Where does the Laffer curve bend?
By Dylan Matthews
With the Bush tax cuts due to expire soon and debates about raising top rates further to cut the budget deficit soon to follow, the Laffer curve is bound to come up again. The idea, popularized by economist Arthur Laffer and writer Jude Wanninski in the 1970s and '80s, is simple. Tax rates of zero percent produce no revenue, for obvious reasons. Rates of 100 percent should produce no revenue either, as no one would bother making the money that falls into that bracket knowing it would all be taken away. Thus, presumably, there is some rate in between the two that maximizes revenue. Go above it and revenue would fall because people would avoid taxes or stop working; go below it and revenue would fall because less money would be taxed.
I decided to ask some tax experts and political activists where, in the current personal income tax, and particularly in the top tax bracket, they think that Laffer curve peaks -- that is, what that revenue-maximizing rate is. The responses were varied, to say the least. Let's start with the experts.
ŠTA KAŽU EKSPERTI The Tax Experts
Emmanuel Saez, E. Morris Cox professor of economics, University of California at Berkeley:
"The tax rate t maximizing revenue is: t=1/(1+a*e) where a is the Pareto parameter of the income distribution (= 1.5 in the U.S. and easy to measure), and e the elasticity of reported income with respect to 1-t which captures supply side effects. The most reasonable estimates for e vary from 0.12 to 0.40 (see conclusion page 47) so e=.25 seems like a reasonable estimate. Then t=1/(1+1.5*0.25)=73% which means a top federal income tax rate of 69% (when taking into account the extra tax rates created by Medicare payroll taxes, state income tax rates, and sales taxes) much higher than the current 35% or 39.6% currently discussed."
Joel Slemrod, Paul W. McCracken Collegiate Professor of Business Economics and Public Policy, University of Michigan:
"I would venture that the answer is 60% or higher.... The idea that we're on the wrong side has almost no support among academics who have looked at this. Evidence doesn't suggest we're anywhere near the other end of the Laffer curve.... The elasticity of response, which is the key parameter here, isn't some absolute parameter that we just have to deal with. It depends on policies. Let me be specific. There's an article about how the IRS has reorganized itself to crack down on tax evasion of high-income people and corporations moving their operations or assets offshore. That's the kind of policy initiative that can affect the elasticity of response by closing up a loophole. You want to raise tax rates at the same time you look at these kind of initiatives.... If we're talking about just deficit variations, we're not talking about what the government spending, the answer is no. It doesn't matter what this response is. If you're not changing government spending, any change in revenue now will have to offset by some change in revenue in the future. If that's the case, then if the responsiveness is high now, it's going to be high later, too."
Read Saez, Slemrod, and Seth Giertz's latest paper (PDF) on the subject.
ŠTA KAŽU LEVIČARI TJ. DEMOKRATE The Left
Brad DeLong, professor of economics, University of California at Berkeley:
Dean Baker, co-director, Center for Economic and Policy Research:
"It would be somewhere around 70 percent and possibly a bit higher. It is important to realize that you can have many different rates so we can have only a very small fraction of people actually paying the top rate and even then only on a small portion of their income."
ŠTA KAŽE DESNICA - KONZERVATIVCI The Right
Larry Kudlow, host, CNBC's The Kudlow Report:
"Personal income tax of 15-20%, business, sales tax rate of 8-10%. I can make some generalizations which would suggest, in terms of just the personal income tax rate, 91% was too high, Reagan cut it to 28.... We've done pretty well in the economy these last three decades, apart from this Great Recession, which is more financial related. Maybe it's a range of 35-40%, it seems like that worked pretty well. If you started encroaching on 50, that would cause trouble.... Once you get into the 40 or 45% range, in my view, you're risking a long-term revenue slowdown and a long-term growth slowdown."
Pat Buchanan, syndicated columnist, former presidential candidate:
Would prefer not to be quoted exactly, but says the revenue-maximizing combined state and federal rate is about 33 percent.
Donald Luskin, columnist, SmartMoney.com, National Review:
"19%... I am saying that the way to maximize the take from personal wage income tax is with a 19% rate on that tax."
Stephen Moore, senior economic writer and editorial board member, Wall Street Journal:
"The revenue maximizing rate is probably around 40 or 50 percent. But the growth maximizing rate, even given the current deficits, is probaby about 20 percent. So the goal is to get the rate down to 20 to 25 percent. For cap gains the revenue maximizing rate is between 15 and 20 percent."
Bruce Bartlett, columnist, Forbes.com; former adviser to Reagan and Bush I:
"I would hate to venture a specific number.... I would, however, say that I think the top rate could be quite a bit higher than it is without significantly impairing incentives or leading to excessive amounts of tax avoidance. I think 50 percent is an important threshold and I would be very reluctant to go higher even if it raised net revenue.... Anthony Atkinson, probably the leading public finance economist in England, estimates (PDF) that the top rate could go as high as 63% to 83% before it became counterproductive in terms of revenue...The European Central Bank...finds that only two European countries are on the wrong side of the Laffer Curve. All other countries could raise substantial additional revenue by raising tax rates."
"Since our rates are much lower than those it Europe, it suggests that we have a very long way to go before the top rate became counterproductive."
Andrew Samwick, professor of economics, Dartmouth College:
"I would not hazard a guess. Even a guess requires a careful study of the data on high income taxpayers, which I have not done."
Greg Mankiw, Robert M. Beren professor of economics, Harvard University; former chairman, Council of Economic Advisors:
"My guess is that that the short-run answer and the long-run answer are quite different. For example, if you raised the top rate from 35 to, say, 60 percent, you might raise revenue in the short run. Over time, however, you would get lower economic growth, so the additional revenues would fall off and eventually decline below what they would have been at the lower rate.... I will pass on offering a specific number, as it would require more time and thought than I can offer just now, but I will opine that I think the long-run answer is actually more important for policy purposes than the short-run answer."
Edward Lazear, Jack Steele Parker Professor of Human Resources Management and Economics, Stanford University; former chariman, Council of Economic Advisors:
Martin Feldstein, George F. Baker Professor of Economics, Harvard University, former chairman, Council of Economic Advisors:
"Why look for the rate that maximizes revenue? As the tax rate rises, the "deadweight loss" (real loss to the economy rises) so as the rate gets close to maximizing revenue the loss to the economy exceeds the gain in revenue.... I dislike budget deficits as much as anyone else. But would I really want to give up say $1 billion of GDP in order to reduce the deficit by $100 million? No. National income is a goal in itself. That is what drives consumption and our standard of living."