The Laffer curve

Source: The Guardian

It all began in 1974, when Laffer walked into a bar with Dick Cheney and Donald Rumsfeld, who were working for the Ford Administration at the time. Out of it came the “Laffer curve,” a U-shaped graph illustrating the relationship between tax rates and revenue.

The ends of the curve are basic enough – at a tax rate of 0, the government will raise $0 in revenue, and at a tax rate of 100, the government will still raise $0 in revenue because people won’t work without take-home pay.

At the extremes, the Laffer curve is correct, but that doesn’t tell us anything about the points in the middle. Laffer’s idea, however, was that a “tipping point” existed on the continuum in between, where people’s incentives to work and invest decreased because tax rates were too onerous.

From Laffer’s graph, Republicans had the academic justification to justify slashing tax rates for corporations and the rich.

President Ronald Reagan adopted Laffer’s supply-side theory wholesale in his deregulatory and low-tax agenda. In the decades since, Laffer has clung to relevancy, appearing on cable news to vehemently defend the alleged benefits of slashing taxes, even when the evidence provided otherwise.

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The Laffer Curve superficially makes a lot of sense.  Obviously, at 100% tax, no one will work, so tax revenue is zero, while at zero tax, no one pays any tax, so tax revenue is also zero.  The thing is, there's a third parameter/dimension, and that's how easy is it to earn that pre-tax income?  If it's easy, then you might go on working even if the tax rate is 80%.  For example, if you are in a profession, with fixed costs for your staff and premises, and clients need answers, are you really going to say, I'm not going to do this, because tax?  If you have inherited millions, what are you going to do to avoid tax?  More to the point, the work done by the middle class and above, who pay higher taxes, is determined by office hours and retirement age.  You won't work less because of higher taxes.  You might, of course, work shorter hours if you are in the office until 9 at night, but that's just because normal hours end at 5 or 5:30.  And frankly, that's a better life-work balance anyway.  Working class people, paid by the hour, won't work more because taxes are cut, because their tax rate is already low.

At any rate, Laffer drew his curve peaking at 50%.  Even if the peak is higher (60%?  70%?) it still means that if we are on the low side of the curve, cutting taxes reduces overall tax revenue.  Cutting the top marginal tax rate from 80% to 70% might well increase tax revenues.  But by Laffer's own reckoning, cutting them from 30% to 20% will not.

Moreover, if tax rates above 50% inhibit endeavour, then surely that applies also to welfare claw-back rates?  These happen when you are receiving welfare and you earn some additional money.  In Australia, for example, the clawback rate for the dole starts at 50%, then rises to 60%, and that's without counting the cost of other benefits which are withdrawn as income rises.  If there are disincentive effects for the tender rich, surely they exist at the other end of the income scale too?

There's also the point that $2 to a beggar represents far far more than $2 to a millionaire.   This is the whole argument behind a progressive income tax, where the tax rate rises as income rises.  The wealthy benefit from expenditure by the collective entities such as municipalities, states/provinces and the nation.  Police, defence, roads, hospitals, schools, street lights are all paid for by everyone.  Plus, reduced inequality makes society, including the rich, safer. 

Like many insights from the neo-liberal consensus, there is some truth in the Laffer curve.  Only, it's applied even when its results are destructive, because those who advocate it either don't really understand it, or worse, do, but want to cut their contributions to society anyway.