Where do countries stand on the Laffer Curve?

by on September 16, 2009 at 7:38 am in Economics | Permalink

From Mathias Trabandt and Harald Uhlig, there is a new study:

We characterize the Laffer curves for labor taxation and capital income taxation quantitatively for the US, the EU-14 and individual European countries by comparing the balanced growth paths of a neoclassical growth model featuring “constant Frisch elasticity” (CFE) preferences. We derive properties of CFE preferences. We provide new tax rate data. For benchmark parameters, we find that the US can increase tax revenues by 30% by raising labor taxes and 6% by raising capital income taxes. For the EU-14 we obtain 8% and 1%. Denmark and Sweden are on the wrong side of the Laffer curve for capital income taxation.

I guess some of those countries should cut their tax rates.  The title of the paper is How Far Are We From the Slippery Slope?  The Laffer Curve Revisited.  You'll find some ungated versions here

Bill September 16, 2009 at 9:20 am

Cutting individual income tax rates is one thing, but, in terms of overall tax policy there may be equivalent or better things to consider, even if you accept the Laffer curve.

Here’s the point: the US tax system has favored capital investment–we have accelerated depreciation, various tax credits for investment, etc. And, for the most part, that tilt toward the use of capital in the human effort to capital production equation has, until now, served us well. But, if you look at effective corporate tax rates, what you see is that capital intensive industries pay substantially less corporate taxes than less capital intensive industries. This can have consequences–we may be favoring companies in reducing employment at a time of high unemployment, we may be taxing service industries at a higher rate when service (computer programming, healthcare, etc.) are areas that we want to have investment in, but of a different character–an investment in human capital. Similarly, we permit depreciation deduction for equipment but not for education when we should be encouraging education.

Also, to the extent that we favor capital intensive investment with our tax policies–policies that were developed when we were a creditor nation (which were last since 1985), these policies may not be the best ones when we are a debtor nation. Do we want to goose more borrowing on international markets because our tax policies favor capital intensive industries.

All this requires some balance and consideration. Obviously, we don’t want to lose efficiency…but, fixed capital (hard goods) are not the only form of capital in the production equation, there is human capital as well, and because we favor one form of capital over another with our tax policies favoring hard capital investment, we are limiting our own production possibility frontier.

Trevindor September 16, 2009 at 9:54 am

Their generated curves are based on a “simple neoclassical growth model.”

Blackadder September 16, 2009 at 11:23 am

If the conclusion is “I guess some of those countries should cut their tax rates.” (I think you might be referring to Sweden and Denmark, is not there a corollary: the US should raise its tax rates?

No, because there may be reasons to have tax rates below the Laffer maximum. Having tax rates above the Laffer maximum, by contrast, is just irrational, as you could get more tax revenues by lowering rates.

josh September 16, 2009 at 11:40 am

What discount rate is used when people try to calculate the Laffer maximum?

A related, but even more incalculable question is ‘does our government provide worse service than a pure revenue maximizer?’

Blackadder September 16, 2009 at 11:45 am

Allan,

That’s fine for cigarettes, but presumably Denmark and Sweden aren’t trying to discourage capital investment.

Allan September 16, 2009 at 11:59 am

Cliff,

The number of hours are not reduced. The taxation is increased. If these leads to some reducing hours, it could be better. Allow me to expand.

With a few exceptions, everyone is fungible. A job performed by one can generally be performed at the same level as by someone else. Thus, all things being equal, it is just as effecient to have two people working 40 hours per week as it is to have one person working 80 hours per week. Arguably, it is better, because one’s abilities begin to wain after working a certain number of hours (a better example would be that having 5 people work 40 hours per week would be the same as having 4 people work 50 hours per week).

On the other hand, there is a theory that we do not live to work. Rather, we work to live. So, working 40 hours a week is better for the individual. Additionally, one with children would have more family time if one worked less hours. And, it could be argued, persuasively, that children need their parents. And children with parents around benefit society. Consequently, fewer working hours is not only better for the individual and the family, but better for society as a whole.

In some circles in the US, there is a theory that working more is better. Thus, they want lower tax rates, even if it means less quality time for parents and children. In other words, the US tax rates could arguably be a policy decision that working is more valuable than raising families. Sweden and Denmark seem not to concur.

