Tuesday, August 10, 2010

The Shape of Things (Well, Just Taxes)

The Laffer curve is an inverted U-shaped curve which dominates the economic and policy discussions of taxes. It illustrates the relationship between tax rates (x-axis) and tax revenue (y-axis): as tax rates increase, the government gets more money until rates are so high, people leave the formal sector altogether and stop paying taxes. At both 0% and 100%, government gets no revenue.

The discussion about increasing or lowering taxes often reverts to where we are on the Laffer curve. If we're to the left of the peak, raising taxes raises revenue while on the right of the peak, lowering taxes lower revenue. Brad DeLong recently posted this graph of OECD countries' tax rates and revenue, claiming the peak is pretty far to the right.

What's bizarre about these discussion is that there's so much incentive to operate the peak. Raising taxes on everyone by just a bit (or raising taxes on unpopular people by a bit more) gives lawmakers a huge chunk of change to hand out to constituents. From the politician's perspective costs are low and benefits are high. In lowering taxes even more so: you get to lower taxes, raise revenue, and tell the truth! No politician would give up that option. So it seems pretty obvious to me that most countries operate at more or less the peak of the curve.

So why does DeLong have this graph with a clear upward sloping relationship? Because each country has a different peak. Operating in the extralegal sector means you can't operate in the legal sector. Therefore, the opportunity cost of going extralegal is higher in some countries than in others based on the quality of the legal sector. This is why developing countries, with an awful legal sector, have to depend on inflation to make ends meet. It's also why Sweden keeps a high tax rate: its government functions very well (for various demographic and cultural reasons). If you want to make a claim in favor or against taxes efficiency is much firmer ground.

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