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Where do countries stand on the Laffer Curve?
From Mathias Trabandt and Harald Uhlig, there is a new study:
We characterize the Laffer curves for labor taxation and capital income taxation quantitatively for the US, the EU-14 and individual European countries by comparing the balanced growth paths of a neoclassical growth model featuring ”constant Frisch elasticity” (CFE) preferences. We derive properties of CFE preferences. We provide new tax rate data. For benchmark parameters, we find that the US can increase tax revenues by 30% by raising labor taxes and 6% by raising capital income taxes. For the EU-14 we obtain 8% and 1%. Denmark and Sweden are on the wrong side of the Laffer curve for capital income taxation.
I guess some of those countries should cut their tax rates. The title of the paper is How Far Are We From the Slippery Slope? The Laffer Curve Revisited. You'll find some ungated versions here.
Posted by Tyler Cowen on September 16, 2009 at 07:38 AM in Economics | Permalink
Comments
Cutting individual income tax rates is one thing, but, in terms of overall tax policy there may be equivalent or better things to consider, even if you accept the Laffer curve.
Here's the point: the US tax system has favored capital investment--we have accelerated depreciation, various tax credits for investment, etc. And, for the most part, that tilt toward the use of capital in the human effort to capital production equation has, until now, served us well. But, if you look at effective corporate tax rates, what you see is that capital intensive industries pay substantially less corporate taxes than less capital intensive industries. This can have consequences--we may be favoring companies in reducing employment at a time of high unemployment, we may be taxing service industries at a higher rate when service (computer programming, healthcare, etc.) are areas that we want to have investment in, but of a different character--an investment in human capital. Similarly, we permit depreciation deduction for equipment but not for education when we should be encouraging education.
Also, to the extent that we favor capital intensive investment with our tax policies--policies that were developed when we were a creditor nation (which were last since 1985), these policies may not be the best ones when we are a debtor nation. Do we want to goose more borrowing on international markets because our tax policies favor capital intensive industries.
All this requires some balance and consideration. Obviously, we don't want to lose efficiency...but, fixed capital (hard goods) are not the only form of capital in the production equation, there is human capital as well, and because we favor one form of capital over another with our tax policies favoring hard capital investment, we are limiting our own production possibility frontier.
Posted by: Bill at Sep 16, 2009 9:20:38 AM
How about we abolish both personal income tax, capital gains tax, and corporate taxes, and replace it with a revenue neutral CO2 tax?
Posted by: Vehical Driver at Sep 16, 2009 9:42:26 AM
Their generated curves are based on a "simple neoclassical growth model."
Posted by: Trevindor at Sep 16, 2009 9:54:15 AM
If the conclusion is "I guess some of those countries should cut their tax rates." (I think you might be referring to Sweden and Denmark, is not there a corollary: the US should raise its tax rates?
Posted by: Allan at Sep 16, 2009 10:48:35 AM
If the conclusion is "I guess some of those countries should cut their tax rates." (I think you might be referring to Sweden and Denmark, is not there a corollary: the US should raise its tax rates?
No, because there may be reasons to have tax rates below the Laffer maximum. Having tax rates above the Laffer maximum, by contrast, is just irrational, as you could get more tax revenues by lowering rates.
Posted by: Blackadder at Sep 16, 2009 11:23:32 AM
Blackladder,
Just as there are policy reasons to have tax rates above the maximum, there may be reasons to have tax rates above the maximum.
"I guess some of those countries should cut their tax rates" implies that the main reason for taxes is to generate revenue.
I do not think that having tax rates above the Laffer curve is irrational. As an example, I would give cigarrette taxes. The maximum revenue might be gained if rates were X, but if policy were to reduce cigarrette use, a rate at X + Y would be rational. Similarly, if the purpose of the taxes in the country is to create income equality, it would be rational to be above the Laffer curve equilibrium.
Posted by: Allan at Sep 16, 2009 11:36:01 AM
What discount rate is used when people try to calculate the Laffer maximum?
