How Your Tax Rate Is Determined

By Lisa Smith AAA

When it comes to the government and taxes, it often feels like too much is never enough. You might be surprised to learn that there is actually a measure that governments use to determine just how much they can squeeze from your wallet.

Tutorial: Personal Income Tax Guide

The Laffer curve, a mound-shaped indicator, was designed to find the "ideal" tax rate that would help the government, as well as the people it serves, prosper. The idea is credited to economist Dr. Arthur Laffer, although Laffer himself notes that Muslim philosopher Ibn Khaldun wrote about it in "The Muqaddimah", a 14th-century text. Economist John Maynard Keynes also wrote about it in his economic works. In this article, we will take a general look at this economic concept and its impact on how much you lose off your check each month.

The Logic of the Curve
The logic of the Laffer curve can be most easily seen at the extreme ends of the taxation spectrum. If the tax rate is 0%, the government will earn no revenue and if the taxation rate is 100%, the government will be the recipient of all revenue generated by the economy and will thereby maximize revenue. At first glance, this appears to be a rather intuitive state of affairs, but, like everything else about taxation, the Laffer curve is not without its complications. (To learn more about taxes, check out What Is Fiscal Policy?)

The rather simplistic idea that 100% taxation would maximize government revenue runs into the economic reality that almost nobody would be willing to work if all of their hard-earned money went directly to the government. At the other end of the spectrum, a tax rate of 0% would not generate enough revenue to perpetuate the existence of government and support government projects, such as defense and infrastructure development, as well the salaries of public officials.

In light of the economic reality that neither a 0% tax rate nor a 100% tax rate will maximize governmental revenues, Arthur Laffer and his predecessors postulated that the ideal tax rate lies somewhere between the two extremes.

The Basis of the Theory
Arithmetic Effect
Underlying this theory is the idea that tax rate changes have two effects on government revenues. The first effect is strictly mathematical: an x% decrease/increase in the tax rate will result in a corresponding x% decrease/increase in tax revenues. Laffer refers to this as the "arithmetic effect." Here again, this seems logical enough at face value, but is actually more complex when the second effect comes into play. (For more, read Understanding The U.S. Tax Withholding System.)

Economic Effect
This second effect, which Laffer refers to as the "economic effect" recognizes that tax revenues increase/decrease in the exact opposite direction of the change in tax rates. In other words, this effect contributes to how raising taxes decreases revenue and lowering taxes increases revenue.

According to this logic, higher taxes discourage business activity and drive down tax revenues. For example, at a certain point, high taxes encourage the creation of tax shelters and encourage business activity that generates paper losses from depreciable assets rather than business activity that creates jobs and generates revenue. Money spent on plush office suites, the purchase of private jets and the leasing of luxury cars becomes more advantageous, via its ability to lower marginal tax rates, than business activity designed to generate a profit. In this case, businesses may tend to choose to be less productive in order to be more profitable.

Conversely, lower taxes encourage business investment and high after-tax income provides a greater incentive for employees to work more. This increased economic productivity results in an increase in tax revenues despite the lower rate of taxation. Because the economic effect and the arithmetic effect move in opposite directions, the bottom-line implications of any given tax increase or decrease are not easy to predict with exact certainty. (For related reading, see Do Tax Cuts Stimulate The Economy?)

The Ideal Tax Rate and the Politics of the Debate
Determining the tax rate at which productivity and revenues are both maximized is the subject of great political debate because the Laffer curve does not provide a clear numerical answer to the taxation question - it merely suggested that such a hypothetical rate does exist.

In the world of politics, it all comes down to theories on how to manage the economy. The Laffer curve is an idea closely aligned with supply-side economics and the tax-cutting policies of former President Ronald Reagan, which are often referred to as "Reaganomics". (To learn more, read Understanding Supply-Side Economics.)

The Argument
Sound bites from the competing sides of the debate have characterized their opponents as either "trickle-down" Republicans or "tax-and-spend" Democrats. The Republicans' stance is that rich capitalists create jobs for the poor; as such, the rich should be given free reign to manage their businesses with a minimum of government interference. The benefits of increased productivity will then flow to the poor. Therefore, the gains from the tax breaks will allow the rich capitalists to provide more jobs to the poor. According to this view, additional tax revenue is generated because the poor have higher incomes to tax. The Democrats' counter arguments state that governmental redistribution of society's wealth via taxation is a vehicle to take from the rich and give to the poor. They view the Republican idea as giving the majority of the benefits to the rich and letting the remnants trickle down to the poor.

The Evidence
Both sides of the debate cite an extensive array of statistics, often about the exact same events and studies. Neither side agrees with the statistics provided by the other, but both groups generally agree that the Laffer curve is legitimate. Supporters of supply-side economics argue that the economy is always positioned on the Laffer curve in a manner such that tax cuts increase revenue, whereas their counterparts argue the reverse.

For example, to support their argument that tax cuts jump-start the economy, supply-siders, including Laffer himself, cite statistics from the three major tax-cut proposals implemented in the United States over the past 10 decades. Laffer notes that the Harding-Coolidge cuts in the 1920s, the Kennedy cuts in the 1960s, and the Reagan cuts in the 1980s were "remarkably successful as measured by virtually any public policy metric" ("The Laffer Curve: Past, Present, Future" (2004)).

On the demand side, democrats cite the differences between the economy under Bill Clinton versus the economy under Ronald Reagan and George Bush. They characterize Clinton as having raised taxes on the wealthy, but also as having created jobs, implemented budget surpluses and presided over years of prosperity. (Learn more about how the different parties treat taxes, read Parties For Taxes: Republicans Vs. Democrats.)

The U.S. and Taxation
When the dust settles, supply-side economists still favor tax cuts of all types, using the Laffer curve to support their arguments. Demand-side economics rarely favor across-the-board tax cuts, instead choosing tax plans that favor lower income workers over those classified as wealthy. Both sides of the debate continue to look at the exact same scenarios and arrive at wildly different conclusions.

So, where does this leave the American economy? What comes immediately to mind is a remark often attributed to Benjamin Disraeli, a British Conservative statesman and literary figure: "There are three kinds of lies: lies, damned lies and statistics." With each side of the debate arguing the correctness of its views, the country's economic direction is largely a matter of which political party is in control at any given moment. Neither side has found the "ideal" tax rate, but both sides are still looking and acknowledge that the Laffer curve may be the closest we can get.

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