Wednesday, August 11, 2010

U.S and European tax policy, and misunderstanding the Laffer curve

Dylan Matthews on Ezra Klein's site writes an interesting article asking some economists what the revenue maximizing tax rate is.

The answer from the conventional wisdom of public-finance economics is about 60-70%. This is based on relying on current estimates of the short term estimates elasticity of taxable income, measured in micro-studies where different people get different tax changes. This is also what I have been taught. However as the work of Raj Chetty has shown, due to costs of adjusting to tax rate these comparisons probably underestimate the responsiveness to taxes. I think if Dylan Matthews asks the same question 10 years from now the answer will have changed somewhat.

What strikes me most however is the answer by Bruce Bartlett. At one point, Bartlett was on the right. But people occasionally change ideology. Currently Bartlett is best described as a European style Social Democrat. Most of what he writes are attacks on the American right, demands that taxes be raised, defense of President Obama, meanwhile pretending he is on the right in order to get more media attention (a Social Democratic attacking free market policies is not news, someone pretending to be a “right-winger” doing so is).

Dylan Matthews knows this perfectly well, and is therefore quite dishonest in classifying Bartlett as on the “right”.

Bruce Bartlett thinks the revenue maximizing tax rate may be 83%, higher than any of the leftist economists Klein interviewed.

The important paper from Uhlig that Bartless cites is interpreted by most economists as a strong case in favor of lower taxes, not higher taxes. Harald Uhlig is a brilliant U-Chicago macro-economists. As a rule of thumb macro-economist conventional wisdom believes in higher responsiveness of economic activities to taxes than micro-economists and therefore that taxes are more distortive than micro-economist think.

Uhlig believes that Europe on a whole is quite close to the top of the Laffer curve, especially on capital taxes.

He also thinks that taxes in the United States can only go up by less than one third before the U.S. hits the revenue maximizing rate. This is not enough to fund the massive new welfare state that the left is trying to build.

Now, remember always that the criteria for an optimal tax rate is not to maximize revenue. Long before the revenue maximizing rate is reached, the government is destroying 2 dollars or more from the private sector just to collect 1 dollar for the public sector.

The marginal government expenditure it is quite unlikely to produce twice or several times as much social good than what is spent.

Uhlig thus concludes that “In the EU-14 economy 54% of a labor tax cut and 79% of a capital tax cut are self-financing.”

A 54% self-financing tax cut means that if the state puts more than 2$ in the pockets of the tax-payers, government spending only has to go down with less than 1$. Sounds like to pretty sweet deal to me.

A 79% self-financing tax cut means that the state can give 5$ to the private sector with only a loss of 1$ for the public sector. Only fools or committed socialists would defend this rate of taxation.

This is evidence of a deeply dysfunctional system, not something the United States should emulate, as Bartlett wants to do.

We can rank the social value of everything the state spends on from best to least necessary. Sure, there are some public expenditure items that may be worth 5 times what they cost, such as (say) police and cancer research. But in countries where 40-50% of national income is public (the United States is getting close to this as well), there are lots and lots of marginal forms of public expenditure, such as subsidies to leisure activity, subsidies to weak sectors and agriculture, various forms of unemployment and sick leave expenditure.

The social benefit of these activities are hardly worth 2-5 times what they cost.

Many people do not not really understand the Laffer curve. They think as long as we are to the left of the revenue maximizing point, everything is fine. The left seems to think that preferably we should be exactly on top, maximizing revenue as a share of GDP.

But getting close to the top of the Laffer curve means that we are exponentionally getting closer to an infinite marginal cost of government activity. At the top, that is the cost of government activity. After the top we are in negative region, every tax dollar destroys lots of private activity as well as lowering public sector activity.

Let me also give you a simple graphic illustration of tax rate and tax revenue in the U.S and western Europe (defined as the EU-15 minus Luxembourg that Trabandt and Uhlig provide data for, and assuming that workers on average spend all what they earn).

We all know that tax rates are higher in Europe than in the United States. But we also know, or should know, that the U.S is far richer than Europe. Tax revenue is a function of tax rates and of per capita income.

The OECD provides data on taxes as a share of GDP, and on per capita GDP. This gives us the relevant variable for determining public expenditure, which is tax revenue per capita.

In the latest available year, 2007, per capita tax revenue for Western Europe was 13.440$ .

For the United States, it was 13.140$, or only about 2% less. You can see this in the figure below.

However according to Uhlig the average of labor and consumption taxes are 51% in Europe and only 31% in the U.S, as seen in the second figure.

