Laffer Curves and Tax cuts

McCain’s idea that reducing the tax rate increases overall government revenue due to increased business growth is based largely on the idea of the high-income Laffer curve - if you tax everyone 100%, then no one will work to make money since they don’t get to keep it. Therefore, reducing taxes will increase business, and therefore will increase tax revenue. Makes sense!

However, the same argument can be made for 0% taxation – business might be huge, but the government gets nothing unless you raise taxes.

The end result here is that just like everything else, there is at least one optimal solution somewhere in the middle of the extreme cases – most likely somewhere tending toward the lower quarter mark (~25%), where people grumble, but still go to work everyday.

Austan Goolsbee - Obama's chief economic adviser agrees (or agreed, as this paper is from 1999):

“This paper has used evidence from seven different tax changes since 1922 to examine the evidence in support of the high-income Laffer curve and the New Tax Responsiveness Literature. While that work emphasizes the potential importance of behavioral responses to marginal tax rates, the results in this paper suggest that the evidence on which those conclusions are based—evidence from the 1980s—is atypical in the historical experience. Using the same methods that NTR authors have used for the 1980s, the elasticities of taxable income calculated for other tax changes seem to be much more modest with several indistinguishable from zero. This is true in the aggregate cross-sectional tax return data as well as in panel data on executive compensation. The largest estimates of the taxable income elasticity from all of the previous historical periods is lower than the smallest estimates of the elasticity in the literature based on the 1980s. Given the importance of the behavioral response to taxation, it is my hope that this will stimulate further research on the topic using data outside of conventional tax returns in the 1980s and 1990s.

The notion that governments could raise more money by cutting rates is, indeed, a glorious idea. It would permit a Pareto improvement of the most enjoyable kind. Unfortunately for all of us, the data from the historical record suggest that it is unlikely to be true at anything like today’s marginal tax rates. It seems that, for now at least, we will have to keep paying for our tax cuts the old fashioned way. “


You can read the full paper here: http://faculty.chicagogsb.edu/austan.goolsbee/research/laf.pdf