Tag: taxation

The Laffer Curve Shows that Tax Increases Are a Very Bad Idea – even if They Generate More Tax Revenue

The Laffer Curve is a graphical representation of the relationship between tax rates, tax revenue, and taxable income. It is frequently cited by people who want to explain the common-sense notion that punitive tax rates may not generate much additional revenue if people respond in ways that result in less taxable income.

Unfortunately, some people misinterpret the insights of the Laffer Curve. Politicians, for instance, tend to either pretend it doesn’t exist, or they embrace it with excessive zeal and assume all tax cuts “pay for themselves.”

Another problem is that people assume that tax rates should be set at the revenue-maximizing level. I explained back in 2010 that this was wrong. Policy makers should strive to set tax rates at the growth-maximizing level. But since a growth-generating tax is about as common as a unicorn, what this really means is that tax rates should be set to produce enough revenue to finance the growth-maximizing level of government - as illustrated by the Rahn Curve.

That’s the theory of the Laffer Curve. What about the evidence? Where are the revenue-maximizing and growth-maximizing points on the Laffer Curve?

Well, ask five economists and you’ll get nine answers. In part, this is because the answers vary depending on the type of tax, the country, and the time frame. In other words, there is more than one Laffer Curve.

With those caveats in mind, we have some very interesting research produced by two economists, one from the Federal Reserve and the other from the University of Chicago. They have authored a new study that attempts to measure the revenue-maximizing point on the Laffer Curve for the United States and several European nations. Here’s an excerpt from their research.

Figure 6 shows the comparison for the US and EU-14. …Interestingly, the capital tax Laffer curve is affected only very little across countries when human capital is introduced. By contrast, the introduction of human capital has important effects for the labor income tax Laffer curve. Several countries are pushed on the slippery slope sides of their labor tax Laffer curves. …human capital turns labor into a stock variable rather than a flow variable as in the baseline model. Higher labor taxes induce households to work less and to acquire less human capital which in turn leads to lower labor income. Consequently, the labor tax base shrinks much more quickly when labor taxes are raised.

There’s a bit of jargon in this passage, so here are the charts from Figure 6. They look complex, but here are the basic facts to make them easy to understand.

The top chart shows the Laffer Curve for labor taxation, and the bottom chart shows the Laffer Curve for capital taxation. And both charts show different curves for the United States and an average of 14 European nations. Last but not least, the charts show how the Laffer Curves change is you add some real-world assumptions about the role of human capital.

Some people will look at these charts and conclude that there should be higher tax rates. After all, neither the U.S. or E.U. nations are at the revenue-maximizing  point (though the paper explains that some European nations actually are on the downward-sloping portion of the curve for capital taxes).

But let’s think about what higher tax rates imply, and we’ll focus on the United States. According to the first chart, labor taxes could be approximately doubled before getting to the downward-sloping portion of the curve. But notice that this means that tax revenues only increase by about 10 percent.

This implies that taxable income would be significantly smaller, presumably because of lower output, but also perhaps due to some combination of tax avoidance and tax evasion.

The key factoid (assuming my late-at-night, back-of-the-envelope calculations are right) is that this study implies that the government would reduce private-sector taxable income by about $20 for every $1 of new tax revenue.

Does that seem like good public policy? Ask yourself what sort of politicians are willing to destroy so much private sector output to get their greedy paws on a bit more revenue.

What about capital taxation? According to the second chart, the government could increase the tax rate from about 40 percent to 70 percent before getting to the revenue-maximizing point.

But that 75 percent increase in the tax rate wouldn’t generate much tax revenue, not even a 10 percent increase. So the question then becomes whether it’s good public policy to destroy a large amount of private output in exchange for a small increase in tax revenue.

Once again, the loss of taxable income to the private sector would dwarf the new revenue for the political class. And the question from above bears repeating. What should we think about politicians willing to make that trade?

And that’s the real lesson of the Laffer Curve. Yes, the politicians usually can collect more revenue, but the concomitant damage to the private sector is very large and people have lower living standards. So that leaves us with one final question. Do we think government spending has a sufficiently high rate-of-return to justify that kind of burden? This Rahn Curve video provides the answer.

