Higher taxes less revenue

October 18, 2012

A reader sent me the link to this YouTube clip which supports my contention that a higher tax rate doesn’t mean a higher tax take.

The speaker is UCLA Economics professor, Tim Groseclose who uses the Laffer Curve to explain why:

He gives examples from the USA but we’ve had similar results here where increasing the tax rate decreased the tax take and lowering taxes raised more revenue.

He also quotes Christina and David Romer who wrote a paper on , “The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks.

Access to that requires a subscription to access but Professor Groseclose wrote about it in  the Laffer Curve and new evidence that taxes stifle economic output:

The Romers examined the effects of tax policy on GDP.  They found that the effects are very large.  Specifically, they found that for every 1% that taxes rise (as a percent of GDP), this causes GDP to fall about 3%.  The authors employed some clever methods to try to find what economists call “exogenous” changes in tax rates.  When they employed their methods, they found much higher effects than economists had previously found.

The article was something of a Nixon-goes-to-China phenomenon.  That is, while conservatives tend to claim that taxes strongly decrease GDP, liberals tend to claim that taxes have at best a weak influence on GDP.  When the Romer-Romer article reported a strong influence, one of the most interesting aspects of the finding was that it came from a very liberal quarter – namely, one of its authors was a senior member of the Obama administration. . .

. . .  the Laffer Curve specifies that there exists a “hump” tax rate – a rate that maximizes revenue to the government, and if the government raises taxes above the hump rate, then its revenue actually decreases.

Academic economists generally agree that the hump rate is very high, something like 70%.  However, although Romer-Romer article did not explicitly discuss the Laffer Curve, its results imply that the hump rate is much lower, something like 33%.

To see this consider the following example.  Suppose a country’s GDP is $100 billion, and suppose its tax rate is 33%.  Then its tax revenue will be 33% of $100 billion, or $33 billion.  Now suppose it raises taxes to 34%.  If the Romer-Romer result is accurate, then this will decrease GDP by 3% to $97 billion.  Tax revenue will be 34% of $97 billion, or $32.98 billion.  Note that this is slightly less than the revenue at the 33% rate.  If you experiment with other tax rates, you’ll see that revenue is maximized when the tax rate is 33 1/3 %.   Moreover, as the tax rate increases to rates higher and higher than 33 1/3 %, government revenue becomes smaller and smaller. . .

Remember this next time someone suggests raising taxes over 33 1/3%.

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