A related, but even more incalculable question is 'does our government provide worse service than a pure revenue maximizer?'
Posted by: josh at Sep 16, 2009 11:40:24 AM
To pursue income equality by reducing the number of hours worked by high-income earners is madness pure and simple. It is absolutely antithetical to any measure of human welfare.
Posted by: Cliff at Sep 16, 2009 11:43:33 AM
Allan,
That's fine for cigarettes, but presumably Denmark and Sweden aren't trying to discourage capital investment.
Posted by: Blackadder at Sep 16, 2009 11:45:22 AM
I just finished reading this interesting paper. One issue:
Given the average post deduction labor tax of 26% in the US (from their paper), and given they think that this is significantly to the left of the peak of the Laffer Curve, the question becomes "Where would one increase labor taxes?" You see, even post deduction, the rich are paying far more than 26% on their labor in high tax jurisdictions.
You may think that capital gains are a juicy target, but according to this paper, taxes on capital are actually higher in the US than the EU-15; they may already be to the right of the Laffer peak (I didn't see this conclusion in my speed read, and Tyler didn't point is out). And of course, capital taxes are capital taxes. Not labor taxes. And their conclusion, highlighted in Tyler's post here, is that labor taxes can be increased.
Given the reality of the US tax code, and their conclusions, I can only assume that it's taxes on the middle class and poor which have the greatest room for "optimization"?
Posted by: Tuttle at Sep 16, 2009 11:52:43 AM
Cliff,
The number of hours are not reduced. The taxation is increased. If these leads to some reducing hours, it could be better. Allow me to expand.
With a few exceptions, everyone is fungible. A job performed by one can generally be performed at the same level as by someone else. Thus, all things being equal, it is just as effecient to have two people working 40 hours per week as it is to have one person working 80 hours per week. Arguably, it is better, because one's abilities begin to wain after working a certain number of hours (a better example would be that having 5 people work 40 hours per week would be the same as having 4 people work 50 hours per week).
On the other hand, there is a theory that we do not live to work. Rather, we work to live. So, working 40 hours a week is better for the individual. Additionally, one with children would have more family time if one worked less hours. And, it could be argued, persuasively, that children need their parents. And children with parents around benefit society. Consequently, fewer working hours is not only better for the individual and the family, but better for society as a whole.
In some circles in the US, there is a theory that working more is better. Thus, they want lower tax rates, even if it means less quality time for parents and children. In other words, the US tax rates could arguably be a policy decision that working is more valuable than raising families. Sweden and Denmark seem not to concur.
I make no judgments on policies. I am just trying to explain the rationality of the tax rates. Indeed, you may disagree with the rationale. But it is out there.
Posted by: Allan at Sep 16, 2009 11:59:46 AM
Just a question, but has the tax cuts on "capital" in multiple tax cut bills since 1997 promoted the increase in productive capital in the US?
Or has it simply promoted the creation of phantom capital which has vanished several times in the past decade?
I've heard the claim that $7 trillion in capital was lost in 1999-2000, and now that the US economy has suffered a loss of from $5 trillion to $14 trillion in capital since 2007. I have no clue how to objectively come up with anything to verify such claims, and I conclude that anyone who is talking in those terms is likely to advocate tax policies to spin gold from straw, unlimited government free lunches, and the scientific proof of vacuum energy.
However, I would suggest that we can benchmark the relative tax policy burden on the US economy against the relative performance of the US economy.
Which is in a sense what the Laffer curve implies. Taxes too too low can have an adverse impact just like taxes too high. The performance of the economy when the tax burden is in the 21% range is historically better than when taxes are in the 19% range.
Posted by: mulp at Sep 16, 2009 12:02:25 PM
I do not have a subscription, so cannot read the full paper. I hope that the paper does not suggest that the goal should be to maximize tax revenues. And secondly, if the data is relying on data from 2007 or beforehand (and maybe even 2008), it's probably obselete. As the credit bubble deflates, what we know about income distribution will change dramatically.
