Are Taxes Too High?

And if they are what are they smoking? Wait. I’m getting my topics confused. I blame old age. Let me go back to the beginning. And God said, “Let there be light”. Nope. Not that beginning. Just wait. I’ll get unconfused in a moment. OK. I’m having a discussion at The Economist about tax revenue maximization and what the ideal rate of taxation should be.

I left a few links there. Let me start with Asia Times. It is a discussion of the Laffer Curve.

All this assumes the Laffer Curve is a smooth curve rising to a single well-defined peak and then declining. This is intuitively attractive, but there is no reason for this simplicity to hold in all cases, since a multitude of factors affect both taxpayer behavior and economic outputs.

For example, the very high tax rates from the 1930s to the 1970s may have suppressed top management remuneration, since boards of directors were not able to get useful additional effort out of managers by paying them extra cash. Pharaonic perquisites would frequently avoid tax, but it was much more difficult to tie them effectively to performance. Hence management played a lot of golf, and economic output maybe suffered. In the real world, boards of directors’ incentives are not very closely aligned with shareholder reward, and management’s own incentives are different again.

There are a number of factors on which the Laffer Curve peak might conceivably depend:

One is the efficiency of tax collection. In a very inefficient system, such as Russia, high marginal rates of tax are completely ineffective, because the costs of tax evasion are relatively small, and consist mostly of paying off the right officials. Tax collection becomes an instrument of state control: Those with good political connections negotiate a favorable tax deal, whereas those who have alienated the authorities (such as Mikhail Khodorkovsky) find the tax code used to impose draconian criminal penalties.

In such a system, the 13% flat tax introduced by Russia in 2001 produced a huge increase in revenues, indicating that the Laffer Curve optimum tax rate there was not much above 13% and may even have been below it.

They go on to discuss other regimes. I’ll get to Europe in a bit. Dan Mitchell, a libertarian, discusses the Laffer Curve.

…very few of the respondents made the critically important observation that it should not be the goal of tax policy to maximize revenue. After all, the revenue-maximizing point is where the damage to the overall economy is so great that taxable income falls enough to offset the impact of the higher tax rates. Greg Mankiw of Harvard and Steve Moore of the Wall Street Journal indicated they understood this point since they both explained that the long-run revenue-maximizing rate was lower than the short-run revenue-maximizing rate. But Martin Feldstein of Harvard explicitly addressed this issue and hit the nail on the head.

Why look for the rate that maximizes revenue? As the tax rate rises, the “deadweight loss” (real loss to the economy rises) so as the rate gets close to maximizing revenue the loss to the economy exceeds the gain in revenue…. I dislike budget deficits as much as anyone else. But would I really want to give up say $1 billion of GDP in order to reduce the deficit by $100 million? No. National income is a goal in itself. That is what drives consumption and our standard of living.

Dan has other resources there, including videos, to help you get educated.

And now we come to a position paper by one of the Economics Departments of the EU. The European Commission Directorate-General for Economic and Financial Affairs. And they hit the nail on the head and may possibly be driving it into the brains of their politicians. But I doubt it. They summarize their work on the subject with:

Although higher tax rates raise additional tax revenue, the economic costs of higher distortionary taxation in terms of output contraction are substantial.

So there you have it. The choice is between fattening the calf and fattening government. But not exactly. A fatter calf does in time provide more meat for government and way more meat for the citizens. Some politicians object to the citizens being better off if they can’t get a very large cut of the meat. After all you will find it hard to miss what you never had and never knew was available.

Now you know. Take aim at the low growth politicians this November. Don’t miss.

Update: 22 June 2012 1934z

Commenter SteveBrooklineMA has left a link to a marvelous post that looks not only at the short term effects of higher taxes but also the long term effects. While doing that he gives a wonderful exposition on the Laffer Curve. Have a look.


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7 responses to “Are Taxes Too High?”

  1. Kruger Avatar
    Kruger

    “For example, the very high tax rates from the 1930s to the 1970s may have suppressed top management remuneration, since boards of directors were not able to get useful additional effort out of managers by paying them extra cash. Pharaonic perquisites would frequently avoid tax, but it was much more difficult to tie them effectively to performance. Hence management played a lot of golf, and economic output maybe suffered. In the real world, boards of directors’ incentives are not very closely aligned with shareholder reward, and management’s own incentives are different again. ”

    What are you, a moron or something? Have you or your co-blogger buddies ever actually held down a real job other than blogging, building computers, or writing stories? Economic growth between the 1930s to the 1970s was higher than economic growth between the 1980s and . . . now.

  2. Simon Avatar
    Simon

    Kruger,

    Uh. I think you may need a remedial reading course.

    Growth rates were high – in part due to the aftermath of WW2 – but they could have been higher if the incentives were properly aligned with economic growth.

    And the EU’s own economists said:

    “Although higher tax rates raise additional tax revenue, the economic costs of higher distortionary taxation in terms of output contraction are substantial.”

    Notice the bit about output contraction?

    Notice any output contraction lately? In the US? In the EU overall?

  3. Will Avatar
    Will

    The main purpose of taxes is not to raise maximum revenues. It is all about power; the power to punish and the power to reward.

  4. John S. Avatar
    John S.

    Hear, hear!!

  5. John S. Avatar
    John S.

    Re: the title of this post… the people who are clamoring for higher taxes to address our debt/deficit seem to have a misunderstanding of what our actual problem is. The problem is not that our tax revenue isn’t high enough… the problem is that our government spends too g*dd@mn much money. The debt and deficit are merely symptoms of the problem, not the actual cause. (Of course, just like the symptoms and side-effects of AIDS, they will still suffice to kill the patient.)

  6. SteveBrooklineMA Avatar
    SteveBrooklineMA

    I toyed around with the Laffer curve with respect to growth.

    http://saltzafrazz.blogspot.com/2010/08/laffer-curve.html

    The numbers are made up, but I think they are not too wild and it gets the point across. If increased taxes lower growth, then it doesn’t take long before the government is getting little more than it would with lower tax rates. And the economy can take a big hit.

  7. SteveBrooklineMA Avatar
    SteveBrooklineMA

    Hey, thanks for the praise!