Patriotism, Loyalty, Tax Competition, and ‘Tax Fugitives’

I fight to preserve tax competition, fiscal sovereignty, and financial privacy for the simple reason that politicians are less likely to impose destructive tax policy if they know that labor and capital can escape to jurisdictions with more responsible fiscal climates.

My opponents in this battle are high-tax governments, statist international bureaucracies such as the Organisation for Economic Co-operation and Development (OECD), and left-wing pressure groups, all of which want to impose some sort of global tax cartel—sort of an “OPEC for politicians.”

In my years of fighting this battle, I’ve has some strange experiences, most notably in 2008 when the OECD threatened to have me thrown in a Mexican jail for the supposed crime of standing in a public area of a hotel and advising representatives of low-tax jurisdictions on how best to resist fiscal imperialism.

A few other bizarre episodes occurred in Barbados, back when I was first getting involved in the issue. Here’s a summary of that adventure.

As part of its “harmful tax competition” project, the OECD had called a meeting in 2001 and invited officials from the so-called tax havens to attend in hopes of getting them to surrender their fiscal sovereignty and agree to become deputy tax collectors for uncompetitive welfare states.

Realizing that the small, relatively powerless low-tax nations and territories would be out-gunned and out-manned in such a setting, I organized a delegation of liberty-minded Americans to travel to Barbados and help fight back (as regular readers know, I’m willing to make big sacrifices and go to the Caribbean when it’s winter in Washington).

One of the low-tax nations asked me to provide technical assistance, so they made me part of their delegation. But when I got to the OECD conference, the bureaucrats refused to let me participate. That initial obstacle was overcome, though, when representatives from the low-tax country arrived and they created a stink.

So I got my credentials and went into the conference. But this obviously caused some consternation. Bureaucrats from the OECD and representatives from the Clinton Treasury Department (this was before Bush’s inauguration)  began whispering to each other, followed by some OECD flunky coming over to demand my credentials. I showed my badge, which temporarily stymied the bad guys.

But then a break was called and the OECD announced that the conference couldn’t continue if I was in the room. The fact that the OECD and some of the high-tax nations had technical consultants of their own was immaterial. The conference was supposed to be rigged to generate a certain outcome, and my presence was viewed as a threat.

Given the way things were going, with the OECD on the defensive and low-tax jurisdictions unwilling to capitulate, we decided to let the bureaucrats have a symbolic victory—especially since all that really happened is that I sat outside the conference room and representatives from the low-tax jurisdictions would come out every few minutes and brief me on what was happening. And everything ended well, with the high-tax nations failing in their goal of getting low-tax jurisdictions to surrender by signing “commitment letters” drafted by the OECD.

While the controversy over my participation in the meeting was indicative of the OECD’s unethical and biased behavior, the weirdest part of the Barbados trip occurred at the post-conference reception at the prime minister’s residence.

I was feeling rather happy about the OECD’s failure, so I was enjoying the evening. But not everybody was pleased with the outcome. One of the Clinton Treasury Department officials came up and basically accused me of being disloyal to the United States because I opposed the administration’s policy while on foreign soil.

As you can probably imagine, that was not an effective argument. As this t-shirt indicates, my patriotism is to the ideals of the Founding Fathers, not to the statist actions of the U.S. government. And I also thought it was rather silly for the Treasury Department bureaucrat to make that argument when there was only a week or so left before Clinton was leaving office.

I’m reminded of this bit of personal history because of some recent developments in the area of international taxation.

The federal government recently declared that a Swiss bank is a “fugitive” because it refuses to acquiesce to American tax law and instead is obeying Switzerland’s admirable human rights policy of protecting financial privacy. Here are some details from a report by Reuters.

Wegelin & Co, the oldest Swiss private bank, was declared a fugitive after failing to show up in a U.S. court to answer a criminal charge that it conspired to help wealthy Americans evade taxes. …The indictment of Wegelin, which was founded in 1741, was the first in which the United States accused a foreign bank, rather than individuals, of helping Americans commit tax fraud. …Wegelin issued a statement from Switzerland saying it has not been served with a criminal summons and therefore was not required to appear in court. “The circumstances create a clear dilemma for Wegelin & Co,” it said. “If it were to adhere to current U.S. legal practice aimed at Swiss banks, it would have to breach Swiss law.” …Wegelin has no branches outside Switzerland.