American tax revenue per capita is thus only 9% lower than for example France, even though the average French worker pays 50% of their income in combined labor and consumption taxes compare to 31% for the average American worker.

Which society do you think should want to emulate the other one? Or are we supposed to think high tax rates have intrinsic value, even if they only give rise to mediocre tax revenue?


  1. Yea, I wish more people would point out that the Laffer curve is a static analysis. Mankiw gave the best explanation that there's a difference between short-term (where all the published measurements have been done) and the long-term.

    The best analysis would come from treating the problem as a NAV of government revenues problem. It should be very difficult to turn what you're discussing into a multi-period Laffer curve problem, no?

  2. I'm not trying to be a jerk, but your proof is inadequate. You have to remember that tax revenue per capita does not reflect only taxes raised from labor and consumption taxes. As it turns out, there are several states in the US that don't have income taxes at all. Texas is the biggest, of course, but also Alaska, Washington, Nevada, Wyoming, South Dakota, Tennessee, Florida, and New Hampshire.

    Similarly, Alaska, Delaware, Montana, New Hampshire, and Oregon don't have sales taxes.

    States without income and sales taxes still generate tons of revenue from property taxes. The property taxes in Texas, for example, can be crippling for homeowners.

    So, it's quite possible that your two sets of taxes are not co-extensive. Furthermore, this is possible even if the per capita number excludes state taxation, because labor and consumption taxes will exclude things like capital gains taxes.

    You just haven't provided enough information for someone to determine if your thinking is accurate.

  3. Reece:

    Since there are hundreds of tax rates, it is hard to compare two regions with one straight figure. But quantively labor and consumption taxes shown in my graph are the lion part of tax revenue, accounting for about 80% of *total* federal and local tax revenue in both the U.S and Western Europe.

    The difference between the U.S and Europe is as you point out smaller when it comes to capital taxation. But even there Europe has higher rates.

    You are also example right about property taxes. But property taxes, one of the few taxes higher in the U.S than Europe, are 3.1% of GDP in the U.S and 2.1% of GDP in Europe. So they are not enough to account for much of the difference.

    I believe Uhligs figure already includes state and local taxes on labor and on goods.

  4. To bolster my point, it's worth recognizing that there is not federal consumption tax in the US. So, if we're excluding state level taxes, the combined consumption and labor tax in the US is going to be lower no matter what. But since labor and consumption are not the only kinds of taxes, US revenue probably comes from other taxes. So, again, the taxes that make up "tax revenue per capita" are not just the taxes that make up "labor and consumption taxes."

  5. "if we're excluding state level taxes"

    But we are not. The local and state consumption tax you are refering to is included in the graph, that is the 4.1% figure Uhlig provides.

    Yes there are things not in the graph, but they are a small fraction of taxes, and not even all those tax rates are necessarily lower in Europe.

  6. That's fine, but we're not working with the same sets.

    I'm not an economist--just a guy with a little too much free time at work today, but I think it's also worth remembering that the per capita GDP in EU-15 is (I think) about $37,000 while in the US it's $46,000. That is, on a per capita basis, the US economy is significantly larger than the EU-15 economy. And when you have a higher per capita GDP, you'll return more revenue from a lower tax rate.

    If we want to figure this out, we have to account for the fact that per capita tax rate is relative to the size of the economy.

  7. But Reece, that's exactly the point.

    America's low tax, low regulation economy grows faster than France' high tax, heavily regulated economy.

    We are richer and can provide our government with French levels of tax revenue, while maintaining much higher per capita levels of disposable income.

  8. You really should note in Bartlett's defense that he explicitly said he does NOT want tax rates to be that high. Very few people actually want taxation to be at the Laffer Maximum (though there is usually agreement even on the left that they shouldn't be to the right of the maximum, unless of course the point of the tax is to discourage a behavior).

    I don't know whether Bartlett has come out in favor of social democracy (his usual line is that spending less is unlikely and "starving the beast" resulted in even higher spending, so we might as well settle on the least harmful way to pay for it in a deal which includes cost-control measures). I would like to hear him come down one way or another.

  9. Read this serenade for European Welfare States, full of innacuracies, straw-men, and exagerations (in favur of Europe, and against the U.S).

    At one point he writes:

    "One way we can learn from them [European Social Democracies] is how to have a tax system that raises considerably more revenue as a share of the economy than ours does without killing the goose that lays the golden eggs.

    The reason Bartlett claims high taxes does not "kill the goose the lays the golden eggs" is that Europe has grown at the same rate at the U.S.

    But this is ignorance. Standard economic theory does not predict that the higher tax country in an international system where innovation flows between countries grows less from equilibrium. It predicts that they have permanently lower per capita GDP.

