The New Laffer Curve Logic and the Lack of Evidence for It

After being shown again and again that tax cuts don't increase revenues, those who make the Laffer curve argument stopped making the claim generally and shifted the argument to say that while it may not be true across the board, there is evidence that it is true for the very top rates. Now, as Lane Kenworthy discusses below, the argument has shifted again. But even after all of this reformulation of the argument to try and make it work somehow, somewhere, the evidence is still pretty shaky:

The New Laffer Curve Logic, by Lane Kenworthy: “When you cut the highest tax rates on the highest-income earners, government gets more money from them.”

This sounds like an argument by Arthur Laffer, probably on the Wall Street Journal op-ed page circa 1978. Actually, it is by Arthur Laffer … in the Wall Street Journal … but in 2008 rather than 1978. The piece is titled “The Tax Threat to Prosperity” (here). In it, Laffer reiterates his famous, and famously-influential, claim about the detrimental impact of tax rates on incomes and therefore on tax revenues.

But the argument has changed. The notion at the heart of the original “Laffer curve” argument was that higher marginal tax rates on those making the most money discourage them from investing, starting new businesses, and working hard. The result is less income growth, and hence lower tax revenues. Laffer now argues that the problem with high marginal tax rates is that they encourage high earners to hide and shelter their income. The “supply-side” problem now is said to be tax avoidance.

What is the evidence? Laffer notes that while the top marginal income tax rate has been significantly altered over the past generation, the effective tax rate — the amount of income actually paid in taxes — for the top 1% of households has been fairly stable. The chart below shows this. (The data on effective tax rates are from the Congressional Budget Office here. This, he says, is because when the top marginal rate is increased, high-income taxpayers reduce their taxable reported income via “tax shelters, deferrals, gifts, write-offs, cross income mobility, or any of a number of other measures.” When the top marginal rate is reduced, they increase their taxable reported income.

This is certainly plausible. But it is equally plausible that the effect on tax avoidance, while real, is quite small. Suppose the top marginal tax rate is reduced by 10 percentage points. Is it likely that most of those in the top 1% will call their accountants and instruct them to go easy on the exemptions and deductions?

If changes in the top marginal tax rate in fact have little impact on tax reporting by those with high incomes, what accounts for the fact that the effective rate on the top 1% is far less variable than the top marginal rate? Two things. First, the top marginal rate applies to only the top portion of these households’ incomes. Second, and more important, when Congress and the president have altered the top marginal rate they frequently also have changed the rules about loopholes, exemptions, deductions, and tax compliance.

There are have been four noteworthy changes in the top marginal tax rate since the late 1970s. Let’s consider them in turn.

1. Tax reform in 1981 reduced the top marginal rate from 70% to 50% beginning in 1982. Few exemptions and loopholes were closed. The fact that the effective income tax rate on the top 1% of households fell only slightly in the ensuing years appears to support Laffer’s argument.

But there are two important qualifications. First, the drop in the top marginal rate is misleading. As Eugene Steurle points out in his book, Contemporary U.S. Tax Policy, “Even before 1981, high-income individuals often avoided a top tax rate of 70 percent through a special provision of the tax code that limited the tax rate on earnings, or income from labor, to a maximum of 50 percent.” Furthermore, in 1982, 1983, and 1984 additional tax reforms were enacted that reduced loopholes and enhanced tax compliance and collection via expanded reporting requirements and heightened penalties.

2. Tax reform in 1986 reduced the top marginal rate from 50% to 39% in 1987 and 28% beginning in 1988. The effective rate on the top 1% actually increased slightly in the following years. This, however, is fully explained by the fact that the 1986 reform dramatically reduced loopholes and exemptions. This wasn’t a case of high-income households deciding to hide less of their income because the top marginal tax rate had been lowered. They had no choice.

3. Tax reform in 1993 raised the top marginal rate from 31% to 40%. The effective rate on the top 1% increased from 21% in 1992 to 24% in the latter part of the decade. Did the hike in the marginal rate of 9 percentage points encourage tax avoidance? Possibly, but if tax avoidance increased, it was more likely due to the massive rise in incomes among the top 1% that occurred in the second half of the 1990s. The next chart shows this. Average pretax income in this group nearly doubled between 1993 and 2000, soaring from $750,000 to $1,450,000.

4. Tax reform in the early 2000s reduced the top marginal rate by four percentage points, from 39% in 2002 to 35% in 2003. In this case the effective rate on the top 1% of households fell by exactly the same amount, from 24% in 2002 to 20% in 2003.

None of this is to suggest that tax avoidance doesn’t occur or isn’t worth worrying about. Far from it. But the notion that lowering the top marginal tax rate dramatically reduces such avoidance appears to be wishful thinking.

