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Monday, April 16, 2012

The Laffer Curve Refuted

Mike Kimel at Angry Bear has several nice posts on the "Laffer Curve" that underlies much of conservative economic orthodoxy in this country. As you may know, Art Laffer famously claimed that at tax rates of 0 and 100%, you would get zero tax revenue, and that in between, there is an inverted U shaped curve, where taxes collected first increase as the tax rate goes up, then decrease as tax rates go higher still, back down to zero tax collected when the tax rate is 100%.

The Kimel post linked above was prompted by an economist at the American Enterprise Institute, Alan Viard, telling the New York Times that all economists know that when the top tax rate is 35%, cutting rates further will reduce tax revenue.
“The Reagan tax cuts, on the whole, reduced revenue,” he explains. “The Bush tax cuts clearly reduced revenue. There is no dispute among economists about that.”
Except, as Kimel points out, lots of conservative economists dispute this, including one who co-authored a paper with Viard! For his trouble, Kimel became the subject of a post at the AEI blog by James Pethokoukis, which started by completely misidentifying him and going downhill from there. For Kimel's enjoyable takedown of this post, see here.

All this led me back to an earlier post of Kimel's, where he makes an empirical estimate of the Laffer Curve, using U.S. data all the way back to 1929, the first year for which official U.S. data exists. I'll spare you the technical details (see Kimel's post), but here's the bottom line: Laffer got it exactly backward, with tax revenue initially falling as tax rates increase, then rising after a further increase in rates. Here is Kimel's estimate of the "true" Laffer curve:




Not only that, as one of Kimel's commenters, Robert Waldmann points out, we actually have experience with a country having a top marginal rate over 100%, Sweden in the 1970s. Contrary to Laffer, not only was tax revenue not equal to zero, in 1975, Sweden's tax revenue was 41.3% of gross domestic product! (OECD statistics, click on "data by theme," then "public sector, taxation, and market regulation," then "taxation," then "revenue statistics - OECD member countries," then "comparative tables") 21.2% was central government revenue, i.e. excluding subnational government and social security. Either way, a long way from zero.

Not to belabor the point, but Viard was right about tax revenue after President Bush's tax cuts. Here is the OECD data for the federal government, excluding Medicare, Medicaid and Social Security. First we see the effects of President Clinton's tax increase, then President Bush's tax cuts.

Year          Tax/GDP

1992          10.7%
1993          11.0%
1994          11.3%
1995          11.7%
1996          12.2%
1997          12.7%
1998          13.1%
1999          13.2%
2000          13.5%
2001          12.5%
2002          10.4%
2003            9.8%
2004          10.0%
2005          11.2%
2006          11.9%
2007          11.9%
2008          10.4%
2009            8.4%
2010            9.1%

Source: OECD, directions as above for Sweden

Before you supply-siders get too excited about the increase in 2006 and 2007 to 11.9%, remember that the higher Clinton tax rates brought in more revenue for five straight years, 1996-2000.

Though many journalists get it wrong, chessplayers like myself know that "refute" means to conclusively disprove. And the Laffer Curve stands refuted.

18 comments:

  1. You didn't refute the Laffer Curve, you refuted Kimel's use of it. Yeah I know what refute means, you didn't address the data in the Laffer curve, which is empirical data on taxation vs revenue. The Laffer curve is facts, and unless you have a problem with the factual numbers, it's not refuted.

    You also left out of your conclusions factors that directly affect good conclusions to be drawn from the Laffer curve data. You completely ignored the tech bubble in siting Clinton's tax rate in "giving us" more revenue. Very sloppy work leads to very bad conclusions, usually. You know a stopped clock is right 2 x a day so ...

    Sweden's dynamics greatly differ from those in the US. The effect of taxation on revenue depends on how it's reacted to. Clinton did tax retroactive. The dynamic in the data is that it's alive, it's people reacting to policy as they will always do. Many effects take a while to go though the system, the domino effect takes as long as reactions take to effect the next reaction.

    Some of the reactions to policy are quick. When those reactions cause change as in a business quits a certain behavior & others slowly die off that affects other business & behaviors of the people involved.

    The whole thing is very simple if it is to be correct. The complication is only in that there are so many components in the economy, those are people.

    Reward for work is a motivation. Profit for business is a motivation. Of course if reward is lowered motivation to seek that reward is diminished.

    This article stinks of politically driven motive to erroneous conclusion.

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    1. I think you are forgetting that there was an even bigger bubble during the Bush administration than Clinton's tech bubble, yet federal taxes/GDP never got above 11.9%, a level topped in 5 of Clinton's 8 years in office.

      As for facts and data, I know that Mike Kimel is happy to share the data if you want to do your own calculations and regressions.

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    2. There were other things going on in Bush's administration. We don't want to forget 911 & it's profound effect on the economy, do we?

      The policy of the Bush administration it seems evident for bringing us back quickly from the economic downturn that came on the end of the Clinton administration. Then it brought things back pretty quickly from the 911 caused fall off.

      Tax revenues came up after & it would follow, under Bush's tax cuts.

