Under The Hood With The Laffer Curve

The Laffer Curve has it’s tax policy implications but it also serves as an interesting case study of how mean green liberals view the world and how it is different from how many conservatives view the world.

Mean green liberal thinking is characterized by the rejection of complexity and a “snap shot” view of the world. By “snap shot” I mean they take a static view of systems instead of seeing one part of a system effects another and actually changes the behavior of the system over time.

Additionally, the mean green view external forces acting on people as the keys to everything and see often see peoples’ internal motivations as unaffected by external forces. Given all this, let’s think about the mean green view of tax rate hikes:

It’s pretty simple (starting at the top):

• Rising deficits lead to increased pressure to raise tax rates
• Tax rates rise increasing the amount of tax collected
• The increased tax collections reduce the deficit
• Note that the economy is treated as exogenous, i.e. the size of the tax-able economy is not affected in any way by tax rates

In this world view, you can increase marginal tax rates up to very close to 100% and every tax rate increase will produce an increase in the taxes collected.

As marginal tax rates rise, the incentive to avoid taxes increases. Put simply: if your marginal tax rate is 10% you would be crazy to spend more than one dollar to avoid paying taxes on 10 dollars. BUT, if the marginal tax rate is 90% you could spend $8 to avoid paying tax on the last $10 in income and still come out ahead (you pay $8 to avoid $9 in taxes).

Let’s take the exact same diagram we used above but let’s look harder at the size of the tax-able economy and how it is affected by tax rate increases.

The top loop, higher tax rates lead to greater tax collections, is the same but now there’s a bottom loop (starting with the Tax Rate):

• As the tax rate increases, the incentive to avoid taxes increases
• As the incentive to avoid taxes grows, people spend more time, effort, and money to both manipulate (or hide) income to avoid taxes and people’s investments become more driven by the tax implications of the investments than by sound economic issues.
• As people act less on what makes sense economically and more based on avoiding taxes, the tax-able economy is reduced from what it would have been otherwise (note that this might show in a reduced growth rate as opposed to an actual reduction in size)

One thing the Laffer Curve is telling us is that at low marginal tax rates the upper loop predominates: higher tax rates do result in higher tax revenues, even though higher rates introduce progressively greater inefficiencies into the economy.

The other thing the Laffer Curve is telling us is that, at high rates of marginal taxation, the reductions in tax-able income (the lower loop) have a bigger effect than increases in tax rates (the upper loop) and thus the amount of tax collected will go down even as tax rates rise.

Thus we’ve seen empirical evidence that the Laffer Curve is real (nicely summarized in the center for Freedom and Prosperity’s videos in my previous post) and we have a systems thinking explanation of how the Laffer Curve is working under the hood.

Mean green liberals denying the Laffer Curve is pretty straightforward:

• Denying the curve, and the systems thinking behind it, supports the mean green rejection of complexity and
• The Laffer Curve treats people as reacting to, adapting to, and even frustrating government efforts to control them, which is a problem for the mean green “One size government fits all problems and that size is BIG” way of thinking

What is interesting is that many Republicans have also turned their backs on the Laffer Curve, preferring to chant “tax cuts, tax cuts” when the Laffer Curve indicates that, at the kind of marginal tax rates we have now, tax cuts do not pay for themselves and thus tax cuts mean higher deficits, which Republicans used to think was bad.

An intellectually honest Republican Party would have to explain why tax cuts are worth higher deficits or, alternatively, explain that we are on the far side of the Laffer Curve, but they do neither.