Sep 02 2009
What are you Laffing at? The relationship between tax rate and tax revenue
Published by Jason Welker at 1:05 am under
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WikipediaA short walk on the supply side | Free exchange | Economist.com
The Economist’s Free Exchange Blog wrote this timely piece on supply-side economics and the Laffer Curve. I couldn’t have (in fact, I didn’t) explained this better myself!
“The basic reasoning behind the so-called “Laffer curve” is plain, uncontroversial, and by no means was discovered by Arthur Laffer. There is nothing to tax if no one produces anything. But taxes affect the return and therefore the motive to supply labour to economic production. An increase in the tax rate can reduce the pool of wealth to tax — the tax base — by reducing the supply of labour. No taxes, no revenue. Also, 100 percent tax rates, no revenue. Somewhere in between — exactly where depends on, among other things, the responsiveness of labour supply to after-tax wages — there will be a point at which an increase in rates delivers a decrease in revenue. If the tax rate is already past that point, a tax cut delivers more revenue.
…labour supply is just one of many ways in which an increase in tax rates may reduce the effective tax base. In addition to working less, individuals may alter their savings and investment patterns, bargain to shift more of their labour compensation to untaxable perks and benefits, move to a different tax jurisdiction, consume more tax-deductible goods, or simply hide income from the tax authorities.”
As Laffer’s model shows, at certain tax rates, a tax cut will lead to an increase in tax revenue. So how can policy makers be sure whether a country’s tax rate is at such a level? In America, where relatively high income earners pay around 35% tax, economists calculate that a tax cut of 10% would increase taxable income due to more labor and greater productivity, but indeed decrease overall tax revenue.
Conclusions? “Supply-siders” who advocate tax cuts need to look more carefully at where America is on the Laffer curve.
Republican politicians of late have exhibited a dismaying lack of respect for basic science, and it is not much of a surprise that many are also cavalier about fiscal economics. At current tax rates, new cuts will not “pay for themselves” in the short run. Emphasizing this point, however, does not begin to imply that raising tax rates is smart or harmless.
Discussion questions:
- Under what circumstances would a tax increase harm not only workers and firms, but reduce government tax revenue as well?
- What do you think of the Republican view in the United States that tax cuts will “pay for themselves” through increased national income? Will cutting taxes lead to more tax revenue in the short-run? What about in the long-run? Discuss.
- What is the likely relationship between tax rates and economic growth? Explain.
About the author: Jason Welker is a teacher at Zurich International School in Switzerland, where he teaches Advanced Placement and International Baccalaureate Economics. In addition to maintaining numerous online resources for economics student and educators, Jason developed the online version of the IB Economics course for Virtual High School and is currently authoring a textbook for IB Economics students for Pearson Baccalaureate which will be available in Spring of 2011. His economics student wiki won the 2007 "Best Educational Wiki" award from the "EduBlog Awards". Related posts:
- Supply – side economists: “lower taxes, more growth, more tax revenue!”
- Obama – probably not a “supply-sider”
- Advice to Republican presidential nominee on taxes – “raise ‘em!”
- SAS student Alice Su critiques John McCain’s tax plan
- The role of taxes in income re-distribution – another preview of my textbook
Do you like what you read on this blog? The author is currently working on an Economics textbook that will be available to order in Spring 2011. For more information, click above.
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The Laffter Curve’s purpose, I believe, is to show at what taxing percentage would the tax revenue be most beneficial. I find this interesting because toward the end of this article, it states:
“In addition to working less, individuals may alter their savings and investment patterns, bargain to shift more of their labour compensation to untaxable perks and benefits, move to a different tax jurisdiction, consume more tax-deductible goods, or simply hide income from the tax authorities.”
Doesn’t this mean that the graph could never be precise? The graph’s purpose is to show at what exact point on the graph would be most beneficial, but that point can change daily if, according to this quotation, so many individuals have the options to alter their savings, which, for that individual, changes the number of which the best percentage would benefit the government more. Individuals in the free market can do this at any time, so how could the Laffer Curve be accurate? What does it really show? It may point governments in the right direction, but not much else.
The article states “The basic reasoning behind the so-called “Laffer curve†is plain, uncontroversial”. I agree that the reasoning is basic and plain, but uncontroversial? The accuracy is arguable.
[...] Hey, what are you Laffing at? The relationship between tax rate and tax revenue [...]
