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The Laffer curve. Can cuts in tax rates increase the total tax revenue for the government?

von Martin Pruschkowski (Autor) Alexander Grimm (Autor) Wolfram Stiasny (Autor)

Hausarbeit 2014 38 Seiten

BWL - Rechnungswesen, Bilanzierung, Steuern

Leseprobe

Table of Contents

Preface

Table of Contents

List of Abbreviations

List of Figures

List of Tables

List of equations

1. Introduction
1.1 Objectives
1.2 Structure

2. The Laffer-curve
2.1 The theory behind the graph
2.2 Elasticity
2.3 Taxes and elasticity
2.4 Inconsistencies within the Laffer curve

3. Case study: Reagan Tax Cuts in the early 1980s
3.1 Background on Reagan Tax program
3.2 Methodology
3.3 Results of income groups analysis
3.4 Conclusion of the case study

4. Case study: Tobacco tax program in Germany
4.1 Background on the tobacco tax program in Germany
4.2 Methodology
4.3 Demand and elasticity of cigarettes
4.4 Elasticity and tax revenues of cigarettes
4.5 Conclusion of the case study

5. Conclusion

Appendices
Appendix A: “Important tobacco tax data”

Bibliography

Further reading

Declaration

List of Abbreviations

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List of Figures

Figure 1: The Laffer-curve (Source: https://en.wikipedia.org/wiki/File:Laffer-Curve.svg.); Modified by Alexander Grimm

Figure 2: Derivation of Laffer curve ( (Becsi, 2000); Modified by Alexander Grimm

Figure 3: Elasticity of demand and supply (part 1) (Source: http://econknowhow.blogspot.de/2011/08/word-of-day_13.html)

Figure 4: Elasticity of demand and supply (part 2) (Source: http://econknowhow.blogspot.de/2011/08/word-of-day_13.html)

Figure 5: Inelastic demand and rising revenue

Figure 6: Elastic demand and dropping revenue

Figure 7: Switching point from elastic to inelastic demand

Figure 8: Possible elasticity around the switching point from elastic to inelastic demand

Figure 9: % Difference between Actual tax (At) and old law predicted tax (Ol) with % Tax cut average for 1980-1984

Figure 10: „Laffer curve“ axle arms of income groups 1984

Figure 11: Elasticities of Incomes applied on the US taxpayers subject to tax cuts

Figure 12: Laffer Curve „Correct“ and „Wrong Side“ Gruber (2011)

Figure 13: Composition of tobacco tax (own creation)

Figure 14: Demand curve and elasticity of cigarettes (own creation)

Figure 15: Development of cigarettes and substitutes sales (own creation)

Figure 16: Cigarettes price history (own creation)

Figure 17: Laffer curve of cigarettes (own creation)

List of Tables

Table 1: Tax payments by taxpayer groups 1980 – 1984. Lindsey (1987) adapted by Wolfram Stiasny

Table 2: Average Elasticity out of Lindsey (1987)

List of equations

Equation 1: Calculation of price elasticity

Equation 2: Calculation of price elasticity of cigarettes

1. Introduction

Apparently mapped out on a napkin during a dinner with the journalist Jude Wanniski in 1974, the Laffer curve - called after Arthur B. Laffer who is widely seen as “The father of supply-side economics” - has become one of the most controversially discussed topics in terms of tax politics since published by the before mentioned journalist in 1978[1].

As taxes are the most important income source for all governments, politicians around the globe are trying to determine the highest realizable tax revenue. Therefore they are using whatever they can to justify their decisions and the Laffer curve was and is used since the 80’s to promote tax cuts as a way to increase tax revenue.

1.1 Objectives

The objective of this work is to analyse a tool that is consistently used to establish decisions that sound great in the ears of potential voters but that is – at least at first glance – not very convincing in its approach as there are obvious conceptual limitations. Ultimately the question shall be answered if the Laffer curve is suited to increase the total tax revenue by cutting tax rates.