Update: See also Do capital gains tax cuts increase revenues?, by Justin Fox.

Comments

[sa]

I don't understand how Kenworthy's article addresses Laffer's main point that cutting marginal tax rates has a a diminshing marginal benefits curve implying that it's great to cut top tax rates from 90% to 80% but it's not that hot to cut them from 40% to 30%. I mean this is common sense not high falutin economics.

[bakho]

A well funded PR campaign can have greater impact than being credible:

"Dr. Laffer has been widely acknowledged for his economic achievements. He was noted in Time Magazine's March 29, 1999. cover story "The Century's Greatest Minds" for inventing the Laffer Curve, which it deemed one of "a few of the advances that powered this extraordinary century". He was listed in "A Dozen Who Shaped the '80s," in the Los Angeles Times on Jan. 1, 1990, and in "A Gallery of the Greatest People Who Influenced Our Daily Business." in the Wall Street Journal on June 23, 1989. His creation of the Laffer Curve was deemed a "memorable event" in financial history by the Institutional Investor in its July 1992 Silver Anniversary issue, "The Heroes, Villains, Triumphs, Failures and Other Memorable Events."

[spencer]

If the top marginal rate is high tax payers will use tax loop holes, tax shelters and other loop holes. The impact of most of these is to reduce reported "taxable" income. So when you reduce the top marginal rate these tax shelters are not as valuable -- and remember under Reagan's tax reform many of these shelters were eliminated as a trade off for the lower tax rates -- so top tax payers will report a higher taxable income. However, it may not impact their total income. So if these studies or looking at taxable income it can appear that you get the Laffer effect
when what you are really getting the impact of the elimination of tax shelters.

Since on balance the tax shelters cause investments to be misdirected lowering top rates to eliminate tax shelters is a good thing, but it does not mean the concept behind the "laughter" curve is valid.

[ken melvin]

The Laffer Curve works very well for those at the top. It's also most believable for those at the top and their toadies.

[reason]

sa..
That may be so, but is that what Art Laffer is saying today?

[Damian]

I'm fairly ignorant about this stuff but I had a question - in the WSJ article Laffer says:

"Since 1980, statutory marginal tax rates have fallen dramatically. The highest marginal income tax rate in 1980 was 70%. Today it is 35%. In the year Ronald Reagan took office (1981) the top 1% of income earners paid 17.58% of all federal income taxes. Twenty-five years later, in 2005, the top 1% paid 39.38% of all income taxes."

Isn't this just further proof of income disparity and the concentration of wealth among the richest?

[cm]

spencer: Is that a testable hypothesis? If so, where is the evidence that fewer loopholes and sheltering schemes are in use (not just different ones)?

Considering how much time many are prepared to spend to handle paperwork squeezing relatively trivial deduction amounts from their tax bill, it doesn't strike me as very plausible that tinkering with tax rates, as opposed to closing loopholes, has much of an effect in that regard.

[ScentOfViolets]

The argument that lowering rates will somehow reduce tax avoidance seems to be an example of magical of thinking; logically, it would seem to me, that as long as it costs less to avoid taxes than to actually pay them, we will have this sort of behaviour, no matter how high or low the rate is as a rate.

Is there something wrong with this reasoning? If so, I wish Laffer would have explicitly enunciated this point, and then refuted it.

[john c. halasz]

cm:

I'm no expert and certainly would defer to Spencer's response, but one of the main effects of the 1986 tax reform was to shift income streams from C corporations to S corporations (i.e. limited partnerships). The increase in S corporations was especially pronounced in the financial sector.

[bakho]

Damian- Only about 40% of Federal revenue comes from personal income tax. In 2006 personal income tax was about $1 Trillion of the $2.4 Trillion collected.

Social Insurance taxes, which are mostly capped have a much larger contribution from those other 99% SI Taxes were about $0.8 Trillion.

Don't mix apples and oranges (% of all taxes, % of INCOME taxes)

[calmo]

Absolutely Damian.

Isn't this just further proof of income disparity and the concentration of wealth among the richest?

But you won't hear this from Mankiw or other similarly winged economists because that is "a politically charged rendering of the data".
Similarly, (just take it like the politically discharged Man you are) the recognition of Laffer then or now is politically charged by laughable nincompoops who wouldn't have a chance against me and my mojo, juju and tofu.

[RW]

What do the Laffer 'theory,' social security privatization, and Intelligent Design all have in common outside their utility to specific and readily identifiable sociopolitical movements?

