Thursday, April 14, 2011

The Laffer curve: Time to set the record straight

In this post I will again come back to the subject of tax rates and tax revenue, and how they relate.

The Laffer curve, for those unfamiliar to it, shows how tax revenue changes with different tax rates. The concept, in simple terms, is something like this: If you raise taxes, you will initially get more revenue, but if they go too high, people are going to stop working and no-one will want to invest in your country, and so, if you raise taxes beyond a certain point, you'll actually get lessrevenue.

Every serious economist in the world agrees with the concept; if taxes are 100 %, no-one is going to work. Where we disagree is regarding where this "breakoff" point is: What is the ideal tax rate? There is no really safe way of calculating it (that doesn't mean thousands of economists haven't tried).

However, what we must remember, is that your motivation to work isn't only affected by the tax rate. There is one more (economic) factor that will decide how much you work, how high salary you ask for and so on: Unemployment benefits.

If unemployment benefits are high, you just might decide not to work at all, or at least not to apply for any job where you have to wear a name tag. The income gained from working is really your salary minus whatever welfare you would have been able to get had you not been working.

Now imagine the difference between the two of those is $30 000 a year. The government decides to raise taxes, making the difference only $27 000 a year - normally, this would discourage working and lead to more people choosing to be unemployed.

Now imagine they cut unemployment benefits as well, by $3 000 (depending on how high they were in the first place, this may or may not be possible). The difference will then be the same, and the incentive to work will be unchanged. It will still be just as profitable to work as it used to be. Of course, the higher the taxes are, the greater is the incentive to sell your services on the black market, but except for that, it should be possible for the government to raise taxes as long as they cut unemployment benefits correspondingly.

A disturbing thought: If taxes go up, people may actually work MORE since they need to work more to bring home the same income (and thus keep their living standard). This is assuming prices move down slowly and the central bank doesn't change its policy. In this case, while you may vote for someone else in the next election, it's not unlikely that you may work overtime just to keep your income. Obviously, consumer spending is likely to fall and so demand for your company's products may be down and there may not be any work for you to do, but theoretically speaking if you are very prone to keep your living standard, working more may be the only option when your disposable income goes down.

That would be completely contradictory to what the Laffer curve predicts, but any such effect would only be highly temporary.

There is an obvious limit to the argument made earlier, that taxes can become higher as long as unemployment benefits become lower: Sooner or later, unemployment benefits will be equal to zero, and so you won't be able to cut them anymore (unless you are going to fine people for being unemployed). The second limit is political: The same people who supports tax hikes tend to be the same people who support social welfare.

Therefore, when taxes go up, government has a tendency to use this money to increase unemployment benefits rather than decreasing them, so that the negative effect is doubled: You lose $3 000, and unemployment benefits increase by $3 000, for a net loss (in terms of how much you gain from working vs being unemployed) of $6 000. In order for our incentive to work not to be affected, wages would then have to increase enough to compensate for this, which would mean layoffs (which always happen when wages increases without a corresponding increase in productivity).

The Laffer curve is not complete without taking this into account; it does matter how the money is spent. In economics, we tend to lump all demand and supply together into "Aggregate supply" and "Aggregate demand", but the fact of the matter is that how consumption is structured matters a lot for the economy. And how the government spends its money matters too, since it affects how much we work.

Finally, it matters how easy it is to commit tax evasion. If it's easy, it will be hard to charge high taxes since people will find a way around it. It matters how easy it is for people to leave the country, and to immigrate - part of the reason why you can in fact get more revenue by lowering taxes is because people immigrate to countries where taxes are low (that's part of the reason I emigrated to Ireland). Something for "anti-immigration" conservatives to consider.

In order to motivate working, we need to look at the whole pictures and not just the taxation parts of it. Pablo, a good friend of mine whom I know doesn't agree with me on the Laffer curve's existance, talks about "talk radio conservatives vs Governance conservatives". This is an issue were governance conservatives really have to step in and educate the public, instead of trying to woo them. Tax cuts does nothing unless all other pieces fall into place. And there are more pieces than the ones I mentioned here. We need to explain the whole picture to the voters, or else we are actually misleading them. Yes, our opponents does that too, but aren't we supposed to be better than our opponents? And if we are not, then why do we deserve to win?

I have to say, "Create an IRS you cannot escape from" doesn't make for a very good slogan. Quite a dilemma, isn't it?

I personally support the FairTax, since it would eliminate income taxes, make it more profitable than ever to work and invest and since there are no deductions, people can't cheat by deducting more than they are legally available to deduct.

Whatever the solution, we need governance Republicans willing to educate the public on economics, even if it means risking their seats in the process. Remember that both Reagan and Goldwater tried to educate the public, and that if one of them hadn't run, the other would not have won. Goldwater's run was not a failure in any way, it was a great success since people actually learned something. Not enough people to make him win, of course, but he planted a seed. Now before some people on this site suggests that since Goldwater's campaign wasn't a failure, we should nominate someone who is likely to lose by even bigger numbers than he did; that's not the point. You need to be smart enough to educate people for there to be any point with running an educational campaign. Ron Paul was, and because of him and his "revolution", there are now more critics of the Federal reserve than there has been since probably the 1920's, and it is common knowledge today that the Federal reserve had a great part in creating the housing bubble.

I'm sorry I went off topic. I hope you understand what I mean. Please ask if you got any questions,

John Gustavsson


OhioJOE said...

Marvelous post! I for one believe that one should work (if one can) even if welfare and unemployment are high for one's dignity. However, you make a good point that UE benefits are a factor along with taxes as to the intentive for work. You also bring up a lot of good points in your post, some of which I have thought about, some I did not. The bottom line is that ignorance of the Laffer Curve is probably the main economic reason that our country is turning into a Banana Republic.

I am glad that there is somebody mature enough around here to educate Americans on the economy. If we fail to take at least some of your advise, we as a society will most likely pay a high price.

Thanks again Mr. Gustavsson for promoting capitalism!

John said...

You're very welcome OhioJoe.

You're right about there being dignity associated with working. Unfortunately, people can and do make up all kinds of excuses not to work if it's not profitable enough.

C4H said...


You need to get something up on Huckabee.

John said...

"Something up"? What does that mean? Sorry, english isn't my first language after all :P

Pablo said...


I haven't neglected your post yet. Just been busy. I will read it over tonight and comment.