Getting the Laffer Curve Right

BY Paul Solman  April 17, 2012 at 11:46 AM EST

Watch Arthur Laffer explain the Laffer Curve in “Taxes: How High is Too High?

Paul Solman frequently answers questions from the NewsHour audience on business and economic news on his Making Sen$e page. Here’s Tuesday’s query:

Name: Marc Miles

Comment: As one who has been an advocate of the Laffer Curve since its inception, I appreciate your attempt to be even-handed on the subject. However, your emphasis missed the true Laffer Curve message. The Curve in NOT about the direct relationship between tax rates and labor force participation (work/income), but simply a relationship between tax rates and tax revenues. If you look at the Curve, it is simply an application of the ubiquitous total revenue curve for a business or a corner store. As prices charged rise, customers look for cheaper alternatives, and at some point, raising prices actually reduces revenue.

Making Sense

Tax revenues can change in several ways. Your point is certainly part of the equation. More income, more revenue. But it is probably not the most important direct aspect for upper-income individuals. Higher maximum tax rates may or may not affect income earned by those upper-income people (your point). However, it certainly changes their investment behavior. The higher the tax rates, the greater the net of tax return from sheltered investments relative to those that are not sheltered. We both remember the numerous shelters like cattle feed lots that existed in the 1970s and early 1980s. It was not that these investments were an efficient use of savings/capital, rather that their net of tax return was greater. It was not that upper-income people invested less, rather that they invested more in less efficient (from the economy’s perspective) investments. While they were better off after tax, the potential output of the economy diminished.

Hence the relationship between maximum tax rates and income is a by-product, not a direct relationship. It is correct to argue that higher marginal tax rates reduce income in the economy but only because they in turn cause less efficient use of investment.

Paul Solman: Yes, this is a good point, Marc. One obvious response is that the problem comes first and foremost from the tax-sheltered investments, not higher tax rates. If such vehicles disappeared, so would this form of “tax avoidance.” But isn’t the whole point of tax-sheltered investments to make them attractive enough to encourage investment? Municipal bonds, for instance, to sustain local governments? Low-income housing?

The Laffer Curve shows a hypothetical relationship between taxes and revenues for the government. Image by Vanessaezekowitz via Wikimedia Commons.

I’m not making an argument for tax shelters, mind you: the home ownership “shelter,” for instance (mortgage, real estate tax and maintenance deductions) has come under well-deserved scrutiny and the proliferation of obvious and odious tax dodges has been amply documented, even by us some years ago, in “Taxes at the Top.”

But unless I’m misunderstanding you, your implicit argument seems to be that we should lower top marginal tax rates to discourage tax-sheltered investments. Wouldn’t it be a tad more straightforward to deal with the tax-exempt status of the ‘investments’ themselves?

This entry is cross-posted on the Making Sen$e page, where correspondent Paul Solman answers your economic and business questions