It’s time for me to again be unpatriotic because I’m on the side of the “fugitive.” To be blunt, a Swiss bank operating on Swiss soil has no obligation to enforce bad U.S. tax law.

To understand the principles at stake, let’s turn the tables. What if the Iranian government demanded that the American government extradite Iranian exiles who write articles critical of that country’s leadership? Would the Justice Department agree that the Iranian government had the right to persecute and prosecute people who didn’t break U.S. law? Of course not (at least I hope not!).

Or what if the Chinese government requested the extradition of Tiananmen Square protesters who fled to the United States? Again, I would hope the federal government would say to go jump in a lake because it’s not a crime in America to believe in free speech.

I could provide dozens of additional examples, but I assume you get the point. Nations only cooperate with each other when they share the same laws (and the same values, including due process legal protections).

This is why Wegelin is not cooperating with the United States government, and this is why genuine patriots who believe in the rule of law should be on the side of the “fugitive.”

For further information, here’s a video I narrated on tax competition.

The moral of the story is that “tough on crime” is the right approach, but only when laws are just. At the risk of stating the obvious, the Internal Revenue Code does not meet that test—especially when the IRS is trying to enforce it in a grossly improper extraterritorial fashion.

The Ethos of Universal Coverage

Associated Press photojournalist Noah Berger captured this thousand-word image near the Occupy Oakland demonstrations last month.

(AP Photo/Noah Berger)

Many Cato @ Liberty readers will get it immediately. They can stop reading now.

For everyone else, this image perfectly illustrates the ethos of what I call the Church of Universal Coverage.

Like everyone who supports a government guarantee of access to medical care, the genius who left this graffiti on Kaiser Permanente’s offices probably thought he was signaling how important other human beings are to him. He wants them to get health care after all. He was willing to expend resources to transmit that signal: a few dollars for a can of spray paint (assuming he didn’t steal it) plus his time. He probably even felt good about himself afterward.

Unfortunately, the money and time this genius spent vandalizing other people’s property are resources that could have gone toward, say, buying him health insurance. Or providing a flu shot to a senior citizen. This genius has also forced Kaiser Permanente to divert resources away from healing the sick. Kaiser now has to spend money on a pressure washer and whatever else one uses to remove graffiti from those surfaces (e.g., water, labor).

The broader Church of Universal Coverage spends resources campaigning for a government guarantee of access to medical care. Those resources likewise could have been used to purchase medical care for, say, the poor. The Church’s efforts impel opponents of such a guarantee to spend resources fighting it. For the most part, though, they encourage interest groups to expend resources to bend that guarantee toward their own selfish ends. The taxes required to effectuate that (warped) guarantee reduce economic productivity both among those whose taxes enable, and those who receive, the resulting government transfers.

In the end, that very government guarantee ends up leaving people with less purchasing power and undermining the market’s ability to discover cost-saving innovations that bring better health care within the reach of the needy. That’s to say nothing of the rights that the Church of Universal Coverage tramples along the way: yours, mine, Kaiser Permanente’s, the Catholic Church’s

I see no moral distinction between the Church of Universal Coverage and this genius. Both spend time and money to undermine other people’s rights as well as their own stated goal of “health care for everybody.”

Of course, it is always possible that, as with their foot soldier in Oakland, the Church’s efforts are as much about making a statement and feeling better about themselves as anything else.

New Congressional Budget Office Numbers Once Again Show that Modest Spending Restraint Would Eliminate Red Ink

Back in 2010, I crunched the numbers from the Congressional Budget Office and reported that the budget could be balanced in just 10 years if politicians exercised a modicum of fiscal discipline and limited annual spending increases to about two percent yearly.

When CBO issued new numbers early last year, I repeated the exercise and again found that the same modest level of budgetary restraint would eliminate red ink in about 10 years.

And when CBO issued their update last summer, I did the same thing and once again confirmed that deficits would disappear in a decade if politicians didn’t let the overall budget rise by faster than two percent each year.

Well, the new CBO 10-year forecast was released this morning. I’m going to give you three guesses about what I discovered when I looked at the numbers, and the first two don’t count.

