Sunday, June 3, 2012

Moving the Laffer Curve (by Francesc Trillas)

Teaching taxation in the undergraduate course about Public Economics I explained to my students the Laffer Curve, which associates taxation rates with taxation revenues. According to this curve, there is an optimal level of taxation, beyond which increasing taxes is counterproductive because it decreases taxation revenues. The reason is the existence of behavioral reactions of individuals to raised taxation: working less, sending money to other jurisdictions, tax avoidance and tax evasion. The big empirical debate in many historical circumstances is to assess if we are on the right or on the wrong side of the Laffer Curve. For example, during the Reagan administration, conservative economists won the political debate by persuading the political arena that the US were on the wrong side of the Laffer Curve, i.e., taxes were too high. Recent work from Emmanuel Saez and his co-authors revisits the issue. Their insight is that regardless of what we think in terms of being on one side or the other of the optimal taxation level, the Laffer Curve is not something fallen from heaven, but a relationship that is endogenous and that can be modified by policy. For example, if one takes as given and fixed the level and opportunities for tax avoidance, the optimal level of taxation will probably be low, because high taxes will encourage easy avoidance. However, by eliminating loopholes and enlarging tax bases, policy may discourage the opportunities for avoidance, which makes high taxation possible and on the right side of the Laffer Curve. It seems to me that the idea is more general: many political debates take the context as given, while policy itself should sometimes be about changing the context.

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