The Laffer Curve makes a lot of sense. Unfortunately, there is just no way to determine where the tax that will lead to maximum revenue will be at. This leads to great debate, since policy makers, depending on their political agenda, are able to manipulate and discern for the public where they think the point is at. For Republicans and supply-siders, they keep mantaining that the tax is above the maximum level, and that there should be tax cuts. However, there is nothing solid to prove or disprove this theory. In the end, it all goes back to politics as leaders know that the ordinary non-economist citizen would love to have tax cuts, and then support that government. So in effect, the Laffer curve is quite useless.
This concept of the relationship between tax rate and tax revenue seems logical. However, since the article mentions that we never really know where we are on the curve, doesn’t it make the Laffer Curve useless? Tax cuts have become merely a tool for political leaders to gain support. The common citizen would raise their fists and shout “Aye!” at the sound of a tax cuts. Afterall, tax cuts means you’re better off right? Or not.
I kind of lol at the Laffer Curve every time I see it. Why? Well, obviously its name, but also as others have pointed out, its (lack of) usefulness. Sure, it’s logically sound, but I’m not entirely convinced of its practical use. Nick asks if the Laffer Curve could ever be accurate — and the clear answer appears to be no. McCain and co. like to go on about tax cuts for all, apparently ignorant of the significant portion — a portion we could possibly be on — of the Laffer Curve that show a decrease in taxes may only decrease revenue.
Blah blah. A lot of what they say is talk, anyways.
The explanations for the Laffer Curve make perfect sense. At a certain point, tax revenues are maximized. Low tax rates will stimulate investment etc while high tax rates will allow the government to bring in tax revenue. Somewhere in the middle, tax revenue is maximized. However this is simply theoretical because at low tax rates, nobody knows what the people will do. If tax rates are lowered, some people might go out and make more money. However some might work less and make the same amount of money. In that case, investment is not stimulated and people just simply work less. So its make sense but its theoretical
Theoretically wouldn’t the government be able to determine the nation’s position on the Laffer curve by experimenting with tax cuts and raises and seeing their effect on the amount of tax revenue?
The Laffer Curve is logically sound, but as nations can never really determine where they are on the curve, it doesn’t seem all that useful. There really isn’t a way to determine what tax rate would generate the greatest revenue. For example, a lowered tax rate doesn’t invoke a universal response; some people may spend more of their money, while others may not.
Do nations actually have to determine precisely where they are on the Laffer curve? Can’t they figure out an approximate range (as in whether they will benefit from raising or cutting taxes) and proceed based on that? For instance, if a nation knows it is well below the “M” point, through determining/experimenting as Kevin Yeh pointed out, raising taxes should increase tax revenue. Then based on determining whether the tax revune is enough, they can change their policies the following year and see the effect. I just don’t see why it’s essential to know where point “M” is and precisely where a nation is on the curve. (This is all assuming the reasoning behind the Laffer Curve is uncontroversial and ceterus paribus)
Laffer Curve is a great illustration of the relationship between tax rates and tax revenues, as we know for a fact that if the tax rate is raised to 100 percent, there would be no tax revenue because there is no incentive to work when people are required to give all their income to the government. However, despite the logic behind this Laffer Curve, we do not know where the nation’s tax rate is on the Laffer Curve. In order to find the optimal point m, the government would have to experiment and determine what the tax rate should be. Yet, it is time-consuming and an experiment on the entire nation is not so easy. The Laffer Curve could also be flawed, since we do not know whether or not a declining tax rate acts as an incentive to work.
The concept behind the Laffer Curve is pretty straight forward illustrating its relationship between tax rate and tax revenue. But like what Jack already mentioned I don’t really see much significance in this whole “Laffer Curve” because the point of the the desired tax rate to achieve the maximum tax revenue cannot be determined by any unit or equation.
Laffer Curve actually makes senses. Being a consumer, we don’t want to buy things more expensive than we expected especially when we know the part of what we pay goes to government. Firms are profit maximizers as well, so why would they invest a lot when they don’t get the expected rate of return back. Even though there’s no equation can actually help us to determine what tax rate would maximize tax revenue, it still gives the government basic idea about what consumers and firms think.
