Ezra Klein has an interesting column (h/t Paul Roales) looking at where the Laffer Curve bends. The basic explanation of the Laffer Curve – and I am capable of no other – is that, on one end, taxes can be so high (e.g. 100%) that no one will bother working and tax revenues will be down and that, on the other end, taxes can be so low (e.g. 0%) that the government will capture very little tax money. Government wants to find the top of that curve – capture a lot of tax money without discouraging it’s citizens from being industrious. This is of some interest with the Bush-era tax cuts expiring and the Clinton-era tax structure reviving.
Klein interviewed a bunch of people and tried to get a sense of where the top of the curve might be. The tax experts and lefties he spoke to seemed to offer up a top marginal rate of 70% as the peak of the curve. The folks on the right he spoke with seemed more reluctant to offer a number but, where they did, seemed to fall in the 20-30% range. They also cautioned that, while short-term revenues might increase at higher levels, there was also a risk of limiting growth and, therefore, long term gains.
I can’t articulate it well and, may just be wrong, but my guess is that low rates are associated with an incentive to just move money around instead of doing different kinds of work that contribute more to productivity in the long term. About the best I can offer is that, if you can gamble, hit a jackpot, then walk away with enough money to quit the game, you might not bother with the harder work of creating a system that generates lesser, but steadier, gains year after year after year.
I just read an article by Mr. Laffer. His point seems to be that because reducing the tax rate in the 60’s was good for the economy, that it must always be good. I didn’t get the sense he saw a curve until you were in the single digits, but I could have misunderstood.
Personally, I disagree and think it is more in the 50-70% range.
From his article
Yeah, that makes sense, but it was DOWN to 70%, and we’re crying about 38% now?
I guess on re-reading it, his point isn’t that we should find the top of the curve, but that increasing taxes during an economic downturn is always a bad idea.
When considering the Laffer curve, it is important to note that the top marginal rate is NOT the 35% stated in the tax code. Many deductions “phase out” at higher income levels. These phase-outs can increase your marginal tax rate to approximately 50% (not to mention SS taxes).
If the deductions phased out, wouldn’t that just get you closer to the actual 35%?
And, on the flip side, payroll taxes phase out at something like $100 – $110k.
If the deductions phase out, your “average tax rate” would be approaching 35%, but your “marginal tax rate” would actually be above 35%. People (at least rational ones) don’t care about their average taxation when determining how much to work, and are (or should be) more focused on their marginal taxation (what will be the amount of tax on my next dollar of income).
You are correct that the Social Security portion of payroll taxes is capped at about $110k of wages. I meant to say Medicare, which does not have a payroll limit. However, we shoudl recognize that amount is per wage earner, not per family. A two income household doesn’t hit the SS cap until a possible income level of $220k.
Still, we’re talking about a max of 35% compared to 70% AFTER the Kennedy tax cut, which increased revenues. Seems like the top of the curve would be somewhere between 35% and 70% to me.
Paul, maybe I’m in the wrong income group or irrational, but I have never in my life decided to work less & take in less money because I might have to pay more in taxes.
At worst, if I were right next to a tax bracket, I might donate more so I give more of my money to my church rather than to the government, but regardless, I earned MORE.
I’m sure that somewhere out there, there is some millionaire that might decide to work less because he’ll only get 65% of the money he earns. However, most people I know or have heard of know that 65% of MORE is still more, and try to get it. Even if I’m only getting 30% of the money I earn, it is still more than earning none at all. Seems rational to me.
The caveat being that there are other things in life besides just piling up money. At some point, your time becomes more useful to you for other things besides earning money.
In fact – just musing here – there may be an argument to be made that that point is lower at a higher tax bracket because the necessities are already taken care of. So maybe government revenues would go up if you just taxed 100% of the first $1k (or whatever) and then dialed it down from there.
Yes, I agree Doug, but I don’t think the tax level really affects that as long as it isn’t an insane level. If you have enough money and want to do the other things in life, you’ll do those other things. If you want more money, you’ll go get more.