I make no judgments on policies. I am just trying to explain the rationality of the tax rates. Indeed, you may disagree with the rationale. But it is out there.

Dave September 16, 2009 at 12:26 pm

I do not have a subscription, so cannot read the full paper. I hope that the paper does not suggest that the goal should be to maximize tax revenues. And secondly, if the data is relying on data from 2007 or beforehand (and maybe even 2008), it’s probably obselete. As the credit bubble deflates, what we know about income distribution will change dramatically.

Allan September 16, 2009 at 2:03 pm

Adam,

That sound you hear is my premise rushing over your head.

I do not suggest replacing a physician who works 80 hours a week with a physician who works 40 hours per week and a secretary who works 40 hours a week.

I suggest that we get two physicians to work 40 hours per week.

That might mean we need more physicians, but it is doable.

Allan September 16, 2009 at 2:17 pm

Doug,

Your point simply is untrue. What is true is that not everyone does the job the same. What is not true is that only one person can do a job. Those who work harder or better might be worth more per hour, but that does not mean they are not fungible and that things will fail if they were not there.
If that were true, the best employees would not be allowed to go home, retire, quit, or die.

Almost everyone is fungible. There are some exceptions, but they are few: Einstein comes to mind.

Doug September 16, 2009 at 3:52 pm

“Your point simply is untrue. What is true is that not everyone does the job the same. What is not true is that only one person can do a job.”

I never said that only one person can do a job. You are making up a false claim, and attributing it to me in order to prove me wrong, but I never said that. You said a job can generally be performed AT THE SAME LEVEL by someone else. The problem is, in most instances, businesses have a hard time replacing a good employee with another employee that wil perform AT THE SAME LEVEL. This is not a rare exception, but something that is common to almost any business.

“Those who work harder or better might be worth more per hour, but that does not mean they are not fungible and that things will fail if they were not there.”

First that is not the original point that YOU made. Second, being worth more per hour DOES mean that they are not fungible, and whether or not a company would fail if an employee was not there has nothing to do with whether or not employees are fungible.

Fungibility is the property of a good or a commodity whose individual units are capable of mutual substitution. If people do not do the job the same, and their labor is worth a different amount per hour, then they are not capable of mutual substitution, and thus, are not fungible. A 10 pound sack of grain is fungible because it can be replaced by any other 10 pound sack of the same type of grain. An hour of one guy’s labor cannot necessarily be substituted with an hour of any other guy’s labor, even if they have the exact same educational background–and most people do not have the same backgrounds. Thus, they are NOT fungible.

“If that were true, the best employees would not be allowed to go home, retire, quit, or die.”

Not allowed to die? Not allowed to retire or quit or go home? What parallel universe do you live in where employers have the right or even the power to dictate such terms to their best employees? What point are you trying to make with such absurdities?

Allan September 16, 2009 at 4:09 pm

Blackadder – that analogy is wrong.

It is like saying: we have to cook some turkeys for four hours. We can rent one oven or two ovens. It costs $x/hour to rent an oven. Assume that 1) the ovens are of an infinite size (we can fit all the turkeys in one oven) as is the kitchen; 2) the total time attending the ovens is the same (we are watching football in the other room, anyway); and 3) that we really don’t care when the turkeys are done (we are going to put them directly in the freezer). Should we rent one or two? It just does not matter.

Granted, there are some projects that take less total time if one person does them, but I am unsure how much that matters in the grand scheme of things.

Allan September 16, 2009 at 6:16 pm

This is a ridiculous analogy from the start.

Hiring two people will certainly cost marginally more money than hiring one person. If taxes are low, you can’t justify hiring two instead of one (or 5 instead of 4).

But if the cost of working 80 hours is not worth it to the worker, the worker will only work 40 hours and you will need to hire someone else or you will have to pay the worker more to compensate for the higher taxes.

If the former, the individual will benefit in non-monetary ways, as will his family, as will society. Thus, higher taxes on income.

If the latter, the individual will benefit monetarily.

That is the rationale for being above the Laffer maximum. Yes, it is a higher cost to business. But the way the US does it takes a higher cost on society.

John Breig September 16, 2009 at 7:17 pm

Fungible? Sounds like Ellsworth Tooey speak to me.

Allan September 16, 2009 at 7:51 pm

Yancey,

I do not assume that there are enough workers.

