Tax season

It is officially tax season, and while gathering all my financial documents to get ready to prepare them, I started to wonder how things would officially pan out for me this year.  I was reminded of a study I read in an accounting course regarding the Laffer Curve and wanted to hit on a few points regarding it.  

The Laffer Curve illustrates the two most important things we need to know about taxes: how much money the government can raise from taxes and at what level of tazation the government might start getting less, not more, revenue.

The Laffer Curve is illustrated by a normal graph.  The horizontal line is the tax rate that the government chooses, and the vertical line is the revenue that the government receives from that tax rate.  

If the tax rate is zero, the government receives zero revenue.  Accordingly, point (0,0) is the first point on the curve.  And if the government keeps raising the rate, then revenue will continue to go up, at least when we're in the low tax rate part of the graph.

If the government charges a 100% tax rate, no one would work, and the national income would be zero.  This means that government revenue would be 100% of zero.  So another point on the curve must be all the way to the right on the tax rate line at 100% where revenue equals zero.

A study by Christina Romer and her husband David Romer, both economics professors at University of California Berkeley, was written and published in the American Economic Review.  This study examined how the national income responds to tax rates.  It was calculated that the hump on the Laffer Curve occurs where the tax rate is around 33 percent.

No matter what your politics, you should not want tax rates to be above around 33 percent.  Obviously, conservatives and many moderates think the rate should be lower than that.  But even if you are an extreme left-winger and your only goal is to make government as big as possible, you should oppose a tax rate more than 33 percent because when taxes go higher than that, the government actually gets less money.


Dave Tufte said...

Eddie: 100/100

My apologies: I am suffering from the font corruption problem related to the February 10th Windows update. In short, I can barely read what I'm writing on this screen ... so give me a pass on spelling errors.

Eddie's correct about the theory, but not about its practical relevance.

1) Theoretically, there is nothing wrong with the Laffer curve. This is an expression, in terms of tax revenue, of a "parabolic" relationship similar to what a firm experiences when they plot their revenue against the quantity of their product sold.

2) In ManEc and micro (generally starting at the 3000 level) we make the point that firms always operate to the left of the peak of that parabola. That's a basic outcome of profit maximization. Governments should do the same thing with their tax revenue.

3)I put parabolic in quotes up above because a parabola has to be symmetric. All we know theoretically about the Laffer curve is that it has a peak somewhere in the middle. We know nothing about whether or not it's symmetric.

4) When estimates are made of Laffer curves, they tend to show the peak occurring quite far to the right, at very high tax rates. There's little or no evidence of governments actually operating past that peak in the real world.

5) Even conservative macroeconomists do not make the claim that we are in a position that a cut in tax rates will raise revenue. Read what they say carefully: it's always in terms of a tax rate cut will lead to less underreporting of the tax base. Basically, if a tax rate cut leads to more tax revenue, it's because people aren't cheating as much. Even Laffer says this if you read between the lines. Note that this effect can still be quite large, particularly for things like asset sales. But it isn't correct to label this as a Laffer curve effect.

6) Romer and Romer [2007] do not estimate a Laffer curve, and make no claims about the optimal tax rate. Instead, they estimated the size of the tax multiplier, and found that a 33 cent increase in taxes decreases GDP by about a dollar. That works out to a multiplier of -3. That's a very strong reason for avoiding tax increases, and far stronger than any Laffer curve effect might be.

If you're conservative, you probably now think that I'm part of the problem. If you're not conservative, then you're probably applauding.

Truth is, I'm pretty conservative/libertarian. As a macroeconomist, I like that the Laffer curve is part of public discussions. But I like it because it's kind of like the boogeyman: it isn't a real threat, but it still scares some people straight. But, as a macroeconomist, I know better than to bring up the Laffer curve in serious discussions with other economists because we all know the evidence is that it isn't very relevant.

Cubbies said...

When it comes to the way the government views tax rates, I am not sure anyone can figure out what they are doing. While I tend to lean conservative, I do see the value in keeping some of the more controversial credits like the EIC and Child Tax credit. As a tax professional I see how the credits help families get caught back up from the year or even be able to take the family on vacation. When looking at people marginal tax rate, it is unusual to see one above 15%. This is due to all of the additional deductions people receive from the government. The biggest savings I see for higher earners is being able to itemize deductions. This is the one area I feel the government should close. The fraudulent deductions people try to pass off are ridiculous. I have had people try to write off cosmetic surgery, home fitness equipment, and charitable contributions to made up charities. If they were to get rid of this it would lead to an increase in tax revenue leading to a decline in the tax rate people are paying. This could even translate into savings for business. As a business owner you would have a lower tax rate leading to more income, which in the end means more money going to employees or building the company. It may even entice businesses to stay in America.

Dave Tufte said...

Cubbies: 47/50 ("When looking at people marginal ...")

I agree with you that "I am not sure anyone can figure what they are doing." In macroeconomics currently, one of the big debates is about how the policies the Democrats put in place (mostly through the Obama stimulus package) made even figuring out the marginal rate difficult for professionals.

