Tuesday, September 22, 2009

Poor FDP! (fg)

Liberals in the current election campains in Germany claim that cutting tax rates might give incentives for both employees and employers to increase working hours and investments with the effects of inducing economic stimulus and providing a channel for higher government revenues. The latter shall be used to reduce sky-rocked debt burdens in the light of the financial crisis.

The Laffer curve is an economic concept used to illustrate the idea that increases in the rate of taxation do not necessarily increase tax revenue. The basic assumption is that a 0% income tax rate will generate no government revenue, and that neither will a 100% rate. An optimal tax rate is therefore assumed to lie somewhere in between. Increasing taxes beyond this optimal point (the peak of the Laffer curve) is assumed to decrease tax revenue. The Laffer curve is central to supply side economics, as it provides an argument for why lowering taxation may actually increase tax revenues. Many economists have questioned the utility of the Laffer Curve.

Recent research of University of Chicago economist Harald Uhlig and Mathias Trabandt (European Central Bank) analyzes the Laffer curve for major industrial countries (for readers not interested in technical details skip the blog quote).
We characterize the Laffer curves for labor taxation and capital income taxation quantitatively for the US, the EU-14 and individual European countries by comparing the balanced growth paths of a neoclassical growth model featuring ”constant Frisch elasticity” (CFE) preferences. We derive properties of CFE preferences. We provide new tax rate data. For benchmark parameters, we find that the US can increase tax revenues by 30% by raising labor taxes and 6% by raising capital income taxes. For the EU-14 we obtain 8% and 1%. Denmark and Sweden are on the wrong side of the Laffer curve for capital income taxation.

In sum, a strategy of decreasing tax rates counteracts the political task of reducing government debts. Poor FDP, you have the wrong manifesto (at least when it comes to tax cuts; as you might guess: I won't comment on the remaining political agenda - abstention in this blog)!

The figures illustrate that the USA and major European countries are on the left side of the Laffer curve; an increase in the tax rate (x-axis) likely will increase revenues (y-axis). Only in the case in which a country would be on the right side of the curve (compared to its maximum), a reduction in tax rates would increase revenues.