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Brooks Wilson's Economics Blog: The Slippery Side of the Laffer Curve?

Monday, February 27, 2012

The Slippery Side of the Laffer Curve?

The United Kingdom increased its top marginal tax rate to 50% for households earning more than 150,000 pounds ($238,000) to attempt to close its budget deficit. Like the political debate in the United States, liberals argue that increasing taxes on the rich produces a more fair tax system. Very early results indicate that the tax increase has decreased tax revenues (“50p tax rate 'failing to boost revenues’”) implying that the United Kingdom is on the wrong side of the Laffer curve named after Arthur Laffer.

The graph plots a possible Laffer curve that is not based on data. It shows tax revenue increasing until the marginal tax rate reaches 57%. The point of maximum revenue does not indicate the best size of government. Raising the top marginal rate beyond that point would punish the wealthy rather than generate more revenues. The maximum revenue level does not suggest the best size of government. It could easily be smaller but not larger.  

Suppose government officials demonstrate that larger government expenditures would increase social welfare. Those expenditures would require deficit financing which may slightly increase the size of government but would soon give rise to unmanageable levels of debt. 

Have the British reached the slippery side of the Laffer curve? Mathias Trabandt and Harald Uhlig suggest they might have given the increase in the top marginal rate in “How Far Are we From The Slippery Slope? The Laffer Curve Revisited” Using date from 1995 until 2007, they conclude that 
 For benchmark parameters, we have shown that the US can increase tax revenues by 30% by raising labor taxes and by 6% by raising capital income taxes. For the EU-14 we obtain 8% and 1%. A dynamic scoring analysis shows that 54% of a labor tax cut and 79% of a capital tax cut are self-nancing in the EU-14….

 However, transition effects matter: a permanent surprise increase in capital income taxes always raises tax revenues for the benchmark calibration. Finally, endogenous growth and human capital accumulation locates the US and EU-14 close to the peak of the labor income tax Laffer curve. 

We therefore conclude that there rarely is a free lunch due to tax cuts. However, a substantial fraction of the lunch will be paid for by the efficiency gains in the economy due to tax cuts. Transitions matter. 
 Trabandt and Uhlig’s work might provide an explanation as to why countries that tax a larger share of GDP than the United States have less progressive tax structures. The rich earn a larger percentage of their income from capital which is inherently more difficult to tax due to the ability of the wealthy to avoid taxes. The United State and the EU-14 may also be much closer to the peaks of their capital Laffer curves than their labor Laffer curves.

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