Monday, October 6, 2008
With Warren Buffett making news again with his support for higher taxes on the rich and higher taxes on dividend income and capital gains, I thought it would be good to review the logic behind the Laffer Curve. Here's my version. There are two points on the curve we know with certainty: #1 and #2. If income taxes are zero, the government collects no revenue; and if the government tries to collect 100% of what people earn, people will stop working and revenues will be zero. Obviously there must be an optimal tax rate, C, that maximizes government revenues because a) it minimizes the incentives to evade taxes, and b) it maximizes the incentives to work, invest, and take risk.
If taxes are "too high" then we are in the A region of the curve, where lower tax rates can yield higher revenues. Taxes that are "too low" puts us in the B region of the curve, since higher rates will yield higher revenue. Art Laffer, a great friend and mentor of mine, has argued since the mid-1970s that we've been in the A region of the curve and still are. He also argues convincingly that the optimal tax structure would be a flat tax with no deductions but with an exemption that would leave most people earning less than the median income with little or no taxes. Raising tax rates on the rich and on capital would be very bad medicine for the economy, especially now. Indeed, the prospect of an Obama victory and the increased risk of higher taxes and a weaker economy could well be part of the reason for the stock market's weakness this year.
Posted by Scott Grannis at 5:52 PM