Program organization including generation of hypotheses is almost exclusively devoted to the defense of the inner theoretical core rather than the generation of new knowledge, prediction of events, or the accomplishment of any of the other tasks we normally associate with a viable research agenda; e.g., http://tinyurl.com/29ld6w; http://tinyurl.com/33wl8g

[save_the_rustbelt]

In order to have a real discussion about this one must:

Consider the current structure of deductions - exemptions - credits, and

Remember the little leghold trap called the AMT

[Alex Tolley]

SOV: "The argument that lowering rates will somehow reduce tax avoidance seems to be an example of magical of thinking; logically, it would seem to me, that as long as it costs less to avoid taxes than to actually pay them, we will have this sort of behaviour, no matter how high or low the rate is as a rate."

Not entirely. Some tax shelters are potentially quite risky and therefore not worth taking that risk if the returns are not so great. It's quite one thing to use a shelter that the IRS acknowledges, but quite another to use one that your accounting firm swears you to secrecy before you are even allowed to see it, in case the details leak out.

As for the data in chart 1, what does the "effective tax rate" actually mean - the income the taxes paid that were declared to the IRS. How does this account for undeclared income from tax havens and other offshore vehicles?

[Dirk van Dijk]

If you really want to cut down on tax shelters etc. then make the Cap Gains tax equal to the person's ordinary income taxes. If there is a big differential there is a big incentive to find ways to take ordinary income and mutate it into capital gains income, and a good accountant should be able to do that.

[Alex Tolley]

DvD: "If you really want to cut down on tax shelters etc. then make the Cap Gains tax equal to the person's ordinary income taxes. If there is a big differential there is a big incentive to find ways to take ordinary income and mutate it into capital gains income, and a good accountant should be able to do that."

That is only a part of the game. You also need to prevent personal spending from becoming a business expense and hiding income from the eyes of the tax authorities. In some cases, it has been worthwhile for people to renounce US citizenship to become tax exiles, like John Templeton.

And before we all get "holier than thou" on taxes, do we all pay taxes on our hired home help? ;-)

[James Killus]

I used to think that making people into tax exiles was a bad thing; now I'm entirely okay with it.

High capital gains taxes have the feature of tending to reduce the turnover of assets. That's another one that I used to think was bad, but I've been rethinking my opinion of it.

[Cynthia]

All I can figure is that Art Laffer is a paid lobbyist for the top 1% of households. But I don't have a clue as to what they're paying him to peddle this junk science of his!

[skeptonomist]

Here's a new graph

www.skeptometrics.org/Taxrate_GDP.PNG

showing the relationship between highest marginal income tax rate and GDP growth. Where are the "diminishing marginal benefits"? GDP growth was higher in the Truman administration (91% tax rate) than any other, and by decade, highest in the 60's (70-90%) and second in the 50's (91%)

And again, the one showing Government income and expenditures, with average GDP by administration:

www.skeptometrics.org/Rct_Exp_GDP_bars.png

Laffer and Reaganomics/Dubyanomics have "powered" us into $500 billion yearly deficits.

[skeptonomist]

ScentOfViolets:

There are some scams that depend on high marginal rates. For example, people used to buy objects of art, etc. for say $10,000, hold on to them for a year and a day, get them valued by an accomodating "expert" for say, $50,000, donate them to a museum and take the $50,000 off their taxable income.Even at a 50% rate, this nets $15,000 (nobody pays capital gains on charitable donations).

Of course, high marginal tax rates tend to promote charitable giving of all kinds, not just those involving dishonesty. Presumably this (honest) kind of tax avoidance is good.

[calmo]

So skepto that charitable donation to Stamp Out Michael Moore Productions the NRA is a good charitable donation...allowing your taxes on your hard earned income to go where you think it should: more bullets for self made men on the hunt...for their brains?

[Worker]

Clearly the Laffer curve exists- 100% tax rates will generate 0 or close to 0 revenue over an intermediate term. Why is it so unreasonable to believe the effect doesn't exist going from 70% to 50% especially when further reductions can be reasonably anticipated?

At some very high level of taxation, reductions do pay for themselves. We're not likely at such a high federal rate currently, but to deny such a basic truth makes one a worse charlatan than an baptist preacher passing off evolution as science.

For example, the Laffer effect was observable in Philadelphia during the mid-late 80's as the city income tax approached 5% with no reprieve in sight. Due to the geography of the ciy (move 5 miles and pay 0%) people with money chose not to pay 5%. Even some of the municipal politicos were caught "living in the suburbs" for tax purposes. A vicious cycle of revenues declines ensued, leading to default and state bail-out.