What the tax does is increase the cost of employing workers for a large number of hours. If there are not enough workers, the higher taxes will force the employers to pay more to compensate for more hours or hire more workers. In countries with the higher taxes, the cost of hiring new workers is simply less than the cost of having a person work more than 40 hours per week.

Under true market systems, the supply of workers would meet the demand. That is what happens in unregulated industries (those without entry requirements, i.e., a law degree or a medical degree). Regulated markets would have more of an issue, but the supply of workers would meet the demand.

Again, the issue is why countries would tax at a high level than justified by the Laffer Curve. The issue is not whether you think the theory is bunk or I think the theory is great.

I ask you to assume that the governments in question are acting rationally. If that is true, why do they not lower taxes to maximize revenue as the Laffer Curve would suggest?

Yancey Ward September 16, 2009 at 8:26 pm

And, it is worth pointing out that the violation of the individuals preferences in regards to leisure/income would lead most of them to substituting more off the books work/income for the leisure you gave them that they didn’t want.

Allan September 16, 2009 at 8:41 pm

Yancey,

I do not hear of shortage of workers in Denmark or Sweden (or France for that matter). There are a shortage of jobs. Given the disparity, the government is making it more expensive to have workers work more, thereby opening jobs to more who need work.

I would suspect that, were there a shortage of skilled workers, either the wages would rise or the tax incentive would go the other way.

This is MY theory on why Denmark and Sweden are over the maximum of the Laffer Curve. Do YOU have a theory?

By the way, not all workers are fungible. Workers in certain classes are fungible. For example, one litigation attorney can be substituted for another and one family practitioner can be substituted for another.

And yes, Tyler, one economist could be substituted for another. If Tyler were gone from his teaching job (appointed to the fed or something), I am sure his school could find a replacement who likely would be better in some ways and worse in others. But there is a replacement. That is fungibility.

Allan September 16, 2009 at 8:59 pm

Another thing…

You and I might not agree on what is rational. You think it irrational that a government would institute policies that would limit people from working as much as they want. I suggest that there are cases where it is rational for a government to do so and that the government’s policy is more important than maximizing tax revenues.

Put another way: maximizing tax revenues, while a rational policy, is not the only rational policy out there.

bluetooth tastatur September 17, 2009 at 3:11 am

It is important to distinguish political goals from hard and fast facts (to the extent that hard and fast facts exist in economics). Often, parties try to justify their tax scheme, whether it involves raising or lowering taxes, by claiming that it will increase revenue. However, many parties who want to cut taxes want to cut them whatever the effect on revenue; low taxation is a goal in itself. They should come out and say so, rather than trying to justify their tax cuts through the back door.

I don’t know how detailed the models are. Certainly if factors such as “if the government raises taxes I’ll leave the country† are taken into account, the model would have to be different for different countries, since for various reasons citizens of some countries are more likely to leave than those of other countries. (Such arguments are largely overblown; in Europe, where there are quite different rates of taxation and where it is relatively easy to move to another country, the number of people who do so for tax reasons is very small. Note that the classic Swiss tax exile is not an example of this. Many countries require their citizens to pay tax regardless of where they live; the attraction of Switzerland was not so much the low tax rate (probably offset by the high cost of living) but the fact that it is easy to hide money so that it income generated from it (interest etc) is not taxed at all. Fortunately, pressure on Switzerland, Liechtenstein and other tax havens has increased and they have actually made it more difficult (but still too easy) to hide money.

Allan September 17, 2009 at 11:05 am

Tracy,

I do agree with your point: One person working 40 hours a week will get more done than two people working 20 hours per week. 4 people working 50 hours per week probably will get more done than 5 people working 40 hours per week.

If the goal was to maximize worker efficiency, tax policy creating an incentive for a 40 hour work week would be irrational. If the goal, however, was to maximize the benefit to society, and someone (sounds 1984ish) decided that would be accomplished by having a 40 hour work week, such a policy would be rational.

A policy to reduce the work week could, as some have suggested, create labor shortages, especially in the most highly skilled occupations. But, given that “someone” is watching, that could be corrected by finding more highly skill individuals or allowing longer work days for highly skilled individuals.

But a laissez-faire policy also has problems. If a person chooses to have a 40 hour work week and another chooses to have a 60 hour work week, if both are of equal or even if the former has greater skills, the person with the 60 hour work week will likely be more productive and will likely be offered promotions ahead of the person with the 40 hour work week. Thus, the incentive is for people to work longer. If you believe that a 40 hour work week is optimal, a laissez-faire policy is perverse and, I submit, irrational.

