Monday, April 23, 2012

The Laffer Curve Revisited

Most people (at least those who took Econ 101) have heard of the Laffer Curve.  This idea is often attributed to economist Arthur Laffer in 1974, but similar ideas were put forth much earlier by John Maynard Keynes and Ibn Khaldun.  In a nutshell, it states that both a 0% tax rate and a 100% tax rate would both yield zero revenue, for obvious reasons, and that the level that would produce the maximum amount of revenue thus lies somwhere in between.  To wit:

However, this is a rather crude representation and the curve need not be symmetric or even single-peaked.  So where exactly is the (highest) peak of this curve?  That is the million-dollar question that has been nagging numerous economists ever since Arthur Laffer himself initially proposed it.  Different sources have given very different answers, and the true answer may very well vary from year to year and country to country.  Probably one of the most reliable estimates of the peak is the midpoint of the results of various studies, which according to the New Palgrave Dictionary of Economics is about 70% as of 2008.  Thus, the real curve would probably look something like this:

Of course, one source of variation of estimates has to do with whether or not you are talking about average rates or top marginal rates (i.e. the rate on the last dollar earned by those in the highest tax bracket), as well as where the threshold of the top bracket lies.  Most studies (and politicians) are more concerned with the top marginal rate, and both those rates and the thresholds for the top bracket have varied a great deal throughout history and from place to place.  The most recent study on the matter puts the peak for the federal top marginal rate at a whopping 76%, assuming no loopholes and all else being equal.  Thus, with a top marginal rate of 35% as of 2012, we clearly have plenty of room to raise it (even double it), close the loopholes, and still significantly increase revenue.  Policymakers should take note next time the issue of budget deficits comes up.

Of course, this is downright heresy to wealthy Republicans and their Tea Party lackeys, so when they aren't trying to deny it directly (which they often do) they at least try to argue that a higher top marginal rate will hurt economic growth and thus hurt all of us in the long run, even if it does raise more revenue in the short run.  But history doesn't really bear this out.  Recall that the top marginal rate hovered around 90% in the 1950s and early 1960s, and hovered around 70% from 1964 to 1981.  Some of the greatest economic growth we have ever had occured during top marginal rates north of 70%.  Which leads us to another, less well-known curve--the Kimel Curve.  Discovered by economics blogger Mike Kimel, this curve plots historical real GDP growth versus the top marginal tax rate and controls for several potential confounders.  And the peak of that curve turns out to be somewhere between 60-70% depending on how the model is specified.  Thus, a top marginal rate of 60-70% actually appears to maximize economic growth rather than hurt it! 

While this may seem counterintuitive to those who took Econ 101, it is entirely plausible that hoarding of wealth by the ultra-rich as well as excessive executive compensation has an adverse effect on GDP growth.  Inequality beyond a certain point appears to harm the economy--just look at the levels of inequality (and tax rates) immediately before both the first Great Depression and the current one.  And a top marginal rate north of 50% most likely discourages such hoarding and excessive executive salaries and bonuses, and encourages businesses to reinvest their profits in more productive ways.  This is similar to the rationale nicely summarized by Kimel himself:

At 70% tax rates, there is more of an incentive to reinvest in the business, creating more growth in the business in subsequent years, and more economic growth thereafter. 70% tax rates are more likely to generate faster economic growth than 25% tax rates precisely because people are self-interested and the higher tax rates induce people to continue investing in things they do well.
Indeed, another study of the 1920s and 1930s found high top marginal rates (even pushing 80%) did not appear to hurt business investments one iota, but possibly even slightly increased the formation of new businesses.  This was a time period in which the income tax was levied pretty much only on the wealthy (with the top rate applying only to the top 0.1%), the top rate varied a lot from year to year, and the tax code was a lot simpler with fewer opportunities for cheating and tax-sheltering.

In addition, there is always the fact that, contrary to popular opinion, sometimes the government actually spends and invests money in better ways than the ultra-rich and mega-corporations would.  Just think of public infrastructure, which enables the private sector to generate most of its wealth in the first place.  And the money for that comes from--you guessed it--taxes.

Thus, advocates of a more progressive tax system (as well as the more intelligent deficit hawks) should feel vindicated and motivated by the results of these studies.  And we can just hear the greediest members of society whining right now.  But taxes are the price we pay for civilization, and the alternative to civilization is far worse.

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