Does it Matter Where the Laffer Curve Bends?

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I am, of course, entirely on board with slapping down educating Republicans who maintain, against all evidence, that we can cut taxes and dramatically increase revenues.  Still, I have been puzzled by the number of liberal bloggers who have been taken with Dylan Matthews' compendium of economists and politicians commenting on where the Laffer Curve might maximize.

I mean, it's an interesting side question, but it doesn't really tell us much about policy, unless you actually think that the object of policy is to maximize the share of income the government takes.  Knowing that the curve maximizes tax revenue around marginal rates of 60% or 70% or 80% doesn't tell you that we maximize public welfare at those rates.  The negative effects of high taxes will kick in long before we've extracted that very last feasible dollar.



And no, I don't just mean the negative effects for those who pay the taxes.  All taxes involve what is known as deadweight loss.  That's money that is lost by the taxed, but doesn't go to the government.  Here's what it looks like in a very simple graphic model:

Thumbnail image for deadweightloss3.png

In a tax free labor market, Q number of employees are employed at wage W. But then we introduce a tax, which for simplicity's sake we'll say is borne equally by employer and employee.  Suddenly, the employee feels that he is making a lower wage, while the employer feels like he is paying a higher one; the result is that both supply and demand of labor drop to a new quantity, QTax.  The loss of the utility/output/cash being produced from those voluntary transactions is not gained by the government; it just disappears.

(How much actually disappears depends on how responsive you think supply and demand are to these changes in the effective price of labor; and who actually bears the tax.  But no one thinks it's nothing.)

That deadweight loss costs the citizenry.  Maybe it costs mostly the rich citizenry, though unlike some bloggers I can't say I think this is irrelevant. But just because a tax is levied on the rich, that doesn't mean the rich are the ones most hurt by it; luxury taxes on yachts put working-class boatmakers out of a job, not corporate CEOs.

One way to think about it is in terms of people with children.  If taxes are low, those people may well pay someone else to care for their children, while Mom and Dad work.  But as taxes rise, this rapidly becomes a less attractive economic proposition.  Say Mom makes $30,000 a year.  In a tax free world, she can pay $10,000 for childcare and still be better off--particularly if she enjoys her job more than she enjoys changing diapers.  But add in a 30% effective income tax rate. Suddenly she's only making a little over $20,000.  Meanwhile, the childcare workers may demand more in order to make up the lost income.  Working outside the home starts to look less and less economically sensible.

If you think, as I do, that it is better for everyone to do the things they are good at and enjoy, and pay specialists to handle tasks like painting their house, you can see how much is lost when taxes start making more and more voluntary exchanges less and less economically viable.  This is one of the reasons that Europeans get more vacation than us, but also spend more of their spare time working around the house than we do.

So the right question to me is not "where do we maximize revenue", but "where do we maximize utility?"  Obviously, that's not an easy question to answer.  But when you add in deadweight loss, and the long-run drag on economic growth it implies, I think it's pretty clear that the right answer is well short of the rate where we collect the most taxes.

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Megan McArdle is a columnist at Bloomberg View and a former senior editor at The Atlantic. Her new book is The Up Side of Down.

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