September 26, 2009
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A Layman’s Explanation of the Laffer Curve
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.
Conclusion:
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.
Comments (9)
I think I recall reading that a Muslim also produced an idea similar to the Laffer Curve much earlier than 1300, but I’m not sure. Just one of those fleeting topics that I passed.
Anyway, I would have liked to see some more specific examples of the Laffer Curve. I have never studied it formally, and the context from what I recall tends to be in public policy. I don’t think we’re really stuck with your concluding question, and the effectiveness is ultimately going to be a result of its empirical findings. The motive to tax is irrelevant to its positive application; though, obviously I am not dismissing the importance of culture on tax policy. The point is that the issue of tax incidence is founded on ideas beyond the Laffer Curve, just like issues of the simplified S&D model are founded on ideas that go beyond the model (e.g., type of competition involved, information costs, etc.). The effectiveness of S&D is based upon its pragmatic merit, regardless of what assumptions it makes (we can always go with other models using different assumptions, or a modified form of the given model).
To the issue of capitalism vs socialism, though, seems misplaced. Socialism does not require that people want to do anything for the common good in terms of how much they are willing to risk of their fortune to benefit others. The issue of taxation rests more upon equalizing a fair assessment of value. Most taxes are in place to rectify externalities or social costs not realized in the price of a good or realized at all. A government is taken to be fair to tax people for things they receive benefits, such as military protection, or a tax to help pay for the costs no one will bear directly such as road use. This does not require socialism or capitalism but a cost-benefit analysis of the full value of items involved. The difference is that when we look at things in terms of “pure capitalism” we tend to neglect inter-personal factors, while socialism makes the social aspects intimately apart of the economics. This does not mean socialism is better, nor that capitalism cannot account for social factors. The theory for those things is independent of those modes of perspective. The point is that characterizing the issue in terms of one or the other is essentially making a false divide (dilemma).
@bryangoodrich - I understand your argument about the false divide. And you are right that there are many socialistic ideas that may be in place without the economy being “socialist.”
The only reason I really was focusing on it being a pure capitalism vs. pure socialism idea was because I was talking about whether or not tax revenue would be zero at the maximum rate. The divide really only exists at the maximum tax rate, but since the Curve defines tax rate as being zero at both 0% and 100% tax rate, the divide at the maximum tax rate is relevant to the very definition of the Curve. At 100% tax rate, people have to still be willing to work even without getting money in order for the tax rate to not be zero (some type of command economy, which would most likely be socialism). In a pure market economy (or mostly market economy), the total revenue at 100% tax rate would most likely be at or near zero, and so the Curve would work. However, in a command economy, people would still work (whether by choice or by coercion) and so the tax rate would not be zero. But if people are being coerced to work, then it is doubtful they would work any harder than they have to, so tax revenue would probably not be maximized. Therefore, the question of whether or not people are willing to work hard for no money by choice is, indeed, the relevant question.
In general, I think the Curve works, inasmuch as that there is an optimum rate somewhere in the middle where the greatest amount of tax revenue can be made. But I don’t think we can say with any conclusiveness that there will be no revenue at a maximum tax rate. Again though, based on what your beliefs are about economics, it will affect your opinion of the validity of the Curve. If you think capitalism works better based on your understanding of consumer psychology, then you are most likely also going to think people will be less inclined to work if they receive no money for it (agreeing with the Curve). If you think socialism works better based on your understanding of consumer psychology, then you are most likely also going to think people won’t be as affected by the amount of money they make (disagreeing with the Curve).
@gsmith03 - First, socialism is not a command economy. That is a totalitarianism, and the two are never the same. The whole idea behind socialism is collective ownership. Being told what to do or what you will have is, by definition, not participating in the ownership. There is inequity in that asymmetry. Socialism attempts to make distributions equitable.
As for the extreme case of a 100% tax rate, it does not simply depend on your belief about consumer psychology. It has to be followed by empirical facts. The soviet union (a communist and militant regime) effectively had a 100% tax rate and they still produced things. The simple fact is that people would not just stop working. That’s like saying people would sit there and starve to death because the government took all their money. The soviets worked and got something in return, even if it was not distributed through a price mechanism that allowed them to exchange things on that given market. If a capitalist society somehow allowed their government to sequester all their income, then they would stop working in that market and find ways to produce things for their livelihood. That’s just survival. Of course, it is entirely comparing apples and oranges. We wouldn’t allow government to take all of our income because we would revolt and overthrow such a government because we have such institutions in place to protect us or authorize us to rebel. Russians were not so lucky when those in power had the military might to crush any opposition. It wasn’t about ideals of socialism or communism or capitalism. It was survival, and economics cannot be parted from politics. The political structure of a society that would exist with a 100% tax rate is a very odd one, but a tax still needs to be defined. Unless the soviets actually had no income, no way of procuring resources, then there was not really a 100% tax. A tax wouldn’t even really make sense because a tax structure requires a certain political and social structure to allow its predication. Instead, it seems more to the point that a 100% tax rate is empirically unattainable in the realm for which a tax rate would even exist. Otherwise, we’d enter an entirely different domain that is incomparable.
