Monday, March 12, 2007

The Laffer Curve and Toledo's Budget

What, you may ask, is the Laffer Curve and why is it relative to Toledo's budget? The answer is that it's a function of taxation and government revenues and everyone in Toledo's leadership needs to understand it.

Arthur B. Laffer, the 'originator' of the curve wrote this article to explain where the idea came from. While there is an interesting story about how the name came into such widespread usage, Laffer explains that the concept dates to the 14th Century.

"The Laffer Curve, by the way, was not invented by me. For example, Ibn Khaldun, a 14th century Muslim philosopher, wrote in his work The Muqaddimah: "It should be known that at the beginning of the dynasty, taxation yields a large revenue from small assessments. At the end of the dynasty, taxation yields a small revenue from large assessments.""

The basic theory is this, Laffer explains:

"The basic idea behind the relationship between tax rates and tax revenues is that changes in tax rates have two effects on revenues: the arithmetic effect and the economic effect. The arithmetic effect is simply that if tax rates are lowered, tax revenues (per dollar of tax base) will be lowered by the amount of the decrease in the rate. The reverse is true for an increase in tax rates. The economic effect, however, recognizes the positive impact that lower tax rates have on work, output, and employment--and thereby the tax base--by providing incentives to increase these activities. Raising tax rates has the opposite economic effect by penalizing participation in the taxed activities. The arithmetic effect always works in the opposite direction from the economic effect. Therefore, when the economic and the arithmetic effects of tax-rate changes are combined, the consequences of the change in tax rates on total tax revenues are no longer quite so obvious."

At a tax rate of 0 percent, the government would collect no tax revenues, no matter how large the tax base. Likewise, at a tax rate of 100 percent, the government would also collect no tax revenues because no one would willingly work for an after-tax wage of zero (i.e., there would be no tax base). Between these two extremes there are two tax rates that will collect the same amount of revenue: a high tax rate on a small tax base and a low tax rate on a large tax base.



The Laffer Curve itself does not say whether a tax cut will raise or lower revenues. ... If the existing tax rate is too high--in the "prohibitive range" shown above--then a tax-rate cut would result in increased tax revenues. The economic effect of the tax cut would outweigh the arithmetic effect of the tax cut.


Laffer points out that people don't work to pay taxes. They work to be able to do things with the money left over. And we all know that people often don't pay attention to taxes until it has a negative impact on their after-tax income.

That's where Toledo is today. People are beginning to see that the taxes we're paying are growing and our after-tax incomes are decreasing. Everyone, regardless of income, is on a fixed budget. There are extemely few, if any, people who can just decide that their paychecks are going to be larger. Even those who are self-employed and might have discretion over such decisions know that more money to them might be a short-term positive for their take-home pay, but a long-term negative in terms of the viability of their business.

And the result of such decreases in available funds mean that we've lost people and businesses. They've gone where they can get an immediate increase in after-tax income - whether that was across the county or across the country.

The Wall Street Journal's editorial page today (subscription required) included a small piece on Iceland's Laffer Curve. According to WSJ, the benefits of low taxes can be seen very clearly in Iceland.

"From 1991 to 2001, as the corporate-tax rate fell gradually to 18% from 45%, tax revenues tripled to 9.1 billion kronas ($134 million in today's exchange rate) from just above 3 million kronas. Revenues have more than tripled again since 2001 to an estimated 33 billion kronas last year. Personal income-tax rates were cut gradually as well, to a flat rate of 22.75% this year from 33% in 1995. Meanwhile the economy has averaged annual growth of about 4% over the past decade."

But it's not just Iceland, Laffer details the growth in the economy following three historical tax cuts. Nationally, the Bush tax cuts several years ago have resulted in economic and job growth (the economy grew 3.4 percent in 2006, slightly more than in 2005), lower unemployment (4.5% in February) and wage growth (4% in 2006).

The lessons are clear, but the discussions in One Government Center are more focused on tax increases than they are on reducing government spending. The idea of a garbage fee is very much on the table - and will probably have the support of some, if not all, the city's unions.

