Jude Wanniski, a writer for
the Wall Street Journal, coined the term “Laffer Curve” after a
concept promoted by economist Art Laffer.Laffer himself says the idea goes
back to the 14th century
The idea is that if
one wants to maximize the government’s tax revenue, there is an optimal
tax rate. (Ignore for the moment whether or not you think this makes good
economics in the long run, or whether or not you think this is even moral.)
Laffer noted that if
the tax rate is zero, then the government gets no revenue. But likewise, if
the rate is set at 100%, the government also gets no tax revenue.
Mainstreamers say that there is no incentive to produce income at 100% tax
rate, and this is true. But even more importantly, there is no means: a 100%
tax rate is pure capital destruction.
Maxima”, i.e. the tax rate which maximizes the tax take, is somewhere
between 0% and 100%. The Wikipedia article shows a picture of a Laffer Maxima
at 70%, and implies that although it’s somewhat controversial this may
be the right number.
There are two points
about the Laffer Curve that are important to consider.
First, what in the
world makes any economist think that he can gin up some differential
equations and compute the right value for this Maxima? In the first place,
every market is composed of an integer number of people transacting an
integer number of trades, and each of those trades consists of an integer
number of goods. People do not behave like particles in an ideal
gas—they have reason and volition. The very idea of modeling a large
number of people with equations is preposterous. Never mind that degrees are
awarded every year to economists who purportedly do just that.
Second, what makes
anyone think that the Laffer Maxima is a constant?
Let’s do a
thought experiment that is in the vein of the Austrian School of economics.
Let’s consider the boom-bust cycle, or what Austrians note is really
the credit cycle. The central bank first expands credit, which flows into
wealth-creating as well as wealth-destroying activities (malinvestment). As
the expansion ages, an even greater proportion of credit funds
wealth-destroying activities. Sooner or later the boom turns to bust.
Malinvestments are liquidated, people are laid off from their jobs,
portfolios take big losses, tax revenues decline, etc.
One clue can be found
right there, in my description of the bust: tax revenues decline.
OK, maybe the Laffer
Curve remains static and the only thing that changes is the absolute tax
comparing the boom and the bust phases. In the boom phase what’s
happening is that economic activity is being stimulated, i.e. beyond what it
would naturally have been. This fuels demand for everything: commodities,
labor, construction, fuel, professional services, etc. And all of the people
hired in the boom are demanding everything too. It feeds on itself
synergistically, for a while.
At this stage, the
frictional cost of taxes may be masked by the lubricant and fuel of credit
expansion. This is especially so when everyone feels richer and richer on
paper. People spend freely and we saw this in spades in the most recent boom
that ended in 2007.
Now let’s look
at the bust phase. The net worth of most people is falling sharply. Many are
laid off, their careers, and sometimes lives, shattered. A huge component of
the marginal bid for everything is withdrawn. People struggle to make ends meet.
Budgets are stretched to the max.
I submit for the
consideration of the reader that in the bust phase, any change in the tax
rate drives a big change at the margin of economic activity. The tax rate is
more significant in the bust phase than it was in the boom phase. The Laffer
Maxima is not a hard-wired, intrinsic value of 70 (or 42 for fans of Douglas
Adams). Like everything else in the market, it moves around. It is subject to
the forces of the markets.
I will close with an
example. Consider the marginal restaurant. Let’s say it is generating
$25,000 per month in gross revenues. Net of $24,700 in expenses, it is
generating positive cash flow of $300 per month. Why would the owner even
keep it open? Well, times may get better…
Now, let’s say the tax
rate goes up a little, say 100 basis points. The restaurant, making little
money, pays essentially no taxes anyway. So this does not cause a direct
impact. But what about the patrons of the restaurant? If their blended tax
rate was 25%, then an increase of 100 basis points (i.e., to 26%) is a tax
increase of 4%. These people will have to reduce their budget by 4%.
One logical place to
cut is eating out. Suppose that they reduce their spending in the restaurant
by $1,000, in aggregate. Now our restaurant has $24,000 per month in
gross revenues. But its fixed costs cannot be reduced. And even the labor
can’t be reduced in this case. The only reduction will be food
supplies. So let’s say food supplies are reduced 1/3 of $1,000, or
$333. So now the restaurant has expenses of $24,367. Whereas it formerly made
$300 profit per month, now it makes a loss of $367 per month.
The owner can’t
continue this very long. And so he closes shop. He defaults on the loans on
the fixtures and tenant improvements, lays off 8 people, leaves the electric
and gas companies with fixed infrastructure which no longer produces revenue
for them, etc.
The impact to the
economy (and hence to the total taxes collected) is negative and
disproportionate to the tax increase.