The Laffer Curve and Limited Government

Ezra Klein from the Washington Post had an interesting piece on the Laffer Curve and where the US currently sits on that curve.

For some background information, the Laffer Curve is an idea popularized by and named after economist Arthur Laffer. It basically says that as the tax rate rises, the tax base falls. Therefore the government can maximize revenue by striking just the right balance between tax rate and base.

Think of a standard bell-curve. On the vertical Y-axis is tax revenue, and on the horizontal X-axis is the tax rate. The top of the curve (maximum revenue) will be somewhere near the middle of the X-axis (before revenues start to fall with a higher rate).

In other words, a tax rate of 0% won’t raise any revenue because nobody would be paying taxes, and a tax rate of 100% would likely raise no revenue either because there would be no incentive to go to work because people wouldn’t be able to keep any of what they earn.

Therefore, as the tax rate rises, the number of people paying that tax declines. Some people might leave the workforce, move their operations out of the country, simply hide their earnings or practice other measures of tax avoidance.

The lesson here is that government might actually raise revenue if it lowered the tax rates.

So back to the article, Klein asks prominent economists, accountants and politicians where does the Laffer Curve actually peak and where does the US currently sit? Are we on the wrong side of the Laffer Curve?

The answers differ greatly, but I think Greg Mankiw’s answer is the best:

"My guess is that that the short-run answer and the long-run answer 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 actuallymore important for policy purposes than the short-run answer."

As I have argued before, I think one of the greatest policy failures of government is being too focused on the short-run and therefore neglecting or even hurting long-run growth.

I also like Martin Feldstein’s answer, in that he addresses another often-neglected economic reality – deadweight loss:

"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."

Deadweight Loss, or excess burden, is the loss to the economy above and beyond the cost of the tax. Without a tax, the economy efficiently allocates resources. Consumer and Producer Surplus are maximized. Add a tax, and the tax incidence ensures that consumers pay a higher price AND sellers receive a lower price than they otherwise would – both parties lose out. This means that consumer and producer surplus no longer maximized because consumers are paying for a product or service that they are not receiving and producers are providing a product or service that they are not getting paid for.

Beyond just raising revenue, taxes come with an extreme backlash because the public doesn’t like having money forcibly taken from them. Even beyond this, the hidden costs to the economy are tremendous. As Feldstein states, it is very possible to cause $1 billion worth of damage to the economy to raise revenue by $100 million.

Taxes are necessary. There is no doubt about that. But because they come with such a high social and economic cost, it is imperative for government to be prudent and responsible. What does that look like? Well a prudent and responsible government is one that does its core functions well and nothing else. These core functions are:

Provide for the common defense;

Protect and enforce property rights;

Protect individual liberty;

Enforce freedom to contract;

Provide a criminal justice system;

Correct any market failures (i.e. monopolies, public goods and externalities).

Beyond these core functions, there is not much for the government to do; therefore the tax burden should be as minimal as possible. Remember, the government’s job is not to raise as much revenue as possible. The government’s job is to raise enough revenue to carry out its duties.

Therefore, to try to find where the Laffer Curve peaks and strive to get there may do much more harm than good because it may mean that government is involved in too many aspects of our lives and has greatly over-extended its reach.