Don’t Quit Your Day Job – Personal Finance, Economics and Investing

When the United States, and even the individual states find themselves in turbulent financial times, a commonly repeated theme they tend to repeat is that taxes need to be increased in order to shore up revenues.  When states and countries find themselves with budget gaps, instead of trimming programs (so called ‘belt-tightening’ in the private population) they tend to attempt to keep the same level of programs by increasing the tax rate.  Is this practice sustainable?

I will write this article in two pieces.  First, in this article, I will cover the theoretical aspects of why this is not automatically true.  In the next article I will give you some empirical data which you can examine and either agree or disagree with me.  Let’s begin.

Tax vs. Work

The main form of tax one thinks of when thinking of tax (in America) is the income tax.  America taxes production in the form of income taxes.  This tax can be looked upon as a tax on working, or a disincentive to work.  In this framework we will view marginal tax rates- high taxes will discourage work while low taxes will encourage work.  Work we will consider productive… the more work that one has incentive to do, the more economic production will result.

In this theoretical framework, we will say that you are your most productive when all of the fruits of your labor come back to you.  This 0% tax bracket also guarantees no government revenues will be collected.  On the other end of the spectrum is the maximum tax bracket, the 100% bracket.  I hope you will agree, (again, theoretically- one article in the New Republic claims Russia had a 100% effective tax rate) that in a country or state where your labor is taxed at 100% you will refuse to work.  Let’s go ahead and make the claim that there is a linear reduction in the amount of work you will do for a given tax rate.  The graph therefore looks like this:

Not very interesting.  You probably envisioned an image like this in your head.  This isn’t the image we are looking for… we need a relationship between the tax rate and government revenues… yes we want to maximize government revenues using this chart.  Let’s graph the amount taxes collect in a new data series:

In our theoretical economy, the most economic units can be collected with a tax rate of 50%.  If this image seems familiar, you’re absolutely correct.  You’re looking at the Laffer Curve.  In our economy, a 50% tax rate means 50 economic units are produced, and the government takes 25 of them.

Not a Law

The Laffer Curve isn’t a law of economics, it’s merely a theoretical framework for understanding why, as President John F. Kennedy said in 1962, “It is a paradoxical truth that tax rates are too high and tax revenues are too low and the soundest way to raise the revenues in the long run is to cut the rates now”.  The graph, even though it is centered at 50%, doesn’t mean 50% is the ideal tax rate.  Many factors will increase or decrease the incentives to work… the United States has a very good infrastructure and law system, for example.  On the negative side, states also impose taxes, and there are taxes on consumption and other things which Americans also pay (sales taxes, car registration fees, property taxes, etc.).

It’s also important to note that if the sole goal of any tax program is to increase tax revenues, it is possible that tax rates are actually too low and could be increased.  While economic incentives for production will decrease with any tax tweaks to the upside, more revenue will come into the government’s coffers.  The Laffer curve is best used as an illustration of the theoretical effects of tax law changes.  However, in my next article I will present empirical evidence that the Laffer curve holds true and tax cuts are followed by economic activity increases which eventually make up for any tax ‘underpricing’ in many scenarios.

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