Oh, and I would question the existence of the Laffer curve itself. Theoretically it simply says that there is an optimal tax rate that exists between the possible tax rate extrema on its domain. As I said above, it is questionable if some of those tax rates are even meaningful (the function may not obtain a value over that whole domain), and I doubt it would have the nice parabolic shape we see. That would need to be argued for empirically, but I have not looked into it. Other than that, it’s a standard economic approach to any trade-off. If we can find a function to represent it over a given domain, then we simply optimize the function to achieve a maximum. The real point of the Laffer curve, from what I read, is to express that a tax cut may lead to an increase in government revenues. While the Laffer curve may express that, it does not capture at all why that might be the case. There is much to how the Laffer curve would be constructed to explain how we get the given relationship, and nothing in the Laffer curve really expresses that. More to the point, there is nothing in the Laffer curve besides the tax rate and the revenue, when there are far more variables involved as to how government revenue obtains and to what level.
@bryangoodrich - ”Socialism attempts to make distributions equitable.” Right, by attempting to administrate those distributions among the respective “owners.” The government attempts to distribute income equitably, but it is still making the decisions regarding how to distribute that income. Since the government is deciding where the money goes, I fail to see how that is not a command (or planned) economy.
Lol…I think Karl Marx would agree with some of the things you pushed regarding empirical data, as much of a materialist as he was. Empirical facts do have to be a basis for your opinion, but unfortunately when it comes to economics there is much theory involved and little empirical data to go on. So it basically boils down to which theory - which school of economics – you agree with, which is the argument I was making. Marxism and Keynesianism both lean more toward a command economy, whereas supply-side economics and Austrianism both lean more toward a market economy. And I agree that the empirical facts do not seem to agree with zero tax revenue at 100% tax rate, at least in a command economy (such as your example of the Soviet Union, though would that be considered tax revenue?). Though you also said something about a capitalist economy where the government sequesters all the income, yet people still find other ways to work out of “survival.” Right, but these would be non-taxed forms of work, as they would be trying to keep something for themselves from the government, so tax revenue would be zero. But ultimately the data and facts are quite limited in supply, and so sociology and consumer psychology come into play quickly, which is what economic theory is based on.
I also think you hit the nail on the head when it comes to how you depicted a society with 100% tax rate. I have to agree that taxes seem pretty irrelevant in a command economy, and a market economy would never allow such high taxes to occur. Therefore, could an economy with 100% tax rate even exist, and what would it look like if it did? Similar to what I said in the last comment I made to you, I agree with the idea that there is most likely an optimum tax rate between 0% and 100% where the most revenue would be made, though I doubt it would be zero income at 100% revenue. I also agree that it is doubtful that it would have a nice, smooth bell shape to the curve, but statisticians have always had a fixation on bell curves. And from what I have read, most of the practical applications of the Laffer Curve are more for determining if a reduction in tax rates can increase tax revenue, a concept which has (understandably) been snatched up by the economic conservatives.
I think we actually agree on this quite a bit. You seem to be a bit more empirical and materialistic in your approach than I am (though I am also quite the materialist myself), but we seem to have a lot of the same basic opinions about the Curve. I could be wrong…
@gsmith03 - You do not understand modern socialism if you think it can only operate through a command economy. The market is not a product of capitalism. It is independent of it. Market democratic socialism is the modern form of socialist thought, which utilizes the market as a means of distributions, through which ownership is not in the hands of capitalist, nor up to a central authority for redistribution. Market socialism operates by collective ownership, and market distributions. It is about decentralization and community.
As for economics, there is plenty of empirical facts. Things left to interpretation, like any philosophy, depend upon ones views and assumptions, but those interpretations are beside the point. Economics is an empirical science that utilizes empirical information to construct models about economic facts. The whole “economic school” is an artifact of economic history for when it lacked much of any scientific backing. For most of history, economics wasn’t even its own field, much less a field with a rigorous methodology. While as a science it is still young, it has come a long way in the past 50 years. Issues of where one is Keynesian or Austrian are only an issue in policy (normative) economics, and not those concerning the facts. While the two are not independent, it would be a mistake to obfuscate them. Trying to interpret the Laffer curve in respect to economic perspectives or types of political structures is such an obfuscation.