Jason – Again, we are NOT talking about a max of 35%. As I already stated marginal taxation does go above the 35% mark and can max around 50% for some taxpayers (more if you count things like college aid). Additionally, your reference to 70% is irrelevant. Yes, 30 years ago, we had taxation at 70%. Yes, pretty much everyone agrees that 70% was not an ideal percentage for tax collections, as it went past the Laffer Curve. So, why is the 70% relevant to this conversation, which (as I interpret it) is discussing the ideal point on the curve for tax collections?
Regarding your 2nd comment, I think you may not grasp what I am suggesting. It isn’t about “working” less. It is about recognizing less income. If tax rates become too high, less “deals” get done because of the prohibitive tax consequences of the recognition of income. This means less money goes to accountants, brokers, bankers, attorneys, and other agents. That money is now not recorded as income by the agents, lowering their taxable income.
The law of diminishing returns certainly applies, and rich people are affected by it. Each individual has a point where they decide their time is worth more than the amount they may receive from not working. Since taxes lower the amount of money people receive from their work, it reduces the economy, especially for those that are less hand to mouth.
No, I think everyone agrees 90% (what it was BEFORE 70%) went beyond the curve.
As to marginal taxation, didn’t that exist back when we went DOWN to 70% and saw a boost in the economy? What changes between the 60’s and now created this phantom tax?
I tread lightly here, so forgive me, I most likely don’t have the same knowledge base as Paul or Jason on this, but isn’t the Laffer Curve mostly speculation?
Shouldn’t it be used, on the back end, as one possible tool to explain why a Government gained more or less revenue after raising or lowering taxes than on the front end to set tax policy?
My limited knowledge and research seems to suggest that there are so many potential variables that it’s unwise to use it for any concrete policy setting. Even Laffer himself said:
“The Laffer Curve should not be the reason you raise or lower taxes,” (http://www.time.com/time/magazine/article/0,9171,1692027,00.html)
When discussing the sweet spot on the Laffer Curve, we should be careful to recognize that there is still debate as to whether there even is one. Other factors exist and should not be ignored, least of all that we’ve already begun limiting ourselves within the subset of supply-side economics.
Additionally, different economies act differently. I understand that is a fairly banal statement, but a less restrained economy would act in a different manner to changes in taxation rates and have potentially a different sweet spot than a more restrained one.
Also, any discussion on the Laffer Curve should involve Hauser’s “Taxation and Economic Policy” (http://bit.ly/ct6db9). Essentially, we may be thinking about it wrong, changes in tax legislation don’t reduce the government’s revenue share of GDP. In this book he submits that “variations of government revenue around the 19.5% mean do not correlate with changes in federal tax legislation.”
So, I don’t think we can say with any certainty where the Laffer Curve bends. And I would question the its veracity. The worst thing we could do is use it as anything but a data point when setting policy.
Michael,
I agree, finding a sweet spot in how we can get the most taxes out of the people to give to the government is the reverse of what we should be doing. I just can’t help myself to a good debate. :)
That said, what we should be doing is deciding what the government actually needs to be doing, then figuring out a fair way to pay for it.
Jason: I am not sure I understand your question to me (but will try to answer it anyway). Yes, marginal taxation has always occurred. Yes, the economy grew when the highest tax rate was lowered from 90% to 70%. Yes, this decrease more than likely helped the economy grow.
Assuming all of the above, this does not mean that 70% is the “sweet spot” for economic growth. What it means is that more people were willing to make transactions at 70% than at 90%. However, we might (nobody can quantify exactly) have had 3 times as much growth (or something like that) if the tax rate had been lowered to 50%. We might have had 4 times as much growth if the tax rate was lowered at that point to 40%.
IF (big “if”) we could figure the optimum tax collections that is a useful factor. Simple economic theory says and shows that taxation affects consumption behavior. So, I slightly agree with Michael in the fact that if we could somehow determine where the Laffer curve bends, I would set that as an upper limit. However, that does not mean it is appropriate to tax up until that point of optimum collections.
Jason, your second question had to do with the creation of this phanton tax. While I have not researched this, my understanding is that the changes between now and the 1960’s that created this “phantom tax” is that Congress has relatively recently (last coupld of decades) decided to start phasing out deductions as a means of recapturing revenue from the rich, rather than use higher standard rates. This is a relatively new (and a little more sneaky) technique from Congress.