What Does “The Laffer Curve” Say is the Best Tax Rate?

Interview with Arthur Laffer

In this interview, economist and author Dr. Arthur Laffer, who created the “Laffer Curve,” discusses the relationship between taxes and government revenues. Find out why higher taxes don’t always generate more income for the government.

Douglas Goldstein: I'm very excited to be talking to Dr. Arthur Laffer. He is an economist who triggered a worldwide tax-cutting movement in the 1980s. For those of us who like low taxes, I guess we have Dr. Laffer to thank. Is that right, Dr. Laffer?

Arthur Laffer: I don't know if you do or not but I loved it. It was wonderful and I enjoyed working the tax and creating prosperity the world over- it was really fun.

Does The Laffer Curve Make Any Sense?

Douglas Goldstein: From time to time, there are people who say this just doesn't make sense. They talk about your Laffer Curve and then they start laughing. They wonder how it is that if you take in less money by cutting taxes, you're supposed to make more money. Is there any logic in what you're talking about?

Arthur Laffer: Yes, there is. They're conflating tax rates with tax revenues. Very seriously, at a zero tax rate you're not going to collect any money. If no taxes are collected on any income, there won't be any revenue collected. At 100% tax rate or even higher, if every time you went to the office instead of getting a check you got a bill, sooner or later everyone would quit working. There would be no tax revenues either.

There are these two points where you have zero tax revenues. As you raise tax rates from a zero tax rate, you're going to start collecting more and more revenues. But as you lower them from 100% you're going to collect more and more revenues. There's some point somewhere in the middle where you get the maximum amount of revenues, and that's the Laffer curve. This relates tax rates to total revenues, which is really what you need to do. There is no logic of relating tax rates directly to revenues. If you increase tax rates by 10%, I guarantee that you will not get 10% more revenue.

Douglas Goldstein: When you said, 'Look in the middle, and you'll see a point where they maximize revenues,' you weren't not referring to a 50% tax are you?

Arthur Laffer: No. There doesn't have to be anything in there. It can be very high at 80%, or very low at 20%. It might be 50%, but that's only under specific circumstances. It depends very much on the time horizon you're looking at. The shorter the time horizon, the higher that rate will be; the longer the time horizon, the lower that rate will be. It depends on a lot of other things, but it's a pedagogic device that explains to politicians that there are two effects - tax rates have revenues. One is the amount of tax you collect per dollar of tax base; that's the tax rate. There's also the economic effect, that is, when you raise the tax rates you reduce the tax base.

Arthur Laffer: No. There doesn't have to be anything in there. It can be very high at 80%, or very low at 20%. It might be 50%, but that's only under specific circumstances. It depends very much on the time horizon you're looking at. The shorter the time horizon, the higher that rate will be; the longer the time horizon, the lower that rate will be. It depends on a lot of other things, but it's a pedagogic device that explains to politicians that there are two effects - tax rates have revenues. One is the amount of tax you collect per dollar of tax base; that's the tax rate. There's also the economic effect, that is, when you raise the tax rates you reduce the tax base.

These two effects always work in the opposite direction. For example, a business can overprice its product and lose money, or underprice its product and lose money. But there's a certain price in there where it makes profits and probably where it even maximizes profit.

Douglas Goldstein: With the Laffer Curve, you're not proposing a specific tax rate. You are simply defining the fact that at zero percent tax, the government makes zero, but if it's 100% tax the government will probably make zero because no one will want to work. There is simply a point that may change depending on a variety of factors, at which the government could maximize its revenue, presuming that is its actual goal.

Arthur Laffer: Also, when you change tax rates, let's say if you raise tax rates, you're not going to collect that much more in revenue. You might even lose revenue depending on where the tax rate is. It gives you a different way of looking at tax rates and the correct way to look at them.

Can The Laffer Number Be Determined?

Douglas Goldstein: How would the politicians or the leaders of any country, who always have the people's best interest at heart, know what that magic Laffer number is?

Arthur Laffer: They don't, but they can know how to get there. For example, the larger the tax base and the lower the rate, the more likely it is that an increase in the rates will raise revenues. The narrower the tax base, the higher the rate, and the less likely it is that an increase will raise revenues. What you never want to have is a low base, high-rate tax, which is what we have on debt taxes in the U.S. We have that in the corporate profit sector, which is the exact place where we don't want to have high tax rates. Social security tax is a very broad-base tax with few exceptions. With those, you can have higher rates and still collect more money, but it gives you a framework of how to design a tax code that actually works.

Douglas Goldstein: Is all this theoretical? The United States has a progressive tax model that presumably, the more you earn, the higher the rate you're going to pay. However, on the curve, you're not really showing that. Are you referring to an average tax or is it ideally a flat income tax?

Arthur Laffer: No. It should be at all rates. If you're looking for revenues, the one tax you should not raise is the highest rate. That has the greatest distance center of effect and these people have all the resources to evade, avoid, and otherwise not report taxable income. Whenever the U.S. has raised the highest tax rate, revenue from the top 1% of income earners has declined. Every time they've cut the highest tax rate, tax revenue from the top 1% of income earners has assured GDP of it gone up. That's exactly what the principles of the curve show you. If you want to get revenues, you don't raise tax rates on the highest income earners.

The Issue of Fairness

Douglas Goldstein: You talk about not raising taxes for the people who earn the most. What about the question of fairness? Don't you think that these people should pay their fair share?

Arthur Laffer: Maybe, but if you don't get it, it's not a fair share, is it? Rich people have all sorts of things available to them. They have the wealth to hire lawyers, accountants, and deferred income specialists. They also have enough wealth to hire congressmen, senators, presidents, labor grabbers, and all these other people. They also have all sorts of ways of getting around taxes. They can change the location or the timing of their income. They can change the volume or the composition of their income. They are the single group in the society that is the most adept at changing the tax bills they pay, given a change in tax rates. They are highly sensitive to tax rates and you just aren't going to get their money. If you get their money, you can cause the economy to collapse in the aftermath.