1.2 Structure

This assignment will first discuss the theory behind the Laffer curve, followed by the explanation of elasticity. Afterwards it will show the influence of elasticity regarding the behaviour of people in terms of willingness to pay taxes and what might happen when tax rates are reduced supposing different scenarios and basic conditions. Those theoretical scenarios mapped out will then be compared to case studies that will discuss different occasions the Laffer curve and the theory behind it has been applied in real-life.

2. The Laffer-curve

“It has been said that the virtue of the Laffer curve is that you can explain it to a congressman in half an hour and he can talk about it for six months.”[2]

This short sentence nicely describes how the Laffer curve and the theory behind it is seen by a lot of economists. Nevertheless was it applied in real-life several times. The most prominent users were Margaret Thatcher and Ronald Reagan in the 80’s. The economic policy in the US using the Laffer curve as fundament was even called Reagonomics.

2.1 The theory behind the graph

The Laffer curve is a very simple visualization of the dependency of tax rate and tax revenue or government revenue as called in figure 1. Obviously there are two fixed points at 0% and 100% tax rates were the according revenue would be Zero. If there is no tax imposed – as with 0% tax rate – there cannot be any revenue. In the other case – tax rate at 100% - no one would work or buy something. Economy would come to a full stop and there would not be any revenue either.

illustration not visible in this excerpt

Figure 1: The Laffer-curve (Source: https://en.wikipedia.org/wiki/File:Laffer-Curve.svg.); Modified by Alexander Grimm

Laffer imposes that those two points on the tax rate-axis are connected with a curve lying on the positive side of the government revenue-axis of the graph. Like at all curves there is a maximum point that describes the point where the tax revenue would be as high as it could get. This point is related to a point on the tax rate-axis that shows the according tax rate (t*) to realize this maximum tax revenue.

Looking at the graph it is easy to understand that a tax cut can only lead to a higher tax revenue as long as the actual tax rate is on the right side of t*. Meaning that the point of maximum revenue has been overstepped and the tax revenue is therefore decreasing.

So in summary, the theory is, that if it is known on what side of the maximizing tax rate the actual tax rate lies, it is possible to determine if a tax cut would increase tax revenue and that a tax cut in this case would always lead to a growth of the tax revenue. This is also shown in Figure 2 which is visualizing this logic by showing that if the tax rate is at T4, as shown in the right graph, the corresponding tax revenue D, shown in the left graph as the red area, can be increased by lowering the tax rate to T3 actually generating a higher revenue represented by the light blue area C on the left side. This growth can be interpreted as the growth in the demand to pay taxes. So while at tax rate T4 only the number at Q4** tax payers were willing to pay taxes, the number of them has increased at tax rate T3 to the quantity Q3**. At tax rate T3 the tax revenue is maximized.

illustration not visible in this excerpt

Figure 2: Derivation of Laffer curve (Becsi, 2000) ; Modified by Alexander Grimm

The Laffer curve is therefore nothing more than an assumed demand curve picturing the willingness to pay taxes. This willingness depends on countless factors and is measured as what is known as elasticity.

2.2 Elasticity

As mentioned in the previous chapter the increase of the willingness to pay taxes is key to the success of the theory behind the Laffer curve. This increase depends on the behaviour of the potential tax payers. This is where elasticity comes in to effect as it is a measure for the magnitude of reactions. Therefore this chapter will explain elasticity.

Elasticity describes the behaviour of consumers or sellers depending on factors like price or income. In short, the more sensitive consumers or sellers react to a change in price or a change in quantity, the more elastic they behave. The less they react, the more inelastic they are.

The formula to calculate elasticity is therefore a mathematical expression of the dependency of the change in quantity and change in price.

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Obviously there are different elasticities[3]. The following list shows the price elasticities:

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The result of these formulas defines the elasticity. If it is >1, the demand or supply is considered to be elastic. If it is <1 it is inelastic. As shown in Figure 3 elasticity is controlling the shape of the demand line, respective supply line.