Everyone seems to be asserting that the Laffer Curve is “useless” because it’s inaccurate and doesn’t allow us to determine EXACTLY where point “m” is on the curve. However, this doesn’t mean that it renders it completely insignificant. The Laffer Curve, like most of the other curves and graphs we have learned about, is a theoretical manifestation of economic philosophy. It is difficult and maybe impossible to pinpoint the exact point on the curve that our economy is located on at the moment, since as Nick Beede pointed out, various factors could cause it to shift as often as every day; however, isn’t this true for the other curves we have learned about as well? The very same factors that cause ambiguity about our position on the Laffer Curve also cause uncertainty in the level of full employment, the exact spot for allocative efficiency, etc. All the statistics that we get from economic graphs and calculations are based on surveys/experimentation with data that could change from day to day. What they are meant for, however, is to help us understand economic concepts such as why tax cuts can be either beneficial or harmful to the economy, depending on the status of the economy at the time; and in this regard, the Laffer Curve serves its purpose in a straightforward and simple way.
In theory if the government raised and cut taxes over the courses of the next few years or decades, it would give them a good idea on which does it yield the maximum point of tax revenue return. It does kind of seem useless at this time, but maybe in a few years, it can give up a new insight into the tax revenue of the past few years or so.
The laffer curve illustrates that there is an optimal tax rate which yields the most possible tax revenue for the government. This makes sense as too high tax rates would decrease peoples’ incentive to work and firms’ incentive to invest.
The relationship between tax rates and economic growth is generally indirect as taxes increase, consumption and investment decrease causing a decrease in AD. In recessions, it would be reasonable to have low taxes in order to stimulate C and I whereas in good times the government should place relatively high taxes in order to balance their deficit from the previous tax cut.
A tax increase could harm workers and firms by decreasing their disposable income, which as a result could also reduce government tax revenues as people would spend less on other taxed goods. An increase in tax could also result in a less incentivized workforce, or with people attempting to evade the taxes.
To a certain point, a cut in taxes would result in flat or increased tax revenue for the government in the long run. Initially, workers could work less and still receive the same disposable income, but eventually the tax cut would incentivize workers to work harder for their money. This is subject to many factors, and should be researched by governments before implemented to find out how beneficial it could be to the economy.
In a Republican view-point there is probably an inverse relationship between tax rates and economic growth. The lower the tax rate is, the more disposable income the consumers have to spend on goods, increasing consumption and investment in aggregate demand. On the other hand, the classical viewpoint might believe that there is no relationship, and that taxes can increase and people will have to work harder, also leading to growth in the economy.
1. Under what circumstances would a tax increase harm not only workers and firms, but reduce government tax revenue as well?
When the tax % is too high, which means that the workers become less efficient, and although their tax is now higher, their productivity has gone down.
2. What do you think of the Republican view in the United States that tax cuts will “pay for themselves” through increased national income? Will cutting taxes lead to more tax revenue in the short-run? What about in the long-run? Discuss.
Initially it might give boost in the morale, urging the workers to be more productive and earn and earn much more. But there is a limit to what people actually need, and in the long-run they will realize that they can now easily sustain themselves by working less.
3. What is the likely relationship between tax rates and economic growth? Explain.
I can’t think of a graph that’d resemble this relationship, other than another laffer curve with economic growth on the x-axis.
What do you think of the Republican view in the United States that tax cuts will “pay for themselves” through increased national income? Will cutting taxes lead to more tax revenue in the short-run? What about in the long-run? Discuss.
I agree with the statement, but not entirely in the short run. A sudden tax cut means that a worker’s disposable income is now higher for the same amount working hours, hence there will be no sudden motivation to work harder or dedicate more time, hence no dramatic increase in productivity. In the long run, however, a nation with lower income taxes will have a harder working force as each individual receives a higher reward, but this is a very generalized statement. Very important is the fact that nations with lower progressive taxes attract high income earners who contribute to the country’s economy and overall national income. From what I’ve seen in Switzerland, it is highly suitable for successful people such as high earning athletes or even firms.
Very high taxes result in a loss of government revenue. Since the tax rate is very high, workers only get to keep a small percentage of their income and therefore have little incentive to work hard. If the economy is in a recession then a tax increase would certainly harm workers and firms as well as reduce government revenue. There is an inverse relationship between tax rates and economic growth. Due to a lower tax rate, consumption will increase because of a higher disposable income and investment will increase because of lower costs for firms. As a result AD would increase and output (real GDP) would increase. The opposite is true for higher taxes. Higher taxes decrease the disposable income of households and increase the costs of firm so consumption and investment would decrease. The fall in AD would cause a fall in output.
