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
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