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Figure 3: Elasticity of demand and supply (part 1) (Source: http://econknowhow.blogspot.de/2011/08/word-of-day_13.html)

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Figure 4: Elasticity of demand and supply (part 2) (Source: http://econknowhow.blogspot.de/2011/08/word-of-day_13.html)

Now supposing that there is a demand to pay taxes and on the other hand a supply in form of an actual tax rate it is possible to transfer the logic of elasticity by simply replacing price with tax rate and quantity with taxable base (number of tax payers x individual taxable base).

2.3 Taxes and elasticity

Now going back to the Laffer curve, there obviously have to be three cases of elasticity along the curve. The first case is an inelastic demand, meaning tax payers are not reacting too much to a change of the tax rate. As Figure 5 and the calculation beside it shows, is in this case the tax revenue increasing with the increase of the tax.

For case t0 * x0 the area that represents the tax revenue = 49 squares.

For case t1 * x1 the area that represents the tax revenue = 60 squares.

Result: Higher tax rate = Higher tax revenue

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Figure 5: Inelastic demand and rising revenue

The other case is an elastic demand that would represent the right side of Laffer’s curve that shows a more significant reaction to changes in tax rate, resulting in a dropping tax revenue as shown in Figure 6 and according calculation.

For case t0 * x0 the area that represents the tax revenue = 49 squares.

For case t1 * x1 the area that represents the tax revenue = 32 squares.

Result: Higher tax rate = Lower tax revenue

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Figure 6: Elastic demand and dropping revenue

The third case is where the inelastic demand is transferring into an elastic demand. Here the elasticity describes a curve and at a certain switching point the value is exactly 1 as shown in Figure 7.

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Figure 7: Switching point from elastic to inelastic demand

According to Laffer’s logic, this switching point must represent the revenue maximizing point, meaning that this is the stage where tax revenue is at its highest possible level (compare Figure 1, page 2).

2.4 Inconsistencies within the Laffer curve

As already mentioned, the Laffer curve is one of the hottest discussed topics in economics as supply-side economists and Keynesian economics consistently become very emotional when arguing about it. Unfortunately there are no evidences neither for nor against the functionality of the Laffer curve.

However, there are several shortcomings and inconsistencies within the theory behind the curve. Going back to the previous chapter and looking closer at the elasticity curve in Figure 7 it is easy to understand that the basic shape of the elasticity curve is undeniable and at first glance supporting the Laffer curve. But Figure 8 will show a possible course of elasticity around the revenue maximizing tax rate with a remarkable effect on the overall theory.

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Figure 8: Possible elasticity around the switching point from elastic to inelastic demand

So now there are 2 tax rates t1 and t2 that would maximize the revenue. And obviously there is nothing wrong in the argumentation. Line 1 is showing the inelastic demand, while Line 2 is showing the elastic demand before and after the switching point. Obviously the assumption that there would be only one point and therefore one tax rate that would maximize tax revenue is wrong. If this assumption is wrong there might be other things not fitting either.

The next point is that elasticities vary significantly depending e.g. on the income situation. While richer tax payers may decide way earlier to bypass taxes by leaving the country, not as rich people might have to stay. Most likely at a certain tax rate those people will move towards working illegally. But this decision, as well as the one of rich people to leave, is entirely subjective. How this behaviour is supposed to be calculated, so that a valuable proposition for an optimal tax rate could be made, is the secret of the supporters of the Laffer curve.

Varian[4] is adding another fact, as he was looking at the influence of the tax on the wages and the labour, supposing that the demand for labour will obviously decrease as soon as the wages go down due to a taxation on income. He is showing that in order for the Laffer effect to occur the elasticity of labour supply would need to be greater than 1. Considering that already existing estimates on labour-supply elasticities have never exceeded 0,2 he states that it seems unlikely that the Laffer effect would arise. At least not in countries with “normal” tax rates. However, Varian admits that the necessary elasticity of >1 might be reached in specific cases when the tax rate is extremely high.