Tracy W September 18, 2009 at 4:27 am

Allan, you say:
“If the goal, however, was to maximize the benefit to society, and someone (sounds 1984ish) decided that would be accomplished by having a 40 hour work week, such a policy would be rational.”

I don’t follow your claim. We may have the goal of maximising the benefit to society, but how do we know that a 40 hour work week would do that? You assume that someone has decided it, but what if they’re wrong? Some people (eg a number of scientists, politicians, artists) work far longer than a 40 hour week, apparently voluntarily, what basis do you have for saying that they’re wrong? Let us assume that you use force to stop people working more than a 40 hour week, how does that maximise the benefit to society?

As for the laissez-faire policy, the guy who works 60 hours a week gets the promotion, the guy who works 40 hours a week gets 20 hours a week more to do whatever he wants. What’s the problem? Yes, if you assume that a 40 hour week is perfect then I see your problem, but once you start using force to stop people working more than 40 hours a week then you’re creating a society that is unfree and I don’t see how that maximises social benefit at all.

You also, in your claim that “someone” could be watching and adjusting allowed working hours when there’s an unavoidable labour shortage implies that you’ve missed the entire socialist calculation problem debate. How can any single person, or group of person, know the marginal value of working another hour for any job? The whole point of markets is that adjustments in price allow people to make their own judgments about value. When the decision is made through a market, employers simply need to consider the marginal benefit to them of an employee working more hours versus the extra amount of money they’d need to pay the employee, while the employee only needs to judge the extra money versus the loss of their own time. Hard enough decisions, but far simpler than your “someone” who has to do this judgment across the entire economy, for multiple jobs. No one is competent to that, and certainly the last person who should do that job should be someone who was so foolish as to think they could.

Allan September 18, 2009 at 1:44 pm

Tracy,

One last thing about working 60 versus working 40 hours per week.

A pretty good argument can be made that working more at one’s job at the expense of leisure activity hurts society.

Take this blog for example. If Professor Cowen spent ALL his time on his job and none on this blog (or his wonderful restaurant reviews) his community of readers would be less well off (and less well fed). If someone worked 120 hours per week (taking only time off to sleep), his family would be deprived, and the neglect of his children the would likely be bad for society. So, society has an interest in deciding the length of a work-week.

How society should address its interests is one thing. And it can be debated, and has been debated (how to weight the good of the whole against the the free-will of the individual).

No society is free. The only issue is how free it is.

Allan September 18, 2009 at 2:52 pm

{hand up in an offer to give a high five to all comers}

Well said, Lefty.

Allan September 21, 2009 at 11:06 am

Again, Tracy, you miss the point.

The question is whether taxing above the Laffer Curve optimum is rational.

You have presented an economic theory to show that, under one set of assumptoms, such a policy is not rational. I agree that the theory is valid. But it is not the only theory out there. There is another theory which shows that such a policy is rational.

Until you show that under NO theory no government would tax above the Laffer Curve, you cannot win the argument. Any theories that such a policy are irrational is irrelevant.

To sum up my point: reality is irrelevant to the question, theories are relevant only to prove the point that the policy could be rational.

Tracy W September 22, 2009 at 4:49 am

Allan, I also noticed when reading through your comments that you appear to be switching between two arguments.
On the the one hand, there’s the claim you make that as long as someone thinks that there’s a reason to reduce working hours therefore it’s rational to reduce working hours. On the other hand, you also appear to be making arguments in favour of reducing a working hour. To quote an example of what you said:

But a laissez-faire policy also has problems. If a person chooses to have a 40 hour work week and another chooses to have a 60 hour work week, if both are of equal or even if the former has greater skills, the person with the 60 hour work week will likely be more productive and will likely be offered promotions ahead of the person with the 40 hour work week.
But when someone criticises this argument for reduced hours, you respond not by trying to defend this argument, but by claiming that you were merely making your claim about rationality. You’re trying to have it both ways, you’re trying to both put forward arguments for actually reducing hours worked, and also to free yourself from having to examine counter-evidence by switching to your first line of argument and thus claiming that responses are irrelevant on the basis that they’re either based on a theory or on practical matters.

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