by John Hawkins | November 15, 2010 6:51 am
If you’re reading a blog like Right Wing News, you’ve probably heard of the Laffer Curve. If you haven’t, here’s the self-explanatory graph:
Long story short, what Arthur Laffer is trying to get across is that contrary to what some people believe, tax increases DON’T ALWAYS increase revenue to the government and tax decreases DON’T ALWAYS decrease revenue.
This is because people’s behavior changes. As tax rates go higher, people are incentivized to work less, cheat on their taxes, and find ways to protect their income from the tax man. Once the tax rate gets up to 100%, the question becomes: Why work at all since every dime will be handed over to the government?
So, what Laffer is saying is that there is some optimal point, where the government can maximize its revenue, and raising taxes beyond that point will be counterproductive.
Makes sense, right?
Okay, now here’s where I’ve noticed some conservatives misinterpreting this theory lately: They’ve come to believe that tax cuts will inevitably produce more revenue and tax increases will inevitably decrease revenue.
This certainly can happen and it often has happened. But, and pay close attention to this, either a tax increase OR a tax cut may increase revenue to the treasury. Moreover, it’s entirely possible that even though the revenue going to the government may increase after a tax cut, it may have increased EVEN MORE had taxes been raised.
If you don’t understand how this can be, then you don’t quite get the Laffer Curve.
Here’s what you have to understand: The Laffer Curve measures MAXIMUM revenue. If you cut taxes, it may stimulate economic activity, increase the income earned by the population, and lead to more money coming into the treasury. On the other hand, raising taxes may slow economic activity, but the increased amount of tax revenue paid per person may more than make up for it.
Here’s a SUPER SIMPLISTIC example to show you what I’m talking about.
Let’s say the tax base consists of 10 people paying $2 a year in taxes. That means the government receives $20 per year in tax revenue. Suddenly, taxes are raised to $3 a year. Because of that, 2 people decide to stop work entirely because it’s not worth their time to work so hard at that level of taxation.
So, how much money will the government take in? 8×3=$24. In other words, the level of economic activity dropped, but the government still took in more revenue.
This is something that Arthur Laffer has noted,
The Laffer Curve itself does not say whether a tax cut will raise or lower revenues. Revenue responses to a tax rate change will depend upon the tax system in place, the time period being considered, the ease of movement into underground activities, the level of tax rates already in place, the prevalence of legal and accounting-driven tax loopholes, and the proclivities of the productive factors.
Long story short: A society with a low tax rate is going to be much more prosperous than a society with a high tax rate. Moreover, can tax cuts increase the amount of revenue coming into the government? Absolutely. Can tax increases reduce the amount of revenue coming into the government? Absolutely. However, that’s not a given. Raising taxes can also increase revenue coming into the government. In fact, if our primary goal was to maximize revenue coming into the government, which in my opinion, shouldn’t be something we should necessarily strive for anyway, it’s entirely possible that raising taxes would be the best way to do that.
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