    Once taxes have taken their toll, lower output, not lower growth, is the cost of taxation, because per capita growth from equilibrium of mature economies is entirely due to new technology, not more hours. And even countries that do not innovate or innovate less can in time adopt the innovations of the countries on the technology frontier.

    So for example the French are at a stable level where their work fewer hours than Americans. This makes them permanently poorer; the U.S is 40-60% richer than France, depending on how you measure.

    Let’s for the sake of the argument accept my premise that the difference in hours worked is taxes.

    But since the Frenchmen who do work can adopt new technologies just like Americans, there is no reason France would grow less. They are just permanently stock at the lower production level.

    When Bartlett and Paul Krugman defend Social Democracy and point to Europe having the same growth rate as the U.S, but ignoring that they are not catching up and are permanently at a lower level, they are deceiving you. Probably in Krugman case he knows what theory predicts and just lies, whereas Bartlett is saying this nonsense out of ignorance and the ideological will to find arguments to defend the European system and attack the American free-market success.

    If America were to follow Krugman/Bartlett and adopt French policies and get French outcomes (to the extent that differences are due to policies, not all are of course), what would happen is that our output would go down to the French level. Americans would become poorer, “killing the goose that lays the golden egg”.

    Of course theory predicts that after a long decline, where we are down to the French output level, we will still grow at 1.5% per year or whatever the technological rate of growth is.
    But from (say) 30% lower permanent level. Or the equivalent of nine or ten 2008 style crashes, with the difference that this decline is not cyclical, but policy driven, and would thus last forever, or until we change policies again.

    You see, Krugman and Bartlett neglect to tell you that part of the story when they laud Europe for having almost the same growth rate as the U.S.

    If you defend Social Democratic policy with Social Democratic arguments, I reserve the right to call you a Social Democrat.

  10. He's not saying high tax rates don't kill the goose that lays the golden eggs, he's saying that their form of taxation (V.A.T/consumption tax) is less distortionary.

    Bartlett replies to you here:

    A large part of Europe's problem is their labor market. My guess is that Bartlett thinks the imitation should be the other way around on that question.

  11. Tyler,

    That's not evident from Tino's argument. You're making a subsidiary point that is not supported. Tino is arguing in this post that higher levels of taxation in Europe produce marginally higher levels of revenue. Now, I certainly made the assumption that economic development was a prior fact to taxation, and I did that to attack the unstated premise that all other things are equal.

    You are now arguing that lower tax rates in the US feed a loop that produces higher incomes, and we know that these two things are not separate. But I don't think you can establish that tax rates are the determining factor that leads to higher per capita GDP in the US. Rather, I think it is a demonstrable historical fact that the US was highly developed before Europe, and this is a sticky fact that has not been changed by tax policies.

    The outline of my argument is that the US had a relatively conflict free environment that lead to the high levels of industrialization and market growth while Europe was repeatedly ravaged by continent wide wars during the same period. This is certainly true roughly from the seventeenth through the twentieth centuries. And parts of the EU-15 are still underdeveloped due to the effects of communism. East Germany has rebounded, but it's still not up to speed with the rest of the country.

    Do you honestly think that European tax policy, and not the history of Europe, has kept Europe from reaching the same GDP levels as the United States? I would be interested in hearing your argument . . .

  12. The only way to obtain real per capita increases in GDP and income is by advances in technology. The US pursued a number of policies that encouraged investment in technology including the fact that the US created the first modern patent system – property rights for inventions. Tax policies can destroy wealth, but they cannot create wealth. At best they can remove impediments to wealth creation. Unfortunately, since 2000 the US has passed a number of laws and regulations that are killing innovation. The incredible innovation of the 90s was based on technology start-up companies built on intellectual capital, financial capital, and human capital. All three of the foundations have been under attack since 2000. Our patent laws have been weakened reducing the value of intellectual capital. Sarbanes Oxley has made it impossible to go public reducing financial capital for start-ups and the FASB rules on stock options have made it harder to attract human capital to start-ups. If we want to create jobs, we need to have laws that encourage entrepreneurial start-ups. These issues are discussed in more detail in the book The Rise and Fall of the American Entrepreneur: How Little Known Laws and Regulations are Killing Innovation – -Regulations/dp/1439261369/ref=sr_1_1?s=books&ie=UTF8&qid=1281637851&sr=1-1

  13. Interesting blog post Tino, but you should note that the compendium of Laffer curve responses is from Dylan Matthews, not Ezra Klein.

  14. Colin:

    Thanks, I did not realize that.