Another point to consider is that if a tax rate is lowered with the aim of increasing the overall tax revenue it is mandatory that the economy is growing, which is most likely the case, if every other economy influencing factor stays the same. But this seems more than unlikely. Perhaps the chance for this could be calculated but this calculation will not be part of this work which will settle for having made aware of this crucial uncertainty.

Furthermore is it necessary to look at the expenditures that will almost certainly go up as soon as someone is forecasting higher tax revenues. Those increasing expenditures will not go unnoticed, not by the tax payers nor by the economy in its whole. So this will endanger the expected growth as well[5].

3. Case study: Reagan Tax Cuts in the early 1980s

The Tax cuts in the early 1980s performed by Ronald Reagan belongs to the major tax changes of the past century in the United States. In the literature a comprehensive discussion can be found whether this change raised tax revenue for the government or not.

The aim of the case study is to figure out if the theory of Laffer can be supported by the results of the Reagan tax cuts.

3.1 Background on Reagan Tax program

When Reagan became president in 1980 cutting taxes was a main part of his political program. Inspired by the theory of Laffer, he was convinced that the existing high tax rates discourage people from hard work. On the other hand he believed that lower taxes would allure people to work more. In consequence he expected a raise of the economy.[6]

The Reagan administration passed a sequence of tax bills from 1981 till 1984. The most important one was the Economic Recovery Tax Act (ERTA) of 1981. The ERTA contains a package of 9 major changes. The most important ones were[7]:

- phased-in 23% cut in individual tax rates; top rate dropped from 70% to 50%
- created 10% exclusion on income for two-earner married couples ($3,000 cap)
- allowed all working taxpayers to establish Individual retirement accounts (IRAs)

- expanded provisions for employee stock ownership plans

The ERTA passed the congress in summer 1981 and especially the cut of the individual tax rates resulted in a change of the tax revenues latest in 1982. But also the other measures of ERTA and the passed bills of the following years influenced the revenues of the government. In consequence the effect of each measure cannot be purely assigned.

3.2 Methodology

To find out if the model of the Laffer curve could be applied to the Reagan tax program, the study will focus on the individual tax rates and the effect on the government tax revenue. As mentioned the ERTA and the following tax programs launched a lot of measures which had also influenced the tax revenue. To find out if there might exist a parallelism to the Laffer curve, the following study simplified the presumptions and excludes side effects like IRAs. Due to the fact, that in the U.S. was no flat tax in place, different income classes might react in a diverse behaviour. Lindsey (1987)[8] separated the taxpayers into 12 income groups which were clustered in 4 following main groups:

- Group 1: Taxpayers with an income of more than $200.000 p.a.
- Group 2: Taxpayers with an income of $50.000 till $200.000 p.a.
- Group 3: Taxpayers with an income of $30.000 till $50.000 p.a.
- Group 4: Taxpayers with an income below $30.000 p.a.

Lindsey provided the following data for income groups per year 1980 till 1984:

- Predicted Tax payments if the old tax model would remain (Ol)
- Predicted Tax payments with the new model (Nl)
- % cut of taxes
- Actual Tax payments (At)

This data and informations were used, aggregated and modified for the study. In the first part of the analysis the yearly effect from 1980 till 1984 for each income group was examined. Therefore the ratio between Actual Tax payments (At) and predicted tax payments according the old model (Ol) was chosen as a key indicator for each income cluster to figure out how the taxpayer group behaves after the tax cut in comparison to the old model.

To find out if this behaviour could be mapped to the picture of a Laffer curve. The values (Ol) with the tax rate before the cut and (At) with the actual tax rate were taken for each income group in the year 1984. To get an indication what the government would have received as revenue before and the real revenue after cutting the taxes for each group. The result of the calculation was transformed in a graph with the Laffer curve shape, meaning an X/Y graph with Tax rate (x) and Tax revenue (Y). The axle arm inclinations between the different income groups were afterwards compared with the Laffer curve trend.

