Finding the Sweet Spot… in Tax-Rates


Among the anti-Keynesians there is a false belief that Keynes advocated for higher taxes.  This simply isn’t true.  Before the “Laffer Curve” became common language among economist Keynes already understood the concept decades before it received a proper name.

 

 

 

 

 

 

 

The Laffer Curve, seen above, shows the relationship between tax revenue and tax-rates.  If taxes are too low then government will not maximize revenue and if taxes become to high then revenue will begin to decline.  The Laffer Curve argues there is a ‘sweet-spot’ in the tax-rate.  Revenue will be maximized at this rate (represented by the top of the bell curve).

What this means for the Keynesian naysayer is that Keynes did not argue for higher or lower taxes.  He argued for a tax-rate that would maximize revenue, which means tax- rates may have to change depending on the state of the economy.

Conservatives and supply-siders argue the Laffer Curve is in favor of lowering taxes because they assume the tax-rate is always on the down-sloping side of the curve.  However, it seems conservatives fail to realize raising taxes may actually increase revenue as well.

I think the past two decades are useful to better understand the Laffer Curve.  In the 1990s the top marginal tax-rate was 39 percent.  Under those rates the economy boomed and the Country ran a surplus.  However, in the 2000s that top rate  dropped to 36 percent. Those lower rates are one of the main drivers of our national debt.  Also, there was not any massive boom in the economy to make up for the lost revenue.  So it could be argued the rate of 36 percent is on the left side of the curve and the 39 percent rate is closer to the ‘sweet spot’.

*Note: this example is oversimplified because the decrease in taxes in the 2000s was more than just for the top marginal rate. It was around a 3 percent decrease across the board.  I think the example is still useful for understanding the Laffer Curve. It still demonstrates how higher taxes can increase revenue.

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3 thoughts on “Finding the Sweet Spot… in Tax-Rates

  1. I’m surprised you didn’t mention the Diamond and Saez working paper on progressive taxation:

    “[…] the optimal top tax rate using the current taxable income base (and ignoring tax externalities) would be *=1/(1+1.5 x 0.57)=54 percent while the optimal top tax rate using a broader income base with no deductions would be *=1/(1+1.5 x 0.17)=80 percent. Taking as fixed state and payroll tax rates, such rates correspond to top federal income tax rates equal to 48 and 76 percent, respectively.”

    Paper found here (pdf): http://pubs.aeaweb.org/doi/pdfplus/10.1257/jep.25.4.165

  2. Pingback: The Purpose of a Tax | Ajones1021's Blog

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