Understanding the Laffer Curve

Despite differing opinions about the size of government, revenue for the most necessary programs has to be generated one way or the other. This is usually done through the taxation of income, savings, and property. When more tax revenues are called for, one option is to increase tax rates, which almost seems intuitive. Almost.

Using said logic is akin to trying to press “pause” on the economy, making a change, and then pressing “play” without anyone noticing. In addition, it requires the assumption that these modifications will produce only intended consequences, without having indirect effects on other aspects of the economy. It is more realistic, however, to acknowledge the fact that economic conditions change each day. Not to mention that individuals are constantly deciding how many hours to work, where to purchase property, what investments to secure, etc. and they can alter these decisions an infinite amount of times. In other words, the average person adapts their behavior to different incentives. In the case of taxes, any change to the tax code or the rate of taxation will likely change consumer behavior.

The Laffer Curve is a representation of the relationship between taxation and revenue. It is drawn below:

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The basic idea is that tax receipts will be zero if the tax rate is 0 per cent (for obvious reasons), and they will be zero at a tax rate of 100 per cent, since no one would work if their entire wage is taken. As tax rates rise from 0 per cent, revenues start increasing. However, there comes a point (as rates keep rising) that people decide to not work–or to move away, close their business, or evade taxes–and tax revenues, therefore, begin declining. This is an important concept for policymakers to understand, since misinterpreting the relationship between revenue and taxation could lead to a scenario in which higher rates of taxation generate lower revenues.

Since the 1960s, for instance, the United States federal government has claimed, on average, 18 per cent of the economy, despite wild fluctuations in the rate of taxation since 1960. In fact, the top marginal tax rate in 1963 was 90 per cent, whereas the current rate is 35 per cent. Nevertheless, federal revenue has remained constant at around 18 per cent, begging the question of whether the rate of taxation influences the amount of revenue. Changes to other taxes, including corporate and capital gains taxes, have had no apparent effect either.

Jean Chretien, arguably the most fiscally responsible prime minister in recent Canadian history, may have also sensed this relationship. Chretien’s administration balanced budgets impressively in the early nineties, opting to raise taxes only minimally, as some marginal income tax rates were already as high as 55 per cent. Forcing them higher could have caused more damage, for the reasons above. Thomas Mulcair, the current leader of the opposition, seems to agree and said recently that marginal tax rates above 50 per cent amount to blatant confiscation. In Atlantic Canada, some cities, such as Saint John, have had serious discussions in city council meetings about having a toll or “commuter tax” to enter the city, apparently unaware of the potential disastrous consequences that derive from the Laffer Curve.

Importantly, though, the Laffer Curve’s tipping point remains unpredictable in most cases. Some academic studies estimate that the rate leading to maximum revenues is between 40 and 70 per cent, depending on the good, service, investment, etc. to which the tax applies. In France, for instance, the top marginal income tax rate is 75 per cent and, in response, many athletes, businesspersons, and entrepreneurs have left. Anecdotes abound, including Facebook founder Eduardo Saverin’s relocation to Singapore to avoid capital gains taxes, or suggestions from Danielle Smith, the leader of Alberta’s Wild Rose Party, that high oil and gas royalties in the province discourage growth (wherein evidence suggests lower fees may have brought in larger revenue through increased growth).

Even if a tax rate is below the “tipping point,” an important point remains. Here, cutting the rate will pay for itself partially though economic growth (but not entirely). For example, Greg Mankiw, an economist at Harvard University, found while capital gains tax rate cuts are not revenue-neutral, they only result in about 50 per cent of the “anticipated” revenue reduction, due to increased growth.

There is one certainty, though: as globalization and the capacity for mobilization intensify, the tipping point is likely to become much lower and policymakers from all ends of the economic and political spectrum could benefit from yielding to these developments. This taxation tightrope can provide revenues for important government programs, while at the same time appealing to economic freedom and helping individuals make ends meet.

Mike Craig is a 2013-2014 Atlantic Institute for Market Studies’ Student Fellow. The views expressed are the opinion of the author and not necessarily the Institute

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