Monday, February 02, 2004

Unicorns, magical gnomes, and sound fiscal policy derived from the Laffer curve

For those of you who don’t know, the Laffer curve is a graph showing total revenue collected by the state vs. the tax rate. The basic idea is that at a 0% tax rate, the country receives $0 revenue and at a 100% tax rate the country also gets $0 revenue. The state can only get money by setting the tax rate in between (duh) and it also implies that higher tax rates are inefficient in that a 1% tax rate increase could yield less than a 1% increase in revenue.

The standard Republican canard since the Reagan years has been to point at the graph, way your hands in the air, pronounce us to be on the far (inefficient) end of the Laffer curve, and prescribe a decrease in tax rates. Now, there’s an interesting thing about the Laffer curve. Go ahead, Google it. Don’t all the pictures show a wonderfully curvy little curvy curve, curving from the 0 to the 100. So smooth! (and curvy). Why? Because no one knows what it really looks like. For all we know the curve could go up and up till 95% and then plummet.

One of the popular Republican beliefs (which I’m not implying they all share) is that 1. Reagan’s tax cuts showed that we were on the inefficient end of the Laffer curve in the 80’s and 2. We are on still on the inefficient end of the Laffer curve and 3. The Laffer curve is a useful device for predicting tax revenue.

First, even the wall street journal’s Bruce Bartlett (relentless, remorseless pusher of supply side economics, the Laffer curve and such) will admit that Reagan’s tax cuts didn’t increase revenues at all. In fact, even Bartlett’s rosy scenario only had the economy increase enough to offset one third of the revenue loss.

Second, to believe that we are still on the inefficient end of the Laffer curve is to ignore that not only are taxes lower than in Reagan’s day but our taxes are lower than almost any other industrialized country.

Lastly, the Laffer curve is just too simple to be of any use. It ignores potential efficiencies that would make our country more competitive. For example, let’s say the US population is spending X dollars on health care and further let’s suppose that other countries experiences show that nationalized healthcare would cost less than X (because of savings on administrative costs). Then, no matter where you are on the Laffer curve, increasing taxes to provide universal healthcare would be the way to go.

Why is this? Because in the case described above, socializing that activity would make the economy more efficient. Don’t believe it? Look at how we socialize national defense and even personal defense (army and police). These are activities for which market forces don’t work (like possibly the incredible insanely inelastic healthcare market).

Now, there are other possible arguments for decreasing taxes that don’t involve the Laffer curve. And if you believe that government should be small (as opposed to “exactly the right size” like I do) there is no reason to stop shrinking taxes just because you’re past some “efficient” point on a fictitious graph. But if someone’s argument rests on the Laffer curve, keep in mind that they have built there house on sand.


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