Public Finance: Relaxing Laffer Curve Assumptions and Revising Tax Rate- Tax Revenue Relationships

As a freshman taking Principles of Economics with Prof. Sunil Gulati, I was intrigued by one of the many theoretical concepts of public finance: the Laffer Curve. On the surface, this curve describing the relationship between tax rates and tax revenues is built on sound assumptions and reasoning. After all, the tax rate-tax revenue relationship can clearly be defined as a function (though most realistically, a multivariable one), and as such there should be a tax rate that maximizes that function (tax revenues). The problem is, however, that tax revenues should be precisely a multivariate function: studying the relationship between tax rates and tax revenues and—most critically—claiming a relationship like the one defined in the Laffer curve can be highly misleading when not controlling for the appropriate variables, or not allowing for different versions of this curve depending on the controls.

The Laffer curve Arthur Laffer curve described may be correct in theory—but it may be so only for a very limited and unrealistic set of assumptions, or values of the other variables under consideration. Much research has already been done on the Laffer curve, and this concept has indeed generally been met with skepticism by empirical studies. After all, one can begin dismantling its many assumptions simply by considering the predicted tax revenues at the tax rates of 0% and 100%. At 0%, the claim that tax revenues will also be zero is most appropriate, even using the simple tax revenue function implied by the Laffer Curve (tax revenues are simply tax rate multiplied by the tax base), since of course anything multiplied by zero will also be zero. Not much imagination, however, is required to think of potential reasons why tax revenues would not be zero at a 100% tax rate. Most critically, would all taxable economic activity (in short, the tax base) actually drop down to zero? We can think of many physiological, social, legal and material reasons, among many others, for why individuals would still work at a 100% tax rate, most important of them being the instinctual need for survival (assuming of course that economic activity would be well-regulated so as to make tax evasion highly difficult for all individuals, if not impossible).

Based on these thoughts, my idea was: how can we relax the Laffer curve assumptions by considering the different types of political and social systems under which people live and engage in economic activity? At its core, the Laffer curve attempts to make a claim about individuals’ motivations to work and remain in the tax base at every given tax rate. What if those motivations were varied based on the social and political scale? For example, under varying degrees of economic and social liberty we could expect varying degrees of commitment to work. Under a hypothetical (though in our world, perhaps not even much so), highly totalitarian system, we could imagine a dystopia of a 100% tax rate where everyone is required to work. In that case, the motivation to work is purely external, but nevertheless perfect. Tax revenues in that case would clearly not be zero (though a complication would of course be how far away from zero those revenues would be: would people give the minimum effort in this kind of system?).

Thus, a truly rigorous examination of the function that describes the relationship between tax rates and tax revenues (abstracting and simplifying from the highly complex and marginal nature of modern-day tax codes) would give way to at least three considerations: individuals’ motivations to work (meaning a simple yes or no decision to enter the labor force), the effort applied to one’s work once one is actually working, and finally the “tax evader” decision: whether or not one will be in the tax base. Laffer made the leap from tax rate to this final consideration: the relationship between tax rate and tax evasion. And at the least, he made the simplifying assumption that a 100% tax rate would automatically mean a “no” to the decision to join the labor force.

The idea, however, is that under different political, economic or social systems, individuals may have varying external and internal public motivations that will compel them to: work, apply a certain level of effort in that work which will translate to a taxable, economic output, and finally submit that output to actually be taxed (meaning, not be a tax evader). Moreover, the classic Laffer curve is myopic in that it considers only one part of the taxpayer- government relationship: it considers how the taxpayer will make her labor and tax responsibility decisions based only on the tax rate she observes when filing her taxes each year. Yet, it does not consider that, underlying that transaction is the promise of a further, later transaction: that of government spending or government transfers that the taxpayer will directly or indirectly benefit from. Thus, it fails to consider the simple fact that, yes, higher taxes makes a taxpayer unhappy, but that tax rate should in theory (and this requires several assumptions of our own) imply a larger government budget and, in turn, a larger array of government services that should, in the net, benefit the taxpayer. Be it as indirect as paying the government debt (an action that is intangible and less direct) or as direct as building a new railway that will connect the taxpayer’s town to a major hub of economic activity, the promise of public services (particularly under different economic, social, and political systems) should also be considered when trying to formulate the different possible shapes of the tax rate- tax revenue relationship. Moreover, the political and social system also plays a role in this factor, through the issue of information: we might expect that in more democratic, open and less corrupt political systems, information as to how tax revenues are being spent by the government would be more readily available, allowing the taxpayer to make a more informed decision as to this portion of the taxation transaction Thus, in a society where the government regularly shares information on its budget, or where the taxpayer regularly informs the government as to her preferences regarding that budget—be it through participatory budgeting or some other mechanism—the willingness of the taxpayer to work, make effort, and pay taxes may be very different from one in which the government is very closed and taxpayers are not informed as to how their money is being spent. In the former, more open society, we might expect taxpayers to be more willing to pay higher taxes; in the latter, this asymmetric or incomplete information (from both sides: taxpayers either not having the chance to share their interests or the government not disclosing expenditures), might make taxpayers hesitant to accept lower disposable incomes.

