Wednesday, November 26, 2008

Laughing at Curves

The Laffer Curve is an economic theory drawn on a cocktail napkin many years ago. It has to do with income tax rates and government revenue and it says, basically, that raising rates provides a disincentive to make money and therefore actually reduces the amount of money that the government takes in. People, and businesses, decide that if most of the additional amount that they earn is going to be eaten up by tax, then they will just not bother to earn it.

It’s an interesting theory even though, while I have heard many people complain about taxes, I have never seen anyone decline a raise or tell a client, “I don’t want any more money.”

Let’s say you are Joe the Plumber. Do you remember Joe, of 2008 election fame? He supposedly was making $280,000 per year. (Actually, he was making less than $40K and owed some back taxes, but…)

He was concerned about the tax increase that Barack Obama was proposing; an increase of the 36% rate to 39%. So let’s explore the incentive effect of that tax increase.

The first $200,000 is unaffected, so the increase is on $80,000 and the amount of the increase is 3%, which comes to $2400 per year. Just for reference purposes, that is a bit less than 1% of his overall tax bill. Also for discussion the increase changes the amount that Joe keeps out of that $80K from $51,200 to $48,800.

What is Joe’s incentive, then, to go ahead and make that additional $80,000, and to what degree did the tax increase change that incentive? If Joe can’t keep, in round numbers, $51K then is he going to spurn $50K? Really? I mean, $48,800 will buy quite a lot of nice things.

And if he doesn't want that $48,800, he can give it to me.

Supporters of the Laffer Curve use the Reagan tax cuts and the concurrent economy as proof that tax cuts cause the economy to boom and tax revenues to increase. (They conveniently ignore the last round of Bush tax cuts.) Their theory is that if two things happen at one time then one thing therefor caused the other thing. Ipso facto. They get to pick which was cause and which was effect.

Okay, temperature rises after the sun comes up. Was the temperature increase caused by the sun coming up? Well, in fact it turns out it was. Here's another one. Car crashes are much more numerous when the sun is in the sky than when it is not. Are car crashes caused by the sun being in the sky? No. The sun being in the sky is coincidental to there being more cars on the freaking road, which is the cause of the increase in car crashes.

Another thing drawn on a cocktail napkin was the scoring system for stock car racing, and it works about as well as the Laffer Curve. It is universally unpopular with fans, and NASCAR refuses to change it.

The moral of this story is beware of plans drawn on cocktail napkins.

1 comment:

  1. Hmmm, I know someone who once had a VW bus to sell and had planned on selling at price X. A young adult/teenager came to look at it, really liked it, but thought they couldn't afford said price, so off they went to look at a few more VW buses. Later they called to see if the first bus they had seen had been sold yet, as it turned out to be the one in the best body and engine shape. It was still for sale so they came back to buy it from the seller. The seller was then concerned about the buyer spending more money than he could really afford, so the seller dropped the price, even though the buyer was willing to pay the original price of X. The buyer then kept bidding the price up, while the seller kept bidding the price down. It can happen, but I think there are about only two in the world that I know of who would do such a thing. Want to guess who they are? Or why I am related to teh second one for only part of my life and the first one for all of my life?