The Laffer Curve

Mention of the Laffer curve frequently pops up in discussions of government budgets. Local politicians announce something like, “We collect $50 million in wage taxes, so we propose to raise the tax rate by 10%, thereby getting an additional $5 million that will balance the budget.

Common sense and experience tells us taxes do not work that way. Raise city wage taxes by 10% and more people will move to the suburbs. Others will find loopholes and exceptions. The $5 million additional money is only the maximum. In reality, it will be something less—maybe much less.

Laffer curve

(Click to enlarge)

This is where the Laffer curve comes in. How much money will be raised with a tax rate of 0%?  Obviously zero. How much money will be raised with a tax rate of 100%? Also zero. Nobody would bother working if all their salary went for taxes.  No work = no salary = no taxes.  The Laffer curve predicts a sweet spot—a tax rate between zero and 100% that will produce the most revenue before the losses overcome the gains. But it is not a magic predictor. The data has to come from another city or past experience, and how it will play out in a new situation is still only a guess. The important point is recognizing the principle.

A recent example is the New York City tax on cigarettes where a single pack is taxed $4.35 by the state and $1.50 by the city.   Those and other taxes raise the final cost to more than $12 per pack.  The obvious solution for many is to ask a friend coming in from New Jersey to buy cigarettes for them there.  Local NYC smoke shops also ship them in from other states via UPS.  It is estimated 58% of cigarettes smoked in New York City are smuggled in, and tax revenues fall far short of expectations.  In Washington, D.C., revenues fell by $7 million after they raised the cigarette tax from $2 to $2.50 per pack.

I saw this principle up close many years ago at a biomedical convention. In an after-dinner discussion, one person posited How much should a company charge if they discovered a one-pill cure for cancer? A million dollars a pill? Ten million? It was a lively discussion. Charge too much and no one will be able to afford it. Too little and the company will lose profits. It was a pure Laffer curve question. What factors determine the sweet spot?

The discussion went on for about a half an hour, but how much a pill cost to produce or how much research went into its discovery was irrelevant. The important considerations were how much other treatments cost, how much pain and discomfort was involved with the cancer, and how easily could competitors produce similar products.

The discussion was Dr. Strangelove creepy, and I stayed out of it.


About Roger Walck

My reasons for writing this blog are spelled out in the posting of 10/1/2012, Montaigne's Essays. They are probably not what you think.
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