The Misunderstood Laffer Curve

The Laffer Curve is everywhere misundestood (even I think by Art Laffer himself). The point of tax policy is not to maximize revenue. Modern governments can print their own currency. If a government wanted to maximize revenue, it could simply print money. The point of a tax policy is to maximize the government’s long term purchasing power. And theoretically, In a democracy, the goal is to maximize the life time purchasing power of the median voter. Thus the real Laffer Curve effect to watch for is not the change in revenue, but the change in productive output.

For example, raising the income tax rate from 30% to 60% might increase short term revenues in nominal dollars. It might even raise long term revenues in nominal dollars. But if the tax increase suppresses investment, production, and innovation, the tax hike might lower growth over the next decades, and thus the tax hike ends up lowering the total long term purchasing power of the government. The government has more money in ten years, but can buy less with that money.

However, it is also possible that raising the top tax rates might decrease revenues but actually grow purchasing power. Imagine the government raises the top rate on normal income to 95%. Lawyers only work three months of the year. Financiers retire early. Athletes take less money to be with their hometown team. Government revenue falls. Despite all this, it is possible that the purchasing power of the median voter rises. If athlete salaries fall, there will not be fewer athletic games. Team spirit will not fade. If lawyers booked fewer hours, we would probably all be better off - lawyers mostly create litigation that other lawyers have to deal with. If financiers are mostly getting wealthy by bilking the public, then having them go into early retirement would be a boon.

Let’s say that the net impact on output is zero - some productive people retire but also anti-productive people retire. So the remaining impact is that the rich have less money to spend. The nominal dollars that would have gone to the lawyers, instead gets paid out as corporate profits/dividends, or goes to bid up salaries, or just gets stashed away. If paid out in dividends or salaries the average person benefits. If it is stashed away, that means fewer dollars chase the same number of goods, which means that the purchasing power of the average person rises. So either way, despite the fact that the tax did not increase government revenue, the tax still had its intended impact - the tax increases the purchasing power of the voter.

Both the left and right commit the money illusion fallacy with regards to the Laffer Curve. When a tax rate raises revenue, the left says, “ah ha, the tax hike worked!” When a tax hike causes revenue to fall, the right claims the hike failed. But both claims are irrelevant. The impact on short term nominal revenues does not matter one whit. What matters is the long term impact on purchasing power. And that can only be estimated by looking at the micro level and seeing how the work habits of productive and parasitic workers change.

From a deductive, micro perspective, I suspect that high capital gains taxes have a negative impact on long term output. (full disclosure - I work for a tech startup and stand to benefit personally from low capital gains taxes). If capital gains were taxed at something like 80% for all income over $1,000,000, then there would be virtually no point in ever becoming an entrepreneur. If the business fails you make nothing. If you are the one in ten that succeeds you barely end up better off than if you had worked for wages. Thus I’d expect high capital gains taxes to inhibit productivity and innovation.

However, I think an ordinary income tax of 80%-90% of income over $1 million may have very little negative impact on output. If you earn a great sum via capital gains, it is because you created some productive improvement that exists outside of your own person- you created some lasting technology, machinery, building, etc. But if you earn money via ordinary income, the productivity is entirely within yourself. You have created no value that exists outside of your own output, there is no permanent lasting technology that you gave to society. Furthermore, observationally, the people earning those incomes tend to be victors of contrived winner take all tournaments (athletes, movie stars). Or they are excellent at gaming bureaucratic systems (lawyers, lobbyists). Or they great at salesmanship. Or they are executives that have played the bureaucratic game well but who have not increased the value of their company. If these people all have their income capped, and thus end up working less, is the median person really worse off?

Empirically, the 1950’s to 1970’s were a period of lowish taxes on capital gains, very high taxes on income, and very high growth (source).

Of course, having an enormous disparity between the income tax rate and the capital gains tax rate invites all sorts of gamesmanship which might be impossible to deal with efficiently.

Also of note, in the case of Britain, the example that prompted this essay, the bankers who are retiring due to tax increases may be both parasitic and beneficial to England. That is, since Britain is a world financial hub, the financiers may be skimming primarily from the funds of other countries, and thus Britain benefits from having them work as hard as possible and in order to bring purchasing power to the island.