Posted by: Dave at Sep 16, 2009 12:26:25 PM
@Allan:
"With a few exceptions, everyone is fungible. A job performed by one can generally be performed at the same level as by someone else."
I expect my patients will not agree with this fallacy. If I work 20 hours instead of 60, and my secretary takes care of my patients during the 40 hours I am not working, the total amount of hours worked by us are the same. The quality of health-care these patients may have a right to, or currently pay for, would probably be lower.
Posted by: adam at Sep 16, 2009 1:43:09 PM
Adam,
That sound you hear is my premise rushing over your head.
I do not suggest replacing a physician who works 80 hours a week with a physician who works 40 hours per week and a secretary who works 40 hours a week.
I suggest that we get two physicians to work 40 hours per week.
That might mean we need more physicians, but it is doable.
Posted by: Allan at Sep 16, 2009 2:03:21 PM
"With a few exceptions, everyone is fungible. A job performed by one can generally be performed at the same level as by someone else."
It is shocking to me that someone could actually believe this. Have you ever worked? Do you not recognize that different people have different training and education levels? That some work harder or are more skilled than others? Have you never experienced the fact that some people are good at their jobs, and others are terrible, even holding training and education levels constant? This isn't a fallacy, it is lunacy.
Posted by: Doug at Sep 16, 2009 2:04:26 PM
Doug,
Your point simply is untrue. What is true is that not everyone does the job the same. What is not true is that only one person can do a job. Those who work harder or better might be worth more per hour, but that does not mean they are not fungible and that things will fail if they were not there.
If that were true, the best employees would not be allowed to go home, retire, quit, or die.
Almost everyone is fungible. There are some exceptions, but they are few: Einstein comes to mind.
Posted by: Allan at Sep 16, 2009 2:17:37 PM
Doug and adam, you have failed MBA school. Anyone who has worked for a real corporation knows that the always correct in theory and practice MBAs hold that labor is fungible and that a high wage employee can readily be fired and replaced by a new low wage employee without any loss to the productivity or output of the corporation. He knows this with authority because he has an MBA and that is taught in every economic theory class. Labor is, with rare exceptions, a commodity and fungible.
Posted by: mulp at Sep 16, 2009 2:30:06 PM
"Your point simply is untrue. What is true is that not everyone does the job the same. What is not true is that only one person can do a job."
I never said that only one person can do a job. You are making up a false claim, and attributing it to me in order to prove me wrong, but I never said that. You said a job can generally be performed AT THE SAME LEVEL by someone else. The problem is, in most instances, businesses have a hard time replacing a good employee with another employee that wil perform AT THE SAME LEVEL. This is not a rare exception, but something that is common to almost any business.
"Those who work harder or better might be worth more per hour, but that does not mean they are not fungible and that things will fail if they were not there."
First that is not the original point that YOU made. Second, being worth more per hour DOES mean that they are not fungible, and whether or not a company would fail if an employee was not there has nothing to do with whether or not employees are fungible.
Fungibility is the property of a good or a commodity whose individual units are capable of mutual substitution. If people do not do the job the same, and their labor is worth a different amount per hour, then they are not capable of mutual substitution, and thus, are not fungible. A 10 pound sack of grain is fungible because it can be replaced by any other 10 pound sack of the same type of grain. An hour of one guy's labor cannot necessarily be substituted with an hour of any other guy's labor, even if they have the exact same educational background--and most people do not have the same backgrounds. Thus, they are NOT fungible.
"If that were true, the best employees would not be allowed to go home, retire, quit, or die."
Not allowed to die? Not allowed to retire or quit or go home? What parallel universe do you live in where employers have the right or even the power to dictate such terms to their best employees? What point are you trying to make with such absurdities?
Posted by: Doug at Sep 16, 2009 3:52:44 PM
With a few exceptions, everyone is fungible. A job performed by one can generally be performed at the same level as by someone else. Thus, all things being equal, it is just as effecient to have two people working 40 hours per week as it is to have one person working 80 hours per week.
