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Laffer Curve – The Income Effect Spotted In The Wild

The Laffer Curve is one of those things that certain types love to insist doesn’t actually happen. Yet also one of those things which is simply a basic truth about our world. There are tax rates high enough to lower the amount of revenue collected. This means that, if the rate is currently above that, then revenue can be increased by lowering rates. The corollary is also that there are rates too low to be revenue maximising.

It doesn’t then go on to prove what Art Laffer himself has been saying for some decades now, that lower tax rates always pay for themselves. It does say just what it does say, that there’s a – or even several – peaks in revenue collection as a tax rate goes from 0% to 100%.

The difficulty in calculating exactly what that rate is comes from two different levels of complexity. The first is that it is different for every tax within a certain societal structure. Famously, the European Union showed that 0.01% for a financial transactions tax was above the Laffer Curve peak – it lost revenue, not gained it. The rise in VAT rates from 7 and 8 % to 15 and 20% shows that the peak for a VAT is, well, it’s not 7 or 8% at least.

The second level of complexity comes when we start to talk about income taxation for there are two effects. At some point people look at their post-tax pay and declare “Sod it, I’m off fishing.” This is the substitution effect. People will also, sometimes, look at their post-tax income and declare that “I gotta make my nut” and so work longer hours at a higher tax rate. This is the income effect.

We’re near all affected by one or the other at certain times and income/tax levels. A very few are affected only by one or the other. The Laffer Curve is the effect of both over the population.

We’ve seen hte substitution effect as doctors refuse to work extra NHS shifts as their tax bills rise to monstrous levels – the interaction with their pensions and the limits upon what you can have in one. So, it’s nice to also see the income effect:

Alfan, 25, was one. When the light turned red, he walked in silence, barefoot, and stood in front of the stopped traffic. He bowed deeply for a few seconds and then struck a pose like a statue: standing straight, he raised his right hand to his temple and gave a salute in silence for about a minute without blinking.

At the end of his brief performance, Alfa gave another deep bow and approached the riders and drivers for a donation.

“I’ll go home when I have got enough money. The other day I got 80,000 rupiah ($5.70) before 10pm, so I went home,” Alfan said after he returned back to the footpath.

Alfan, who has two young children, is one of many cash-strapped Indonesians who have taken up the street art of manusia silver, or silvermen, to make ends meet during the pandemic.

I’ve made my nut now I’m going home. It’s exactly that that can make people work more hours when income taxes rise.

We can now see the two basic causes of the Laffer Curve out there in the wild. So, perhaps, we can put an end to the claims that it doesn’t in fact exist?

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dodgy geezer
dodgy geezer
19 days ago

The theoretical argument for Laffer starts from the axiom that there are two positions where tax income is zero – that is, tax at 0% and tax at 100%. But these are only true for a free society. With varying levels of compulsion the state can raise increased income right up to 100%. A slave economy, for instance, is an effective 100% tax on all work done. If VAT, or other taxes, are raised to 100% or higher, people will still pay for essential goods. Petrol provides the classic example here. But perhaps they might simply use less of it?… Read more »

Spike
Spike
19 days ago
Reply to  dodgy geezer

I think the important distinction here is not degree of compulsion but this: The Laffer Curve theorized about amount of resulting activity if the gov’t seized from 0% to 100% of the benefit. Petrol is one input and can be taxed above 100% without either extinguishing the profit of the filling station or the benefit to the driver.

A better analog would be gov’t requiring payment in-kind. If gov’t demanded 100% of the petrol pumped, refueling would cease.

Spike
Spike
19 days ago
Reply to  Spike

Sorry, not amount of resulting activity; the Curve graphs total amount seized.

Quentin Vole
Quentin Vole
18 days ago
Reply to  Spike

Petrol is currently taxed ~300% of the cost price (in the UK). But for Laffer purposes, it’s the tax proportion of the end price that matters, and that can only approach, never reach, 100%.

john77
john77
16 days ago
Reply to  dodgy geezer

A finite VAT rate takes less than 100% of the money changing hands: you are being confused by the description of our VAT rate which is called 20% when it is actually 16.6recurring% of money changing hands. A nominal VAT rate of 100% is actually only 50% of money changing hands and below the top rate of income tax on employed and self-employed individuals in 2011 [the 2% that is labelled NI is simply a tax on income].

Barks
Barks
19 days ago

This very day, looking for a strawman to burn or windmill to joust with, former US Senator Al Franken has a piece simply giddy about the Laffer Curve not working with a particular set of facts. Celebrating that the Curve does not work with his particular set. True, he’s especially dim, but still…..

TD
TD
19 days ago

You will find some on the left who acknowlege the Laffer Curve, but then they would argue that lower tax receipts from too high a rate isn’t the point. The point is they want people to be poorer and consume less. If a doctor doesn’t work as much because of high marginal tax rates that’s fine. His income is lowered and that is the goal. If you ask about the people who aren’t treated they’ll counter that the doctor was too tired in any event.

Esteban
Esteban
18 days ago

A wee problem with this example is that Lefties don’t generally argue about the Income Effect, it’s the Substitution Effect they deny or minimize. And, if cornered, they’ll claim higher taxes are justified on the basis of “fairness” even if they hurt the economy when we’re trying to climb out of a recession as Hopey McChange did around 2008 when a journo asked him.

jgh
jgh
17 days ago

When I was on taxi licensing I saw the work-until-money happening with taxi drivers. Most of them would keep working a shift until they’d made enough money, and if they hadn’t, they’d keep going and going and going trying to get that pot. Conversely, the drivers who actually made more money were the ones who did a solid fixed number of hours and went home at the end regardless of how much they’d made. But it seemed so counter-intuitive to most drivers to go home after eight hours having made no money. As licensers we would tear our hair out,… Read more »

Bill Coleman
16 days ago

Missing is how rich folks hire lobbyists to write tax legislation with abundant tax loopholes, bypassing the simple Laffer effect. Those industries with loopholes benefit at the expense of those without. A small business has enough to worry about without having to deal with learning how to use and lobby for loopholes.

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