      Clinton had a perfect storm of sorts, increased revenue do to retroactive taxation, and a bubble.

      To deny that tax cuts usually increase business production is obtuse to the human aspect of the economic system. Why do so many try to ignore the human element when it's obviously what drives the economy?

      Government centric entities like to teach us that what gives them more control is good for the economy, it's not. It's only good for government control.

      One can speak of tax rates of 70%, but the fact is no one paid that, there were loop holes.

      Big Gov loving types also try to teach us government jobs are the same as any other, but they are obviously not. No increase wealth you must create wealth. Printing $ isn't creating wealth, it increases the notes representing the total wealth, while the wealth doesn't increase, causing inflation. Inflation is the invisible tax.

      It's not that complex, wealth is created when goods are created & in a certain way when services are done. Government increases no wealth. The money they pay is inflationary. Not that it's always bad, government facilitates trade by making a safe place to trade. A monetary system facilitates trade by making it easier than strait up barter, of course.

      When you get beyond facilitation, Government hinders trade & economy. Government officials tend to strive for more power. When they get the right to choose winners & losers they have power, become more important, and worse something they can sell, and they will, or powerful people will put in politicians who will sell it.

      This is what's happening with Obama. He's selling to the highest bidder. Destroying small business & killing start ups. The end game to this is we the consumer are forced to consume from a limited number of wealthy entities who had the $ to buy government. I mean if Obamacare isn't an example of that to anyone they're blind. The selling us off started BEFORE the bill was passed, and it wouldn't ever have been passed without promises to big businesses & bribes to legislators. Height of Corruption, and exceptionally damaging.

      Now that's a lot to go into, but there is a reason the economy does what it does. There is a reason the Laffer curve works, it's simple human behavior.

      Wealth is not $. Wealth does not come from government. If you really get into the dynamics of the economy it's obvious.

      Colleges are paid by entities that want big government power. All but idiot leftist goofballs who can't stand a debate on facts are being pushed out in most places. The truth is being distorted. Government pours $ into colleges, facilitates financing, and the quality of instruction goes down while the price goes up. 2/3 of college grads test less or equal to the levels they did on entrance. Over all with exceptions it's much less about education, much more about indoctrination.

      I have a wordpress account but this damned thing won't let me use it, so anonymous, call me Omegahpla.

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    3. What about the economic collapse at the end of 8 years of George' W. Bush's administration? Explain that! Is that somehow also Clinton's fault?

      The USA has experimented with supply side economics for 30 years. 30 YEARS! The USA is worse off now, economically, than it was at the beginning of the Reagan administration. CONFIRM/DENY? Remember back when we had factories? Remember back when a college degree was a ticket to a guaranteed job? Why the fuck should we take seriously some stupid idiot who is proposing the same crap that they proposed, back when we had an economy, that then destroyed that economy when we implemented it?

      Ayn Rand was a dumb bitch.

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    4. Omegahpla,

      Though I'm not an economist, as far as I can see Professor Thomas is presenting an analysis based on observable data. Your claim that he is motivated by a political agenda is completely unfounded. If you think his conclusions are erroneous, then I would like to see you provide some evidence to back that up. It seemed that you started to do that in your first comment and at the beginning of your second post, bringing up issues that do bear discussion and debate.

      However, the political diatribe that follows clearly shows YOUR motivations. Can you not engage in debate and discussion about observable and verifiable data without resorting to talking points based on political doctrine and childish insults?

      We get it. You're angry. You are a doctrinaire, and Professor Thomas' conclusions offend your fanatical devotion.

      But could you put that aside for the time being and address the data and conclusions in a professional and respectful manner? I actually thought you were raising some interesting questions, but then you lost me with your diatribe.

      Professor Thomas - I believe it was right around the mention of "government centric entities" that Omegahpla stepped off into the deep end. But I would be interested in your response to the issues he or she raised before that regarding the impact of 9/11 and Clinton's "perfect storm" of economic factors.

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    5. Correction Anonymous who answered me Omegahpla. I wasn't angry with the Author, simply pointing out the origins of the conventional "wisdom" which are the root of his opinion. This isn't original stuff, and what you hear from most of academia is so obtuse it's glaring, yet it's what is taught. You don't just leave pertinent factors out of cause & effect analysis naturally. That's taught, indoctrinated. Paradigms built that basically blind one to facts. It's amazing phenomena of human behavior.

      Plus, if one deviates from this & it's politically threatening to the controllers of this atmosphere, they get a light treatment of Vatican vs Galileo. Light only by comparison with threatened death, sadly.

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  2. The author has stated numerous facts that contradict what is understood to be the Laffer curve. Howsoever, this is the first time I ever heard it called 'empirical' it was an hypothesis when Laffer made it, an a priori argument which was used to suggest it. And in fact, since no argument was ever offered about the nature of the derivatives of the function, or even their implicit dependencies, no 'curve' could thereby be generated.

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    1. If you don't understand that the Laffer Curve is Empirical data put into contrasting graph, what are you being taught? Why wouldn't you see through such sloppy presentation?

