The Return Of The Laffer Debate

Posted: Jun 21, 2010 1:41 PM
Much has been made of the so-called Laffer Curve, which theoretically determines the amount government can actually earn from tax revenues as the result of raising taxes. After a certain point, government earns less from raising taxes, because it inspires more income-earning people to pursue tax shelters, tricky accounting methods, or decrease production.

Most of the debate centers around where exactly the point lies where the government earns fewer dollars as the result of raising tax rates. Most Republicans argue that the point at which government stops making money from raising tax rates is at a lower rate of taxation. Most Democrats, and a number of other economists, argue that the point at which government stops making money from raising tax rates is at a higher rate of taxation. Here is a basic visual display of the Laffer curve, courtesy of the Heritage Foundation:


I'd argue that where exactly the point lies is a debate of the past, for the most part. What is important is Laffer's new editorial in the Wall Street Journal, where he takes up his theory again and applies it to the new Bush tax cuts that are being phased out at the end of this year:
... if people know tax rates will be higher next year than they are this year, what will those people do this year? They will shift production and income out of next year into this year to the extent possible. As a result, income this year has already been inflated above where it otherwise should be and next year, 2011, income will be lower than it otherwise should be.
Therefore, tax revenues will be less. Does that indicate impending economic collapse? No really, says Laurent Belsie in the Christian Science Monitor:

The problem with his argument is that he only tells the short-term story. Laffer relates how Americans and corporations will shift as much income as possible from 2011 to 2010. Thus, tax revenues will be lower next year than they would be otherwise.

That's all true. But America's economy is not going to crash because government revenues go up or down in a single year. The real policy question is what the long-term effect of the tax hikes will be.

No question they'll have a negative impact on growth. But that effect will be far smaller than the short-term effect...That's not insignificant. But the developed world is embarking on an austerity drive and starting to bring budgets back into line.
I'd argue that bringing budgets back in line shouldn't rely on increased taxation regardless of austerity drives, Laffer curve indicators or political tides. But that's for another post.

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