How high can taxes go before the ‘Laffer effect’ kicks in?

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I was asked yesterday if it was true there was such a thing as the Laffer effect – that if taxes in the UK are increased then tax revenues would fall.

I replied that of course there is, very crudely a Laffer effect – if taxes ar 0% or 100% on all income then there’s no tax revenue. In between there are revenues, so in a sense there’s a Laffer curve. But that’s not the argument. The argument is whether or not we’re at the point where cutting taxes would raise revenues. Kevin Drum raised this on Mather Jones a week or two back, and in reply to my questioner I offer some of his commentary as explanation as to why the argument that cutting taxes would help raise revenue now is wrong:

Okay, this isn’t actually raw data. In fact, it’s very, very cooked and calculated data. But just so you know, Peter Diamond and Emmanuel Saez have tried to calculate the tax rate on the rich that would maximize revenue to the government. Paul Krugman summarises:

In the first part of the paper, D&S analyze the optimal tax rate on top earners. And they argue that this should be the rate that maximizes the revenue collected from these top earners—full stop. Why? Because if you’re trying to maximize any sort of aggregate welfare measure, it’s clear that a marginal dollar of income makes very little difference to the welfare of the wealthy, as compared with the difference it makes to the welfare of the poor and middle class. So to a first approximation policy should soak the rich for the maximum amount—not out of envy or a desire to punish, but simply to raise as much money as possible for other purposes.

Now, this doesn’t imply a 100% tax rate, because there are going to be behavioral responses—high earners will generate at least somewhat less taxable income in the face of a high tax rate, either by actually working less or by pushing their earnings
underground. Using parameters based on the literature, D&S suggest that the optimal tax rate on the highest earners is in the vicinity of 70%.


Actually, Krugman is being conservative here. If you assume a broad base and no deductions, Diamond and Saez peg the revenue maximizing rate for top earners at 76 percent. That’s for federal income tax only. (See page 173 here.)

You can decide for yourself if you think top marginal rates should be that high. After all, revenue maximization isn’t our only social goal. Roughly speaking, though, this is a calculation of the peak of the famous Laffer Curve. (For top earners, anyway.) Above 76 percent, you really can generate higher revenues by lowering tax rates. Below that, higher rates generate higher revenue, just like you’d think.

I but that: it accords with the world as I observe it.

So for all practical purposes the answer to the Laffer question of ‘will we increase taxes by cutting rates?’ is a simply and responding ‘No’.

NB Can’t remember who sent me the link – but thanks