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It's said that nothing in this world is certain except for death and taxes, and
while there seems to be general agreement on how to treat death, the debate over
taxes seems like an eternal struggle.
Let's apply some common sense to try to clarify part of this debate.
Let's first look at how government approaches taxes.
The static model shows that as tax rates increase,
tax revenue increases proportionately.
There's no change to behavior nor any real change to the economy,
but this flies in the face of the axiom that if you tax something you get less of it,
and there's also the truism that things can be taxed to death,
or what if you already have a tax in place?
If you tax something less, you'll get more of it.
You might even get so much more of it that you take in more tax--a tax cut that
pays for itself,
but anyway this curve will cross this line wherever you start, so the shape is
relative,
but we still have these two points.
No tax is collected at the zero percent tax rate just by definition, and no tax
is collected at a one hundred percent tax rate because whatever activity that
was being tax would have been taxed to death,
so there's some point in between where tax revenue is maximized. I'll just draw it here
for now,
and then there's some curve passing through these three points:
this is what is known as the Laffer curve.
Now for any particular tax this works pretty well,
but what if we want to talk about taxes on the entire economy and how tax rates
affect growth.
Well, our current tax code is really complicated,
and there'd be way too many assumptions involved in dealing with a basket of
different rates,
so, for the sake of simplicity in this discussion,
we may as well just throw it out for something like a flat sales tax.
Now a tax on consumption is as equally valid as a tax on production.
Consumption and production are just different sides of the same coin, but
there's a problem:
if we have a one hundred percent sales tax, you just double the price of
whatever you're buying to get the total bill,
so the merchant gets half,
and the government gets half, but that's a fifty percent rate according to our
other chart,
so we need to convert between a tax-inclusive rate and a tax-exclusive
rate.
Here's just how the conversion works using N for the inclusive rate and
X for the exclusive rate.
Something like a twenty percent income tax could be replaced by twenty-five
percent sales tax, and the conversion can be made the other way if needed.
So these relationships exist between the two systems.
But what would be the exclusive equivalent to a one hundred percent inclusive rate?
Using the formulas shows that the exclusive rate approaches infinity
percent
as the inclusive rate gets closer to one hundred percent,
but just plugging in the numbers produces some fuzzy math.
But anyway we now have this awesome tax-exclusive based Laffer curve,
but, hmm,
hey, for a curved based on only three points we seem to have lost one.
What if we look at just really high tax rates instead of this impossible
infinite rate?
Say I go to the dollar store and see this adorable honey badger plushie.
Ooh, fuzzy!
If the sales tax were infinite, it's sort of a non-starter so no honey badger
for me,
but how about a finite rate like one hundred octillion percent?
That's a one followed by twenty-nine zeros, but it is still finite, and
according to our conversion formulas is something like an inclusive rate of ninety-nine
point nine nine nine nine nine nine nine nine nine nine nine nine nine percent,
but I really must have the honey badger, so I whip out a *** of dollar bills
bigger than the earth to pay for it.
Okay, not really. The pallet of cash would probably proceed to smash and burn and
smother everyone on earth; not going to work.
How about ten trillion percent?
the total price of the honey badger would be over one hundred billion
dollars,
so not even someone like Warren Buffet could buy it.
So for all practical purposes this line doesn't extend on forever, so the curve
still has its three points, and this also spot checks the original Laffer curve;
there's some rate at least slightly less than one hundred percent where tax revenue
becomes zero.
But there's still this issue of me wanting this honey badger.
What if the tax rate were nine hundred percent?
One dollar would go to the store, and nine dollars would go to the government,
but I think I'd rather just go across the border to get ten honey badgers at
the same cost.
Hmm...
and that brings us back to the whole point of all this;
tax rates affect behavior. If tax rates are too high, people may leave the economy, or
go underground,
or they might not invest in something they ought because the risk stays the same
even as a reward gets taxed away.
All of these economic disruptions affect growth.
Remember, this tax-maximizing point is simply where tax revenue starts to fall.
There's a negative impact on growth before this point,
just not enough to cause revenue to drop.
And I don't think zero percent is the growth-maximizing rate
because anarchy doesn't seem very conducive to growth.
But if the growth-maximizing rate is less than the tax-maximizing rate, what
are we really looking at?
I mean, if the economy grows faster at a lower rate than at a higher rate,
eventually you'd be able to get more tax at the lower great if the economy had grown
sufficiently larger,
so here we're only really looking at a snapshot.
To better understand this let's set up an experiment.
Say we could pick just one tax rate to maximize revenue over the next ten years,
but we could pick a different rate if the time were to be expanded to twenty
years or thirty or so on.
Would they each be different?
Well, the longer time frame you have to work with,
the more growth becomes the major determining factor of how much tax can
be collected,
so this might be the curve for ten years this for twenty and so on. With longer and
longer intervals each tax-maximizing point moves closer and closer toward
the growth-maximizing rate. Since the growth-maximizing rate isn't zero, there will
also be an inflection point over on the left--this isn't the growth-maximizing
rate. The growth-maximizing rate will always be to the right of this
inflection point, and the inflection point will actually move toward the growth-
maximizing rate with more and more time. The higher growth rate stretches out
the curve, or, since we're scaling it, the growth essentially squeezes the
curve,
and eventually at a time infinitely out the curve just becomes a straight line.
But anyway we can take all these tax-maximizing points and plot them on a
curve--a curve of curves. Ten years out was maybe here. Twenty years was lower.
Thirty a bit lower. And there's a limit at the growth-maximizing rate.
So there's not just a Laffer curve;
there's a Laffer curve for every timeframe--
infinite Laffer curves.
So instead of asking "where are we on the laffer curve?" Ask
"which laffer curve are we on?"
That is, how far into the future are we concerned?
And if our curve based on three points turns out to change over time,
how about this other curve based on three points--
this underlying growth curve?
Does it shift or change or get squozen over time too?
Hmm...