In the second part the analysis focuses on the elasticity of the different income groups. Average figures for elasticity could be taken out of the Lindsey’s study for income levels of 50, 100, 250 thousand and 1 Million$. Combined with the results of the first part of the analysis these elasticity values will be used to find out whether the theory described in Chapter 2.3. is supported.

3.3 Results of income groups analysis

Table 1 shows the key data for the income groups and the sum of all taxpayers distributed over the years 1980 till 84. In the first row of each year the value of tax income is shown predicted for the year if the old law (Ol) would have been in place. Followed by the predicted value for the new tax system (Nl). The next rows show the %Tax cut and the %Tax rate. The actual tax (At) figures out what the real revenue in the specific group has been.

The last value ratio of actual and old law shows the difference between expected with the old law and the real one. This key indicator is highlighted in the figure 8 for all income groups added by the red graph of the average % tax cuts for all income groups. In the years 1980 and 1981 only small movements of the key factor could be recognized. ERTA passed the congress in summer 1981 so the %tax cuts and the expected effects were incisive. In 1982 a tax cut of 14,2% in average leads to a slight increase of 2,6% for the top income group with more than $200.000. For the other groups a significant minus from about 10 to 13% could be recognized. In the following year the tax cuts reached a level of 21,9% in average. For the groups 2, 3 and 4 the minus trend got nearly doubled. On the other side the group 1continous the positive increase very clearly to 9,4%. In the last year of the view 1984 the average %tax cuts ends with a percentage of -25%. In this year the gap between the top earner group and the rest reaches an extreme level with a positive value of 23,5% for group 1 and negative percentage of 29,5% for group 4. The comparison of income groups below $200.000 after implementation of the new tax system shows the less income and the higher the tax cuts the less revenue was received.

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Table 1: Tax payments by taxpayer groups 1980 – 1984. Lindsey (1987) adapted by Wolfram Stiasny

As an overall result a polar opposite behaviour between the top income group above $200.000 and the rest could be identified after cutting of taxes.

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Figure 9: % Difference between Actual tax (At) and old law predicted tax (Ol) with % Tax cut average for 1980-1984

The values absolute tax rate before and after the tax cuts and the according values for tax revenue for old and new tax system for each group in the year 1984 transformed in a graph are shown in figure 9. Income groups 1 – 3 follow a decreasing revenue trend after tax cuts and could be assigned to the left axle of the theoretical Laffer curve. The top earner group with more than $200.000 income present an increasing gradient, which fits more to the right axle of the Laffer curve.

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Table 2: Average Elasticity out of Lindsey (1987)

The average elasticity values for the according incomes in Table 2 were taken out of study of Lindsey[9] evaluated for the period of the tax cut. For an income of $50.000 the elasticity was calculated with 0,725. This value raises continuously with the income up to more than 2 for an income of a million dollars. Mapping these values with figure 3 of the theoretical part of this document leads to the elasticities shown in figure 10.

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Figure 10: „Laffer curve“ axle arms of income groups 1984

For taxpayers with an income of more than $100.000 p.a. the curve can described as relatively elastic. Lowering the price (tax) will lead to a greater demand (tax revenue). The income group around $100.000 might participate with a nearly proportional effect on tax revenue with a new tax model. The prediction for people with a taxable income below $100.000 might react relatively inelastic to tax cuts. Figure 11 shows these elasticities per income group.

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Figure 11: Elasticities of Incomes applied on the US taxpayers subject to tax cuts

3.4 Conclusion of the case study

There are studies which considers the cutting of taxes initiated by the Reagan administration as successful. For example Tempalski[10] or the Heritage Foundation[11] came to the conclusion that the new tax model has led to more revenue. On the other hand a lot of literature can be found declaring the tax cuts as not successful. For example Dadkah (2009)[12] expresses that the tax collection of the government fell from more than 19% of the Gross domestic product in 1981 to 17% in 1984. And also Mankiw (2004)[13] came to the conclusion that tax revenues decreases after the ERTA measures.

