Wednesday, August 11, 2010

Is Your Opinion on Tax Policy Informed?

At least since the advent of Reaganomics, the question of optimizing tax rates has been hotly argued between denizens of the right and the left. Right now, conservatives argue that lower taxes are just the ticket for encouraging economic growth. And liberals are sure we can raise taxes to mitigate the deficit and finance new programs, without substantial harm. We can FULLY expect this argument to play out in public from this day forward until the 2012 elections.

It's unsurprising but still peculiar that both wings are prone to featuring the most simplified of arguments about taxes, which fail to incorporate the notion of optimizing tax rates. Or at least trying to do so.

I don't want to focus on the merits of either side's simplified arguments, Instead I'd like to try to give folks a place to start, a reference point from which they can evaluate the insight and good faith of other folks arguments, Expect many of the arguments you see to be uninformed at best, and biased at worst.

Fortunately, Ezra Klein can helps us out by askingWhere Does the Laffer Curve Bend?:

With the Bush tax cuts due to expire soon and debates about raising top rates further to cut the budget deficit soon to follow, the Laffer curve is bound to come up again. The idea, popularized by economist Arthur Laffer and writer Jude Wanninski in the 1970s and '80s, is simple. Tax rates of zero percent produce no revenue, for obvious reasons. Rates of 100 percent should produce no revenue either, as no one would bother making the money that falls into that bracket knowing it would all be taken away. Thus, presumably, there is some rate in between the two that maximizes revenue. Go above it and revenue would fall because people would avoid taxes or stop working; go below it and revenue would fall because less money would be taxed.

This is the place to start, with an understanding that raising or lowering taxes could potentially increase or decrease government revenue.

From there, it's also worth noticing that increasing or decreasing government revenue is far from the only important matter when it comes to tax policy. If you click through to Ezra's article in the link above, you'll find many thoughtful and useful and brief! summary thoughts that are worth considering when you think about taxes, what is fair, and what is necessary for our nation. So check them all out.

In closing, I'd like to call attention to one notion that I think is especially important to consider alongside government revenue. Fortunately, one of Ezra's quotees has done some of the work for me:

My guess is that that the short-run answer and the long-run answer are quite different. For example, if you raised the top rate from 35 to, say, 60 percent, you might raise revenue in the short run. Over time, however, you would get lower economic growth, so the additional revenues would fall off and eventually decline below what they would have been at the lower rate.... I will pass on offering a specific number, as it would require more time and thought than I can offer just now, but I will opine that I think the long-run answer is actually more important for policy purposes than the short-run answer.

In other words, it is at best risky to focus only on maximizing government revenue. Over time, higher tax rates may adversely effect economic activity to the point where we are worse off down the road for having optimized revenue a few years earlier.

If you want a reasonable baseline for evaluating the merits of tax policy arguments from politicians and talking heads and random blowhards, I think this makes a good start.


  1. A few points: First, Klein may be bright and glib, but his knowledge of economics is, shall we say, somewhat less than highly informed and empirically rigorous. A BA in PoliSci and a few years as a liberal journalistic wunderkind is not a credential in the field. In this case he asks what seems to be the right question, but ...

    Second, it is a decidedly major conceptual error to think of the Laffer Curve and the apex thereof as static. They are not fixed. They are moving targets. Ponder the policy implications of trying to balance on the head of an invisible pin -- and what the goal of same is.

    Third, no factor exists in isolation. It may be possible to maximize government revenue, but that doesn't mean it's desirable. Unless you believe that maximizing government qua government is a good thing in itself, a highly disputable assertion. See the Laws of Bureaucracy, including Pournelle's Iron Law. Efficiency in siphoning money to government is NOT the same thing as maximizing government efficiency. Not even close. (I am reminded of a bumper sticker from earlier times: "Support your local police for a more efficient police state.")

    Over time, higher tax rates may adversely effect economic activity to the point where we are worse off down the road for having optimized revenue a few years earlier.

    Bingo. There is a "Laffer Curve" for size of government as well. It ranges from "minimum required to avoid societal collapse" to "maximum possible without collapsing a free society into totalitarianism." And there is ALWAYS a tradeoff between current revenues and future growth. I would suggest that it's highly desirable to stay on the "left" side of both of those curves.

  2. Thanks Tully. I think your comments will help. As I tried to make clear here, the purpose of this post is only to be a decent starting point. A comparatively unbiased one.

    And I'm not touting Klein as an ceonomic expert, in case anyone though that.

    I think he did a good job by starting with an accessible layman's explanation of the Laffer curve as it relates to potential changes in tax policy, and then he deferred to a variety of experts, providing meat from a range of perspectives.

    I like that approach. Anytime you want to help me out with such ventures, even via quickie a drive-by, it's always appreciated.

  3. It's absolutely no surprise to me that I find Mankiw and Feldstein's responses to be the most honest and realistic. But I'm also a touch surprised that neither mentioned that any Laffer apex would be inherently dynamic, not static. One of the few things I used to enjoy in explaining real econ to students was the occasional "light bulb" as a student had the flash-realization that "OMG, it's alive!" Yep. Economies are living dynamic/organic systems, not mechanistic ones that can be fine-tuned like a piano or a V8 engine.

    Feldstein in particular nails down the problem with the "revenue maximization" approach, intimating the same thing I explicitly said about government qua government, albeit from a different angle. To the government-worshipper, revenue-maximization is the ONLY goal.

    Then again, ya gotta trim for space ... and take into account both the editor and the audience. I see that no one mentioned the other side of the balanced-budget formula: spending. Or at least it didn't get by the editor. :-)

  4. Well the dynamic point thing is a bit of a grad-level understanding. Not really, but so to speak. l mean, it's a great start to get relative layfolks to understand that it's simple and logical that there is an optimization point between No tax and all tax. Because it just stands to reason, due to the fact of both endpoints being on the x-axis.

    When you say its always moving, then it starts to sound like quantum mechanics to some. Best that we ease folks into that. :-)