Not the Laffer Curve again!

I’m a little embarrassed that my previous, rather nasty post was at the top of the home page for so long. I haven’t posted since August! The human has changed jobs and only recently acquired a new netbook that I’m now appropriating. Anyhow, I’m going to make my right-wing bashing a bit more measured going forward. And what better place to start than the Laffer Curve, that piece of economic fantasy from the 1980’s that every now and again gets dragged out and dusted off. Given the supply-side tendencies of the current US vice-presidential hopeful Paul Ryan, such theories are very much in vogue right now.

The theory behind the Laffer curve (originally, so legend would have it, drawn on a napkin during a 1974 meeting) is essentially sound, and intuitive. If you accept that a government cannot raise any revenue at a tax rate of zero percent, or at a rate of 100 percent, there must be a rate somewhere in between at which revenue is maximised. Where the fantasy comes in is with any attempt to show where this point is. Indeed, any attempts to actually plot data for any given country shows a series of disconnected dots not even resembling a curve. The problem with data of this nature is that it is very difficult to establish what effect the tax changes alone have on the economy. Any study that could actually show that the Laffer curve is more than just a warm feeling in the conservative bosom would be big news indeed, especially with the current ideological war raging in the US.

So when I saw this video, I was intrigued:

Firstly I had a bit of a chuckle over what Tim Groseclose had to say about his economics textbook from 1984. My economics textbook from the same era has this to say about it: “Again, things did not turn out as supply-siders hoped. The tax cuts of 1981 did not generate additional tax revenues. Government deficits ballooned.” Oops!

But Groseclose claims we were all misled. And the really interesting bit is that he cites the Romer and Romer study from 2007 as evidence that the curve peaks at a 33% tax rate. He makes a big deal out of the fact that Christina Romer was an economic adviser to President Barack Obama, and the Romers are liberals. Of course, the king of all arguments from authority is one delivered by your ideological foe but supporting your position. Unfortunately for Groseclose, the Romer study does no such thing.

Here’s the study. I’ve spent a few days getting to grips with it, econometrics not being my thing much at all. The Romers isolated the effects of tax changes implemented for mainly ideological reasons, and conclude that such a tax increase has a significant negative effect on GDP (the study did not cover effects on government revenues). It doesn’t show anything we didn’t already know (although it’s great to have the data), that specific, targeted tax changes can be very effective in changing economic behaviour. This is what I’ve been saying for a long time, and it’s why I support the Irish government’s low corporation tax rate; something I’ve been criticised for by some of my more left-leaning friends.

But Groseclose must have some brilliant insight that he’s not sharing with the rest of us when he claims if you “do the math” you come to 33% as a revenue-maximising tax rate. I can’t figure it out and I’m not the only one. Even his fans are scratching their heads over that one. Come on Tim Groseclose, you owe it to conservatives everywhere to show us the math and prove us supply-side sceptics wrong.




13 thoughts on “Not the Laffer Curve again!

  1. You’re missing a big part of how GDP is calculated, in that Government spending is a part of GDP. If the Government is collecting more in taxes, then the ideological spenders (liberals) are most likely in charge. Thus, it’s only logical that GDP will go up, but that doesn’t fix problems with unemployment and malinvestment. Nor does that change the sustainability of resources, nor increase net exports or consumption. These are the factors we should be focused on increasing. The most sound principles in increasing these factors of GDP is to reduce deadweight loss.

    You’ve taken an economics class. You know the most common occuring factors of DWL.

    • Thanks for commenting, and best of luck with your studies. I’m not making any claims about changes in GDP resulting from tax increases or decreases. My point is that the Romer study does not support the assertion that the Laffer Curve peaks at 33% – unless you take one of the Romer findings (that under some circumstances a tax increase of 1% will have up to 3% negative effect on GDP) and apply it across the board to all taxes everywhere at all times. I can only assume that this is what Tim Groseclose did, completely ignoring the rest of the study he is citing that goes to great lengths to point out the impossibility of doing so.

