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October 18, 2006

Laughing at Laffer

Via Mark Thoma, an IMF working paper studying flat taxes worldwide has just come out, and it's results aren't terribly encouraging for supply-siders:

there is no sign of Laffer-type behavioral responses generating revenue increases from the tax cut elements of these reforms; their impact on compliance is theoretically ambiguous, but there is evidence for Russia that compliance did improve; the distributional effects of the flat taxes are not unambiguously regressive, and in some cases they may have increased progressivity, including through the impact on compliance; adoption of the flat tax has not resolved common challenges in taxing capital income; and it may have strengthened, not weakened, the automatic stabilizers. Looking forward, the question is not so much whether more countries will adopt a flat tax as whether those that have will move away from it.

The Laffer Curve, folks will remember, is the idea that lowering tax rates increases economic growth and thus results in more tax revenue. In other words, tax cuts increase tax revenue. It never made much sense (save in regimes with truly exorbitant tax burdens), but conservatives predicated their support for tax cuts and a flat tax on the theory anyway. Now it's clear the theory is shite. On the bright side, another claim of flat taxers does look promising -- that if you make the tax easier to comply with, compliance will go up, and there will be more revenue because of decreased evasion.

The sterling reputation of flat taxes has largely come because money of the countries who adopted them saw rapid growth and success in the succeeding period. The authors of the study, however, don't think the flat tax deserves the credit:

The flat tax has commonly—almost universally—been adopted by new governments anxious to signal a fundamental regime shift, towards more market-oriented policies. In several cases, the signal appears to have been well-received. Where no such reputation needs to be acquired, the appeal of the flat tax is consequently less.

So the adoption of the flat tax has been a big signpost by new regimes claiming themselves free of old, anti-business nostrums and open for new investment.

October 18, 2006 in Taxes | Permalink

Comments

Well, technically the Laffer curve doesn't say that cutting taxes will increase revenue. It says that it will happen under some conditions. Of course it also says that raising taxes will raise revenue also.

The Laffer curve says that at zero tax rate revenue is zero, and at 100% tax rate, revenue is zero, and somewhere in between it is maximized, and so for some parts of the curve lowering taxes will raise revenue.

This study has proven that the point where revenue is maximized is somewhere higher than where taxes are right now.

Posted by: Chuck | Oct 18, 2006 1:16:46 PM

Here's my favorite thought experiment on the Laffer curve....

Start with a $100 economy, and tax it at 30%, for tax revenue of $30. Now, cut taxes to 25%, and your revenue falls to $25. Question for the class - how much does the economy have to grow for revenues to return to previous levels? It has to grow 20% to $120 dollars.

Now here's the kicker - by leaving $5 in the economy, the economy grew $20 - that 400% return on that $5 investment.

That's pretty freaking awesome. People sure must do something special when they invest those tax dollars!

Posted by: Chuck | Oct 18, 2006 1:17:41 PM

The Laffer Curve, folks will remember, is the idea that lowering tax rates increases economic growth and thus results in more tax revenue. In other words, tax cuts increase tax revenue.

That isn't right. It depends upon where the current tax rate is on the laffer curve. Even Arthur Laffer would admit that increasing income taxes from 2% to 5% would probably increase revenue. (The economy will not shrink by 60%)

The Laffer Curve is a reality. What (smart) supply siders argue is not that cutting taxes always increases revenue. They argue that the US and other countries are on the far side of the laffer curve.

Posted by: tomboy | Oct 18, 2006 1:24:32 PM

As I say in the post, the Laffer curve may hold true in regimes with massive tax burdens, but that's not here. As it's been applied in American politics, by supply siders (and the Bush administration), it argues that lowering taxes will increase revenues.

Posted by: Ezra | Oct 18, 2006 1:37:06 PM

I may be mistaken, but I don't think the flat tax has anything to do with making compliance easier (unless by flat tax you mean both a single tax rate for all forms/levels of income and no deductions , rather than simply referring to a single tax rate regardless of income level).

Posted by: Ian | Oct 18, 2006 2:10:59 PM

I think you spelled "many" wrong about 2/3 of the way through the post.

Posted by: Cryptic Ned | Oct 18, 2006 2:16:28 PM

I may be mistaken, but I don't think the flat tax has anything to do with making compliance easier

Well, flat-tax advocates such as Steve Forbes make much of how tiny their tax form is, so such advocates are deliberately ignoring that it's not different tax rates, but rather figuring out taxable income, that makes taxes so complicated.

