Wednesday, September 16, 2009

The Laffer Curve

Much has been made about President Obama’s efforts to raise taxes on high income individuals in order to fund additional spending programs such as health care, energy, and the stimulus. Critics cry class warfare and complain that the wealthy shouldn’t be punished in order to provide a welfare state. Defenders say that the rich can afford higher taxes without any big impact on their well-being. The bigger concern to me, and one that isn’t getting the attention that it deserves, is this – it won’t work.
Raising tax rates on high income individuals will not raise as much money as expected and may raise even less money than before. The idea behind this is known as the Laffer Curve and it basically argues that work effort is a declining function of tax rates and that there is some tax rate that maximizes the amount of revenue collected. At low tax rates, people work but the government gets very little tax revenue. As tax rates rise, people will work less so that tax revenues will still rise but at a decreasing rate. At some point, tax revenues will begin to fall as the reduced work effort dominates the higher tax rate. At extremely high tax rates, people won’t work and no money will be collected. If you wish to draw it, the Laffer Curve looks just like an arch.
There is some tax rate that would maximize total taxes, but people disagree on what that rate is. Keynesian economists (Democrats) tend to believe that we are below that point so that higher tax rates lead to higher tax revenues. Meanwhile, supply-side economists (Republicans) tend to believe that we are beyond that point so that raising tax rates actually reduces tax revenues.
In reality, the revenue maximizing tax rate depends on income and you can make a strong argument that high income people should be taxed at lower rates than middle class people. The determining factor is whether or not people have a substitute for working. High income people include business owners, professionals, doctors, lawyers, … and anyone in the highest income levels probably has some control over their career and how much they work. They have the option of taking more vacation, retiring earlier, sheltering income, deferring income, or take some other action that reduces the amount of tax revenue that the government takes in. Any reduction in the amount of work done by these people, and therefore their income, will result in lower tax revenues. Meanwhile, middle class people have less flexibility in their job. Employers expect 40 hours per week with two weeks of vacation – no more, no less. Low income people actually have greater flexibility too in that they can receive state support or work in informal (and untaxed) jobs instead of working in a traditional job.
It is politically infeasible to have lower tax rates on high income people, so the government really needs to determine the tax rate that maximizes tax revenues for this group and then set tax rates for middle and lower income people either equal to or below that rate. So, what rate maximizes tax revenues for high income workers? I honestly don’t know, but I have a feeling we are probably already close to that rate. The highest marginal Federal Tax rates are set to go up to 39% plus state and local income taxes and sales taxes means that we’re probably already at about 50%. I really don’t think that higher rates will lead to higher revenues.

Not everyone agrees with this. Tax rates have been significantly higher than they are today – as high as 91% under Eisenhower – and the economy did just fine. Indeed, there is very little correlation between economic growth and the highest marginal tax rate. There are two reasons for this. First, tax rates should affect the level of income, not the growth rate. When tax rates change, there may be short term effects on growth as people change their work habits, but once these habits are set, there is no reason that the growth rate should be affected. Second, changes in tax rates will only affect a small percentage of tax payers. If you raise tax rates on the highest 2% of workers, then they may cut their effort, but it won’t have a huge impact on the overall economy.
Again, some people disagree and say that the tax cuts just help the rich get richer. As proof of this giveaway they point to the increase in income inequality since the 1950s when tax rates were 91%. In actuality, their argument is self-contradictory and shows the Laffer effect. When tax rates go down on the highest income individuals, they have greater incentives to work and invest which causes their income to go up. Lower tax rates lead to higher before tax incomes. Conversely, higher tax rates lead to lower pre tax incomes. As far as the effect on tax receipts goes, it depends on the strength of that relationship. If an increase in the tax rate from 40% to 50% causes income to fall from $100,000 to $80,000, then tax receipts are unchanged. A smaller impact on income, say a decline to $90,000, would result in higher tax receipts while larger declines in incomes would lead to lower tax receipts. Overall, I think that higher tax rates will do very little to raise revenue, but it might reduce income inequality. This might be a worthwhile objective, but it won’t pay for additional programs.

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