The Laffer Curve and Kansas

What is the matter with Kansas? After several years of budget crisis, they are finally admitting—in a dramatic fashion—that cutting taxes maybe contributed to the state budget deficit. The argument for cutting taxes in the first place hinged on an arcane bit of economic theory called the Laffer Curve. Named for Reagan’s economic adviser, the Laffer Curve asserts that under certain circumstances, lower taxes can actually allow the government to make more money.

The Laffer curve is not as crazy as reports make it sound—though it isn’t exactly the most urgent model either. The idea is that the higher the tax rate, the less people buy because it drives up the final cost; the higher the price of pizza the less you buy. Presumably, consumers don’t care very much if the price reflects tax, profit, or business expenses. That means the tax base, the amount of money that can be taxed, is shrinking. At the same time, the higher tax rate means that the amount of the tax base that becomes tax is higher.

This tug-of-war between a shrinking tax base and a growing tax rate doesn’t play out in any general way; there is no rule for when one might expect one to outweigh the other. With that said, let’s take a pretty standard supply and demand graph like you might find in an introductory textbook. You would expect to find two straight lines, one sloping up and one sloping down. The numbers* I assumed are purely fiction, chosen for their mathematical form and not based on Kansas data. Nonetheless, they illustrate the essential problem to a good approximation. Graphing the amount of revenue the government earns versus the tax rate gives you this chart:

Laffer Curve.png

Notice that until the tax rate is a whopping 200% the government makes more money for raising taxes. 200% isn’t an unusual number to get for the turnaround point on the Laffer Curve for a broad range of assumptions, though I must note it is possible to contrive models that put it near Kansas’s tax rate. Nonetheless, for a number of completely standard assumptions, the warning of the Laffer Curve is that if you lower taxes, the government will make less money.

Why did Governor Brownback fall for something freshmen getting econ degrees could have computed as wrong? I suspect it is wishful thinking. The analysis that Brownback relied on was sophisticated, and had an additional supposition that the low tax rate would draw businesses into the state. (They never came.) There is something appealing to my contrarian nature about the idea that taxes going up makes revenue go down, and I bet that would be stronger if I were conservative. It’s also possible—though I can only speculate—that Brownback just doesn’t care if revenue falls.

Trump’s budget makes the same kinds of claims, that if we cut taxes, GDP will roar. Conservatives in particular like to talk about the States as “laboratories of Democracy”; it is one of the places I agree. The experiment succeeded in Kansas; under normal circumstances, cutting taxes leads to decreased revenue, not an increase.




*I used {S: p=q} and {D: p=10-q} in case anyone is dying to verify my work.

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s