      • In a slightly more opinionated response- I think the laffer curve is just a figurative model, just like supply and demand. These models don’t EXACTLY exist, but they display some kind of inevitable truth to them. Generally speaking, when we lower taxes to some extant, businesses hire more workers, and those workers pay taxes, thus we increase the size of the tax bracket, thus we increase tax revenue.

        But there is a “peak” that we miss. We either lower them too far or raise them too far, because just like “equilibrium” it’s purely conceptual and realistically unattainable. That’s why I find myself leaning towards the right. In the Ryan Plan (not the Romney Plan) the proposal was to remove the corporate income tax entirely. The natural response there after would be to charge a new tax on goods produced. Thus, the bigger the company is, the more the taxes they are charged, and these companies don’t utilize deductions and loopholes, because they simply do not exist.

        However, there are some clear flaws. Do we charge the tax based on COGS? Do we charge a set percent on each good, per net income of the company? Is there anyway that we can utilize a consumer surplus in this tax, but still decrease producer surplus and gain Government Revenue? Would patterns maintain in accordance with rules of MB=MC?

      • Those are good points – I want to do a post on taxes soon and I’ll bear those observations in mind.

  2. “The tax cuts of 1981 did not generate additional tax revenues.”

    Actually according to this site they did.

    The tax cuts of 1981 did not generate additional tax revenues.

    Perhaps you have a more credible site that shows revenues in 1982 as being less.

    Anyhow, about the Laffer curve, the video makes the case that at 100% tax rate taxes would be zero. Now we know that they would be zero at 0%. So the laffer curve argues that at some point between these two zeros there is a peak . Would you say that this is not true?

    • Revenues have grown during every decade since the Great Depression – actually the growth during the 80s was one of the lowest in terms of overall percentage. Further, I suppose you could make the argument that Reagan’s tax cuts caused growth in GDP, resulting in higher revenues for future years, but then you would also have to account for the high growth in GDP during the 50s, 60s and 90s.

      Regarding the Laffer Curve, as I stated in my post, the reasoning is sound. But with so many different types of taxes being enacted for different reasons it’s impossible to state with any certainty where the curve peaks. I’m just as sceptical of those who say it’s 70% as those who say 33%.

      • And I had meant to say before, thanks for commenting – you guys are my first real engagement with comments. The female human put the post up on Reddit and before I knew what was happening my views went from one or two every other day to over 1000. I have no idea how that works but I’ll take it.

  3. Pingback: Not the Laffer Curve again! « Economics Info

    • Thanks for commenting – I haven’t done a post in ages and had no idea this particular one was still attracting attention. I have also fixed the link to the Romer study as the old one no longer works.

      It is is indeed so that if you assume that any tax change of 1%, from any given tax rate, affects output by 3%, and if that output change results in a direct proportional change in revenues (something the Romer study doesn’t examine), then your revenues peak at 33%, or 25% if the drop is 4%, 20% for 5% drop and so on…

      My problem is you have used one qualified conclusion from the Romer study and applied it to all taxes at all times, regardless of any other economic factors in play. You are then surprised that it’s not big news, even though the study states in its conclusion:

      We also examine the behavior of output following changes in other measures of taxes. The estimated output effects obtained using broader measures of tax changes, such as the change in cyclically adjusted revenues or all legislated tax changes, are substantially smaller than those obtained using our measure of exogenous tax changes. Thus, failing to account for the reasons for tax changes can lead to substantially biased estimates of the macroeconomic effects of fiscal actions. Finally, we find suggestive evidence that tax increases to reduce an inherited budget deficit do not have the large output costs associated with other exogenous tax increases.

      We can perhaps agree that a good conclusion of this particular Romer study is that tax changes implemented for ideological reasons (ie. not directly related to achieving output shifts), such as raising corporation tax purely for the sake of being seen to be “punishing” business, is a bad idea.

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