Something you may or may not have heard about when hearing people discuss economics is the Laffer Curve. Whether you have heard of it or not, taxes are definitely something you hear about a lot, and they are also a subject that most people have a vested interest in. The Laffer Curve is a very relevant topic when it comes to taxes and economics as a whole.
EDIT: I was asked to provide pictorial examples of the Curve, so I have included a basic pictorial representation for those of you who are more visual-oriented.
Definition and History of the Curve:
The Laffer Curve is credited to Arthur Laffer, an economics professor who proposed the curve in 1978 on a dinner napkin. The general purpose of the curve is to demonstrate, by comparing tax rates versus total tax revenue received, that at a specific point in time there is an optimum tax rate where the government will incur the maximum amount of revenue. The graph typically is depicted with tax rates on the X-axis and tax revenue on the Y-axis, making a bell-shaped curve with a peak at the maximum tax revenue.
Though Arthur Laffer is credited with the curve, he wasn’t the first person to think of the idea. John Meynard Keynes discussed the concept in one of his famous works, General Theory of Employment, Interest and Money (from which Keynesian economics is derived), though even he wasn’t the original source. One of the earliest people that can be credited with the idea is (now this is from Wikipedia, so take it with a grain of salt) a North African polymath named Ibn Khaldun who wrote about it in 1377.
Explanation of the Curve:
On a macroeconomic scale, the graph assumes that all entities (consumers and businesses alike) are being taxed the exact same tax rate as everyone else, that no graduated tax brackets, tax incentives, or anything of the like are being employed. This seems like a very gross simplification of what is actually going on in a taxed economy, but a lot of it is just to demonstrate a general idea of what is happening. On a microeconomic scale, it can be broken down by individual tax brackets, industry tax brackets, taxes going to different levels of government, and by type of taxes, among others. When it is viewed from a microeconomic perspective, each segment can be broken down and viewed individually with its own curve.
I realize some of that may be over my readers’ heads. All I said was that the Laffer Curve is a broad generalization of how the economy works when it comes to tax rates. When using it to talk about the economy as a whole, it can’t be used as a completely accurate representation of the economy, only as a rough model. Each specific industry is affected differently by different factors, and so the curve will look different for each industry. The same also holds true for tax brackets, especially since we use a graduated income tax, meaning that richer people pay a higher percentage of their income in taxes, and so they will be affected differently by alterations in the tax rate. The other thing about tax brackets is that the government usually alters tax rates by brackets, not for the economy as a whole. The curve does provide a good, simplified, overall representation of what is going on, though.
In general, the idea of the curve is pretty simple. If the government were to charge a 0% tax rate, then it obviously wouldn’t make any tax revenue. But if the government were to charge a 100% tax rate on income then it would be pointless for anyone to work and pointless for businesses to engage in normal operations with no income to be gained (both because no consumers would have income to spend and because 100% of the money the business does make goes to the government), and so nobody would be making any income and the government wouldn’t have any income to tax. There lies a point somewhere in between where the government can make as much tax revenue as possible without discouraging consumers from working and discouraging businesses from making money. This is not saying that the government necessarily needs to be making the most they possibly can in taxes, it just means they can use the graph as a barometer to see if the tax rate is too low or too high. If tax rates are increased and the government receives more money, then the tax rate was below optimal. If tax rates are increased and the government receives less money, then the tax rate was at or above optimal.
A commonly-held misperception about tax revenue is that if the government needs to make more money in taxes then it simply needs to raise the tax rates to do so. This is not necessarily true. Just think about it as a business trying to maximize its profits by altering the price of its goods. For example, a grocer could charge $1,000 for a jug of milk. Using the logic of higher tax rates = higher tax revenue, then this should make the grocer more money because he has raised the price. However, it is highly doubtful that he would sell any milk and wouldn’t make any money, based on simple consumer psychology. Your average consumer is not going to think a jug of milk is worth $1,000, especially if they can go to another store and buy it for considerably less, so the grocer will probably not make too much money off of his milk, if any. But obviously he can’t just give away the milk, because then he wouldn’t make any money either, and won’t be able to keep his milk in stock because everyone would take it. There is an optimal price in between where the price is high enough to keep merchandise in stock, but low enough to where people will still be willing to buy it (Economics 101: Supply and Demand). The same holds true for the government. If higher tax rates = higher tax revenue, then one would have to then assume that a 100% tax rate would generate the most tax revenue. But how many people do you think would work if the government took every cent they made? Not too many, at least not in a capitalist society. There becomes a point where the tax rates will become so high that citizens will no longer see the point of continuing to earn income, or they will move to another country (no longer paying taxes to that government). Just like with the grocer, there is an optimal tax rate where the government would have enough income to provide its services to the people, but low enough to where people would still be willing to earn money.