The premise here is false, but it doesn't really matter, as the conclusion doesn't follow (if you think it does follow, try substituting "eighty people working one hour per week" for "two people...") It's kind of like saying "the recipe says to cook for two hours at 200 degrees, so I'll cook for an hour at 400 degrees; should be the same."
Posted by: Blackadder at Sep 16, 2009 4:01:26 PM
Blackadder - that analogy is wrong.
It is like saying: we have to cook some turkeys for four hours. We can rent one oven or two ovens. It costs $x/hour to rent an oven. Assume that 1) the ovens are of an infinite size (we can fit all the turkeys in one oven) as is the kitchen; 2) the total time attending the ovens is the same (we are watching football in the other room, anyway); and 3) that we really don't care when the turkeys are done (we are going to put them directly in the freezer). Should we rent one or two? It just does not matter.
Granted, there are some projects that take less total time if one person does them, but I am unsure how much that matters in the grand scheme of things.
Posted by: Allan at Sep 16, 2009 4:09:52 PM
"It is like saying: we have to cook some turkeys for four hours. We can rent one oven or two ovens. It costs $x/hour to rent an oven. Assume that 1) the ovens are of an infinite size (we can fit all the turkeys in one oven) as is the kitchen; 2) the total time attending the ovens is the same (we are watching football in the other room, anyway); and 3) that we really don't care when the turkeys are done (we are going to put them directly in the freezer). Should we rent one or two? It just does not matter."
Are you actually saying it makes sense to cook the turkeys in one oven for 2 hours, then take the turkeys out, return that oven, rent another oven, move the turkeys into that oven, and finish cooking them in the second oven? Even if both ovens were there the whole time and you only paid rent while you were using them, you would still have to spend the time and effort to move the turkeys from one oven to the next.
If you meant should you rent one or two for the whole four hours, why would you rent two if all of the turkeys could fit into one? It would cost twice as much for no reason. Either way, this makes no sense.
Posted by: Doug at Sep 16, 2009 5:43:58 PM
This is a ridiculous analogy from the start.
Hiring two people will certainly cost marginally more money than hiring one person. If taxes are low, you can't justify hiring two instead of one (or 5 instead of 4).
But if the cost of working 80 hours is not worth it to the worker, the worker will only work 40 hours and you will need to hire someone else or you will have to pay the worker more to compensate for the higher taxes.
If the former, the individual will benefit in non-monetary ways, as will his family, as will society. Thus, higher taxes on income.
If the latter, the individual will benefit monetarily.
That is the rationale for being above the Laffer maximum. Yes, it is a higher cost to business. But the way the US does it takes a higher cost on society.
Posted by: Allan at Sep 16, 2009 6:16:26 PM
Allan,
I have read your comments with much amusement. It is hard to even know where to begin puncturing the fallacies you have written here. However, the root of your problem is that you are misusing the word "fungible".
I guess the easiest place to start is at the very beginning. Let us suppose we have a worker that earns $100,000/year while working 40 hrs/week. To keep this simple, let us agree that his income means that his output, the value added to society, is $100,000/year. Now suppose that we raise the tax on his labor enough that he is willing only to work 20 hrs/week. At this rate of work, he will only add $50,000/year of value to society. You are supposing, with your "people are fungible", that a second worker can now be hired to make up the lost $50,000, but the question you never answered is this: what was this second person doing before this new "opportunity" was created by your added tax? Why was he doing what he was doing before?
The key to understanding where you went wrong is this- if people were truly fungible in the manner you described, then this fungibility would drive the economy towards an equilibrium in which wage rates for everyone approached equality- doctors would make the same rate of pay as people at McDonalds, or secretaries would make the same rate of pay as microchip engineers.
Posted by: Yancey Ward at Sep 16, 2009 6:58:33 PM
Fungible? Sounds like Ellsworth Tooey speak to me.
Posted by: John Breig at Sep 16, 2009 7:17:37 PM
