Understanding the relationship between tax rates, tax revenues and taxable income in accordance with the laffer curve

Abstract

The Laffer curve shows the relationship between tax rates and tax revenues, with the insight that taxable income is not predetermined. The Laffer curve is best known for demonstrating that, at a certain point, higher tax rates fail to produce more revenue, but the key insight is the much more modest point that changes in tax rates cause changes in taxable income, which leads to some level of revenue feedback. Politicians on both sides often exaggerate, with Republicans sometimes arguing that the Laffer curve means that "all tax cuts pay for themselves." Some Democrats, by contrast, argue that tax policy has no impact on economic performance.

This paper uses real world evidence to demonstrate that certain tax cuts can have a positive impact on economic performance and that "supply-side" tax cuts therefore do not "cost" the government much in terms of foregone tax revenue. This paper further explains how the Joint Committee on Taxation's revenue-estimating process is based on the untenable theory that changes in tax policy - even dramatic reforms such as a flat tax - do not effect economic growth. In other words, the current system assumes the tax rates have no impact on taxable income. Because of congressional budget rules, this leads to a bias for tax increases and against tax cuts. This paper explains that "static scoring" should be replaced with "dynamic scoring."