Evidence on the High-Income Laffer Curve from Six Decades of Tax Reform

Abstract

IN THE 1980S, federal income tax policy took center stage in the political arena. An influential group of supply-side economists argued that high marginal tax rates were severely reducing the incentives of people to work, and that cutting tax rates, by stimulating people to work harder and earn more income, could actually raise revenue. This idea is known in popular parlance as the Laffer curve, after the economist Arthur Laffer, who (according to rumor) sketched out the idea on a cocktail napkin. In fact, political debate in the United States over whether cutting rates can raise revenue dates back many years.(1) Even if they do not pay for themselves, if cuts in taxes lead to large behavioral responses by individuals, the implications are quite important for the making of tax policy. Basic theory suggests that high marginal rates cause an inefficiency that rises with the square of the tax rate. The greater the behavioral response, the less revenue is raised by the higher rates. In the extreme, if the Laffer curve is correct and high rates fail to raise any revenue, they are, quite literally, less than worthless. As a testable hypothesis, however, the Laffer curve has not fared well. Somewhat unfairly, the public has taken the explosion of budget deficits following the rate cuts of the 1980s, and the elimination of deficits following the rate increases of the 1990s, as a refutation of the idea. More careful econometric analysis has not been any more supportive. An extensive literature in labor economics has shown that there is very little impact of changes in tax rates on labor supply for most people, particularly for prime-age working men.(2) This would seem to indicate that the central tenet of the Laffer curve is demonstrably false--marginal rates seem to have little impact on the amount that people work. The past decade or so in public finance, however, has seen the birth of a new and important literature very much in the spirit of the Laffer curve, but more sophisticated and potentially much more persuasive. I call it the New Tax Responsiveness (NTR) literature. Perhaps most associated with the work of Lawrence Lindsey and Martin Feldstein but including many others, the NTR literature's main hypothesis is that high marginal rates have major efficiency costs and fail to raise revenue at the top of the income distribution.(3) In doing this damage, high tax rates need not induce people to work less. Instead, they need only lead people to shift their income out of taxable form. The work of Lindsey, Feldstein, and others has shown that, if people do shift their income in this way, it can imply the same revenue and deadweight loss problems as in the original Laffer curve even if the elasticity of labor supply is zero. The NTR literature has tried to estimate the impact of this shift with data on high-income people, and it has tended to find large effects. If true, this work means that the marginal deadweight cost of the income tax is quite high, and it calls the progressivity of the tax code into serious question. The central goal, then, of the NTR literature is to estimate the elasticity of taxable income with respect to the marginal tax rate (or, more precisely, to one minus the tax rate). This parameter is critical for determining the deadweight loss of the income tax, the revenue implications of tax changes, even the optimal size of government.(4) As Joel Slemrod has put it, recently ... much attention has been focused on an elasticity that arguably is more important than all others, because it summarizes all of what needs to be known for many of the central normative questions of taxation. This is the elasticity of taxable income with respect to the tax rate(5) As one might expect of something so influential, considerable controversy surrounds the magnitude of this elasticity. Indeed, estimating it has been one of the most active areas of research in public finance of the last decade. …