The Washington Post’s Ezra Klein had a great idea this week: He asked a bunch of economists and pundits to tell him where the Laffer curve bends. In other words, what is the marginal tax rate above which higher taxes lead to lower revenues? Meanwhile, coincidentally or not, Paul Krugman blogged on the very same question.
There’s a lot worth mentioning here, but let me start with one point that will be relevant below: Imposing a 20% income tax is not the same as cutting your wage by 20%. That’s because the income tax grabs not just a chunk of your current wages, but also a chunk of the future interest and dividends those wages enable you to earn. So a 20% income tax will, in general, discourage work more effectively than a 20% wage cut. This is important if you’re using data on wage cuts to predict the effects of income taxes.
That having been said, let’s see what we can learn from the responses:
- If your post-tax wage rate falls by 1%, your hours worked will fall by some percentage we can call e (for “elasticity”). Paul Krugman, having done exactly the same calculation I’d have done, concludes that the critical tax rate t is given by t = 1/(1+e).
- Emmanuel Saez, who has thought about these issues far harder than either Krugman or I, observes that our naive calculation implicitly assumes everyone’s in the same tax bracket. A more realistic assumption is that there are multiple tax brackets, and that our contemplated tax increase is concentrated at the top. This creates the possibility that a tax increase will cause people to move into lower brackets, which is something that Krugman (and I) ignored. This leads Saez to the conclusion that t is approximately 1/(1 + 1.5 e). At first, I couldn’t figure out where he got this formula, but then I found the paper that made it clear.
- Now that we have our formula, all we have to do is figure out what e is.
- Saez goes on to say that the reasonable estimates of e range from .12 to .40, with a best guess of about .25. This gives us a critical tax rate of about 73%.
- Careful now. That’s not a 73% federal income tax bracket; it’s a 73% marginal tax rate — which includes state income taxes, sales taxes, and so on. So the Laffer curve for federal taxes only peaks somewhat earlier; Saez says at about 69%. (I’d have expected this adjustment to be much bigger — pushing the peak substantially farther left — and am not sure why Saez says the adjustment is so small.)
- I have not digested the literature from which Saez got his estimates of e, but it seems to me that it’s possible they are partly estimated from data on wage cuts. If that’s right, then — because income taxes take a bigger bite than wage cuts of the same size, per the second paragraph of this blog post — the Laffer peak is probably somewhat further to the left.
- Ezra Klein divides his respondents into “The Tax Experts”, “The Left”, and “The Right”. The guys on the left guessed 70%, which is probably not far off (unless we need a substantial correction per the bullet point directly above). The guys on the right guessed ridiculously low.
- Greg Mankiw made the excellent point that it matters whether we’re talking about short-run or long-run effects. If I cut your wage by 20%, you probably won’t change your hours very much right away — but eventually you’ll look for a different job with different hours. So the long-run Laffer peak is probably well to the left of the short-run peak.
But Martin Feldstein gave the best answer of all, which was, in essence, that the whole question is stupid. Nobody, not even the most way-out leftist, thinks that the goal of tax policy should be to maximize government revenue. We also care about things like, you know, the quality of life.
Asking “what tax rate maximizes government revenue?” is like asking “what conscription rate maximizes the size of the army?”. Who cares? The right question is: What tax rate, and what conscription rate, will make us happiest in the long run? There is more to life than feeding the government.