"Sometimes, tax rate increases create the very problems that the spending is intended to cure.” – Arthur Laffer
The prospect of major tax reform is obviously playing a very prominent role on the political stage right now. Given the current focus, we thought we’d write about a widely debated symbol of supply side economic theory - the Laffer Curve. This simple graph is an effective tool for illustrating a concept that has been at the heart of the tax policy debate for decades, and while we know this post will only scratch the surface of the issues at hand we hope it will serve our readers in their own reflection and communal discussion around the topic.
Arthur Laffer is an American economist who is best known for his influential role in popularizing supply-side economics during the Reagan era. The term “Reaganomics”, in fact, is probably more relevant in describing Art Laffer than it is Ronald Reagan. Laffer has served in an economic advisory role for many of our country’s political leaders in recent decades, and although he is known to be a staunch fiscal conservative and libertarian he was also an outspoken supporter of President Bill Clinton on the 90’s.
At a lunch with several Nixon/Ford administration officials in 1974, Laffer famously drew what is now known as the “Laffer Curve” on one of the restaurants’ cloth napkins (that napkin is now on display in the National Museum of American History). The topic of conversation centered around Ford’s plan to implement a 5% tax increase in order to generate more federal revenue which could be deployed back into the economy to spur growth. The point of Laffer’s napkin art was to illustrate that the federal government should not expect a linear increase in revenue as tax rates were increased, and that at some level increasing tax rates might actually lead to a decline in tax revenue.
Changes to prevailing tax rates, Laffer argued, have both an “arithmetic” and “economic” effect on future expected tax revenues. The arithmetic effect simply accounts for the increased tax rate, assuming that the pool of income subject to that taxation, the “tax base”, remains unchanged. If we assume a tax base of $100, for instance, an increase in the tax rate from 25% to 35% should generate an additional $10 of tax revenue. Simple enough.
The economic effect, however, is much more nuanced. It states that changes in tax rates fundamentally impact a complex network of incentive structures present for corporate and individual players throughout the economy. Changes to these incentive structures, and especially dramatic changes, will impact the behaviors exhibited by those economic participants, and with thus result in changes to the tax base. This dynamic, called “taxable income elasticity”, leads to the conclusion that dollar for dollar changes in tax revenue cannot be expected from corresponding changes to tax rates. Policy makers must also seek to understand the likely shifts in the underlying tax base that will result from a given change to tax rates.
As described by Investopedia…
Laffer argues that the more money taken from a business in the form of taxes, the less money it has to invest in the business. A business is more likely to find ways to protect its capital from taxation, or to relocate all or a part of its operations overseas. Investors are less likely to risk their own capital if a larger percentage of their profits are taken. When workers see increasing portion of their paychecks taken due to increased efforts on their part, they will lose the incentive to work harder. For every type of tax, there is a threshold rate above which the incentive to produce more diminishes, thereby reducing the amount of revenue the government receives.
Graphically, here’s what the Laffer Curve looks like (credit Wikipedia*). NOTE: The actual curve was originally drawn sideways, but this vertical depiction feels more intuitive to us.
Along the horizontal axis we have the prevailing tax rate, and along the vertical axis we have tax revenue. The further right we go the higher the tax rate, and the further up we go the higher the projected tax revenue. The Laffer Curve itself is drawn three different ways in this image. Focusing on the black line first, we can see that point 1 represents a world in which the tax rate is 0%. Obviously zero multiplied by any number is still zero, so expected tax revenues are obviously nil at this point on the graph. Point 3, then, represents a world in which the tax rate is 100%. The thinking here is that if the government were going to take 100% of your income, there would be no incentive to work and thus no tax base. So 100% of nothing is still nothing at this point on the graph.
It’s the area in the middle on the graph that is interesting. The implication is that there is some optimal point 2 on the graph where tax revenue is maximized. Any increase from this optimal rate will have a counterproductive impact on underlying economic activity and will ultimately result in lower tax revenue, while any decrease in rates from this point will not sufficiently stoke economic activity to fully compensate for the lower government rake.
While few would argue that some sort of Laffer Curve dynamic necessarily exists, the actual curvature and slope of the Laffer Curve – how it should be drawn to reflect reality – is the subject of widespread and heated debate! The black version above illustrates Laffer’s point with a perfectly symmetrical curve, implying that the optimal tax rate is 50% exactly. This, obviously, is for illustrative purposes only and is not intended to accurately depict how the world really works. A more conservative, small government, view would tend toward the red version of the line, showing that the optimal tax rate is relatively low (perhaps around 30%), while a more liberal, large government, view would tend towards the blue version of the line (perhaps closer to 70%). This reason this is important is that knowing what tax policy is justified necessarily requires that one make a judgment about whether we currently reside on the upward or downward sloping portion of the graph. Thus the shape and slope of the graph makes a big difference to the efficacy of your argument.
Of course there is a lot of nuance here that a simple graph cannot effectively capture. First of all there are many more factors than just the prevailing tax rates at play in the economy, and the shape of the true curve certainly ebbs and flows over time as economies evolve. Readers of this blog know that we use the platform for high level education and discussion, and we avoid taking firm, black and white stances on politically charged issues (although we certainly hold those personally!). We also subscribe to the “chaos theory” view of economics, which leads us to hold conclusions loosely in light of the complexity of what’s being analyzed. But regardless of where you are on the political spectrum, we think discussions around tax policy should take an objective and dynamic view of the economic effect of changes to tax rates. Otherwise what’s intended as a cure might actually turn out to be a curse.
*By Vanessaezekowitz at English Wikipedia, CC BY 3.0
Author David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.
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