Note on Laffer curves

Tim and Richard have been having an argument about Laffer curves. Here, in no particular order, are my notes on the matter.

1. There are (at least) two Laffer curves - one that relates top tax rates to GDP, and on that relates them to tax revenues. The two probably do not coincide. For example, if a top earner responds to higher taxes by continuing to work but by dodging tax, GDP is unaffected but revenues fall. For this reason, the revenue-maximizing top rate is probably lower than the GDP-maximizing rate. To this extent, Richard is right to stress the importance of tax dodging. As Alan Manning says, a rise in the top rate must be accompanied by efforts to reduce avoidance and evasion. (Film tax relief has always struck me as an invitation to conmen.) Given that the deficit doesn't much matter, I would rather we thought more about the effect on GDP than on revenues.

2. Even if high top tax rate do reduce incentives, this needn't be a bad thing. They disincentivize rent-seeking, office politics, exploitation and negative externalities such as risk pollution as well as productive activities - maybe more so, given that the intrinsic motivations to engage in the latter are greater.

3. We should distinguish between incentive effects upon employees and the self-employed. The former might well be trivial: if someone stops working because of high taxes, his employer will replace him. The latter might not be.

4. There's very little robust UK evidence here, simply because the top tax rate didn't change for years. And it's hard to infer anything from the rise in the rate to 50% in 2010 because of forestalling and because the rate didn't last long enough to have longer-term behavioural effects.

5. The shape of the Laffer curve depends upon tax morale. if you think taxes are theft, you'll try and dodge higher ones or stop working. If you think they're the price to pay for living in a civilized society, you'll accept them. This implies that the revenue-maximizing tax rate will vary from time to time, place to place and people to people. For this reason, even good international (pdf) evidence might not be a good guide to tax-setting in the UK. The first two of Kling's laws apply: sometimes it’s this way, and sometimes it’s that way; and the data are insufficient.

6. Relevant evidence here also comes from laboratory experiments. Some of these suggest that a 50% tax rate maximizes revenue.

7.As Tony Atkinson says, taxes might not be sufficient to reduce inequality. One reason for this is that pre-tax inequality also matters.

8. There are two contrary but tenable positions here. One is "the revenue-maximizing tax rate might be high, but high taxes are undesirable because they infringe freedom." The other is "The revenue-maximizing tax rate could be low, but high taxes are justified to reduce the adverse effects of inequality." Both of these positions are rare - which makes me suspect that there's quite a lot of motivated reasoning on both sides.

Comments

[Luis Enrique]

a related point - I think some people have this idea of the public sector sucking the blood out of the private like a parasite that lives off it. So you have a Laffer curve because as you extract more blood, you start to kill the host. What that forgets is that the blood circulates, and as the state grows the quantity of goods and services provided by the state also grows, so that private sector actors live off the state just as much as vice versa. Taxes can go all the way to 100% so long as goods and services become 100% publicly provided too. (full blown communism?). There is a separate argument to be had about what happens to the size of the pie as you move towards 100%, but my point is that the pie doesn't approach zero and taxes approach 100%, which seems to be the idea the Laffer curve is based on. A more sensible Laffer curve merely says there is some interior maximum, not that the curve bends back down to zero at tax = 100%.

That separate argument about pie size is that taxes affect behaviour, discourage economic activity, and the public sector often inefficient, so that as taxes rise beyond some point, GDP does start to fall. Of course any Laffer GDP argument also has to say something about productive public expenditure - but on basis there are diminishing returns to that, that merely complicates but does not fundamentally change the argument. (empirical evidence: http://www1.worldbank.org/publicsector/pe/pfma06/CJE.pdf).

When I encounter really rabid anti-taxers (say, Worstall commentators) I get the impression they have a parasitic model in mind, taxes are all taking and no giving.

[Luke]

On purely anecdotal evidence, I reckon changes in rate could be as important as the rate itself.

When I started working as a lawyer, the older partners had lived with 85% taxation. When it came down from 60% to 40%, they literally howled with delight (they were listening to Nigella's dad on t'radio). WIthin a few years, there were no City lawyers over 50 - they'd formed their spending habits with 85% tax, and after a few years at 40%, they had more money than they knew what to do with.

[Matt Moore]

Point 8 is brilliant. I'm in the first camp actually. And actually, I think most free-market-people are. It just doesn't seem like it because we talk about top marginal tax (beyond revenue maximising) and not the important average rates (clearly below maximising)

This is a key point that was missed.