BTW: If you're a tax professional, I wouldn't view the 15% marginal rate as the end of the story. All those additional programs you mentioned modify that. Casey Mulligan (an economist from the University of Chicago) has documented that the marginal rate on some of the working poor is already over 100%.

It's interesting that you zeroed in on itemized deduction fraud. Let's look at the big picture here: the itemized deduction is how Congress operationalizes a view that some spending is better than others (and deserves a tax break). The debate shouldn't be about how individuals respond to that, but rather about whether the whole mind set of legislators is actually helping.

Ted said...

As a Tax Professional myself, I completely understand the effect of higher tax rates leading to under reporting. I would like to focus on the other half of Cubbies comment (the portion which was not mentioned). Cubbies mentioned Schedule A itemized deductions which, are important. However I would like to comment on Schedule C, the small business taxes for individuals.

As individuals make more income in their small business (or w-2 income) I see them get craftier and craftier with coming up with tax deductions on schedule c. If individual tax rates were lower, it could lead to less fraudulent reporting. While I am of the opinion, it doesn't matter the tax rate, some people will always think its too high, and try to maximize their deductions. However when tax rates are lower, some people will bother less with maximizing their deductions because they view the tax as minimal.

On the reverse side of this argument, if the tax rate did increase (or the tax multiplier becomes lower -4 as opposed to -3) people could begin to work less thus creating less gross income / revenue to be taxed upon in the first place. This leads to a taxation paradox - if you will- for congress to sort out in order to create a tax code which will bring in optimal tax revenue.

Dave Tufte said...

Ted: 41/50 (for inconsistent capitalization of Schedule C, you mean "Cubbies'" not "Cubbies", "congress" should be capitalized, I'll let you slide on whether or not it's OK to capitalize Tax Professional when that's not really a title, and I have seen "under reporting" written as both two words and one).

Your second paragraph is on point with macroeconomists' views towards tax rates: higher rates lead to underreporting and reductions of the tax base. Note that isn't the same thing as saying we're worse off with higher rates; macroeconomists aren't so sure about that.

As to the tax multiplier, that isn't really something that macroeconomists think changes without cause like that. In fact, I think they'd be hard pressed to come up with a reason why it would change at all; it's analogous to an elasticity measurement in that we're trying to pin down the value rather than hypothesize about it changing.

Anyway, the causality doesn't run from the value of that multiplier to taxpayer behavior. So I don't think Ted's argument from the third paragraph will hold.


On a personal note, I've had experience with Schedule C going both ways. I'm sure some of my deductions would be considered questionable. But on the other hand I was paid as an employee by another university for what amounted to a consulting job. I found out the hard way that, because this meant that income went to me personally instead of my consulting corporation, that this introduced a threshold into what I was allowed to deduct for a home office. The IRS was unsympathetic to my position that I should be able to deduct a home office where I did the work since that employer didn't provide an office at all in their location.


N.B. Ted has attempted to use something called an em-dash in the third paragraph. This is used to isolate thoughts within a sentence. Many people type this incorrectly. Ted did, using a hyphen. If you want your writing to look more professional, you can type an em-dash by holding down the ALT key, and then typing 0151 on the numeric keypad. That method is called an ALT code, and if you're interested, they are a good way to type some unusual characters quickly.

EC said...

Dr. Tufte explained that evidence of the Laffer Curve is not all that relevant in a serious discussion of economics. Nevertheless, the general theory behind it seems to be quite logical; raising tax rates will likely reduce a taxpayer's motivation to earn and report income.

The Laffer Center at the Pacific Research Institute argues that increased tax rates will likely hurt the economy. This article discusses how individual states provide us with evidence of this claim by comparing their policies to economic conditions.
When I first tried to understand how raising taxes could decrease tax revenue, I considered taxpayer responses with a narrow perspective. On an individual basis, tax rates increasing would likely result in a decreased desire to report or earn income. What I did not consider was the effect that increasing tax rates would have on an economy at the state or national level. Lower tax rates are likely to attract businesses to a state or country. New business means more jobs, paid wages, and tax revenues. The article referenced above discusses this in a bit more detail, but the general argument is that states with lower tax rates are experiencing healthier economic stability.

Dave Tufte said...

EC: 50/50

I think EC's summary of my position is spot on: Laffer curves are theoretically interesting and important, but not that common.

Then EC links to the Laffer Center. I think these folks do great work. But I try to discipline myself to remember that they are a think tank that's selling a particular product (to the conservative audience). So I make sure my tin foil hat is securely in place first.

Anyway, what I see in the linked article is a very solid point that people vote with their feet: they don't like incomes taxes, and are willing to move where they are lower. Note their language: "... No-income tax states have two and one-half times the population growth of the highest income tax states, and yes, the no-income tax states even have higher tax revenue growth ...".

That is a strong result that there is tax competition between states, and that lower rates are beneficial to states in such competition.

BUT, it is not a Laffer curve result. Instead, it's a fairly standard non-Laffer curve result, dressed up with the name Laffer in the brand of the company pushing the result.

So, what I see is that Laffer himself is pushing ideas other than the Laffer curve he's known for, because it's not actually that easy to show that the Laffer curve (by itself) is very important in practice.