This week’s „Der Spiegel“ is concerned with the increasingly problematic relation between nominal tax rates and actual fiscal revenues in Germany. The Cover-wide headline asks „Why the state is asking ever more money from its citizens but gets less and less of it“? Its a good question – one with a simple theortical answer (that, at least, is something) but a fearful complexity in practice. The simple answer looks like the curve below.


(Source: http://upload.wikimedia.org/wikipedia/commons/thumb/6/6a/Laffer_curve.png/220px-Laffer_curve.png)

It’s the famous „Laffer Curve“, named after Arthur Laffer who was the theoretical support behind Reagonomics. The relationship the curve depicts is pretty straightforward: If you increase the (overall national average) tax rate (t) from 0% the tax revenue (T) will first increase to a maximum (T*) before finally declining back to zero once the tax rate reaches 100%.

The general assumption is that taxes are a disincentive to economic activity and once a certain level of taxes is reached – where the tangent to the curve is parallel to the axis – econmic activity will either stop or be transferred to black (and therefore non-taxed) markets. In both instances, the overall effect for a tax collecting state will be declining revenues.

Thus, if a polity actually knows that it is currently on the right hand side of the Laffer curve, the only reasonable action would be to reduce taxes as it would both increase legal economic activity and the fill the coffers of the state. That’s what Reagan argued. That’s what never happened (that is, if there was any effect at all, the lag was so large attributing it to Reagan became a Republican exercise in epistemolgy in the late 1990s). As so often with a convincing and simple theoretical point, reality is not a friend of those trying to implement such a strategy. There simply is no way of really telling which tax rate would constitute a Laffer maximum.

The Laffer curve is a nice explanatory and propaganda tool, but is not actually helpful in construing useful fiscal policy.

Economics and the people making individual decisions simply are too complicated to easily devise policy around a general idea like the Laffer curve. Check this document for a more technical analysis of the curve and some implications. This is also where I found the beautiful illustrations.

So, knowing about the curve, we can suggest a closer look at tax rates as the simple theoretical answer to the question posed by „Der Spiegel“. But we also know that it is by no means clear it is the right suggestion in the fearfully complex economic reality. Too bad.