Too often, Laffer curve discussion focuses on the top marginal rate. The revenue maximising rate here might be quite low, due to the high international mobility of the wealthy. In fact, if our goal was to maximise tax revenue, we'd be putting up taxes on the immobile poor. (And so it is, mostly semi-hidden sales taxes - "sin" taxes, VAT, fuel duty etc.)

Therefore, I think we are well below the revenue-maximising rate of average tax, which might be about 40-50% on all incomes. But this is a massive assault on freedom, and I opposite it as such. Ergo, I am in the first bucket.

[Dave Timoney]

As Matt notes, the Laffer curve is a simple political misdirection that causes us to obsess about a top tax rate that is marginal to revenue (though emblematically important to morale).

But rather than putting up taxes on the immobile poor, why not increase taxes on land? Not only does it have the virtue of immobility, but a land value tax is an incentive to productive use and carries no deadweight loss.

[UberLibertarian]

Yes, I too hold a nuanced position.
You can have "small" government in tax burden terms like Singapore, but authoritarian, autocratic, top-down , centrally planned, with lots of govt. involvement in housing, energy, transport, etc. And then you get traffic lights that move you seamlessly thru traffic, and adjusts for ambulances and stuff.
Or you can have the NFL, in which every team has to have the same wage bill and all the incomes are pooled, etc. - but it remains flexible and accommodating, and popular as well, with plenty of randomness and opportunity.
I'm a Libertarian mostly, precisely because our govt. just doesn't seem to spend the huge monies it gets/takes in such a way as to justify the amounts - either in terms of quality and efficiency of public services or in terms of poverty reduction (i.e. people actually moving wholesale into bourgeois middle-classness on a permanent basis).

[Ari Andricopoulos]

Point 2 is very interesting. The assumption made by Laffer is that the super rich are those driving the economy. What if the opposite is true? They are actually the leeches.

I vote the latter, personally. I can't actually think of any super rich people of whom I think, thanks, we all owe you one for helping the economy.

I am biased though.

[Blissex]

«high taxes are undesirable because they infringe freedom»

That's a standard "Libertarian" position but it is wholly wrong as long it is legally possible to leave a country.

When it is legally possible to leave a country, paying tax in that country is a purely voluntary bargain of mutual advantage.

Just like nobody forces you to work for minimum wage if you can legally leave the job, as it then is a purely voluntary bargain of mutual advantage.

There is market in country residence, just as there is a market in jobs, and as long as you can legitimately refuse a deal, from a Libertarian point of view there is no coercion.

[Blissex]

«The assumption made by Laffer is that the super rich are those driving the economy.»

That's the standard Libertarian truthiness, that looters and moochers produce nothing of value, and all value is produced by a small number of exploited "Randian heroes" like Fuld, Cayne, Lay, ONeill, Greenberg, ...

And it is also Central Truthiness of Economics, that income corresponds exactly to productivity, save for government distortion.

[Blissex]

«tax morale. if you think taxes are theft, you'll try and dodge higher ones or stop working. If you think they're the price to pay for living in a civilized society, you'll accept them.»

There are several studies that show that *in general* tax morale is strongly influenced by whether tax funded spending benefits the taxpayer's own group (not even the taxpayer personally), and that the worst tax morale exists in countries that were ruled by foreign conquerors or otherwise by "other" elites that spent tax revenues on their own group. That tax morale is thus lowest in countries ruled for a long time by foreign conquerors.

BTW Randian/Libertarian arguments against taxes are based on a curious variant of the argument, where it is a majority of knaves that exploits a minority of heroes.

I think that the basis for tax morale is not fairness but reciprocity: the idea that tax funded spending is *potentially* available to the taxpayer or their relatives and friends, instead of always benefiting the same minority of "others".

In other words as always the "motivated reasoning" behind the Laffer curves are not the hypocritical ones of the coercion of taxation or the wastefulness of spending or the optimal size of government, but which way redistribution goes.

In a slightly different wording, many/most taxpayers don't mind some redistribution or a lot of social insurance within their own "tribe", but resent one-way redistribution to another "tribe".

Thus the malicious arguments used by reactionaries; for example in the UK where tax spending is described as solely reserved to a specific elite of "others" who have 3 generations on benefits, who are given so much money that they live in mansions with many spare bedrooms, whose benefit income is much higher than average income.

The malice of the argument is based on ignoring that most taxes are paid by (working) men, and most spending is to the benefit of the (rentier) women who are close relatives or friends of those men in the same tribe, not to the benefit of men and women belonging to a mythical small caste of hereditary scroungers ("looters and moochers").

[Blissex]

«but which way redistribution goes»

Joining this to my argument that conservativism is in essence the protection and furthering of the interests of whichever dominant category, tribe or caste of insiders a body politics has, when redistribution based on taxes and spending flows from outsiders to insiders then conservative political parties become "big government" conservatives and favour high taxes (on outsiders) and high spending (on insiders).