[Cyrille]

"100% tax rates will generate 0 or close to 0 revenue over an intermediate term"

Hell no! It certainly won't -in fact it may well be that 100% tax rate is the rate collecting the biggest amount. It sure won't get near 0, however much Dick Cheney wanted to believe it.

[calmo]

Worker (at what dear comrad?)[Such an important thing to bear in mind: regulars here are not regular workers, not really.] opines with the following sense and sensibilia:

At some very high level of taxation, reductions do pay for themselves.[Make for a more productive economy...now that the wealthy can afford to smoke real Cuban cigars.] We're not likely at such a high federal rate currently, but to deny such a basic truth makes one a worse charlatan than an baptist preacher passing off evolution as science.

You figure the schemata [I can walk somewhere between zero and 4 mph...somewhere in there is the best.] was put forward as a basic truth...on a par with a box having 4 corners?
Or do you figure is was motivated to get you to accept another proposition that had little to do with the number of corners in a box or the work /(care) capacity of a population? ...a proposition about there being an optimal taxation rate and that wealthy dudes might be over-contributing on route to an overall less productive economy?
I can see a wealthy dude nodding along to this line...of BS, but your tag says "Worker"? Possibly a science teacher? Possibly highly taxed science teacher looking to start up a Church?
Not likely, but seriously Worker...this is not "a basic truth", this is just base...a con...hard to know if you are not deliberately perpetrating it...hard to know if I would prefer that level of mendacity...to the apparent innocence.

[skeptonomist]

"So skepto that charitable donation to Stamp Out Michael Moore Productions the NRA is a good charitable donation"

Calm down, Calmo. Contributions could also go to Michael Moore's foundation (if he has one). I was pointing out another possible argument in favor of higher marginal rates, according to conservatives' own logic.

The question of whether interest groups should be supported by tax law is a different one.

[Worker]

Worker, I think, is the opposite of a marxist theoretician, which is what one has to be to deny the existence of a link between tax rates and peoples' willingness to pay.

For example, a worker knows that when the tax rate reaches 100%, work stops. Much like if I don't pay my construction crew work stops. I also know with certainty that a 70% rate would result in substantially less tax revenue from this Worker than 33%.

I appreciate the efforts that academic economists make to measure something as complex as the effect of tax rates on collections and enjoy reading the material here.

[alex tolley]

It is a pity that Laffer's iconic curve was so continuous and symmetrical. I see nothing wrong in the assertion of the correctness of the 2 extreme points. There is both logical and empirical evidence to back up these extremes. The problem is the shape of the "curve" in between. To my mind, none of the data presented on this thread, or other similar ones, has refuted the basic idea, but rather has only shown that any effect is muddied by other effects, or that the data is not testing the model. It is rather like trying to refute the law of gravitation by showing that feathers do not fall as fast as hammers on earth. Funnily enough, economists will assume the correctness of other models even when data is too fuzzy to confirm it, simply because it is required to support the rest of the edifice.

Which brings me back to the "curve". The assumption of both sides is that the trajectory of tax returns follows the curve in either direction. But as indicated by this quote from the article:

Is it likely that most of those in the top 1% will call their accountants and instruct them to go easy on the exemptions and deductions?

this may not be likely, while the reverse case with rising tax rates is likely. So maybe we have an effect that is more like hysteresis. What if the curve of increasing tax rates shows a rising tax take until at some critical point, there is a collapse in the take, which is not reversible?

One can posit any number of mechanisms and curves. Perhaps instead of worrying about the shape of teh curve, we should accept that the 2 edge cases are correct and that the way to maximize the tax take is to consider the balance between the costs and benefits of tax avoidance (and evasion) and try to tailor the tax code and penalties to reflect that balance?

[James Killus]

Actually, Alex, we've had some observations here recently pointing out that a 100% tax rate corresponds to Soviet-style Communism (at worst, it may simply correspond to milder forms of socialism). When the State owns all capital and pays whatever it wants to its workers, the marginal tax rate is effectively 100%.

Yet the total income for the Soviet Union was not zero. So the upper end of the Laffer Curve is incorrect. Perhaps this is incorrect reasoning, but it is not so obviously incorrect that one can pin the 100% tax rate revenue to zero without further discussion. Yet that is what Lafferites have always done, ignoring the much more easily grasped axiom that zero tax rates produce zero income.

[alex tolley]

JK: A counter example was the first year of the Jamestown colony. Mass starvation because the men would not work the fields for the common good. The solution was to have the men farm their own fields.

If you want to argue that the state can tax 100% by denying you food and shelter unless you work, therefore 100% taxation does not require 0 returns, then OK. Slavery disproves the axiom too. Perhaps we should include the explicit - "given a free choice"?