Yes, you guessed it. As the chart illustrates (click to enlarge), balancing the budget doesn’t require any tax increases. Nor does it require big spending cuts (though that would be a very good idea).

Even if we assume that the 2001 and 2003 tax cuts are made permanent, all that is needed is for politicians to put government on a modest diet so that overall spending grows by about two percent each year. In other words, make sure the budget doesn’t grow faster than inflation.

Tens of millions of households and businesses manage to meet this simple test every year. Surely it’s not asking too much to get the same minimum level of fiscal restraint from the crowd in Washington, right?

At this point, you may be asking yourself whether it’s really this simple. After all, you’ve probably heard politicians and journalists say that deficits are so big that we have no choice but to accept big tax increases and “draconian” spending cuts.

But that’s because politicians use dishonest Washington budget math. They begin each fiscal year by assuming that spending automatically will increase based on factors such as inflation, demographics, and previously legislated program changes.

This creates a “baseline,” and if they enact a budget that increases spending by less than the baseline, that increase magically becomes a cut. This is what allowed some politicians to say that last year’s Ryan budget cut spending by trillions of dollars even though spending actually would have increased by an average of 2.8 percent each year.

Needless to say, proponents of big government deliberately use dishonest budget math because it tilts the playing field in favor of bigger government and higher taxes.

There are two important caveats about these calculations.

1. We should be dramatically downsizing the federal government, not just restraining its growth. Even if he’s not your preferred presidential candidate, Ron Paul’s proposal for an immediate $1 trillion reduction in the burden of federal spending is a very good idea. Merely limiting the growth of spending is a tiny and timid step in the right direction.

2. We should be focusing on the underlying problem of excessive government, not the symptom of too much red ink. By pointing out the amount of spending restraint that would balance the budget, some people will incorrectly conclude that getting rid of deficits is the goal.

Last but not least, here is the video I narrated in 2010 showing how red ink would quickly disappear if politicians curtailed their profligacy and restrained spending growth.

Other than updating the numbers, the video is just as accurate today as it was back in 2010. And the concluding message—that there is no good argument for tax increases—also is equally relevant today.

P.S. Some people will argue that it’s impossible to restrain spending because of entitlement programs, but this set of videos shows how to reform Social Security, Medicare, and Medicaid.

P.P.S. Some people will say that the CBO baseline is unrealistic because it assumes the sequester will take place. They may be right if they’re predicting politicians are too irresponsible and profligate to accept about $100 billion of annual reductions from a $4,000 billion-plus budget, but that underscores the core message that there needs to be a cap on total spending so that the crowd in Washington isn’t allowed to turn America into Greece.

New Academic Study Confirms Previous IMF Analysis, Shows that Lower Tax Rates Are the Best Way to Reduce Tax Evasion

Leftists want higher tax rates and they want greater tax compliance. But they have a hard time understanding that those goals are inconsistent.

Simply stated, people respond to incentives. When tax rates are punitive, folks earn and report less taxable income, and vice-versa.

In a previous post, I quoted an article from the International Monetary Fund, which unambiguously concluded that high tax burdens are the main reason people don’t fully comply with tax regimes.

Macroeconomic and microeconomic modeling studies based on data for several countries suggest that the major driving forces behind the size and growth of the shadow economy are an increasing burden of tax and social security payments… The bigger the difference between the total cost of labor in the official economy and the after-tax earnings from work, the greater the incentive for employers and employees to avoid this difference and participate in the shadow economy. …Several studies have found strong evidence that the tax regime influences the shadow economy.

Indeed, it’s worth noting that international studies find that the jurisdictions with the highest rates of tax compliance are the ones with reasonable tax systems, such as Hong Kong, Switzerland, and Singapore.

Now there’s a new study confirming these findings. Authored by two economists, one from the University of Wisconsin and the other from Jacksonville University, the new research cites the impact of tax burdens as well as other key variables.

Here are some key findings from the study.