Criticism of the Curve:
The Curve does make several assumptions about consumer psychology. In a capitalist society, greed is usually assumed to be the motivating factor in economics, where people are making decisions based on what is going to have the greatest positive (or least negative) effect on their wallet. However, what if people are not being greedy? If taxes are going into government programs and are being used to provide people with a way of life, then perhaps some people will not mind being rid of all their money. This is essentially a Marxist state, where people work for the good of society rather than for personal gain. In such an economy, taxes wouldn’t really even exist anymore, as all income would go directly to the state. Possession no longer is dictated by having the financial wherewithal to buy it; it is distributed evenly (or at the government’s discretion). Obviously, there are going to be quite a few within the society that will not bother working because they don’t want to lose their buying power. But since the Curve is simply looking at government tax revenue, what will the impact on tax revenue be? A critic would say that the revenue would not be zero unless 100% of the society is motivated by greed.
One might say that greed isn’t the only factor, that the reason people don’t want to give their money to the government is because they don’t trust the government with their money, either because they think the government is corruptible and/or they think the government is inefficient. In either case, people are afraid to give their money to the government because they don’t trust the government to do the right thing with their money. People want to have control over their money so that they can decide what best to do with it, whether it be investing, spending, or saving. Though since it is the desire to have control over their money, wanting to keep and “hoard” it (if you will), one could also argue that this is essentially the same thing as greed. One also has to look at whether the lack of income would be enough of a motivator to stop people from working, even for those people who are motivated by greed.
Regardless of whether or not a 100% tax rate would provide zero tax revenue, the question also remains as to if a 100% tax rate would provide the most tax revenue. Again, one would have to look at what percentage of the society is being motivated (consciously or subconsciously) by greed or control. Would enough people still work (and work hard) to generate income solely for the government? Would enough businesses (most likely government agencies in this type of economy) be motivated to be profitable if all of their income is being taken? This is a question of economic theory and statistical projection, and it is difficult to answer. It ultimately boils down to the age-old argument of government control vs. private control.
Regardless of whether or not the Curve works, the basic question at stake is who will be the most efficient and profitable with resources, the government or the individual? This is not a simple question, and it has been debated for ages, ever since the first economy was born. The natural impulse is to hold onto one’s own resources to ensure one’s own survival. But as evolution (for lack of a better term) occurs, the survival of the family, race, and species as a whole eventually become higher priorities. In order to aid in someone else’s survival, resources will obviously have to be sacrificed, whether that be through specifically giving it to the less fortunate person or giving it to a group who will administer the aid in your stead (like a charity or a government). Since resources have to be given away, personal control over the resources and greed will have to diminish for this to succeed. But care also has to be taken to make sure the resources are used responsibly, otherwise it will lose its resources and not succeed.
Does the Laffer Curve work? The answer is conditional. In a pure market economy, where the absolute minimum of resources is in the hands of the government, then yes. In order for such a society to succeed, people have to be motivated to be responsible and profitable with their resources, or else they will lose them. In such a society, administrative (government) expenses would be considered “overhead,” and any business person will tell you that overhead is something you are always trying to minimize. Therefore, a 100% tax rate would not be desirable in a pure market economy. However, in a pure command economy administration is the key to success, and so all of the resources would need to be devoted to maintaining the government. In order for such a society to succeed, people would have to be motivated to trust the government with their resources, and the government would have to be motivated to be responsible and profitable with the resources they have. In such a pure command economy, a 100% tax rate would be the most desirable because everyone would be working hard and contributing the maximum amount of their income, and so the Laffer Curve is wrong.
The simple answer is a question: which do you agree with more, capitalism or socialism? The answer will affect your opinion about the effectiveness of the Laffer Curve.