    Great point. Technological progress is however hard to take credit for in that it raises the wealth of all developed nations, so it can appear to have no effect if you compare good policy with bad policy nations.

  15. TGGP:

    1. So does Paul Krugman, so do many European Social Democratic economists. Are they also libertarian?

    2. I have never actually read Bartlett spend time writing about this issue (Unlike Paul Krugman, who actually criticized European labour market regulations once or twice). Googling Bruce Bartlett and Card Check for example gives no relevant results.

    You think in theory it is possible that he holds this view, even though he never writes about it? Maybe. But that is hardly the standard we judge public figures.

  16. Arvid:
    Scott Sumner identifies as a libertarian and supports moving toward a more European method of taxation. He also thinks though that high tax rates have caused Europeans to work less hard and have less GDP. So he probably doesn't want that high a level of taxation, he just wants the taxes we do raise to exclude investment.

    It was precisely because I didn't know for a fact that I said "guess". And yes the fact that even Paul Krugman thinks so is one reason that I was willing to make such a guess without knowing what Bartlett had written.

    Tino misrepresents what Bartlett said about Europe in his column. He said "I don't mean to imply that Europeanization is unambiguously good; only that it's not unambiguously bad, as virtually all conservatives believe. There are many ways I think we could learn from the Europeans and they from us". Throughout he discusses how there are certain respects in which Europeans seem better off, just as there are ways in which we do, and of course there are differences among European countries. Bartlett misrepresents the Road to Serfdom though (as do most people who comment on it). In that very book Hayek endorses a welfare state, what he opposes is central planning (which as Bartlett rightly notes was a real problem with liberals back then). Of course the U.S already has a welfare state, with our government spending about the same on healthcare as Europe. He is mistaken to focus on growth rates rather than levels, since theories of "catch-up growth" seem pretty well founded, so it only serves as an argument against more extreme claims about the defects of European policy.

    I don't know of Bartlett endorsing higher welfare spending. His usual claim is that conservatives once believed that by "starving the beast" we could hold down spending, but history has shown that it only served to remove any limit on spending, and that the resulting huge deficits show little sign of going away but must be paid for. Casey Mulligan and Robert Barro have a different perspective, that deficits themselves aren't that harmful but spending is and so raising taxes to cover increased spending isn't that responsible (Steven Landsburg seems to have a somewhat similar view). I don't know what Mulligan & Barro's thoughts are on the effect tax changes have on the political economy of spending, but Mulligan has reported that "invisible taxes" do not creep up higher because they are disguised.

  17. TGGP:

    I think we agree on the substance, with the difference that you are very generous in interpreting Bartlett, and in my view a little naive. For example you write:

    “I don't know of Bartlett endorsing higher welfare spending.”

    Here is what Bartlett told the economists recently:

    ““Eventually, American conservatives need to make the deal that European conservatives made after the war: liberals basically spend the money—subject, roughly, to a balanced-budget constraint—and conservatives raise the money in ways that don’t overly burden capital. This means that conservatives have to accept the welfare state and liberals have to give up redistribution on the tax side.”

    In my world, someone whose comment on the debate about introducing a welfare state is that we should “accept the welfare state” and let liberals spend the money is a proponent of the welfare state. Especially if this person in the attacks and misrepresents opponents of the welfare state, takes policy position after position after policy position to the economic left, and writes articles downplaying the problems of the welfare state through the use of straw-men arguments.

    I am not misrepresenting him at all. But I don’t have to accept his straw-man arguments and rhetorical tricks. His aggressive use of this type of argumentation, as well as his biased (to the left) interpretation of how well Europe is doing, tells us he is not disinterested din the subject.

    His claim that “I don't mean to imply that Europeanization is unambiguously good; only that it's not unambiguously bad, as virtually all conservatives believe.”

    Notice the straw-man? It is simply not true that “virtually all conservatives believe” that Europeanization is “unambiguously bad“.

    Europeanization is a *trade-off* between economic efficiency and individual liberty and reducing inequality and economic uncertainty.

    Conservatives and libertarians believe that the tradeoff is not worth it, liberals that it is.

    If he were honest, he would deal with the central arguments made by conservatives and libertarians, instead of making up false arguments. The opponents of the welfare state argue that:

    1. Would sharply reduce the *level* of economic activity in the United States. He just sort of skips this central argument, giving the impression that he dealt with it by using growth figures.

    2. The welfare state reduces economic liberty. Instead he focuses on the extreme straw-man that Europe is not “totalitarianism”.

    Obviously if you confiscate 50-60% of my earnings and let politicians decide how it is spent, you are taking away something in the order of 50-60% of my economic liberty.

