Laffer Curve: How individuals react to changes in the tax rates.

Although Arthur Laffer does not claim to have invented the Laffer curve concept; he has been one of its most important “promoters”. In 1974, Arthur Laffer held a meeting with Nixon/Ford Administration officials Dick Cheney and Donald Rumsfeld in which he reportedly sketched the curve on a restaurant’s napkin to illustrate his argument. The term Laffer Curve was coined by Jude Wanniski, who was also present at the meeting.

The Laffer Curve states that if tax rates are increased above a certain level (t*), then tax revenues can actually fall because higher tax rates discourage people from working (see graph).

The two endpoints of the Laffer Curve are easy enough to calculate. At a tax rate of 0%, the government will collect $0 in tax receipts (TAX RATE x TAX BASE = TAX REVENUE). However, at a tax rate of 100%, the government will also collect (virtually) $0 in total receipts, because people will either stop generating income, or they will operate in the black market and fail to report their income to the authorities.

Between these extremes, the government will collect positive revenue. If we assume a smooth curve, then there is a tax rate; greater than 0% but smaller than 100% (that is t*) that maximizes total tax revenues. (I bet you remember Rolle’s Theorem of your high school Maths courses)

While correlation between tax rates and tax revenue is generally accepted, the precise nature of this interaction is still debated. In practice, the shape of a hypothetical Laffer Curve for a given economy can only be estimated. The relationship between tax rate and tax revenue is likely to differ from one economy to another and depends on the elasticity of supply for labor (how much does unemployment increase with a 1% increase in tax rate?), as well as various other factors. Even in the same economy, the characteristics of the curve could vary over time. Complexities arise with progressive taxes and possible differences in the incentive to work for different income groups complicate the task of estimation.

Behavioral responses to changes in the tax rate:

As mentioned above, Laffer supported the idea that increases in the tax rate increase the income tax revenue up to the maximizing point (t*). If tax rates are raised beyond that point then the tax revenue falls. Why does this happen? According to Arthur Laffer, it is caused by the responses that each individual has to a tax increase.

J. Slemrod (1998) ackowledged that responses to taxation can be categorized as:

1. Real Substitution: Tax changes induce individuals to seek a different consumption bundle (microeconomics: consumption-leisure model).
2. Avoidance Responses: Tax payers decide to retime, rename and plan taxable activities in order to reduce their tax liability.

Other authors, such as M. Feldstein (1995) proposed that a taxpayer can respond to higher tax rates by working less hours (traditional labor supply response) but also in a variety of other ways that would reduce the taxable income, such as working less hard (reducing the productivity) or by receiving compensation in ways that are excluded from taxes (health insurance, subsidized children education…)

Not all of them agree at all, in 2014 Kazman conducted an econometric analysis with quadratic and log-log ecuations. His research showed that raising taxes for top-income earners had an elasticity higher than 1. This means, that rising tax rates by 1% increased tax revenues by more than 1%. This theory would contradict the assumption that high income earners change the way they declare taxes (Slemrod: Avoidance Responses). Kazman used 48 years of data, however its accuracy is even questioned by Kazman himself. Kazman even said that more accurate data could lead to elasticities bellow 1.

An economic expansion, for example, could make people more willing to accept a tax rate increase without any income switching response. Jude Wanniski once said that even at 100% tax rate the economic activity would not cease. However it would change to a form of barter. Even in extreme situations such as war economy it is forseable to have this barter economy.

My conclusion is that the Laffer Curve is a simple yet powerful model. It has been used by various governments; USA Regan’s Administration in 1980 and Trump’s nowadays, to justify tax cuts. However the equation is not as straight forward as Laffer proposed. Several other factors such as progressive tax rates, income groups, having kids or not, economic cycle… could lead to more sophisticated models to predict responses to changes in the tax rates. I will continue with my investigation on the matter, however the “no” availability of accurate data is one of the struggles right now.

David Sánchez Manzanero.

BIBLIOGRAPHY:

1. David R. Harper (2019). Understanding supply-side economics. Link: https://www.investopedia.com/articles/05/011805.asp
2. M. Feldstein (1995). Tax Avoidance and the Deadweight Loss of the Income Tax. National Bureau of Economic Research.
3. Samuel B. Kazman (2014). Exploring the Laffer Curve: Behavioral Responses to Taxation. University of Vermont.
4. A. Goolsbee (1999). What happens when you get rich? Evidence from executive compensation. University of Chicago.
5. A. Goolsbee (1999). Evidence on the High-Income Laffer Curve from Six Decades of Tax Reform. University of Chicago.
6. J. Slemrod (1998). A general model of the behavioral response to taxation. National Bureau of Economic Research.