Sunday, August 07, 2005

The Laffer Curve

Paul Krugman, the world's most dangerous liberal pundit, and former award winning economist has been attacking supply side economics and "the Laffer Curve" a lot recently. In last week's column;

Mr. Kristol led by example, using The Public Interest to promote supply-side economics, a doctrine whose central claim - that tax cuts have such miraculous positive effects on the economy that they pay for themselves - has never been backed by evidence.

As well as numerous times before.

This of course is a strawman argument, since the Laffer curve, the basis of this part of Milton Friedman style supply side economics never claims that tax cuts "pay for themselves rather, quoting from Wikipedia:

The Laffer curve, developed by economist Arthur Laffer and often used to justify tax cuts, is intended to show that government can maximize tax revenue by setting a tax rate at the peak of this curve. The curve is clearly accurate at both extremes of taxation --zero percent and one-hundred percent-- where the government collects no revenue. At one extreme, a 0% tax rate means the government's revenue is, of course, zero. At the other, where there is a 100% tax rate, the government collects zero revenue because taxpayers have no incentive to work or avoid taxes and the government collects 100% of nothing. Somewhere between 0% and 100%, therefore, lies a tax rate percentage that will maximize revenue.

Now if I could figure this out, with my grand total of two undergraduate economics courses, then you would think that a John Bates Clark award winner could. Of course John Nash has a Nobel Prize in economics and he only took 1 economics class in his academic career, so maybe too much exposure to academics is harmful...

In any case, what seems truely amazing is that Krugman seems completely unaware of the basic economic fact, that tax rates have a major impact on the economy. You can't just get a 50% rise in tax revenue by increasing taxes by 50%, as he has been saying should happen, first with his claim that we should be getting 28% of GDP in federal tax revenues, and then in his recent debate in which he proclaimed "I don't know why not" when asked about the possibility of raising federal tax revenues by 50%.

Bob Doyle has a great letter posted on the Conspiracy to Keep you Poor and Stupid, on the history of tax rates vs revenues in the United States. He basically points out that even when the top tax rates were 90%, we still didn't get much over 20% of GDP in tax revenue, so where was this money going to come from? I highly recommend you read it, but I wanted to look at another part of Krugman's claim, "the total tax take in America would go from roughly 27 percent of GDP, including state and local, up to 35 percent. In many advanced countries, the take is close to 40 percent."

Yes, it is true that there are "advanced countries" which receive close to 40% of their GDP in tax revenue. The OECD lists the following countries as having over 40% of their GDP as tax revenues in 2003:

Austria 43%
Belgium 45.8%
Denmark 49%
Finland 44.9%
France 44.2%
Iceland 40.3%
Italy 43.4%
Norway 43.9%
Sweden 50.8%
Average 44.69%

Unites States 25.4%

So, would the US be able to increase tax revenues by 50%, to 38.1% of GDP merely by raising taxes 50%? Well, maybe, but what Krugman doesn't mention, and what the Laffer Curve shows, and any economist not named Paul Krugman knows, that doesn't mean total tax revenues would increase by 50%. Raising taxes by this amount would give you 38.1% of a much smaller economy. For example let's run those high tax rate countries through Excel and figure out how much tax revenue they are getting per capita:

Austria $12,900
Belgium $13,282
Denmark $15,288
Finland $12,257
France $12,155
Iceland $12,453
Italy $11,631
Luxembourg $22,922
Sweden $13,614
Average $14,305

United States $9,601

So these 10 countries are on average paying 76% more of their GDP for taxes, and but on a per capita revenue basis only getting 49% more. This gets worse though, if you remove tiny Luxembourg (think Brad DeLong and Botswana) this decreases to only 39% more.

These are just rough estimates of course, since to be completely accurate you would have to adjust for population and other factors, but to be completely honest, if Krugman wanted a 50% increase in tax revenues, he shouldn't be calling for a 50% increase in tax rates. Using these comparisons he would have to call for something approaching a 100% increase.

So maybe there is something to the Laffer curve after all?