In my writings on the Laffer Curve, I probably sound like a broken record because I keep warning that a nation should never be at the revenue-maximizing point.
That’s because there’s lots of good research showing that there are ever-increasing costs to the economy as tax rates approach that level.
So the question that policy makers should ask themselves is whether they’re willing to impose $10 or $20 of damage to the private sector in order to collect $1 of additional revenue.
New we have further evidence. Let’s take a look at a new study by economists from Spain, Arizona, and California. Here’s the issue they decided to study.
As top earners account for a disproportionate share of tax revenues and face the highest marginal tax rates, such proposals lead to a natural tradeoff regarding tax revenue. On the one hand, increases in tax revenue are potentially non-trivial given the income generated by high-income households. On the other hand, the implementation of such proposals would increase marginal tax rates precisely where they are at their highest levels, and thus where the individual responses are expected to be larger. Therefore, revenue increases might not materialise.
And here’s what they found.
…the increase in overall tax collections – including tax collections at the local and state level and from corporate income taxes – is much smaller: 1.6%. Figure 2 shows why. As τ increases there is a substantial decline in labour supply, the capital stock, and aggregate output across steady states. Aggregate output, for example, declines by almost 12% when τ = 0.13. Hence, the government collects taxes from a smaller economy… The message from these findings is clear. There is not much available revenue from revenue-maximising shifts in the burden of taxation towards high earners…and that these changes have non-trivial implications for economic aggregates.
The key takeaways from that passage are the findings about “a smaller economy” and the fact that there are “non-trivial implications for economic aggregates.”
That means less prosperity.
And the authors even acknowledge that the damage to the productive sector is presumably larger than what they found in this research.
…it is important to reflect on the absence of features in our model that would make our conclusions even stronger. First, we have abstracted away from human capital decisions that would be negatively affected by increasing progressivity. Since investments in individual skills are not invariant to changes in tax progressivity, larger effects on output and effective labour supply – relative to a case with exogenous skills – are to be expected. Second, we have not modelled individual entrepreneurship decisions and their interplay with the tax system. Finally, we have not modelled a bequest motive, or considered a dynastic framework more broadly. In these circumstances, it is natural to conjecture that the sensitivity of asset accumulation decisions to changes in progressivity would be larger than in a life-cycle economy. Hence, even smaller effects on revenues would follow.
Richard Rahn’s latest column in the Washington Times also looks at this issue, reviewing the work of James Mirrlees, an economist who was awarded a Nobel Prize in 1996.
Back in 1971, a Scottish economist by the name of James A. Mirrlees wrote a groundbreaking paper, in which he attempted to answer the question of what an optimum income-tax regime would look like… Mr. Mirrlees had been an adviser to the British Labor Party, which supported the high tax rates in effect at that time. He did a careful analysis of the variation of people’s skills and the effect tax rates had on their incentives to earn. Much to his surprise, he found the optimum tax rate on high earners was about 20 percent… In his 1971 paper, Mr. Mirrlees concluded, “I must confess that I had expected the rigorous analysis of income taxation in the utilitarian manner to provide an argument for high tax rates. It has not done so.”
In other words, tax rates above 20 percent ultimately are self-defeating – even if you’re a statist and you want to maximize the size of the welfare state.
And there’s plenty of data from around the world on specific case studies that show the negative impact of class-warfare taxation, including research from the United States, Denmark, Canada, France, and the United Kingdom.
And here’s Part II of my video series on the Laffer Curve, which provides additional evidence.
P.S. If you want some good data showing why Krugman and other class warriors are wrong about tax rates, Alan Reynolds did a very good job of skewering their analysis.
P.P.S. The right tax rate is the one that finances the legitimate functions of government, and not one penny more.
P.P.P.S. Since we’re discussing the Laffer Curve and class-warfare taxation, it’s appropriate to share this very encouraging survey of economists. They were asked whether they agreed with the fundamental premise of Thomas Piketty’s work on inequality and taxation.
Wow. This is about as close as you can get to unanimous rejection as you can get.
By the way, even if 2-3 percent of economists are right, that still doesn’t justify Piketty’s policy prescriptions.
P.P.P.P.S. In addition to writing about taxation, Richard is the creator of the famous Rahn Curve.
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[…] Back in 2014, I shared some data from the Tax Foundation that measured the degree to which various developed nations punished high-income earners. […]
[…] Back in 2014, I shared some data from the Tax Foundation that measured the degree to which various developed nations punished high-income earners. […]
[…] Back in 2014, I shared some data from the Tax Foundation that measured the degree to which various developed nations punished high-income earners. […]
[…] Back in 2014, I shared some data from the Tax Foundation that measured the degree to which various developed nations punished high-income earners. […]
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Government taxation ALWAYS removes productivity from the private sector. The Laffer curve, unfortunately only shows how to increase government intake, not how to make society more productive. We should not confuse the two. The ideal society is one where the free market rules, and everybody behaves. Since the latter is not the case, some government and rules are necessary. But let’s not lose site of the fact that ANY government at all removes from the productivity.
Simple example- Take $1000 from a producing member of society and you have reduced both his spending and investing power. Give that $1000 to somebody to be a ruler over that person and his ilk. That person will not only NOT be productive (and is not expected to be) but will likely find a way of extracting another $1000 (perhaps in fees or fines) from that productive member to justify their job. Each $1000 once removed from the circle of productivity does not ever see what we learned is a multiplying effect in our Econ 101 classes. So, it has further hampered the society it may have helped by simply being removed. Add the regulatory burden and the other things that come with government (audits, paperwork, etc.) and you can see this ugly circle has just begun. And when you find that each $1000 removed is used to justify more government jobs, you realize that you have just created a parasitic organism that will feed on others and grow if unchecked.
That’s what constitutions are supposed to be for.
In layman’s terms, once could just look at the empirical evidence: France and its 0.5-1% growth trendline — to decline.
Sure there is more than tax rates involved in growth. But tax levels are also a proxy for a nation’s overall cultural propensity towards statism and coercive collectivism — quantities that comprehensively correlate to growth — the only factor in long term prosperity.
The long term effects, wrapped in jargon in the paper, go something like this:
“Don’t bother Jacques, those who tried to do exceptional things in the French production motivation environment finally came up more expensive, or not as good as the competition, or a combination thereof – and hence failed. You do have the brains but don’t bother wasting your youth with entrepreneurship. There enough weights in France that you will never beat international competition. You will waste your youth in work and stress and accomplish little. Mediocrity is good enough.”
Jacques takes the advice ….because indeed he IS wise.
Papers will be written…
“But, a redistribution dollar today at the polls is worth five perpetually compounding growth dollars in the future”. Hence,… French choices… and decline for most of the western world’s voter lemmings.
Stay mobile.
More importantly: Teach your children to be mobile and not become too attached to their homeland.
Will economy improve much in election year? The foot in mouth âWe are are war with Isisâ has over shadowed our economy but the economy is the most important issue in America. Unemployment is down to 5.7% from itâs high 10.0 in 2009. But households in the middle of wealth distribution decline from $87,992 to $ 56,335. Households in the bottom quarter, net worth fell from $10,129 to $3,200. Lowest five per cent worth fell from a negative $9749 to negative $27,410. Spending is looking better as in GDP. Yet 17 million need a minimum wage hike. c.swinney