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Tuesday, August 4, 2009

The AP reports federal tax returns are plummeting. Returns are expected to decrease 18 percent - a substantial drop, exacerbating the Greek fire that is the federal budget deficit.

Unsurprisingly, the AP article immediately tangents to meaningless politics, passing on a valuable opportunity to touch on the fundamentals of the Laffer curve. The term was popularized by Jude Wanniski, partly through is book The Way the World Works (I highly recommend it).


According to Arthur Laffer, "There are two tax rates that yield the same revenues." This is depicted in the above image. It is important to note that while the end points are zero and 100 percent, the equilibrium point is not necessarily 50 percent. Rather, "It is the point at which the electorate desires to be taxed."

In the image, tax returns at point A and A* are equal. A* falls in the prohibitive range because the same amount of tax returns are received but at a higher cost to the economy.

Here's an excerpt from page 100 of The Way the World Works:

Most judgments of tax rates and expenditures by government are made by individual politicians, and it has been the exception rather than the rule throughout history that politicians, by accident or design, have sough to increase revenues by lowering rates. Andrew Mellon, who designed the Harding-Coolidge tax rate reductions of the 1920s, became a national hero as a result and was called the greatest Treasury Secretary since Alexander Hamilton. Ludwig Erhard achieved heroic stature in Germany after his financial policies produced German "economic miracle," as it was commonly described. The Mellon/Erhard "miracles" were simply confirmation of their opinions that tax rates were in the prohibitive range and could be reduced with beneficial effects on both output and revenue.

The idea behind the Laffer Curve is no doubt as old as civilization, but politicians have always had trouble grasping it.
I will write further on the Laffer Curve in a later post.

Posted by Eleutherian

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1 Responses to Decreased Federal Tax Returns - Laffer Curve 101

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