  18. He made the decision to replace the libertarian/conservative argument with two misrepresentations : growth instead of levels, and totalitarian instead of less free.

    And since Europe has the same growth and is not totalitarian, he pretends he responded to the arguments against Europeanization.

    Bartlett concludes his article by writing:

    “Nor does it appear that the welfare state necessarily erodes freedom or places a crippling burden on the economy. As Columbia University economist Jeffrey Sachs recently wrote, "In strong and vibrant democracies, a generous social-welfare state is not a road to serfdom but rather to fairness, economic equality and international competitiveness."

    Why would a libertarian who opposes the welfare state end his article about the welfare state by approvingly citing known proponent of the welfare state Jeffrey Sachs, about how great the welfare state is?

    Why would he conclude that it does not appear “that the welfare state necessarily erodes freedom or places a crippling burden on the economy.”?

    Do you have any articles recently written by Bartlett where he argues against implementing a welfare state?

    Because he relied on straw-men arguments rather than honestly dealing with the case again the welfare state he was forced to put in two qualifiers, “necessarily” and “crippling”. This does not change the conclusion; just make it more clear that Bartlett is a sleazy guy.
    At any case, both are false. Most Americans would consider lowering economic output by more than 10 times this crisis a “crippling” burden on the economy. Most would also consider giving an even larger share of your decision making power (your wealth) to the state “necessarily” an erosion of individual freedom.

    Let me also point out a bunch of other questionable claims by Bartlett in this single article alone.

    • The fact that some European countries have “better restaurants” has nothing to do with the welfare state.

    • There is no evidence that Europe’s “lower rates of obesity” is due to the welfare state rather than their diet.

    • He points out that Europeans have “lower murder” rates, but neglects to mention that for many other types of crime, such as robbery and property crimes, the U.S does better than Europe.

    • The number of hospitals per capita or hospital beds per capita is not a measure of welfare, just a measure of how you organize your health care delivery system. Russia, which has appalling health care, has the worlds 4th highest number of hospital beds per capita.

    • He writes that Europe has less poverty than the U.S. In fact, absolute poverty is higher in the EU-15 than in the U.S (10.8% vs. 8.7%).

    Do you notice the ideological patter?
    There is a huge difference between arguing like Sumner that the U.S should *replace* its tax system with a more efficient one, and arguing that the U.S should copy Europe in *adding* more layers of taxation and dramatically higher spending.

    Bartlett is wrong when he claims Europe has lower capital taxation than the U.S. The two regions have virtually the same average tax rates on capital.

    Some of the difference is accounted for the U.S having higher real estate taxes, which economists consider more, rather than less, efficient.

    It is not true that we have no other choice other than accepting the welfare state or using “starve the beast”. We could slowly reduce spending, as many countries have. Or just not vote for more new spending.

    “I don't know what Mulligan & Barro's thoughts are on the effect tax changes have on the political economy of spending, but Mulligan has reported that "invisible taxes" do not creep up higher because they are disguised.”

  19. The fact that America has dropped to 11th. in the world on the economic development index should be the most important factor. But sadly, to supplysiders it's not. This alone should give Americans cause to consider more closely what is derogatorily referred to as the 'European welfare state'. How low can you go? Give the Republicans a chance to lower taxes for the very wealthy again and find out. A revolution by the tea baggies is not a risk as they have been hijacked by the Republicans already. I see it as smooth sailing form now on in. Mexican third world style.

  20. So if US-rates of taxes are better than the EU-rates (meaning lower taxes are better), how come the Western and Northern European countries rank above the US in quality of life indexes? This added quality to life is of course largely financed with government spending.

    Seems to me like the quality of your life is a far more useful indicator than the amount of money in a hypothetical average person's wallet.

  21. I would repeat something Reece said above which I think you are ignoring: "Do you honestly think that European tax policy, and not the history of Europe, has kept Europe from reaching the same GDP levels as the United States? I would be interested in hearing your argument"

    I too would be interested to hear your argument on that. As it is now your post simply does not establish what it seeks to prove.

  22. Hannu

    The Quality of life index is simply a measurement based on assumptions of what makes people happy and is simply an index.

    As far as the 'History of Europe' of course culture plays a large role in any economy. I mean for the love of Pete economics is really a social study on how people view money.

    Finally the main issue that you fail to understand is the question of how large states change the underlying culture of places. I mean compare the former USSR and its economy to that of the USA and try to understand that ALL economies grow as population and trade surplus or deficits and a myriad of other factors are placed on it.

    Lastly, look at all the various countries in Europe. Please note that those without trade surpluses that relied on 'Government Spending' are the ones in the largest crisis.


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