Tuesday, May 17, 2011

The Laffer Effect

With the federal debt at record levels, most people are anticipating higher taxes. Because of this, the Laffer Effect is once again part of the debate over what tax rate would maximize federal government revenues. The Laffer Effect theorizes that federal revenues collected from a 0% and 100% tax rate would be zero. Obviously, if the government does not tax the public, it will not collect any revenues. Likewise, if the government overtaxes its population, there is less incentive for people to earn money. Thus, extremely high taxes become counterproductive and decrease federal revenue. A higher tax rate also means individuals will try to find loopholes in tax laws such as finding offshore tax shelters and even fraudulent methods to avoid paying large sums of money to the federal government. A higher tax rate also means people will spend less money on charities to help the needy. In other words, higher tax rates create more uncertainty and strain economic variables more so than lower tax rates.

The Laffer effect is most often cited by conservatives, who advocate supply side economics, to keep both income and capital gain taxes low. This, in turn, will keep the size of the federal government small and therefore; reduce regulation in the private sector. This cultivates an economy with a greater supply of goods and services at lower prices. Meanwhile, progressives argue that the Laffer Effect is advantageous to the wealthy and therefore, neglects the poor. But liberals fail to point out that the United States pays more money, per capita, for education and entitlements for the poor than any other nation in the world. Liberals are also quick to point out that Russia had very high tax rates, but they still collected enough revenue to support armies and a space program.

Over the course of our history there have been plenty of studies and empirical data to support the Laffer Effect does truly exist in economics. One study indicated the specific tax rate that will maximize federal revenues is between 33 and 36%, but this study did not include local and state taxes. In 1924, Secretary of the Treasury, Andrew Mellon, worked to reduce the upper tax bracket from 73% to 24%. Federal government revenues grew nearly 300 million (30%) over the next 5 years prior to the Great Depression. The Kennedy tax cuts in the 1960s also resulted in greater federal revenue and economic growth. The Kemp-Roth tax act in 1981 reduced the upper tax bracket from 70% to 28%. This too led to increased federal government revenue because it resulted in tremendous economic growth over the next two decades. Some critics of the Laffer Effect point to a 2005 Congressional Budget Office (CBO) study. The study suggests that a United States tax cut of 10%, across the board, would only make up 28% of the lost tax revenue in a 10 year period. However, conservatives quickly point out that the CBO study only assumes a modest 1% increase in the Gross National Product (GNP) from the tax cuts. Whereas, the other tax rate cuts cited above, saw GNP increases of several percentage points.

The result of lower tax rates was not only successful in the United States to generate higher revenues, but around the globe. Russia and the Baltic states instituted a 35% flat tax rate that resulted in economic growth and therefore, higher federal government revenues. Between 1979 and 2002 over 40 countries, mostly socialized Western European nations, decreased the top tax rates to stimulate economic growth.

There is little question, as suggested from global empirical data, that decreasing federal tax rates does more to stimulate and grow the economy and therefore; increases federal revenues. On the other hand, raising taxes to very high levels decreases incentives for the economy to grow and therefore, federal tax revenues stagnate and decrease. Remember the Joe the Plumber example from the 2008 election? He decided not to risk buying a business because he feared higher taxes. Hence, he concluded there was no monetary incentive to take the risk. This is why the Laffer Effect is an accurate economic theory.

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