a bit hard to imagine, as they are outside of my experience, lets elaborate.

Some locales, maybe an oil rich country or Alaska, might have the 0% income tax rate. They tax exports and the workers there do not pay income tax. So, income tax revenue is 0.

The other is harder to imagine. What we do know is that as the tax rates rise, cheating becomes more desirable. If you take out enforcement as a practical issue, you realize that an individual derives little benefit from working in a 100% tax bracket and most would choose not to. There may be a few altruists who do toil under this burden, but the tax revenue would be near 0.

One thing about economics (and the social sciences, generally) is that models are hard to validate. All we have are the collected data of history. While that is a lot of data, it does not allow for experiments that isolate the variables. So it is with the Laffer curve. While we all can basically agree on the end points, how will we know the shape of the curve? Specifically, if we are policy makers how will we know whether we are on the right hand side of the peak or the left?

Without detailed knowlege of it's shape, the Laffer curve is ussualy drawn as half a circle. This shape implies a few things. Firstly, the left half of the curve is above a 45 degree line. This seems implausible, or at least in opposition to one of the Laffer fundamentals, that taxation is a disincentive to work (otherwise the curve would be a straight 45 degree line). Then the curve should be convex and below that staight line.

The second implication is that 50% tax rate is the rate with the peak tax revenue. AFAIK, Laffer never said this, but his curve was used to justify lowering taxes - especially on the highest tax brackets. During Reagan's presidency, the tax rates were cut and revenue rose. Chalk one up for the curve. But was it due to people working more because they took more pay home? Or was it due to normal business cycle? Or one of a million other things that were going on at the time; perhaps a technological breakthrough increased productivity?

We'll probably never know, but it does promote the curve. But I think the same kind of thinking that ispired Laffer to invent the curve in the first place could provide additional insight. I have never met anyone that decided to work more or less due to the tax rate changing. Have you? As long as the rate is between 0 and 100%, the more you work the more you get. Perhaps that is just because I haven't lived under that many tax schemes. But based on that and how I guess I would react, I'd say the Laffer curve looks more like this:

It would be nearly a straight line on the left side and then quickly drop off near the top end, as an underground economy took over.

There are far more factors that actually influence this. A big one is the tax rate relative to other locales (people and to a greater degree companies can move out from under burdensome taxes). Another is that most of the wealthy are not hourly employees, they are salaried - they work hard in competition for their jobs not directly their pay.

Bill de la Vega - February 2005