You are correct, though. The Laffer curve is a product of people trying to identify supply-side economic reasons for a tax reduction, i.e., that by reducing taxes we can gain money. The Laffer curve, however, only at best says that it is possible, not that it is either necessary nor sufficient. This is why the Laffer curve is rather empty without any empirical backing which would only exist on a given case for which we can say “if we lowered taxes and we had an increase in revenue, then we are ahead of the optimum, and if we increase taxes and increase revenue then we are behind the optimum.” But this isn’t entirely true, nor empirically supported. The Laffer curve in that way only depicts a correlation, not a causal connection. There is no basis that tax rate actually is the influence on the revenue in either case. Often the supply-side approach claims “a tax cut puts money into the rich’s hands and they invest it into the economy stimulating growth and revenue.” That is not what the Laffer curve provides, nor is there even support for that complex explanation. The fact of the matter is that revenue accrues for numerous reasons, and what might stunt or enhance it is exogenous to the Laffer curve model. Not to mention, [supply-side economics] is just wrong.
@bryangoodrich - And you apparently do not understand what a command economy is. “Command economy” is possibly a misnomer, because it implies totalitarianism or militarism. But all it means is that some group of people is trying to manipulate (command) the economy as a whole. Command economies do not have to be totalitarian or even authoritarian in nature. All it has to be is some type of bureaucracy (a government or some other faction within the society) trying to administer and control the economy rather than letting it behave in its own way as a market economy tries to do. And socialism, even though modern socialism involves people from the private sector, still controls the distribution of income and allocation of resources, which still falls under the definition of a command economy. Sure, it is probably more toward a market economy than what Marx or Lenin had in mind, but it is still a command economy.
Perhaps there is more empirical data coming out about economics, but the nature of the beast with economics is that there are so many factors all acting independently and jointly at the same time that it is difficult to differentiate what is causing what. While you can find “statistics” that back up positions on whatever side you wish to take, there are always other forces at work and it is difficult to find a correlation. You yourself mentioned this when trying to empirically prove the Laffer Curve, and it applies to economics as a whole because there are so many potential causes for growth or decline, surplus or shortage, inflation or deflation. Not only this, but the length of time before the effects take place isn’t always distinguishable, nor is it easy to determine how long the effects will last. So you may look at an isolated event in time and find what appears to be the “cause,” but how do you know it was that event as opposed to something that happened possibly years before? As a result, the empirical data you get from it is inconsistent, which renders it essentially invalid, and forcing us to fall back on theory. Trust me, I wish I could rely more on empirical data with economics. It would make it so much easier to just have raw, consistent numbers that I can just throw out there and easily determine how it is working. But it just doesn’t work that way.
Well, this has been fun, but I really need to get some sleep. We have also strayed a bit from the topic at hand. I think my part in this discussion is over. Though I have enjoyed being able to have an intelligent discourse with you over this.
@gsmith03 - By your definition, then every economy is a command economy unless there is no market manipulation by an authority. Effectively, it would require that no government exist because the very existence of a market requires a government to secure it, which is one of the proper roles every economist and philosopher has recognized throughout history, even some of the most capitalist oriented (e.g., Milton Friedman), not to mention the value of currency depends on government, among numerous other things we can enumerate some other time. But there is a problem with your definition, you say “some group of people is trying to manipulate … the economy as a whole.” This is rather vague since some rather isolated incidence can impact the economy as a whole, and even in a laissez faire economy individual actors can impact and manipulate the economy for their own end. This is, after all, the point of monopoly (market) power. Thus, if we take that clause to its extreme, every economy is a command economy unless it can entirely remove market power and act only as a perfectly competitive market. This is impossible, both due to natural monopolies and market failures, but also due to geographical displacement and information asymmetries. The perfect competitive market is as ideal as talking about gravity without air friction, or an ideal gas. They don’t actually exist.
As for economic method, while it is true that there are many factors involved, it is not the goal of a model to explain in every detail every causal relationship. Even natural sciences do not attempt this. A model attempts to predict certain elements that are good enough to explain the outcome. A pool player’s shot can be analyzed quite accurately with physics, but it does not mean the pool player even thinks about physics for her shot. Likewise, we an analyze a profit optimization function to accurately represent a firm’s decision patterns, but it does not entail the firm is even using a profit optimization as their motive for acting. This is how inductive inferences work. While it is obviously more powerful to have causal information, that only acts to enhance and support our models by how we derive their maintained hypotheses. All inductive inferences depend on the available information, both in the sample and supporting the model or theory. It would be a mistake to think economic science is deficient because it is in a precarious spot in regard to causal relationships that it is trying to explain or predict with abstractions and theoretical models.
Wellll, since socialism has never worked well yet for any length of time, I’m in favor of capitalism. However, it doesn’t seem that the majority of our countrymen agree with me. The lazy are always in favor of socialism, unfortunately.
I’m not even reading all the comments, because I can tell by a brief skim that it’s all WAY over my head.
I enjoyed reading your article, though.