If a government raises its direct tax rate too much, workers will be disincentivized to work harder as they will keep less of their income. This has a negative impact on the economy’s level of output. Also, their disposable incomes will shrink which reduces spending. Thus governments will receive less indirect taxes. This could be disadvantageous for the country because governments will not have enough revenue to provide private goods.
In the short run, workers have suddenly faced increased taxes so they will slowly start to slack off in their jobs and start to buy less which will slowly reduce revenue for the government. In the long run I think this will worsen. People may start to find sly ways to avoid being taxed an example may be buying more tax- deducible goods. Or people may leave the country to seek a place to live where they can be taxed less. Thus the government will continually lose tax paying citizens.
Supply-siders will say that there is an inverse relationship between tax rates and economic growth. They view taxes as anti growth because workers are disincentivized to work or stay in the country. But a demand-sider may argue that if taxes are collected and the government spends on infra structure, public goods or health care, people may be incentivized to stay in that country and may be ok with living there despite high taxes. In this case, taxes will not necessarily decrease the nations productivity.
I beg to differ with all the comments on the laffer curve’s usefulness. I understand how you all might perceive this graph to be utterly useless as you can never truly know where your nation currently stands there. However, in my opinion you are all failing to see the “point” of the laffer curve. It is not meant to be used as an exact measurement to know whether to raise or lower taxes (since the ideal tax rate may vary) , more likely, I think, the laffer curve is a graphic representation of the concept that taxes cannot be too high nor too low if the maximum tax revenue is to be achieved.
1) When workers are being less productive and causing them to find measures of avoiding paying high taxes and earning high income (such as moving to another country where tax cuts are less). It is after this point that the government was better off setting lower tax rates so that each person pays less but has more incentive to work harder since they are keeping a larger portion of the money they are earning and are more prone to accept better jobs and higher wages, which otherwise might have forced a worker to think twice about accepting this.
2) In the short run wages are fixed which means that tax cuts will result in higher profits for the firm. This does not become higher tax revenue until the LONG run when wages are flexible. This money earned from not paying tax rates will increase the wages in the firm and invest in more efficient capital and therefore increase incentive to work and increase productivity. But in the short run there should be no difference in the tax revenue with a cut in taxes.
3) Tax revenue increases up to a certain point (the peak on the Laffer curve) but I don’t think economic growth follows this pattern. The greatest economic growth would exist when tax rates are 0% because the incentive for people to work would be at its highest. So the most likely relationship between economic growth and tax rates is an inverse one.
I realized that for my second answer I was only thinking of corporate taxes…
1. A tax increase will hurt both workers and firms as well as the government if the tax rate is far too high. This will cause any number of tax evasion tactics, as listed in the post, which will mean that the government revenue drops. If the government raises taxes high enough, the incentive to work will vanish.
2. I do not agree with the Republican view that tax cuts will “pay for themselves.” Unless the government is taxing at so high a level that tax evasion is the norm, there will be hardly any increase in tax payments. Although a drop in taxes will promote spending and therefore encourage economic growth in the short run, this will generally not be to a significant enough degree to last into the long run. The nation will also lose many vital social services that are essential to the current operation of the economy.
3. If tax rates are lower, then people will spend more, thus encouraging economic growth. Therefore there is an inverse relationship between taxes and growth. However, very low levels of taxes will lead to a decline in economic growth as less people will be able to work (cuts in education and health care) and willing to work (if the government provides the people with nothing, they may move.)
Chamonix
Elaine,
I thought that your post was very interesting. It is true, a lot of the right-wing Politicians seem to have very unrealistic ideas of taxes and want tax cuts without foresight. I think that these people like to use the Laffer Curve to prove untrue points about taxation rates. However, I do think that we can get an idea of where we are on the curve. By examining the rate of tax evasion and comparing it to tax rates, we can understand our place on the curve. (I know that obviously tax evasion is hard to calculate, but we could look at social security numbers or voter registration and changes over time in number of people paying taxes.) By examining these rates in different states or localities, we would be able to get a general idea of the rates of the curve. I think that the main thing is that we are not, as the right-wing like to attest, taxing more than the optimum rate. We would surely see a greater incidence of tax evasion. So, in short, I agree that it’s hard to calculate but don’t think that it’s useless.
Thanks for the post,
Chamonix