Wednesday, August 11, 2010

Where does the Laffer Curve Bend

Back in the 1980's Arthur Laffer drew up the famous Laffer Curve on a napkin. This napkin became a staple in Reaganomics (and Bushonomics). The idea was simple, at what tax rate does the federal government maximize tax revenue. When we say tax rate we are looking at the highest margin tax rate. If the federal tax rates are zero or one hundred percent the government will not collect any revenue. So as the tax rate increases from zero the government will begin collecting more revenue. Eventually there is a point that maximizes tax revenue. Once tax rates increase beyond this maximizing point individuals will work less (higher tax rates reduce after tax income) as the cost of consuming added leisure decreases. Those clamoring for tax cuts often site the Laffer Curve as evidence in favor of large tax cuts. If current tax rates are above the maximizing tax rates then the government can increase revenues by cutting tax rates:

As we can see in the figure to the right, the government can lower tax rates (from B to the Equilibrium point) and increase tax revenue. This is a wonderful outcome. Everyone would like it to be true. Proponents of the Laffer Curve cite the tax cuts by JFK where the highest marginal tax rate was reduced from 90 percent to 70 percent and the Reagan tax cuts that reduced it to 28%. Reagan was later forced to increase the rates to offset large budget deficits.

So why does this matter today? Well under the Bush tax cuts of 2001 the top tax bracket was reduced from 39.6% to 35%, but these tax cuts are expiring at the end of 2010. So as you can imagine the issue has become highly political. We allowing the tax rates increase from 35% to 39.6% decrease tax revenues? This will in turn make the budget deficit even worse? Most seem to think not. So where does the revenue maximizing point lie?

Here's is a great review by Ezra Klein: Where does the Laffer Curve bend?

In reality the Laffer curve is not smooth. Perhaps a more accurate picture of the Laffer Curve is the right.

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