Tuesday, October 20, 2009

A new look at the Laffer curve

The Laffer curve became fashionable among US Republicans in the 1970s and 1980s, leading to the 1981 tax cut that proved that the US was still on the right side of the curve. But since, tax rates have increased overall, as well as in other countries, where they were higher to start with. So are all these countries still on the good side of the Laffer curve?

Mathias Trabandt and Harald Uhlig study this problem using a neoclassical growth model and new estimates of tax data. And the US is still far from the slippery slope, but not surprisingly closer for capital income tax than for labor income tax. Even for Europe, countries are generally on the right side of the curve. Exceptions: Denmard and Sweden for capital income taxes.

Note that the whole argument here is about the maximization of government revenue. That is usually not the objective. And there are also ways to raise significant revenue while improving a country's welfare, like taxing negative externalities and sins. But at least this paper should put to rest the argument that taxes need to be lowered to raise more revenue.


Anonymous said...

"[...] and sins." ?!?

Economic Logician said...

Sin takes, like on alcohol and cigarettes.

Alex Tabarrok said...

The right side of the curve is actually the wrong side, right?

Anonymous said...

" But at least this paper should put to rest the argument that taxes need to be lowered to raise more revenue." Strike "need" from your statement and we are closer to the claim. Replace with "can" or even "will" and rephrase.

Anonymous said...

Eh... but "sin taxes" are a good idea for Ramsey/elasticity of demand reasons, rather than for sinfulness of the act, I would suppose...

Whew... for a second there I was confused.

Awesome blog, keep up the extraordinary work!

Unknown said...

Comment submitted to http://economiclogic.blogspot.com/2009/10/new-look-at-laffer-curve.html:

Alex Tabarrok is right: The right side is the wrong side!

You say, "But at least this paper should put to rest the argument that taxes need to be lowered to raise more revenue."

OK, in the US or the EU, you *could* raise revenue by increasing either capital or labor taxes. But consider the following intriguing quotation from the Trabandt and Uhlig paper:

"...it turns out that revenue is maximized when
raising labor taxes but lowering capital taxes" (page 26, pdf page 28)

This perhaps supports the old idea of eliminating capital taxation altogether (while making up revenue loss with labor tax increases).

Anything like this would be politically impossible (especially for Obama) at least until the public becomes aware that lowering capital taxes causes wages to rise.

Walt said...

At the "optimal" tax rate that maximizes total tax revenue, the dead weight loss of the tax is positive and growing. This means that the deal weight loss per tax dollar collected is infinite at this "optimal" tax rate. So, using any utilitarian weighting, tax rates should be less than the tax revenue maximizing level.

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