Let’s look at an interesting concept in economics that I read about the other day. It’s called the Laffer curve. Ok, so it’s not really personal finance. But knowing the strategies behind how governments set tax rates still affect you. So you should know something about it.
If you’re like me, you don’t know what a Laffer curve is, or who Laffer is. Then again, you might be a financial nerd and already know all this. And here I am thinking I have stumbled onto an obscure idea. Now, who looks silly?
The curve is based on a concept developed by Arthur Laffer. Arthur is a major American economist who taught at the University of Chicago, The University of Southern California and elsewhere. He developed this curve to illustrate the two most important things we know about taxes.
Side note- I think Steven Levitt, one of the authors of Freakonomics, also teaches at the University of Chicago. And if you haven’t heard of Freakonomics, I suggest you go read all their books and listen to their podcast. They truly produce some great material.
Anyway, back to the Laffer curve and taxes
The two most important things we need to know about taxes
The two most important things we need to know about taxes are
- How much money can the government raise from taxes
- At what level of tax can we expect to see the government’s start getting less
The second point interests me. If you didn’t think too hard about it, you would have thought that the government could increase taxes. And you would think this would raise more money for the government.
But what the Laffer curve points out is that there is a level where the government would start to see less money if it kept raising taxes.
The Laffer curve illustrates this by using a graph. The horizontal axis is the tax rate that a government chooses. And the vertical axis is the amount of revenue received from that tax rate.
0% tax rate
The first point on the curve has to be zero. If a government has a tax rate of 0%, then the revenue it generates also has to be zero.
If the government raises the tax rate to 1%, then it will start to receive some tax from the citizens. So there is roughly a linear line between 0% and 1% tax levels.
Now if the government raises the tax level to 2%, then everybody will agree that the government will receive some more revenue. So the relationship between tax take and tax rate to this point is still linear.
And if the government keeps raising the tax rate, then revenue will continue to go up, at least when we’re in the low-tax-rate part of the graph. The curve has an upward slope — at least when we’re in the low-tax-rate-part of the graph.
100% Tax Rate
Now let’s say there was a hypothetical situation where the tax rate is 100%. Who would work in such a system? Nobody! All your money earned would go straight to the government. And if nobody worked, then there would be no tax revenue received by the government. So there has to be a point on at 0 revenue for 100% tax rate.
If we complete the curve between the low tax rate and high tax rate sides, there has to be a hump somewhere in the middle. But it could look very different depending on where the hump falls. Either it falls at the lower end, in the middle, or at the higher end. Surely, I think it must fall at the lower end. Below 50%. Would you want to work if you knew that half of what you earned went to the government? I would have a guess and say that the majority of people would say no.
The fact that the curve has a hump also implies something that is not always obvious. That pushing for higher tax rates to gain higher tax revenue for a government won’t always work. There is a point at which making the tax rate any higher, you’ll actually start to bring in less revenue for the government.
And this has happened in the past. After the great depression, Congress in the united states of America passed the Hawley-Smoot tariff bill. This bill raised the taxes on imported goods to try and increase tax revenue, but all it did was cause fewer goods to be imported, and the tax take went down.
The idea is simple if tax rates are too high- people will work less. As the work they do isn’t worth as much to them since the government is taking a large cut. And if taxes are low, people will work more, as the work they do is worth more to them.
So the question becomes, at what level is the peak in the Laffer curve? Originally, it was calculated to be around 70%. Straight away, I thought that couldn’t be right. I would definitely have worked less if I was being taxed at 50%.
New studies of the US economy between 1959 and 1991 put the revenue-maximizing tax rate at around 33%. And if you look at the personal income taxes around the world there is a large chunk of countries centred around the 33% mark. Including New Zealand.
Is the top tax rate too high?
You might think that with a top tax rate in the 30% range is too high. And by all accounts, there are calls to push the top tax bracket up even higher. After all, people earning a lot can afford to pay more to keep society running.
But if you push the tax rate higher, the people earning this amount of money will stop generating more. Or they will avoid taxes using elaborate schemes. When people lose the incentive to work because they are taxed more the size of the tax base will become smaller, leading to less government revenue.
New Zealand Tax rates
New Zealand has gone through a reform. In the 1980’s the top marginal rate of income tax was reduced from 66% to 33% (changed to 39% in April 2000, 38% in April 2009 and 33% on 1 October 2010) and corporate income tax rate from 48% to 33% (changed to 30% in 2008 and to 28% on 1 October 2010).
Other unique things about the New Zealand tax system is that there are;
- No inheritance tax
- No general capital gains tax
- No local or state taxes
- No social security tax
- No healthcare tax
- No gift duty
So overall, we have it good when it comes to taxes compared to many parts of the world.
I think that the public appointed needs to move away from wanting to raise or lower the tax rate. Rather, we need to focus on growing the tax base.
After all, if you are paying tax, you are earning money. And that is a good thing.
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Really interesting economic concept and it makes perfect sense. Thanks for pointing it out. I too feel that the tipping point would be below 50% because why would you work if you are giving more than half away to the government?
Definitely interesting. There seems to always be a debate about increasing taxes on the high salary and decreasing tax for low salary. But this concept seems to suggest you can only go so far. Governments need to work with what they have rather than appease voters with tax increases and cuts.