Laffer Curve

There is some buzz on the webs about the Laffer Curve. As the government increases a tax rate, at what point do revenues start to go down due to the decreasing tax base? Some economists weigh in here. Interesting reading. You can see a strong dichotomy in how the question is answered by conservative vs liberal economists. More discussion here.

I think the conservative economists make the most interesting points. Most important, they point out that the question depends on the time frame involved, and the effect on the growth rate of the tax base. Here is a Laffer curve I got from the very best of sources... pulled from my *ss. Click to enlarge! Heh.



The Laffer Curve is in blue. You can see that tax revenue starts out at zero, increases to peak around the 65% tax rate, then falls off to zero. Sixty-five percent is in line with some of the more liberal economists. You can see that at the maximum point, government is vacuuming up about 2/3rds of the tax base. The actual tax base has fallen a whopping 40%. Only a loony-lefty government would operate at such a point.

What about a more reasonable point, say around a 30% tax rate? What happens if we raise the rate to 40%? The Laffer curve shows that revenues increase by about 6%, with a similar percent decrease in the tax base. So it looks like the government can get more revenue by going from 30% to 40%.

But what about long term? What about the effect on growth of the tax base over time? Republican politicians usually talk about the effect on higher tax rates on entrepreneurs, saying they will be less willing to start that next business if rates go up. This sounds like a growth argument to me. Suppose that raising the tax rate from 30% to 40% decreases the growth rate from 4.2% annual to 3.6% annual. Again, I have used the very best of sources. The next figure (click to enlarge) shows the result.



The 30% policy is shown in green, the 40% in red. The solid lines are tax revenue, the dotten lines are the tax base. You can see that at year zero the red solid line lies above the green solid line, so revenue has increased. The downside is that the tax base has taken a hit. The red dotted line lies below the green dotted line. You can see that as the years progress, the difference between the red and green solid lines decays. Around 35 years, the government is getting less at 40% than it would have at 30%. Meanwhile, the effect on the tax base is quite pronounced. At 35 years, the 30% policy results in a tax base that is 25% bigger than under the 40% rate.

If you were going to choose between these policies, which seems more reasonable? To me, the two revenue curves look like they are basically right on top of each other, when compared to the much more substantial difference in the tax base curves. So, even though the more liberal economists may be right that the maximum of the Laffer curve is way up there around 65%, that doesn't necessarily mean that the conservatives don't have a valid point.