Thursday, May 25, 2006

The Productivity Curve

The debate about whether we are undertaxed or overtaxed as been raging for decades, and I doubt that I am going to solve it here, but I am going to pour some more fuel on the fire.

The mathematics of economics and tax policy is not an exact science. Any model is bound to be overly simplistic and not take all factors into account. That being said, there are important principles which can be distilled from a mathematical analysis of tax policy.

The Laffer Curve is a concept promoted by economist Arthur Laffer, which shows the relationship between tax rates and tax revenues. It is not intended to be an exact function relating tax revenues to a single variable, but rather, it shows that increasing tax rates does not always increase tax revenues.

We know that the value of the Laffer Curve is zero at 0% taxation, and we also know that it is zero at 100% taxation. There is not an exact value of the Laffer Curve for all points in between. The tax revenues generated are a function of countless interrelated variables, and tax rate is just one of those determining factors.

While we do not know the exact value of the Laffer Curve, we do know a lot about its shape and properties. It is an arch, skewed towards the lower tax rates. The partial derivative of the Laffer Curve with respect to tax rate is fairly well behaved. In English, this means that if you hold all other factors constant, there is a predictable change in tax revenues resulting from a small change in tax rate. In the example above, a 33% tax rate generates the greatest tax revenues. If the current tax rate is 33%, any change would result in a decrease in tax revenues. If the current tax rate was less than 33%, a small tax increase would increase tax revenues. If the current tax rate was more than 33%, a small tax cut would increase tax revenues.

Remember that the Laffer Curve is not precisely known. In reality, instead of being a single line, it is a band with some thickness, to account for the other factors which affect tax revenues. Instead of having a distinct peak, there is a range which contains the peak, but the precise location of the peak can not be determined because of all of the other factors which affect tax revenues.

There is reason to believe that our current tax rates are close to the peak of the Laffer Curve. This means that Republicans have been successful at achieving their goal of implementing a supply-side economic policy. Democrats argue for a tax rate higher than the rate which maximizes tax revenues. They take this position for reasons that I will go into later.

Republicans have argued for years that tax revenues can be increased by cutting tax rates. This argument was made by President Kennedy when he reduced the top marginal tax rate from 90%, and it was made by President Reagan and President Bush. It has proven to be true in every case. However, I claim that maximizing tax revenues is the wrong goal. Only if you want bigger government and more government and you believe that it is better for the government to spend your money rather than you spending your money should you try to maximize tax revenues. If you recognize that government is too big, too intrusive, and too unproductive, your goal should be to reduce tax revenues and increase private sector productivity.

I suggest that instead of attempting to maximize tax revenues, we should instead maximize productivity. A second curve can be derived directly from the Laffer Curve. I’ll call this the productivity curve. It predicts the relationship between tax rates and productivity of the nation’s economy. It is mathematically certain that the productivity curve peaks at a lower tax rate than the Laffer Curve. For the Laffer Curve to peak, the productivity curve must be sloping steeply downward, indicating that it is past its peak. The standard of living of the country is determined not by tax revenues, but by the production of the economy. Prosperity does not come from the government; it comes from the private sector. If we maximize productivity instead of tax revenues, we will increase our national standard of living.

Recognize that the chart above represents the results in a single year. The long-term results look even better for the maximized productivity tax rate. Economic growth is directly related to productivity, maximizing productivity in the current year also increases economic growth for future years because it results in greater reinvestment in the economy. The longer the term you consider, the better the maximized productivity tax rates look. In fact, if you look long term, more tax revenues will be generated by maximizing productivity than by maximizing current tax revenues.

Considering that it is mathematically certain that our nation would be more prosperous if we maximized productivity rather than tax revenues, why have we spent decades chasing after the wrong goal? Primarily it is because we have let the politicians frame the debate. Republicans have argued for a tax policy designed to maximize tax revenues, while claiming to be the party for smaller government. Democrats have taken an even more incomprehensible position, seeking tax rates higher than the rates which maximize revenues. This increases the power of the government, which means that it increases their own power. The further to the right you go on this graph, the larger the share of the economy that the government controls. Liberals believe that government control of the economy is a good thing. This is clearly a self-serving belief for the politicians, but they convince their constituents to buy into that belief by demonizing corporations and business and portraying government as the solution to every problem. By being further to the right on this graph, they give themselves more leverage to buy votes with government money and services, justified in the name of equality.

Neither approach serves the best interests of our nation. Democrats will say that cutting taxes will benefit the rich and increase the gap between the “haves” and the “have-nots”. The reality is that an increase in the prosperity of the country creates more opportunity for anyone to achieve success and share in the prosperity. Democrats don’t like this because it means that they are not the ones providing the wealth redistribution. Government can only transfer wealth. It can not create it. The private sector creates wealth. Government tries to impose equality by changing the way that the “pie” is divided up. The private sector bakes a bigger pie so that everyone can have more without taking it away from someone else. If you prefer the government’s approach, by all means maximize tax revenues. On the other hand, if you prefer unlimited opportunity to equality of outcome, it is time to make major changes to the way we set our tax policy.

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