Of course, this all sounds great in theory. It is easy to criticize the Laffer curve for its shortcomings and limiting assumptions. Yet, empirically testing for the real shape(s) of the tax rate-tax revenue relationship is considerably more difficult than one’s own theorizing and postulations. Most importantly, attempting to test “motivation to work and pay taxes” under different tax rates in different sociopolitical and economic systems essentially boils down to testing whether there is a statistically significant difference between the elasticity of labor supply in the different systems under consideration. In short, is the elasticity of labor supply different in the United States (an arguably more democratic, capitalistic and individualistic society and political system with ample economic liberties) from the elasticity of labor supply in an equally democratic, but more socially-leaning nation such as France? Or a very different nation (politically, socially, and economically) like North Korea? And, in turn, does that translate to different levels of tax revenues in those countries in the scenario where tax rates are close to or at 100%?

Hopefully someday, a rigorous examination of this question can be conducted that (whether it is easy or not) will help guide the leaders of different nations faced with very different social, political, and economic systems (and in turn, the very different public motivations of its citizens) to a sound decision regarding their tax rates.

After all, nations of different sociopolitical and economic systems have for decades been applying the same, almost cookie-cutter prescriptions formulated under specific, oftentimes limiting and inapplicable assumptions without regard to how tax codes should actually look in the kinds of societies they consist of. These, at times, have led to disastrous budgetary, political, and social results. 

Maybe with a closer examination of these issues, nations whose services and public motivations of its citizens require higher tax rates will stop living in the fallacy that lowering tax rates is a perpetually self-financing source of economic stimulus, and will implement the tax codes that adequately respond to the needs and demands of their citizens. Likewise for those with potentially different tax rate prescriptions. 

Different theoretical curves describing the tax rate-tax revenue relationship under different sociopolitical and economic systems

Public Finance: Ricardian Equivalence

Among the most well-known of the classical economists is David Ricardo. Known particularly for the concept of comparative advantage and how it—and not absolute advantage or any other measure—should be the basis for trade between individuals or nations (making trade no longer a zero-sum game), Ricardo is also well-known for laying out the theory behind what is known as Ricardian Equivalence. While he doubted the real-world existence of this proposition (and Robert Barro’s subsequent work in the 1970’s seemingly finding evidence for it is still frequently discussed), Ricardian Equivalence essentially states that taxpayers are rational and infinitely (or close to infinitely) forward-looking. Thus, they internalize the government’s budget constraint, such that they understand that a decrease in tax rates today must imply an increase in tax rates in the future. Instead of spending their tax cut and increasing Consumption (which might be the desire of government officials engaging in expansionary fiscal policy), they will save that money knowing that they will be taxed at a higher rate later. In short, this implies a relative ineffectiveness of fiscal policy (whether expansionary or contractionary) on Consumption and thus on GDP and economic growth.

This proposition assumes of course that there is no dominant wealth effect (thus, that a tax cut today would not be more than compensated for by the larger wealth of subsequent generations, making a tax cut in essence self-financing), that taxpayers are rational, and that they are very-forward looking. Those are of course strong assumptions; we know there are a myriad of biases, egocentric and temporal errors, myopia and temporal discounting, among other decision-making factors that make taxpayers (and economic agents in general) particularly “irrational” actors. On top of that, of course, much has happened between the time of Smith, Ricardo, Mill, Malthus, etc., and economic thought has evolved correspondingly. Heckscher and Ohlin, for example, have built upon the theory of comparative advantage to include factors of production and in turn help explain sources of comparative advantage. 

In a world where public finance has been a central topic of political discourse all around the world, it is essential that economics reach comprehensive and accurate responses to a large number of questions: What is the role of public debt on economic growth and taxpayer behavior? Does deficit spending (with the explicit purpose of stimulating the economy) actually work? Is Ricardian equivalence empirically observed? If so, is its effect different between expansionary or contractionary fiscal policy? How forward-looking are taxpayers? Are tax cuts self-financing? Is there a wealth effect? Do the answers to these questions vary based on demographic makeup, political leanings, or social inclinations of the population under study? And finally, based on the answers to these questions, what is the appropriate tax and fiscal policy to ensure the proper balance between economic growth, the social and political goals of each population, and the proper management of the nation’s resources and what is in essence each generation’s intertemporal responsibility: leave behind a better and more prosperous society (for all) than the one they were born into?