However, at 100% taxation, the incentive to create more falls to zero. The socialist worker or slave works as little as they can get away with. Much as I admire the achievements of the Russian space program, I think history has established that the mixed market democracies of the west did better for the material wealth of their citizens. (at least until now).

I see the arguments for and against the Laffer curve as becoming almost religious, each side insisting on they are completely right and vindicated. Perhaps this is a sign that both sides are arguing from the wrong premises?

[Worker]

Agreed with Alex, but quite an interesting point JK.

So it is true that you can tax 100% of a man's money within the constraints of communism.

But when he runs away, you will have to shoot him in the back dead. You would have produced more revenue if you taxed him at 20% and let him live in peace for another five years.

But thinking like a Marxist, the dead guy is a sacrifice for the collective good. Maybe if it's only 1 out of 20 workers you need to kill to convince shirkers to pay 100%.

Marxist theoreticians can chart the number of deaths required to raise a targeted revenue at 100% rates. It could be called the Anti-Laffer curve.

Unfortunately, if you have to kill 100% of the population, you still get 0 revenue.

[Cyrille]

Hell no, just because you tax 100% does not mean you keep it all for yourself! And if you want to create an incentive, well, someone who does zilch may not have the same situation/ prestige... in the final outcome.

Besides, there are communities who put everything in common you know, they don't necessarily starve.

"Much as I admire the achievements of the Russian space program, I think history has established that the mixed market democracies of the west did better for the material wealth of their citizens."

One thing that is conveniently forgotten is the starting point. Russia was oh so rich in 1916...

[James Killus]

Alex, I believe that your characterization of the Jamestown colony gis simplistic in the extreme. The settlers who starved did not do so because they refused to farm, but rather because they simply didn't know how. Nor did they know how to hunt, fish, or pretty much anything else, being "gentlemen" but landless, as they were generally later sons of the British Gentry. Their situation did not "turn around" with them being given title to land; the first settlers mostly simply died (only about 60 survived). The colony itself survived because new supplies and settlers were sent.

For that matter, the Jamestown myth hardly explains why various tribal cultures, without benefit of private property and an underlyin legal system to support them, nevertheless manage to avoid starvation for millenia. That would include the natives near Jamestown, incidentally.

Likewise, the allusions to "shooting people in the back" to keep them from escaping communism is a comic book view of history that confounds a authoritarian/totalitarian political system with an allied economic system. There have been plenty of political systems that shot people in the back for trying to escape, which nevertheless had plenty of people with private property.

The equation of a "socialist worker" with a "slave" is particularly telling in this regard, since American slavery was explicitly built on a system of private property, and propertarian arguments were used to defend it.

It is not at all clear that obtaining more than minimal work from individuals requires differential monetary rewards. For one thing, there are many rewards that are not monetary in nature; ask any musician, artist, or scientist. Moreover, some of the most demanding, unpleasant, and difficult work is performed by minimum wage workers who do not get more if they work harder, yet the work gets done anyway.

In any case, if all it takes to clean out and replace the current managerial and financial classes in the U.S. is to pay them a bit less, my god, such a deal. They surely are not worth what they are currently being paid, if "being paid" rather than "what they can skim" is the correct phrase.

[calmo]

skeptomotist (as opposed to skeptessomist?) how can I B calm with that (incendiary I tell you!) note about charitable giving?

I was pointing out another possible argument in favor of higher marginal rates, according to conservatives' own logic.

And previously you wrote:

Of course, high marginal tax rates tend to promote charitable giving of all kinds, not just those involving dishonesty. Presumably this (honest) kind of tax avoidance is good.

And I needed to underline why this tax avoidance is not good for the non-recipients...such an obvious little ting, one would have thought.
Presumably, you think that the (charity-giving) tax payer specifying where his tax money is being spent is "good".
Not really.
But thanks for disturbing me.

[Worker]

We're all free to create a commune. Just don't force everyone to join it.

This reminds me how thankful I am that in the US marxists generally don't own guns and live in universities.

And for that I am happy to pay some taxes below 33%.

[Blissex]

«I used to think that making people into tax exiles was a bad thing; now I'm entirely okay with it.»

Well, *allowing* people to become tax exiles has a wonderful consequence: that one can prove that paying taxes in the USA is _entirely voluntarily_. Absolutely nobody is coerced into paying taxes to the USA government.

It is a freely entered bargain: be a USA citizen, pay USA taxes; be a Burmese or Somali citizen, pay no USA taxes. As simple as that.

Curiously enough libertarians (like Megan McArdle) are rather outraged by this argument, while reminding the poor that they are always free to choose between starving or working for a pittance for abusive employers, so if they choose the latter, it must be a voluntary bargain.