Friday, February 11, 2011

Three examples on the Laffer Curve canard

One of the fundamental tenets of supply-side economics invokes the Laffer Curve to argue that we stand on the downward sloping side of the curve and therefore tax cuts will increase revenues. I have blogged earlier to show how it does not square up with recent historical experiences with tax cuts.

Chris Dillow points to three examples that show the economy on the positive (rising) side of the Laffer Curve.

1. Henrik Kleven, Emmanuel Saez and Camille Landais study the response of professional footballers in Europe to tax rates and conclude that the revenue-maximizing tax rate upon them in England is over 80%. This would easily put the current tax rate at the left of the Curve.

2. Orley C. Ashenfelter, Kirk B. Doran, and Bruce Schaller examined a panel dataset of New York City taxi drivers and the impact of permanent fare increases on their number of hours worked. They found a negative elasticity, of around minus 0.2 - a 10% rise in cabbies' revenue per mile caused them to work 2% less. This points to the income effect outweighing the substitution effect in the long run labor supply of males.

On similar lines, if what’s true of cabbies is also true of bankers, higher taxes on the rich will reduce their incomes. And if the income effect dominates, they will work harder to recoup the money. Chris Dillow also points to higher earners having a stronger taste for income than other people - this is why they are high earners. But this increases the chances of them working harder in response to higher taxes.

3. Pierre Cahuc and St├ęphane Carcillo examined the impact on labor supply of the detaxation of overtime hours (exemption on the income tax and social security contributions that applied to wages received for hours worked overtime) introduced in October 2007 to allow individuals in France to work more so as to earn more. They found that it was costly for the public purse and did not have any significant impact on hours worked.

Conversely, it has had a positive impact on the overtime hours declared by highly qualified wage-earners, who have opportunities to manipulate the overtime hours they declare in order to optimize their tax situation, since the hours they work are difficult to verify. This again confirms Dillow's point about higher earners having a stronger taste for income than other people.

I cannot but not agree with Chris Dillow's conclusion,

"Now, this is not to deny that Laffer curves exist. No doubt, there is a point at which higher taxes would be counter-productive and tax cuts would pay for themselves... But where is the hard evidence that, at tax rates around current levels, there are such effects?"

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