The Laffer Curve

The Bush tax cuts were supposed to pay for themselves. they didn’t, but they were supposed to. The reason was that Bush was invoking what is called the Laffer curve. The Laffer curve is a real piece of economics, but it’s not being used well here.

The hypothesis at the core of the Laffer curve is simple: 0% taxation leads to 0 revenue. 100% taxation kills the economy (since no one can make any money) and also leads to 0 revenue. Since there is some level of taxation that leads to maximal revenue , so there must be some stretch of curve between the high point and 100% where lowering the tax rate also increases the revenue with which government can work. This is true, simple (because tax structures are complex) but ultimately true. But it’s not the whole story.

If you listen to Rush Limbaugh you may be under the impression that Bush’s tax cuts are responsible for the economic growth seen under the Bush administration (I guess maybe he expected the dotcom bust to carry on for nearly a decade with out them???)  and now that Obama isn’t going to restore them for the top 2% of households he is creating uncertainty that is hurting the market. I don’t buy that story. I think Obama was pretty clear about what he was going to do. Anyone so stupid as to be uncertain about what is going to happen deserves to lose all their money.

Tax rates aren’t even the whole story however because there are other things that matter too. for instance the Afghani top marginal income tax rate is 20% yet there revenues are still low. There is a complex story that involves not just what your tax rate is but what you have to work with and what you get to do with it. The American economy is pretty well capitalized , it’s the most capitalized economy in the world, and this means we can afford to be taxed more and still keep growing. Since so much of growth is fueled by technologies that can cross political boundaries it’s easier for a country to play catch up than it is for the leaders to progress.

There are still more factors like debt and education that play in as well. An educated population with little bad debt is going to have an economy that grows a whole lot faster than an uneducated population with a large load of bad debt. We spend a lot of money on the services which leave little residual value behind.

The laffer curve is best understood not as a simple 2 dimensional line, but as an N-dimensional landscape, counting where the money is spent and how much of it is borrowed and how much is taxed. If you oversimplify the picture then the illustration eventually becomes useless.

The tea party neo-con Republicans have pushed the picture to it’s simplest and are using it as proof for there long held belief that taxes are too high. They seem to think that taxes need to be pushed back further and further until they are gone, as if that would work.

I’m actually inclined to agree, I think it would be better if taxes were lower, but I think you need to start with spending cuts. If you borrow too much then the overhead on the debt is going to eat up all of the profits you make off the Laffer curve down the line.

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About opcnup

Emerson White is a biology student working on post grad while doing private research on the side.
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2 Responses to The Laffer Curve

  1. Tyrannis says:

    This is quite nice, much better than our article. Keep up the good work.

  2. Pingback: This may not be the worst decision that Obama could make | Opcnup's Blog

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