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Tuesday, April 14, 2015

What Matters and What Does Not about the Laffer Curve

The basic idea is that, if you plot the revenue generated by any given tax against its rate, you'll virtually always observe: (1) no revenue at a 0% rate; (2) no revenue at a 100% rate, and (3) between these rates the function is concave.

This is such a trivial statement that almost nobody with any education in economics will deny that it holds in all but the most pathological cases. In fact, that a statement so basic even has a name attached to it can mostly be attributed to those hostile to some of its implications wishing to brand it a novel idea by that crazy extremist Laffer.

These upsetting implications which follow from the above are also quite simple: (a) If the government hikes a tax rate, it will receive a less than proportional increase in revenues. (b) If the government cuts a tax rate, it will suffer a less than proportional loss in revenues. Et ceteris paribus these points hold always, regardless of where you are on the Laffer curve.

That doesn't mean that hikes are always bad and cuts always good; it just means that hikes always are at least a little worse and tax cuts always at least a little better for the budget than someone economically untutored (i.e., almost all politicians and pundits) would think.

To distract from this basic uncontroversial consequence, critics of the Laffer curve focus on a minor, secondary consequence of the above facts: Yes, there must also exist a revenue-maximizing tax rate and it's not 100%. Yes, if you are above that rate, rate hikes will counter-intuitively cut revenues and rate cuts will raise revenues.

But unless you are politician who wants to set tax rates the way an unconstrained monopolist sets prices, that is, pick whatever squeezes the biggest profits for you from your captive customers, what the exact numerical value of the revenue-maximizing rate is pretty much irrelevant. The important consequences listed above, hold everywhere—at, above, and below the maximizing rate.