      The Laffer curve isn't the conclusions drawn, it's PURE DATA. It's a baseline to use with other pertinent data to test economic theory. It's only as good as the data used with it.

      If you go through your education just memorizing enough to pass, you'll be probably as clueless or more than when you entered. It's a national trend.

      And for hells sake, if you just breeze by this stuff, don't try to argue it & lead others down that road out into the weeds.

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    2. There are 3 tiers of sages in the world. Tier one is the kind of expert who publishes in the given subject. Tier 2 knows a good deal about the subject, but doesn't publish in it. S(h)e can perhaps teach a class in it. Tier 3 knows general facts about the subject, i.e. has maybe taken a class which covers the topic in some degree. Now, most encyclopedias, including Wikipedia cover knowledge at the tier 2 or tier 3 level, So UNLESS you are a tier 1 economic sage publishing in the LAFFER-KHUDUN area, you probably do not have greater expertise than wikipedia which classifies the Laffer curve as 'hypothetical' QED. I'd also like to see your credentials. BTW I am not an economist, I just aced those classes, generally the highest grade in the class. I AM however a biophysical chemist; PhD from Johns Hopkins. I have published in J. Phys. Chem.; J. Chem. Phys. ; Biochhemistry; BBA; J. Theor. Comp. Chem.; Bipophysical Chem. Perhaps you could tell me whether you think an economy is an ergodic system or a nonergodic system (I have published on nonergodic dynamical systems/statistical mechanics)?

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  3. Warning, You're a Professor, if you ever start agreeing with the facts I've brought out & express that ... You're probably never getting tenure. That's how things are kept "in line" & how entities that have taken defacto control of most colleges. Omegahpla

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  4. http://scienceblogs.com/goodmath/2007/07/a_laughable_laffer_curve_from.php

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  5. Some of the Anonymous posters clearly like being a right-wing promoters. No use for data or facts of any kind. Invective that they call criticism. It is too bad that this kind of repartee is the main representation of right-wing comment.
    The Viard comment quoted by Kimel, "there is no dispute," is clearly not correct, although it should be correct. Viard might be a lovely guy, and it seems from Kimel's comment that Viard can recognize a data set when one appears. Regrettably, Viard is not representative of right-wing economists, or right-wing scientists of any kind.

    The recent Anonymous post "lead others into the weeds" is regrettably exactly what one expects from the political right. The suggestion from someone who thinks the Bush 43 administration was successful, that someone else is leading in the wrong direction is (pun alert) a real Laffer.

    Kudos to K Thomas and especially to M Kimel.

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    1. OK, I've had a symantical error is speaking of the Laffer Curve itself. The concept was based on Empirical Data that was shown where taxation rates met revenue levels.

      The actual "Laffer Curve" theory does in fact extrapolate & postulate including assumptions of causal factors in the economy.

      I was of the impression that the empirical relationship between taxation & revenue was in fact THE Laffer Curve, turns out I remembered wrongly.

      The idea still stands, when you take the empirical data relationship add real affecting data you'd come up with the correct relationship, but of course it does depend on getting the factors influencing the result of revenue correct, or close.

      I do insist that when the tech bubble or other such fact is left out of the data as a factor, that the formulation of the equation is fatally flawed. In fact, beyond ridiculous.

      I'm not anonymous my wordpress account won't function here for some reason, Omegahpla

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  6. I know I am late to this party but damn, How is it that there is any tax collection when the top marginal rate is zero? Next thing to note is, why does it go lower when the TMR is at 4%? The tangential of your graph is when the top marginal rate is at 32% then ski rockets from there...

    If the TMR is zero where is tax collection coming from? Economic Principals (econ 101) people are motivated by incentives. You show tax collection to GDP at 25% when TMR is 100% You sir are an idiot. Please let us know where you got your PHD so we can laffer at you!!! Please explain why someone would be willing to work that hard (incentive) to make no profit?

    That is what the Laffer Curve explains @ 0% tax no tax collected at 100% tax no tax collected. Some where in between 0 and 100 is the magic percentage of tax that generates the maximum benefit to government with minimal effect on business.

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  7. Sweedish government invests in dividend paying stocks, mainly in US companys. Special stocks, you and I can not get, which pay guaranteed rates.

    2nd, how big is the Sweedish Navy?? Where would their defence expendatures be if we cut ours? Could they still afford their socialized healthcare?

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    1. What is your source for the first claim? Regarding your second point, you can find military data at http://milexdata.sipri.org/

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  8. I think you make a major error by dividing by GDP in the diagram. High taxes will decrease business oppurtunities, and thus GDP, giving your curve a higher value! The top tax revenue will most likely cooccur with a high GDP, at a tax rate below the minimum in your diagram at 32%, I would guess 25% or so. Try plotting the total tax revenue (not revenue per GDP, but adjusted for inflation) for different tax percentages instead.

    (I believe Laffer is wrong in making the curve entirely symmetrical implying an ideal 50% tax rate. I also dont se entirely zero revenue in either end: there will be some amount of work done with 100% tax rate, as there would be some amount volountary tax payments with 0%.)

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