In economics, the Laffer curve illustrates a theoretical relationship between rates of taxation and the resulting levels of the government's tax revenue. The theory reasons that because no tax revenue is raised at the extreme tax rates of 0% and 100%, there must be a tax rate between 0% and 100% that maximizes government tax revenue.
The shape of the curve is a function of taxable income elasticity—i.e., taxable income changes in response to changes in the rate of taxation. As popularized by the American supply-side economist Arthur Laffer, the curve is typically represented as a graph that starts at 0% tax with zero revenue, rises to a maximum rate of revenue at an intermediate rate of taxation, and then falls again to zero revenue at a 100% tax rate. However, the shape of the curve is uncertain and disputed among economists.
One implication of the Laffer curve is that increasing tax rates beyond a certain point is counter-productive for raising further tax revenue. Particularly in the United States, conservatives have used the Laffer curve to argue that lower taxes may increase tax revenue. However, the hypothetical maximum revenue point of the Laffer curve for any given market cannot be observed directly and can only be estimated; such estimates are often controversial. According to The New Palgrave Dictionary of Economics, estimates of revenue-maximizing income tax rates have varied widely, with a mid-range of around 70%. The shape of the Laffer curve may also differ between different global economies.
The Laffer curve was popularized in the United States with policymakers following an afternoon meeting with Ford Administration officials Dick Cheney and Donald Rumsfeld in 1974, in which Arthur Laffer reportedly sketched the curve on a napkin to illustrate his argument. The term "Laffer curve" was coined by Jude Wanniski, who was also present at the meeting. The basic concept was not new; Laffer himself notes antecedents in the writings of the 14th-century social philosopher Ibn Khaldun and others.
History
Origin
Laffer states that he did not invent the concept, citing numerous antecedents, including the Muqaddimah by 14th-century Islamic scholar Ibn Khaldun, John Maynard Keynes and Adam Smith. Andrew Mellon, Secretary of the Treasury from 1921 to 1932, articulated a similar policy idea in 1924.
Laffer's name began to be associated with the idea after an article was published in National Affairs in 1978 that linked him to the idea. In the National Affairs article, Jude Wanniski recalled a 1974 dinner meeting at the Two Continents Restaurant in the Washington Hotel with Arthur Laffer, Wanniski, Dick Cheney, Donald Rumsfeld, and his deputy press secretary Grace-Marie Arnett. In this meeting, Laffer, arguing against President Gerald Ford's tax increase, reportedly sketched the curve on a napkin to illustrate the concept. Cheney did not accept the idea immediately, but it caught the imaginations of those present. Laffer professes no recollection of this napkin, but writes: "I used the so-called Laffer Curve all the time in my classes and with anyone else who would listen to me".
Precedents
There are historical precedents other than those cited by Laffer. Ferdinando Galiani wrote in Della Moneta (1751) that "It is an enormous error ... to believe that an impost always yields more revenue as it becomes heavier". He gave the example of a toll on late-night entry to a town which would be less remunerative if set unreasonably high. David Hume expressed similar arguments in his essay Of Taxes in 1756, as did fellow Scottish economist Adam Smith twenty years later.
At the time of the Irish famine of the mid-1840s, Edward Twisleton suggested that lower local taxes in Ireland would increase the amount of taxes successfully collected towards relief. An analysis of actual collection rates has indicated that areas with higher rates did collect a lesser proportion of the tax due.
In the United States, the Democratic Party embraced this argument in the 1880s when high revenue from import tariffs raised during the Civil War (1861–1865) led to federal budget surpluses. The Republican Party, which was then based in the protectionist industrial Northeast, argued that cutting rates would lower revenues. Secretary of the Treasury Andrew Mellon wrote in 1924: "It seems difficult for some to understand that high rates of taxation do not necessarily mean large revenue to the government, and that more revenue may often be obtained by lower rates". Exercising his understanding that "73% of nothing is nothing", he pushed for the reduction of the top income tax bracket from 73% to an eventual 24% (as well as tax breaks for lower brackets). Mellon was one of the wealthiest Americans, the third-highest income-tax payer in the mid-1920s, behind John D. Rockefeller and Henry Ford.Cannadine, David. Mellon: An American Life. New York: A. A. Knopf, 2006. pp. 48–49, 165, 349. . While he served as Secretary of the Treasury, his wealth peaked at around $300–400 million. Personal income tax receipts rose from $719 million in 1921 to over $1 billion in 1929, an average increase of 4.2% per year over an 8-year period, which supporters attribute to the rate cut.Folsom Jr., Burton W., The Myth of the Robber Barons, p. 103. Young America's Foundation, 2007.
In 2012, economists surveyed by the University of Chicago rejected the viewpoint that the Laffer curve's postulation of increased tax revenue through a rate cut applied to contemporary federal US income taxes in the medium term. When asked whether a "cut in federal income tax rates in the US right now would raise taxable income enough so that the annual total tax revenue would be higher within five years than without the tax cut", none of the economists surveyed agreed and 71% disagreed. According to Harvard University economist Jeffrey Frankel, a substantial majority of economists rejected the proposition that U.S. income taxes were so high in 2011 that tax cuts would pay for themselves.
