Conservative economists and neoliberal politicians have often discussed the opportunity to increase the taxation revenue by decreasing the tax rates on labor or capital income. The theoretical basis for this assumption is offered by the so called Laffer curve, which describes the relationship between tax revenues and tax rates as a simple single-peak parable. The economist Arthur Laffer, who was also an advisor of U.S. President Ronald Reagan, developed this theory and fostered its execution during Reagan`s term in office to overcome the 1981’s recession. But the true shape of Laffer’s curve is hard to estimate.
In 2011 Matthias Trabandt and Harald Uhlig published a paper about a calibration of different Laffer curves for the U.S. and 14 EU-member states to specify “how far we are from the slippery slope”. Their model was based on the neoclassical growth approach. They computed the curves for labor and capital income and also calibrated the model with different assumption about the elasticities of substitutions. As you can see in Figure 1 the result for the U.S. labor income taxes was pretty clear. In the American taxation system there was no free lunch for tax revenues possible.
But keep in mind there are still distortional effect caused by the current tax rates, which create a fall in output and in result a welfare loss for the economy as a whole. The Laffer curve only shows us, that the government’s budget will decrease, if tax rates are reduced. Furthermore Trabandt and Uhlig pointed out that there is a significant difference between the case in which additional tax revenues are used for lump-sum transfers in comparison to the case of public spending. If the government uses tax raises for additional transfers and redistribution, the distortional effects on the economy will be obviously higher.
We can gain another insight, if we compare this figure with the calibrated Laffer curves for capital income in Figure 2. It is quiet established that taxation of capital is relatively difficult for certain reasons. The Laffer capital income curve seems to confirm this fact, since it is much flatter than the previous one. An increase of the capital income tax rate would generate significantly less revenue than labor income taxation.
Therefore a government, which wishes to increase its revenues – may it be for redistribution or debt repayment – should decrease the tax burden on capital income and raise labor income or consumption taxes. (latter ones have no Laffer peak) This recommendation is also in line with Trabandt and Uhlig’s illustration of Iso-Revenue Curves for the USA. At the so called Laffer Hill the government maximizes its tax revenues on labor and capital income. As Figure 3 shows, the U.S. could increase their public budget by 31% in total, if they would follow this advice. At first sight the government’s decision appears irrational, but probably the choice of the current capital income tax rates is caused politically by redistribution objectives. Notice that in this case there is no free lunch available for the U.S., because they have to increase labor income taxes simultanously to compensate the capital tax reduction. So in conclusion every government has to balance between optimizing tax revenues and redistribution between receivers of capital and labor incomes.
by Nils Picker
Trabandt, M., & Uhlig, H. (Mai 2011). The Laffer curve revisited. Journal of Monetary Economics , 58 (4), S. 305-327.