Tuesday, March 1, 2011

The Myth of the Laffer Curve

How many times in the last several months have you heard the mantra: If you reduce the tax rate, the economy will grow and we’ll get more tax revenue?

That mantra is based on the Laffer Curve, an economic thought experiment named after Arthur Laffer. The thought experiment is based on the following assumptions:
  • If the tax rate is 0%, then the government will get no revenue.
  • If the tax rate is 100%, the economy will collapse as there will be no incentive for private industry, and the government will get no revenue.
  • Between these two end points there is a tax rate that will maximize the governments’ revenue. This is usually represented as a parabola as shown below.

Let’s consider the assumptions:

  • Zero tax rate does not necessarily mean zero income. Many people freely give to charities and other organizations – money, time, products, services.
  • 100% tax rate does not necessarily mean that there will be no federal government revenue. There are at least two ways that this could occur. Exemptions and deductions would allow corporations and individuals to live well under a 100% tax rate. (President Roosevelt increased the tax rate on the wealthy to 91%, in order to curb greed, and the economy grew.) In many totalitarian governments, all the money goes to the government, and an economy still exists.
  • The shape of the curve defies reason. A parabola with a single peak is probably the most unlikely shape of the relationship, if one even exists. If there is a cause and effect relationship between tax rate and government revenue, it is probably much more complicated.

Even if one accepts the curve, in order for the mantra to be true, the U.S. would have to be operating on the right hand side of the curve. There’s no data to assume that that is true. Attempts to gather data in support of the Laffer Curve are very controversial because there is no simple model of an economy, and because we can’t achieve ceteris paribus1. (We can’t make all things equal between the various states of the economy we want to compare.)

Here’s one example of an attempt discussed by Mark Thoma in Economist’s View:

He first shows a curve created by Kevin Hassett, American Enterprise Institute, in order to prove that tax cuts will generate revenue for the government.

First comparing all these different economies is flawed because we cannot assume that all other conditions are the same across all the economies. Secondly, as Thoma points out, the curve “fitting” the data was forced to look like the theoretical Laffer Curve in order to make the political point.

Thoma suggests that a more reasonable fit to the data is as shown below:

As a matter of fact, there’s no data at all to support the Laffer Curve.

It is pretty clear now that a modern economy is a complex system, and as a result, attempts to find casual relationship between the two parameters is futile. The economy is likely a complex system in a non equilibrium critical state. It would not surprise me at all to find chaotic regions in relationships like these.

1 Ceteris paribus or caeteris paribus is a Latin phrase, literally translated as "with other things the same," or "all other things being equal or held constant." It is an example of an ablative absolute and is commonly rendered in English as "all other things being equal." A prediction, or a statement about causal or logical connections between two states of affairs, is qualified by ceteris paribus in order to acknowledge, and to rule out, the possibility of other factors that could override the relationship between the antecedent and the consequent.

1 comment:

  1. The laffer curve is hypothetical curve to illustrate a point. I think you and I could agree that the government would receive more revenue on a 25% tax rate than on a 0% or 100% rate.