The Laffer Curve And Austrian School Economics

Laffer Curve

Jude Wanniski, a writer for the Wall Street Journal, coined the term “Laffer Curve” after a concept promoted by economist Art Laffer.Laffer himself says the idea goes back to the 14th century

The idea is that if one wants to maximize the government’s tax revenue, there is an optimal tax rate. (Ignore for the moment whether or not you think this makes good economics in the long run, or whether or not you think this is even moral.)

Laffer noted that if the tax rate is zero, then the government gets no revenue. But likewise, if the rate is set at 100%, the government also gets no tax revenue. Mainstreamers say that there is no incentive to produce income at 100% tax rate, and this is true. But even more importantly, there is no means: a 100% tax rate is pure capital destruction.

The “Laffer Maxima”, i.e. the tax rate which maximizes the tax take, is somewhere between 0% and 100%. The Wikipedia article shows a picture of a Laffer Maxima at 70%, and implies that although it’s somewhat controversial this may be the right number.

There are two points about the Laffer Curve that are important to consider.

First, what in the world makes any economist think that he can gin up some differential equations and compute the right value for this Maxima? In the first place, every market is composed of an integer number of people transacting an integer number of trades, and each of those trades consists of an integer number of goods. People do not behave like particles in an ideal gas—they have reason and volition. The very idea of modeling a large number of people with equations is preposterous. Never mind that degrees are awarded every year to economists who purportedly do just that.

Second, what makes anyone think that the Laffer Maxima is a constant?

Let’s do a thought experiment that is in the vein of the Austrian School of economics. Let’s consider the boom-bust cycle, or what Austrians note is really the credit cycle. The central bank first expands credit, which flows into wealth-creating as well as wealth-destroying activities (malinvestment). As the expansion ages, an even greater proportion of credit funds wealth-destroying activities. Sooner or later the boom turns to bust. Malinvestments are liquidated, people are laid off from their jobs, portfolios take big losses, tax revenues decline, etc.

One clue can be found right there, in my description of the bust: tax revenues decline.

OK, maybe the Laffer Curve remains static and the only thing that changes is the absolute tax dollars?

Let’s continue comparing the boom and the bust phases. In the boom phase what’s happening is that economic activity is being stimulated, i.e. beyond what it would naturally have been. This fuels demand for everything: commodities, labor, construction, fuel, professional services, etc. And all of the people hired in the boom are demanding everything too. It feeds on itself synergistically, for a while.

At this stage, the frictional cost of taxes may be masked by the lubricant and fuel of credit expansion. This is especially so when everyone feels richer and richer on paper. People spend freely and we saw this in spades in the most recent boom that ended in 2007.

Now let’s look at the bust phase. The net worth of most people is falling sharply. Many are laid off, their careers, and sometimes lives, shattered. A huge component of the marginal bid for everything is withdrawn. People struggle to make ends meet. Budgets are stretched to the max.

I submit for the consideration of the reader that in the bust phase, any change in the tax rate drives a big change at the margin of economic activity. The tax rate is more significant in the bust phase than it was in the boom phase. The Laffer Maxima is not a hard-wired, intrinsic value of 70 (or 42 for fans of Douglas Adams). Like everything else in the market, it moves around. It is subject to the forces of the markets.

I will close with an example. Consider the marginal restaurant. Let’s say it is generating $25,000 per month in gross revenues. Net of $24,700 in expenses, it is generating positive cash flow of $300 per month. Why would the owner even keep it open? Well, times may get better…

Now, let’s say the tax rate goes up a little, say 100 basis points. The restaurant, making little money, pays essentially no taxes anyway. So this does not cause a direct impact. But what about the patrons of the restaurant? If their blended tax rate was 25%, then an increase of 100 basis points (i.e., to 26%) is a tax increase of 4%. These people will have to reduce their budget by 4%.

One logical place to cut is eating out. Suppose that they reduce their spending in the restaurant by $1,000, in aggregate. Now our restaurant has $24,000 per month in gross revenues. But its fixed costs cannot be reduced. And even the labor can’t be reduced in this case. The only reduction will be food supplies. So let’s say food supplies are reduced 1/3 of $1,000, or $333. So now the restaurant has expenses of $24,367. Whereas it formerly made $300 profit per month, now it makes a loss of $367 per month.

The owner can’t continue this very long. And so he closes shop. He defaults on the loans on the fixtures and tenant improvements, lays off 8 people, leaves the electric and gas companies with fixed infrastructure which no longer produces revenue for them, etc.

The impact to the economy (and hence to the total taxes collected) is negative and disproportionate to the tax increase.

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