According to WSPD this morning, Councilman Michael Ashford (Democrat, District 4) has gone through the budget and identified nearly $2 million in questionable spending. Councilman Joe Birmingham (Republican, District 6) said during the same show that he's against any increases in fees or taxes.

We have two representatives who seem to get it...but will the others? Or will it just be easier to raise fees and taxes? Before our Council resorts to that decision, perhaps they ought to study the Laffer Curve.

10 comments:

Brian Duffy said...

Maggie;

Interesting enough I learned this in basic 101 economics, yet when I went to University of Dayton for a masters in public administration, it was not taught in any government financial classes. Considering how few people take economics today, there is little doubt your elected and public officials know nothing of this basic economic theory.

Kate said...

Nice Maggie. We studied Laffer in economics.

In world history we studied regions, cultures - even whole countries who rose and fell under the practice of taxing the citizens and the lengths they were willing to go to exact what they wanted.

I will remember these two councilman as speaking out at this time. And I certainly will remember those who lacked the courage to do so.

Let's count that vote - shall we? How many people do not want a future in politics in the Toledo area? Anyone? Any takers....

Kate said...

brian duffy - do you really think that's possible? Didn't everyone have to take freshman economics?

I'm not being sarcastic - but do you suppose it is possible that we have city officials who have not had an elementary class in economics running the city budget? Which is like 200 million bucks?

Maggie Thurber said...

Brian - part of the Laffer Curve is just common sense...government taxes what it wants to discourage. If you tax earnings, you discourage them - the same as with cigarettes. And while our local leaders think it's a good to discourage cigarettes, they fail to recognize that the same impact applies to earnings.

But you're right - I don't think most elected officials have any clue about basic economics...but then, I can think of only 2 or 3 who've ever been in business (running or owning) where such lessons could have been learned.

Rusty said...

As a former Toledoan I know taxes are too high, but to point to taxes as the major cause of Toledo's economic problems does not work.

The Bush/Clinton/Bush globalization program has pushed for the destruction of a large swath of light and medium manufacturing in this country, under the theory that creative destruction eventually breeds something better.

Cut taxes in Toledo all you want, it won; tmake much difference. Ohio and Michigan are going to deteriorate for a generation or more, and then something different will happen, probably when the southwest runs out of water.

"Til then, we are in trouble.

Maggie Thurber said...

Rusty - I didn't say that taxes were the major cause of Toledo's problems...and if that is somehow implied in my post, it's not intended. The point was that taxes to cover the decifit are not the solution...that perhaps (or probably) we're already in the 'prohibitive range' of the curve.

But I agree with your assessment - especially water, which is why I advocated for an additional water intake facility to position us better for the future.

Water - and our transportation abilities - are key to our future success.

Lisa Renee said...

The problem is given the short amount of time with the way the City is doing the budget process things are rushed thru to balance it rather than taking a good look at it. Some of the points Michael Ashford made were good ones.

Hooda Thunkit said...

Maggie,

Even before you introduced me to the Laffer curve I understood the cause and effect relationship.

From the looks of it, the majority of council does not and probably won't understand/believe/trust the Iceland example either.

But, what of the Republicans on council and their conservative values/beliefs? Surely they should have been pushing for lower taxes to increase income, rather than driving more hard-working taxpayers away.

At least, that's what I would have expected anyway. . .

Rusty said...

Not to be picky, but I believe the wage growth in 2006 was nominal and not real (inflation adjusted). Using the nominal rate is one of the many ways the Bush administration trys to put lipstick on the pig.

Macroeconomics is not may main area, but I not certain even Laffer seriously has tried to apply the model to local economics. Maybe half-seriously.

And Iceland? Not a really good anology folks.

Ask yourself this:

If Toledo cut taxes in half, would there be....

an influx of businesses?
an influx of jobs?
an influx of house buyers?

Toledo, and this entire region, are in BIG trouble.

Maggie Thurber said...

Rusty - not sure you'd see an immediate impact in new companies and new people if you cut taxes - but it would be the first step in making this a friendlier environment...

Cutting taxes alone won't solve any jurisdiction's problem by itself...

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