Posted by: mds | Oct 18, 2006 2:51:37 PM

Well, flat-tax advocates such as Steve Forbes make much of how tiny their tax form is, so such advocates are deliberately ignoring that it's not different tax rates, but rather figuring out taxable income, that makes taxes so complicated.

And that complexity favors (and is "necessary" for) the wealthy, since they're the folks who have the income to push around, recharacterize, and fudge. And of course, corporate income taxes are even more complex.

The rate of income tax compliance among individual workers (the vast majority of people in the country) is very very high, because the government knows the source of most of the dollars they got, and their deductions are similarly easy to track. Ditto for sales tax compliance, which is a larger relative burden the poorer the taxpayer gets. Tax compliance among those who have the ability to fudge or move their income around, not nearly so high.

If you were to tax all income equally, regardless of the source (including inheritance -- after all, that's income to you), you'd have a very simple income tax system, at least for that category (self-employment and other business taxes will almost always suffer from the allowable pre-tax expenses problem). You'd also have a howl of outrage from the Paris Hilton lobby, who drive the tax discussion in the US.

Posted by: paperwight | Oct 18, 2006 3:00:10 PM

"I may be mistaken, but I don't think the flat tax has anything to do with making compliance easier "

The compliance argument is that by decreasing taxes on rich people, you decrease their incentive to fudge stuff. Makes more sense in the context of modern Russia than the US.

Posted by: ptm | Oct 18, 2006 3:05:48 PM

The flat tax=simplicity argument has always seemed strange to me. The complexity of our tax system has nothing to do with its progessivity.

Posted by: Justin | Oct 18, 2006 3:41:56 PM

The compliance argument is that by decreasing taxes on rich people, you decrease their incentive to fudge stuff. Makes more sense in the context of modern Russia than the US.

Gotta love the assumptions stacked into that argument: rich people are lying unpatriotic cheats, so might as well accommodate them.

Posted by: paperwight | Oct 18, 2006 4:28:19 PM

"Now it's clear the theory is shite."

Going Irish in our swearing? (OK, the Scots and the Northern English use 'shite', but it's most prevalent in Ireland)

Here's a good addition to your epithets: gobshite, as in "that gobshite Hugh Hewitt", etc.

Posted by: Urinated State of America | Oct 18, 2006 5:27:04 PM

Cutting Taxes ...Angry Bear

Here's a post from "Cactus" that crunches some historical numbers and, as far as I can understand it, suggests the the minimax rate or "Laffer Peak" is somewhere a little under 50% marginal rate. The Bush cuts were a mistake. Read around it, there are several other posts and a lot of good comments.

Posted by: bob mcmanus | Oct 18, 2006 8:46:04 PM

Comparing the flat tax in Russia to a potential flat tax in the US is insane. The Russian flat tax was introduced in a context where tax inspectors were quite literally SWAT teams.

Posted by: Ginger Yellow | Oct 19, 2006 8:58:50 AM

I'm not a flat taxer for the West (though I am a radical tax simplifier), but I think in the context of Eastern Europe they made sense. They allowed for radical simplification of the system, and because "everyone pays the same", they created social pressure against tax evasion: not only was it harder avoid taxes through complicated loopholes, but your neighbours have a very direct sense of what your "fair share" is. In a country where the "fair share" is different for every taxpayer, it's a lot harder to build that kind of social consensus. In the case of the West, we don't really need to.

It's hard to imagine any Laffer type effects from flat taxes in Eastern Europe, since no one seems to have been actually paying any taxes beforehand.

Posted by: Jane Galt | Oct 19, 2006 10:03:02 AM

"The Laffer Curve, folks will remember, is the idea that lowering tax rates increases economic growth and thus results in more tax revenue."

As already pointed out, this is incorrect. All it claims is that there is an optimal level of taxation that maximizes revenue. As for the supply side theory that lower taxes generates more revenue, it does, at least by one measure. If you cut taxes by $100 million you would expect to see a decrease in tax revenue of $100 million. Increased economic activity will result in revenue not decreasing by $100 million, but it does not necessarily mean that it will generate $100 million dollars either.

Since Reagan popularized supply side tax cuts, economic growth, with two minor blips, has been stunningly consistent. Supply side isn't conservative or liberal. You can be a proud liberal and still embrace supply side economics.

Finally, simplifying how you define taxabale income lessens the biggest advantage that the rich have- smart tax lawyers.

Posted by: Alex | Oct 19, 2006 12:40:34 PM

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