The Laffer Curve and the Cost of Taxation

Reader MJ argues that the Laffer Curve remains important because even if we're not actually maximizing tax revenue, it offers an insight into the economic cost of taxation:  "I also take it to mean that as you move right at any position the economic cost of gathering an additional tax dollar increases. So at a 5% flat tax rate collecting the marginal tax dollar might cost the economy $1.10 (number made up). While at a 35% flat tax rate the marginal tax dollar might cost the economy $2, (or $4). Saying the Laffer curve is not relevant if we are to the left of the apex seems to say the effect on the economic loss ratio isn't relevant. Or do you read Laffer more narrowly to not include this issue?"

Yes.  No.  Maybe.  It's complicated.

I do think there is economic loss to taxation, but that it's probably more vividly and accurately depicted as deadweight loss.  The Laffer Curve shows tax revenue, which is only a poor proxy for economic activity.

There's undoubtedly economic loss from every cent of tax (though liberals would argue, at least as much economic gain from the resultant spending).  But those economic losses do not necessarily show up on the Laffer Curve.  Consider a universe without taxation (because, she explained to her liberal readers, society is so perfect we do not need a government).  Everyone manages the tradeoff between leisure and consumption (aka work) as best they can so as to maximize their perceived utility.

Now say we introduce a 25% tax on income.  At least some people will change the amount of leisure they consume as a result.  But contra conservatives, we do not necessarily know that they will decide to work less.  That's because people are now poorer.  If you're suddenly making 75% as much for working the same number of hours, maybe you cut back your hours because it's just not worth the hassle.  But maybe you get a second job, because you've got a mortgage and a car payment and you want to go to Maui with the family next year.

A tax increase could thus raise the number of hours worked, which would show up on the Laffer Curve as a gain to the government.  But it would still be an economic loss to the country, because it would mean that a large number of people would be consuming less leisure in order to keep their consumption flat.

(Again, I understand that some readers will wish to interject that the spending of the tax revenue represents an economic gain to someone else.  This is true, if not perfectly so.   But right now, let's focus on one thing at a time.)

Whether tax revenues rise or fall, taxes have an economic cost.  It's just that one is easier to measure.