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The Laffer Curve: Closer than you Think

e21 | September 9, 2010

As most expected, this fall is already bringing with it the raging debate over whether or not to increase taxes by letting the current income tax rates – the ones Americans have become accustomed to over the last 10 years – expire. Leaders from both parties have given increasingly impassioned speeches lately detailing reasons why we should, or should not increase taxes, but it boils down to a simple point: Democrats want to raise tax rates to bring in more revenues to finance the already-legislated increases in spending. While on the margins this seems no doubt true – increase tax rates and people will have to pay more – the Laffer curve indicates that there’s a point at which this is no longer true. This has economists pondering the deeper question: just how high can rates get before it has the opposite effect and revenues actually decrease?

Last Month, Dylan Matthews (writing at Ezra Klein’s blog) had a symposium on where America stands on the Laffer curve. Many experts on tax policy have suggested that there is a point – on the top of the Laffer curve – after which further increases in marginal rates actually decrease tax revenue. The reason is that higher marginal tax rates result in increasing the disincentives to work, which can reduce output and consequently tax revenues. At a certain point, the unintended consequence of decreasing output from a tax hike outweighs the gain in income from the tax hike.

The exact place of America’s tax rates on the Laffer curve – as well as what that curve looks like – has been a source of intense partisan disagreement over the past several decades. Democrats have argued that current levels of taxation are far from the peak of the Laffer curve, implying that increases in tax rates could still bring in substantially more revenue. By contrast, Republicans have typically claimed that some rates of taxation are closer to the peak of the Laffer curve, or even potentially on the other side – implying that tax cuts (not increases) would raise revenue.

So where is the peak of the Laffer curve, and where does America fall in comparison? The left-of-center experts who Matthews polls offer estimates that increased tax rates would not decrease revenues until marginal tax rates were in the 60-70% range. Even some economists on the right – notably Bruce Bartlett, an economist who served in the first Bush Administration – have cited research by Anthony Atkinson that projects that this limit may not be reached until rates hit 83%.*

However, there are good reasons to doubt these estimates. As a previous e21 commentary has argued, the response of economic activity to hikes in marginal tax rates varies greatly with the type of analysis used. In the short term, individuals may find it costly to alter their behavior. However, over time, there are a wide variety of behavioral and social responses – such as longer vacations, fewer working mothers, more part-time workers – that result in less labor and less output in the long run as a response to higher taxes.

Greg Mankiw, the Harvard economist, made a similar point in the forum, arguing that:

"My guess is that that the short-run answer and the long-run answer [to where the Laffer curve bends] are quite different. For example, if you raised the top rate from 35 to, say, 60 percent, you might raise revenue in the short run. Over time, however, you would get lower economic growth, so the additional revenues would fall off and eventually decline below what they would have been at the lower rate.... I will pass on offering a specific number, as it would require more time and thought than I can offer just now, but I will opine that I think the long-run answer is actually more important for policy purposes than the short-run answer."

A more rigorous treatment of this topic comes from a paper that Bruce Bartlett references, by University of Chicago economist Harald Uhlig (someone whose work we have previously featured here), and Mathias Trabandt. Though Bartlett takes Uhlig and Trabandt’s work to support the idea that we are far from the Laffer curve; in fact, their analysis shows that policymakers need to think hard before agreeing to future tax increases.

There are three important lessons from their analysis:

1. America has crossed the Laffer “hill.” Uhlig and Trabandt do find that further increases in the tax rates on labor or capital income would raise revenue. Correspondingly, reducing tax rates on either of those taxes individually would result in lower tax revenue.

However, there are large differences between taxing labor and taxing capital. Taxing capital results in far worse effects on the broader economy in terms of foregone output than taxing labor. As a result, a tax reform that cut taxes on capital while raising taxes slightly on labor would actually increase overall tax revenues while also reducing the overall tax burden. This free lunch comes from changing the composition of taxes.

Unfortunately, many of the scheduled tax increases would result in hikes in the taxation of capital. Choosing to increase taxes on capital (while potentially maintaining lower marginal rates for many Americans) increases the likelihood that the nature of our tax system will start to choke off some economic growth. Tax reform that reduces taxes on capital, while potentially raising taxes on other activities, could lower the overall tax burden and increase revenues.

2. Future tax hikes will come at a huge cost. The Laffer curve’s purpose is to project the point at which to set tax rates in order to maximize revenue. However, that point may not be the optimal place to set tax rates at all, as maximizing revenue may have a huge opportunity cost in terms of foregone economic output. For instance, another Harvard economist, Martin Feldstein, argued in the forum:

"Why look for the rate that maximizes revenue? As the tax rate rises, the "deadweight loss" (real loss to the economy rises) so as the rate gets close to maximizing revenue the loss to the economy exceeds the gain in revenue.... I dislike budget deficits as much as anyone else. But would I really want to give up say $1 billion of GDP in order to reduce the deficit by $100 million? No. National income is a goal in itself. That is what drives consumption and our standard of living."

Uhlig and Trabandt explore this issue further. In particular, they finds that 32% of a labor tax cut, and 51% of a capital tax cut are self-financing, in the sense that lowering those taxes raises economy activity, which itself generates additional taxes, and partially offsets lower tax revenue.

By the same token, higher taxes – particularly higher capital gains taxes – will reduce economic activity, especially in the long run. This will result in a substantial amount of foregone income, as a result of the “deadweight loss” incurred through taxation. As the tax rate approaches the top of the Laffer curve, this loss grows higher and higher.

In other words, future tax hikes, which are necessary to pay for the projected path of spending, will come at a high cost. Even if they are sufficient to balance the budget and eliminate the deficit, and even if higher tax rates still result in more revenue, high taxes will still result in less output for all Americans.

3. There is not much room to raise revenue. Uhlig’s analysis finds that America has room to raise labor and capital tax rates by 30% before hitting the top of the Laffer curve, and 6% more by raising capital taxes. Put differently, this suggests that America can only raise 36% more revenue through conventional tools. Efforts to raise additional tax revenue beyond that point through tax hikes would fail, because at that point the costs of higher taxes would exceed the tax revenue they brought in.

Keep in mind that simply doing nothing would result in higher income taxes through real bracket creep, and higher capital taxes by statute. The scope of additional taxation in order to meet spending burdens before hitting the bend in the Laffer curve is therefore limited.

These numbers should give pause to those envisioning our fiscal future. Note that the historical ratio of federal revenue to GDP has remained roughly constant over time at around 18%, while spending has remained a few percentage points higher:

Total Revenues and Outlays

However, future projections paint a gloomy picture. In order to pay for rapid expansions of entitlement spending, federal taxation will need to expand to historically unprecedented levels as well.

Chart 2

A close analysis of America’s tax burden suggests that America simply cannot afford this higher rate of spending. It is doubtful that any level of tax rates would be sufficient to meet the exploding demands from entitlement programs. Even if some mix of new taxes could meet the fiscal burden, the costs of moving America’s tax burden far above historical levels would carry a large cost in terms of foregone output.

* This sentence was later modified to include the phrase "cited research by Anthony Atkinson."  The number 85% was also replaced with 83%.

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