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April 11, 2007

Misunderstanding The Laffer Curve

by Brad Warbiany

I posted this back in 2005 at The Unrepentant Individual, hoping someone would be able to point out a flaw in it. I don’t know if I’m missing something or if everyone else is, but since The Liberty Papers actually has readers, it seemed like a good time to bring it up again (especially after this comment).

Am I wrong? If so, tell me how.

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laffercurve
Many folks believe in the Laffer Curve as a basis for supply-side economics. Listening to folks like Sean Hannity on the radio, they constantly harp on the idea that cutting taxes will increase revenues. The thought is that taxes create a disincentive to work, and that taxes are currently so high that people are choosing not to work at all. Further discussion of the Laffer Curve can be found at Wikipedia or Investopedia. The supply-siders will argue that we’re on the right-hand side of the curve, and lowering rates will increase revenues. The Left, on the other hand, says that we’re on the left-hand side of the curve, and lowering rates will decrease revenues.

The Left is correct. With current tax rates, lowering rates will immediately lower revenues. The problem is not that supply-side economics is false. The problem is that the Laffer Curve is a static analysis. Supply-side economics does not imply that if we lower tax rates, we will immediately increase tax revenues, unless tax rates are tremendously higher than they are now. One of the intelligent leftists I typically debate with has said that it’s nearly impossible to be on the right side of the Laffer Curve. After all, the necessity to work is fairly inelastic. I think the Laffer Curve can be applied more directly to tax avoidance and evasion, although it’s not typically done.

What supply siders do claim is that lower tax rates increase economic growth, which in turn will increase tax revenues down the road. A better curve would be below (tax rates from 0-100%, as my Excel skills are failing me today):

laffer

Of course, this is a simple analysis. Obviously economic growth depends highly on the protection, by government, of private property rights, and the mechanisms to provide that protection require taxation. Likewise, if tax rates are too high, and you have businesses and productive people fleeing for fairer shores, economic growth could be negative, so a right-hand value of 0% may not be correct. Of course, government regulation can affect economic growth the same way, and that’s not even factored in to this chart. Last, it takes a very simple view of “tax rates”, be they income, corporate income, etc., but the Laffer Curve takes that simple view as well.

But I think this is a much better idea than the Laffer Curve. I know “Warbiany Curve” doesn’t have much ring to it, so title it what you want :-)

What supply-side economics is based upon is the idea that a rising tide lifts all boats. So policies, including tax policies, should be designed to increase economic growth. While work can be largely inelastic, the same is not true for investment. Invested dollars are the growth engine of the economy, and high tax rates have two negative impacts on investment. First, high tax rates make the reward for investment much lower, when an individual still carries all the risk for a bad investment. If the government takes 40% capital gains taxes from any positive return I make in a stock, but does not reimburse me 40% for every dollar I lose, it makes me much less likely to invest in the sort of higher-risk investments like startup companies, etc, which fuel technological and economic growth. Second, high tax rates simply take the money away from individuals who may choose to invest it, reducing the available pool of money that could be invested.

Thus, lower tax rates will reduce immediate government revenues. But lower tax rates will increase economic growth. From the Rule of 72, the difference between a GNP growth rate of 5% and 3.2% is huge. At 5%, the size of the US economy will double every 14.4 years. At 3.2%, it will double every 22.5 years. Assuming a $10 trillion economy today, in 45 years that’s roughly a $80T economy if we grow at 5%, and a $40T economy if we grow at 3.2%. Small changes in growth now have huge effects in the future. And it doesn’t take a mathematician to realize that tax revenues will be much greater if we have an $80T economy than a $40T economy.

The difference between supply-siders and liberals is that supply-siders are forgoing immediate gratification of government revenue, in expectation of greater future government revenue and an increased standard of living for all. Liberals, on the other hand, are more than willing to forego future economic growth, if we can provide things like socialized medicine now. Modern conservatives are the worst of both worlds, cutting taxes but increasing spending, pulling in government revenue through debt, which steals money from productive investments and forces greater future taxation to pay the cost of debt plus interest.

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5 Comments

  1. Good stuff.

    Comment by AT QB — April 11, 2007 @ 2:25 pm
  2. There is something to point out that I think many supply-siders don’t emphasize when talking about the federal government (though usually when discussing state governments). Lowering the tax rate a significant amount will attract foreign businesses and individuals. There is some delay, but that depends on how large the tax cut is; the bigger the cut, the shorter the delay. This argument is seen is state discussions. I live in Michigan and with our horrid taxes, the governor of Indiana was actually encouraging businesses to move south last year.

    I also think too often we talk about federal income taxes and ignore other taxes when discussing tax revenue dropping. If the tax rate goes down, I now have more money to purchase that new TV or put a down payment on a new house, both of which directly bring in new tax revenue for the state, not the federal government.

    Comment by trumpetbob15 — April 11, 2007 @ 2:30 pm
  3. My whole problem with the Laffer Curve is its intent. Why do we focus on maximizing tax revenues to the government? Why do aim to squeeze off the largest amount of money from individuals.

    As a libertarian, I believe we should be more focused on minimizing government spending, not maximizing it.

    Comment by Michael — April 11, 2007 @ 4:28 pm
  4. Michael,

    That’s a great point. My goal is lower taxes, not higher government revenues. If I can prove to the people who want the latter that they can get what they want if they give me what I want, is it that bad?

    I’d rather have strong economic growth, low taxes, and a moderate government than weak economic growth, high taxes, and a strong government.

    Comment by Brad Warbiany — April 11, 2007 @ 4:52 pm
  5. What do Supply Siders really believe…

    Brad Warbiany tries to clarify things. One comment though:
    One of the intelligent leftists I typically debate with has said that it’s nearly impossible to be on the right side of the Laffer Curve. After all, the necessity to work is fairly inelastic….

    Trackback by A Second Hand Conjecture — April 13, 2007 @ 3:47 pm

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