Which has been justified for very long times by a lot of specious arguments, and even by suitably crafted theology when parish priest sermons were in the past the equivalent of the Daily Mail or Telegraph (or the Washington post editorials or Fox News).

[e]

In defence of motivated thinking I hope there’s economic practitioners out there who can and will build on number 8’s rarity value for purposes other than division and greed, or just getting by another 5 years.

[Blissex]

«"small" government in tax burden terms like Singapore,»

Singapore's government is not at all "small", it is very "big government", very intrusive and authoritarian as you say, but also high tax and high spending, because the mandatory contributions to the Central Provident Fund etc. are taxes but in name and are pretty large.

The crucial feature of Singapore's "big government" conservative approach using mandatory savings is however that it is only mildly redistributive (and mostly upwards), to the point that is there is very little social insurance, that is no pooling of risk, as all individual transfers from the government to an individual are supposed to be entirely funded by the individual's mandatory contribution to the Central Provident Fund, with zero "safety net" for the poor.

Some of that has been changed over the recent past, but Singapore is the model of conservative politics of a coalition between insider affluent middle classes and the insider upper classes, with outsiders left to "deal with it".

[theOnlySanePersonOnPlanetEarth]

The USA has the highest poverty rates in the OECD, Denmark have the lowest. It is estimated that without progressive tax policy and transfer programs Denmark would be at the level of the US. Putting the Laffer in the dustbin would seem like the best way to deal with Laffer curves.

Do we have to do the apples analogy?
There are 3 people, Janet, John and fat pig greedy cunt face. There are 30 apples, they are distributed evenly. Then fat pig greedy cunt face steals 9 apples each from Janet and John. The currently tally is:

Janet = 1 apple
John = 1 apple
fat pig greedy cunt face = 28 apples.

Now let us work this out, if John and Janet take back say 3 apples, will this create disincentives? Will taking back more than 3 apples actually reduce the overall apple stock?

WTF? Just kill fat pig greedy cunt face and take all the apples. Stop wasting time on ridiculous abstract maths already, which designed to provide justification for the original theft!

[Blissex]

«The USA has the highest poverty rates in the OECD, Denmark have the lowest. It is estimated that without progressive tax policy and transfer programs Denmark would be at the level of the US.»

There are two important differences between the USA and Denmark:

* Danes largely think they belong to the same "tribe"/"group", most of the USA middle class think that the poor don't belong to their "tribe"/"group". The most obvious example for the USA are not the poor of african origin, but the native "indians".

* The USA (and UK) middle classes have fully bought into the "plantation economy" model, in which each of them believes that they will win big and enjoy an "upstairs" lifestyle, and everybody else will lose and toil through a "downstairs" one, while the Danish middle classes believe in risk pooling, perhaps because they are not that confident that each of them will be a winner (in the UK the "blow you Jack, I's allright" mindset of Telegraph/Mail readers).

As to the latter point in the USA:

www.eschatonblog.com/2015/04/why-didnt-i-get-rich.html
«journalists/columnists of a certain age (meaning ones not much older than me and younger) are coming around to the realization that the economy is screwing them, too. There was a moment when a lot of them (we're talking ones at elite outlets, not your random small town paper) thought they'd done everything right, would become celebrities, and get Tom Friedman's speaking fees. The economy sure was working for them, and screw everybody else.»

[Icarus Green]

Just like to add, that the focus on income taxation is amiss. Most of the very poor pay most of their taxes in sales taxes and the like.

Most of the very very rich, pay most of their taxes (if any) on stamp duty, cap gains, dividends and other property related (unavoidable) taxation.

Talking about Laffer curves in relation to the income tax rates is basically a discussion about incentives for or against middle class people to do work.

We need all classes to pitch in.

[Dave]

"For this reason, the revenue-maximizing top rate is probably lower than the GDP-maximizing rate."

I understand that argument for taxes on wage income, which seems to be the focus of this post. For taxes on corporate earnings or capital income, I can easily imagine that the revenue-maximizing rate is higher than the GDP-maximizing rate for taxes on capital, especially over shorter time periods. I could see taxes on capital assets or business operations that are very effective in generating revenue from existing, long-lived assets and operations (e.g., a factory, refinery, or long-established office) but that also discourage additional capital investment.

(Discussing taxes on capital income also requires thinking about complexities like nominal returns vs. real-returns and limitations on applying capital losses against non-capital income, all of which make the true marginal tax rate a bit more complicated to figure out.)