Beside this discussion the data out of a study from Lindsey (1987)[14] were used to find evidences whether the theory of the Laffer curve could be applied to the ERTA or not. Meaning if the taxpayers react like the Laffer curve predicts. According to the beliefs of Ronald Reagan the tax rates were too high, so his expectation was a cut of tax rates would lead to an increasing revenue for the government and raise the economy. Regarding the outcome of this study the expectations of Reagan were not met for the sum of all taxpayers. But a deep dive into the figures

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Figure 12: Laffer Curve „Correct“ and „Wrong Side“ Gruber (2011)

showed that different income groups react with diverse behaviour to the tax cuts. Taxpayers were clustered in 4 income groups. The tax cuts for all groups below the >$200.000 one react with a decrease only the top earner group with an increase of revenue. Regarding the position of the axles in a Laffer curve diagram the income groups till $200.000 would be on the left and the top income group on the right. Gruber (2011)[15] described the left side of the Laffer curve as the “correct side”. On this axle arm raising taxes would lead to increasing revenues and on the “wrong side” to decreasing revenues (see figure 11). To optimize the revenue tax rates on the “wrong side” should be cut to push revenue. The results of the study showed, that income groups 1, 2 and 3 were already on the correct side. In consequence the fall of taxes caused less revenue. Only the top income cluster above $200.000 was on the “wrong side” and caused a plus in tax revenue. This leads to the conclusion, that the Reagan administration got wrong assumptions. They probably thought that all income groups were on the “wrong side” and did not recognize that only the top earners were placed there. Furthermore the elasticity values shows that people with an income above $100.000 could react relatively elastic to changes of tax rates. Means in case of increasing tax rates they might be in the position to leave the country or find other solution to bypass money from the tax system. This leads also to leak of revenue in case of increasing taxes. On the other hand the willingness to pay taxes raises with falling taxes. An optimized measure from the Reagan administration to push tax revenue could have been a cut only for a group of people with an income above about $100.000 and no changes or a slight increase of taxes for the rest of the tax payers.

Finally it should be mentioned that tax systems in most countries are very complex. There are a lot of factors influencing tax rates and revenue for different groups of people and it is difficult to break down all the parameters to a simple Laffer curve. But even so, there is little evidence out of this study that the Laffer effect occurs after the tax cuts of the Reagan administration. Unfortunately the result of the effect was not fully the expected one, due to wrong assumption regarding the starting point on the Laffer curve for most of the income groups.

[...]


[1] (The Laffer Center, 2011)

[2] (Varian, 1999)

[3] (Varian, 1999)

[4] (Varian, 1999, pp. 280-282)

[5] (Becsi, 2000)

[6] Mankiv. Principles of economics 2004. p.170

[7] Tempalski, Revenue effects of major tax bills 2006, p. 12

[8] Lindsey. Individual Taxpayer Response to Tax Cuts 1982-1984 with Implications for the Revenue Maximizing 1987

[9] Lindsey. Individual Taxpayer Response to Tax Cuts 1982-1984 with Implications for the Revenue Maximizing 1987 p. 43

[10] Tempalski, Revenue effects of major tax bills 2006,

[11] The Heritage Foundation, 2004

[12] Dadkah, K. The evolution of macroeconomic theory and policy. 2009. p. 227

[13] Mankiv. Principles of economics 2004. p.170f

[14] Lindsey. Individual Taxpayer Response to Tax Cuts 1982-1984 with Implications for the Revenue Maximizing 1987

[15] Gruber, J. Public finance and public policy 2011

Details

Seiten
38
Jahr
2014
ISBN (eBook)
9783668751644
ISBN (Buch)
9783668751651
Dateigröße
1.5 MB
Sprache
Englisch
Katalognummer
v432952
Institution / Hochschule
FOM Hochschule für Oekonomie & Management gemeinnützige GmbH, Nürnberg früher Fachhochschule
Note
Schlagworte
Laffer curve tax cuts tobacco tax programm Zigarettensteuer theory

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Titel: The Laffer curve. Can cuts in tax rates increase the total tax revenue for the government?