Travels with Laffer

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Photo by Artem Bali on Unsplash

Freshman congresswoman and rising star of the progressive movement Alexandria Ocasio-Cortez recently suggested a U.S. top marginal income tax rate of 70%.  Supporters contend that this would not only increase government revenue but would have no discernible impact on economic activity. Republicans, of course, met her remarks with the usual scorn. But it’s worth taking a closer look at this matter from a more global perspective.

Alexandria Ocasio-Cortez

The theoretical economic basis that Ocasio-Cortez’ comments essentially rest upon was outlined by Arthur Laffer, in what has become known as the Laffer Curve.  Basically, the curve predicts that at some point high taxation will ultimately lead to less government revenue.  Think about a magical country where the tax rate is set at zero percent. If you increase the tax rate to one percent, government revenue will undoubtedly increase; at two percent and you would expect a similar result.  But what if you increased the tax rate to 100%?  In such a scenario, there would be no incentive to generate economic activity since any profit would be collected; thus, government income would shrink over time.  Reducing the tax rate to even 99% would result in slightly higher revenue.  The top of this curve then represents the taxation level that will lead to the greatest overall generation of government revenue.

In theory, this is all well and good.  But setting the actual tax rate is incredibly tricky.  Putting aside any moral qualms regarding government intervention and redistribution of wealth, if we knew precisely where the top of the Laffer Curve existed, all governments would simply equalize their total tax rates at this magical percentage, and that would be that.  While economists have come up with a range of numbers varying from 35% to 70%, Ocasio-Cortez and others in the progressive movement have latched onto the higher end of this spectrum, albeit for only certain high-income earners.

It is entirely possible that for a country in autarky (self-sufficient with no need for international trade), a top marginal income tax rate of 70% is ideal to maximize government revenue.  But we live in a globalized world, and most mainstream economists believe that international trade and specialization provide a net economic benefit.  In such a world (the real world), states are not only competing against one another over goods and services but also in tax rates.  Certain countries, such as Singapore, Panama, and Estonia have found their competitive advantage in part by offering a low tax environment that attracts global business.  A 70% marginal income tax rate would be one of the highest in the world, 10% above Sweden’s highest tax bracket. Putting the United States in such a position would almost certainly have serious negative economic repercussions.

Singapore remains competitive through a low tax regime

Another problem to take into consideration is our rapidly changing economy.  Today, many of humanity’s basic needs require much less labor to sustain.  Take for instance artificial lighting.  According to one study, in 1830, it required an average person to work three hours to generate just one hour of artificial light with a tallow candle. Today, an hour of artificial electrical light can be earned with only a fraction of a second of labor.

This reduction in the labor cost of artificial lighting along with numerous other necessities has resulted in a larger amount of “disposable time” in the developed world.  Since fewer hours are required to provide for our basic needs (food, clothing, shelter, etc.), there is less of an obligation to work.  That, of course, doesn’t mean we do not work.  There are plenty of goods and services, which while not essential for survival, increase our utility (happiness) and therefore can be highly desirable.

Think of it this way, if I offered you a billion dollars, no strings attached, you would certainly take the deal, would you not? The money could be used to increase your utility.  Maybe you would upgrade your car or purchase a new home, possibly take a trip around the world and only stay in five-star hotels. 

What would you do with a billion dollars?

But what if I told you, you had to work 100 hours a week, every week, for 10 years in a soul-crushing job (with basic shelter and amenities provided) and only at the end of 10 years would you receive the billion dollars? That’s still an hourly salary of over $19,000.  Maybe you would take that deal, but there would be a lot of people who for whatever reason would say, “Hell, no!”  Why?  Because those lost hours actually have a higher intrinsic value.

How does this tie into the Laffer Curve? Simple, as it becomes easier for us to sustain our basic needs, our desire to work grows more conditional.  Sure we would all like to earn that extra dollar, but if it throws us into a higher tax bracket, maybe we would rather just stay at home watching Netflix.  The top of the Laffer Curve moves further to the left as more of our income becomes conditional rather than necessary for survival. Greater economic prosperity then might actually make it harder for governments to raise revenue by simply raising taxes.

And as the misnamed “sharing economy” grows so too will the ranks of people like me, individuals who can sustain themselves as digital nomads and are more interested in experiences than accumulating massive amounts of wealth. This new species will be highly susceptible to government policies, choosing countries with low tax environments that allow them to earn a living while amplifying their free time. 

The population of digital nomads has been steadily growing

Even in the cities, much of the gentrification trend is a result of people not looking to maximize their own personal assets but create businesses that speak to them, like a used book store, or a boutique café. How many times now have we heard the familiar story of the Wall Street financier giving it all up to pursue his true calling of curing ham or refurbish old sewing machines? Consequently, higher taxes may not result in more revenue but merely a shift in the population or an overall decline in taxable labor hours.

For many of us, a 70% marginal tax rate is an abstract.  We don’t ever expect to make the millions in income that would place us in this bracket. But even the one percent is not immune to the cultural trends described above. Time is increasingly becoming a commodity in its own right, and paradoxically, the less we value material wealth, the more sensitive we may become to the taxes placed on it.

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