Empirical analysis
One of the conceptual uses of the Laffer curve is to determine the rate of taxation that will raise the maximum revenue (in other words, "optimizing" revenue collection). The revenue maximizing tax rate should not be confused with the optimal tax rate, which economists use to describe tax rates in a tax system that raises a given amount of revenue with the fewest distortions to the economy.
Writing in 2010, John Quiggin said, "To the extent that there was an economic response to the Reagan tax cuts, and to those of George W. Bush twenty years later, it seems largely to have been a Keynesian demand-side response, to be expected when governments provide households with additional net income in the context of a depressed economy." A 1999 study by University of Chicago economist Austan Goolsbee, which examined major changes in high income tax rates in the United States from the 1920s onwards found no evidence that the United States was to the right of the peak of the Laffer curve.
Income tax rate at which revenue is maximized
In the early 1980s, Edgar L. Feige and Robert T. McGee developed a macroeconomic model from which they derived a Laffer curve. According to the model, the shape and position of the Laffer curve depend upon the strength of supply side effects, the progressivity of the tax system and the size of the unobserved economy. Economist Paul Pecorino presented a model in 1995 that predicted the peak of the Laffer curve occurred at tax rates around 65%. A draft paper by Y. Hsing looking at the United States economy between 1959 and 1991 placed the revenue-maximizing average federal tax rate between 32.67% and 35.21%. A 1981 article published in the Journal of Political Economy presented a model integrating empirical data that indicated that the point of maximum tax revenue in Sweden in the 1970s would have been 70%. A 2011 study by Trabandt and Uhlig published in the Journal of Monetary Economics estimated a 70% revenue maximizing rate, and estimated that the US and most European economies were on the left of the Laffer curve (in other words, that raising taxes would raise further revenue). A 2005 study concluded that with the exception of Sweden, no major OECD country could increase revenue by reducing the marginal tax rate.
The New Palgrave Dictionary of Economics reports that a comparison of academic studies yields a range of revenue maximizing rates that centers around 70%.
Taxation of goods and services
The Laffer curve has also been extended to taxation of goods and services. In their 2018 Econometrica paper, Miravete, Seim, and Thurk, show that in non-competitive markets, the strategic pricing response of firms is important to consider when estimating the Laffer curve. The authors show that firms increase their prices in response to a decrease in the ad valorem tax, leading to less of a quantity increase than would otherwise be expected. The net effect is to flatten the Laffer curve and move the revenue maximum point to the right.
Congressional Budget Office analysis In 2005, the United States Congressional Budget Office (CBO) released a paper called "Analyzing the Economic and Budgetary Effects of a 10 Percent Cut in Income Tax Rates." This paper considered the impact of a stylized reduction of 10% in the then existing marginal rate of federal income tax in the US (for example, if those facing a 25% marginal federal income tax rate had it lowered to 22.5%). Unlike earlier research, the CBO paper estimates the budgetary impact of possible macroeconomic effects of tax policies, that is, it attempts to account for how reductions in individual income tax rates might affect the overall future growth of the economy, and therefore influence future government tax revenues; and ultimately, impact deficits or surpluses. In the paper's most generous estimated growth scenario, only 28% of the projected lost revenue from the lower tax rate would be recouped over a 10-year period after a 10% across-the-board reduction in all individual income tax rates. In other words, deficits would increase by nearly the same amount as the tax cut in the first five years, with limited feedback revenue thereafter. Through increased budget deficits, the tax cuts primarily benefiting the wealthy will be paid for—plus interest—by taxes borne relatively evenly by all taxpayers. The paper points out that these projected shortfalls in revenue would have to be made up by federal borrowing: the paper estimates that the federal government would pay an extra US$200 billion in interest over the decade covered by the paper's analysis. In 2019, economists at the Joint Committee on Taxation revisited the macroeconomic and budgetary response to the stylized 10% reduction in statutory ordinary income tax rates, but from the levels set by P.L. 115-97. While incorporating additional tax detail within the modeling framework relative to previous analyses, the paper similarly estimates that this policy change would result in increased budget deficits - both in the short- and long-run - after accounting for revenue feedback from macroeconomic changes.
United Kingdom Following the reduction of the top rate of income tax in the UK from 50% to 45% in 2013, HMRC estimated the cost of the tax reduction to be about £100 million (out of an income for this group of around £90 billion), but with large uncertainty on both sides. Robert Chote, the chairman of the UK Office for Budget Responsibility commented that Britain was "strolling across the summit of the Laffer curve", implying that UK tax rates had been close to the optimum rate.
Australia Australia increased its tobacco excise over the period from 2005 and beyond. The tobacco excise collected reached a peak in 2019 and then began to decline as the tax per cigarette increased.
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