According to the results provided in Table 2, the coefficient on the average effective federal income tax variable (AET) is positive in all three estimates and statistically significant for the overall study periods (1960-2008) at beyond the five percent level and statistically significant at the one percent level for the two sub-periods (1970-2007 and 1980-2008). Thus, as expected, the higher the average effective federal income tax rate, the greater the expected benefits of tax evasion may be and hence the greater the extent of that income tax evasion. This finding is consistent with most previous studies of income tax evasion using official data… In all three estimates, [the audit variable] exhibits the expected negative sign; however, in all three estimates it fails to be statistically significant at the five percent level. Indeed, these three coefficients are statistically significant at barely the 10 percent level. Thus it appears the audit rate (AUDIT) variable, of an in itself, may not be viewed as a strong deterrent to federal personal income taxation [evasion].

Translating from economic jargon, the study concludes that higher tax burdens lead to more evasion. Statists usually claim that this can be addressed by giving the IRS more power, but the researchers found that audit rates have a very weak effect.

The obvious conclusion, as I’ve noted before, is that lower tax rates and tax reform are the best way to improve tax compliance - not more power for the IRS.

Incidentally, this new study also finds that evasion increases when the unemployment rate increases. Given his proposals for higher tax rates and his poor track record on jobs, it almost makes one think Obama is trying to set a record for tax evasion.

The study also finds that dissatisfaction with government is correlated with tax evasion. And since Obama’s White House has been wasting money on corrupt green energy programs and a failed stimulus, that also suggests that the Administration wants more tax evasion.

Indeed, this last finding is consistent with some research from the Bank of Italy that I cited in 2010.

…the coefficient of public spending inefficiency remains negative and highly significant. …We find that tax morale is higher when the taxpayer perceives and observes that the government is efficient; that is, it provides a fair output with respect to the revenues.

And I imagine that “tax morale” in the United States is further undermined by an internal revenue code that has metastasized into a 72,000-page monstrosity of corruption and sleaze.

On the other hand, tax evasion apparently is correlated with real per-capita gross domestic product. And since the economy has suffered from anemic performance over the past three years, that blows a hole in the conspiratorial theory that Obama wants more evasion.

All joking aside, I’m sure the President wants more tax compliance and more prosperity. And since I’m a nice guy, I’m going to help him out. Mr. President, this video outlines a plan that would achieve both of those goals.

Given his class-warfare rhetoric, I’m not holding my breath in anticipation that he will follow my sage advice.

The Laffer Curve Works, Even in France

One year ago, I wrote about how the French government was getting unexpected additional revenues following the implementation of lower tax rates.

This is the Laffer Curve in action, and it’s happening again in France, only this time because the government reduced the wealth tax.

Here’s part of the story at Tax-news.com.

France’s solidarity tax on wealth (l’impôt de solidarité sur la fortune – ISF), which was radically reformed by the government in June last year, has served to yield much greater fiscal revenues for the state than initially predicted.

…[T]he government agreed that the solidarity tax on wealth would in future comprise of only two tax brackets: a 0.25% tax rate imposed on individuals with net taxable wealth in excess of EUR1.3m (USD1.7m), and a 0.5% tax rate levied on individuals with net taxable assets above EUR3m. Previously, the entry threshold at which wealth tax was applied was EUR800,000, with the rates varying between 0.55% and 1.8%. To alleviate any threshold effects, a discount mechanism was also instated applicable to wealth of between EUR1.3m and EUR1.4m, as well as to wealth of between EUR3m and EUR3.2m. Although the new provisions provide for lower tax rates and for the abolition of the first tax bracket, effectively exempting around 300,000 taxpayers from the tax, according to latest government figures, the tax yielded around EUR4.3bn in 2011, almost EUR60m more than originally forecast in the collective budget.

This is not to say that France is an example to follow. There shouldn’t be any wealth tax, and income tax rates are still far too high.

And it’s also worth remembering that tax policy is just one of many factors that determine economic performance.

That being said, nations that shift from terrible tax policy to bad tax policy will enjoy better economic performance, just as nations that go from good policy to great policy also will reap benefits.

In other words, incremental changes make a difference. That’s even the case when the politicians impose a “Snooki tax” on indoor tanning services.

The most dramatic Laffer Curve effects, though, occur when there are big changes in policy. The video after the jump looks at some of the evidence.

This video is part of a three-part series, by the way. Click here if you want to see the entire set.