Arthur Laffer’s Curve: Does Increasing Tax Rates Increase Revenue? (Part II – With Even More Pictures!)

In my previous article I explained why, theoretically, tax rate decreases may in turn increase taxes collected.  This article leaves out a number of other interesting observations.  First, lower tax rates combined with reinvestment and research and development can lead to increases in the theoretical maximum GDP in an economy.  Additionally, I obviously left out any evidence which supports the hypothesis that “Increasing Tax Rates Does Not Increase Revenue”.  This article will clear up those oversights.

More Theory: Increasing Potential GDP

GDP, or gross domestic product, is one way measure of all the goods and services produced in a country in a given period; in essence it’s a country’s overall productivity.  The CIA Factbook lists the United States as having a $14.33 trillion GDP.  In our example economy in our previous article, a tax rate of 50% lead us to a GDP of 50 economic productivity units.  Remember, the government takes 25 of these units.  Some of the 25 unit remainder may actually be used to increase productivity.  We’ll have to make a new graph… this one assumes maximum theoretical economic productivity increases at a rate of 20% of the units which are not taken by the government.  Let’s look at some constant tax rates when held over a 5 year span.  Also, we’re assuming this economy can’t shrink…


How to reproduce this graph?  Determine the growth rate of the theoretical maximum GDP for each bracket.  I’m using 20% growth on the amount not taken by taxes.  Compound the difference to find the theoretical maximum GDP for the year you want.  Multiple the tax rate by the theoretical max scaled by the amount of productivity you determine will be lost in each tax bracket. For year 5, I came up with 5% growth a year in the 50% bracket, meaning a theoretical GDP maximum of 163.81.  Half of that incentive is gone, so you should calculate the tax on what’s left to be 40.95 economic units.

In our wonderfully simple model, it’s better over the 5 year period to tax in the 30% to 40% range because an increasing GDP means the government can draw revenues from a larger tax base.  You can change the numbers as you see fit… different assumptions lead to different numbers.  Still, it’s time to turn to the real world results.

Hauser’s “Law”

Kurt Hauser discovered an interesting fact about tax revenues collected as a percentage of GDP going back a long time in the United States.  Spanning a vast amount of administrations and tax brackets, tax receipts as a proportion of Gross Domestic Product strangely are limited to around 19.5% of GDP.  The Wall Street Journal took a look at Hauser’s law in the period from 1950 to 2007 in the United States.  Sure enough, even with the massive changes in the United States over that 57 year period, the law holds true.  There is seemingly a maximum limit on the amount government can extract from an economy.  Check out the article here.

Furthermore, the (awesomely) interesting economics and investing site Political Calculations ran a similar study on personal income tax collections as a proportion of GDP from 1946 to 2006.  Again, the results are astonishing… the average percent collection as a percentage of GDP is 8%, ranging from 7.2% to 8.8%.  They took a look at 1954’s steeply progressive tax rate structure versus the structure in 2006 and found that even with the new tax structure, 2006 saw more government revenues even adjusted for inflation.

Where Does the Excess Go?

When it comes to tax rate differences between the states, it’s easy to imagine that capital and productivity can move into other states.  That’s why it’s disingenuous for states like California to increase tax rates too high, companies can either migrate or never start in California, but in Arizona or Nevada instead.

On the other hand, country-wide defections are much harder to pull off.  People and companies stay in the United States for more than just taxes.  Our law system, infrastructure, education system, and security all contribute to attracting people and companies to set up shop and stay in the country.  However, with more onerous tax laws, entities may concentrate more of their energy to avoiding taxes than being productive in the first place.  Workers can also decide to work less hours overall, reducing total output.  Some combination of factors leads to the fall off in productivity, and only a moderate tax system can collect the proper amount of revenues while encouraging growth.

So the answer to the question:  In most cases, increasing tax rates does not increase revenues… or it increases them slower than leaving tax rates alone or reducing them would have done.  It’s important than countries (and in the United States, the states) keep this in mind when designing their tax brackets.  Because growth is encouraged with lower tax rates, it’s better to err on the lower side of taxes.  What do you think?

(Ed Note: A reader sent in an interesting video series from the Center for Freedom and Prosperity on the Laffer Curve.  Check out Part I, Part II, and Part III, it’s an enjoyable series)