Douglas Goldstein: Except in extenuating circumstances like a war?

Arthur Laffer: Sometimes, for a very short period of time -

Douglas Goldstein: But in the short term, you can take people's money?

Arthur Laffer: Yes. Short term and with certain circumstances; extenuating circumstances. During the war, rich people paid a lot of taxes. They were very willing to do it because they had the money. But during normal times, Warren Buffett pays about 6/100 th of 1% of his income in taxes, all legal. He doesn't pay taxes on increases in unrealized capital gains or on gifts to his children's foundations, and I could go on. He uses every legal loophole there is and pays only about $7 million in taxes and yet, his income was about $12 billion in 2010.

Douglas Goldstein: Does that income include capital gains?

Arthur Laffer: Yes. He didn't pay any taxes on unrealized capital gains.

Douglas Goldstein: That's not really income. That's growth -

Arthur Laffer: Income is a change in wealth. It's also what you spend plus what you give away. That's the definition of income.

Douglas Goldstein: I'm not familiar with any governments that tax unrealized capital gains.

Arthur Laffer: No, but the unrealized capital gains is exactly one of those loopholes. What you should do on a comprehensive tax is tax a person's spending on goods and services, on passing it on in gifts, and also on the increase in that person's wealth. That is your real income. That's the correct one to tax. Otherwise you'll do what he does. He owns all of his stocks under the shield of Berkshire Hathaway. Berkshire Hathaway will buy and sell stocks, but he won't buy and sell Berkshire Hathaway. Therefore, all of his wealth in Berkshire Hathaway has never been taxed, and it makes him a very powerful man.

And all the others do it too. The top 400 wealthiest people.

Douglas Goldstein: Guys like you and me are doing okay too. We have investment companies. We give a few speeches, write a few books. When they raise taxes, I just bend over and pay.

Arthur Laffer: I'll bet you use a lot more than you really imagined. Do you own your own company?

Douglas Goldstein: I do.

Arthur Laffer: Can you employ your kids and do other stuff like that? When you do all the stuff there with the company, you can define benefit plans. You can describe things and make them so they fit you very well. You can change your tax burden substantially by manipulating the tax codes and tax regulations. I moved from California to Tennessee for one very simple reason - there is no income tax or debt tax in Tennessee.

I bought my house in Belle Meade with my first year's tax savings. I can change the location where I've earned my income and the composition and timing of my income. I can choose when I pay myself and when I don't.

Before the Obama tax increases went into effect, I had a huge bonus that I paid myself from the firm. I had borrowed a lot of debt, and then the next year I didn't pay myself any income. Perfectly legal. I was able to shift the tax burden dramatically by changing the timing of my income.

Do you pay taxes in New York?

Douglas Goldstein: I'm based in Israel, so no.

Arthur Laffer: If you were based in New York, I would suggest you move to Florida.

Why Doesn't Everyone Just Move To No Income States?

Douglas Goldstein: Why don't all the people move to the 'no income tax states'?

Arthur Laffer: They do. I show that they do in my book, An Inquiry into the Nature and Causes of the Wealth of States. Rex Sinquefield and I did that book together. We show the migration patterns. The nine states with no income tax in the U.S. way outperform the nine states with the highest income tax rates. They do this both in population growth, migration, real growth state product, and also in tax revenue.

Douglas Goldstein: How do these states pay for teachers and nurses, etc.?

Arthur Laffer: They have property and sales taxes, but they also don't have as many unemployed people. These states are fast growing and have lots of jobs, so they don't need the welfare. Their schools are far better too. I have a big chapter in my one book comparing Texas with California. It's amazing how much better run Texas is than California. It has better education and less welfare. They have a corporate tax, but they have no personal income taxes.

Douglas Goldstein: What about oil? Isn't that the bottom line with Texas?

Arthur Laffer: They do get a little bit of money from oil, but not as much. The reason California doesn't get its money from oil is they prohibit fracking. They prohibit drilling. It's amazing how little revenue you can get from something you prohibit.

Douglas Goldstein: That will stop it; I guess that's why.

Should Taxes Be Lowered All The Time?

Douglas Goldstein: This has been a very macroeconomic discussion and hopefully all the politicians are listening and getting some good advice. I'm certainly for lower taxes. Are you saying, though, that lowering taxes all the time is the right thing to do? Or are you rather saying that there is a sweet spot in the Laffer Curve where taxes can maximize government revenue?

Arthur Laffer: We tax speeders to get them to stop speeding. We tax smokers to get them to stop smoking. Why do we tax people who earn income? Why do we tax people who employ other people? Why do we tax companies that make great products at low costs and have a lot of profits? We don't do that to get them to earn less, to employ less, and to have less profits. We do it to collect the money.

What you need to do is collect your taxes in the least damaging fashion and spend the proceeds in the most beneficial fashion. Rich people are the greatest people on earth and pay for all sorts of public services. You don't want to make them the enemies. You want to take them out to dinner at night and send them birthday cards. If you make them the enemies, they have the resources to really do you under.

Douglas Goldstein: Hopefully with a new administration, we'll see a lot of great changes in the economy.

Arthur Laffer: Let's hope.

Douglas Goldstein: How can people follow you and your work?

Arthur Laffer: Anyone can get me at drlaffer@laffer.com if anyone wants to contact me for books or anything else. I don't do Twitter or any of that stuff, sorry.

Douglas Goldstein: We will put a link to that and we'll also put a link to some of your books at the show notes of the show. We'll speak to you again soon.

Arthur Laffer: Thanks, Doug.