Academic journal article American Economist

A Non-Singular Peaked Laffer Curve: Debunking the Traditional Laffer Curve

Academic journal article American Economist

A Non-Singular Peaked Laffer Curve: Debunking the Traditional Laffer Curve

Article excerpt


On a cool autumn evening in Washington in 1974, Art Laffer, 35, had one of those moments that end up defining someone for the rest of his life. Gerald Ford's chief of staff, Don Rumsfeld, and his deputy, Dick Cheney, things were different then-were sitting atop the Hotel Washington in the Two Continents lounge near the White House. Watergate and stagflation gripped the country. Ford wanted to WIN-Whip Inflation Now!--with a five-percent tax surcharge, which was supposed to re-ignite the American economy by taking big bites out of it. Today raising tax rates in a recession seems silly to almost everyone except Tom Daschle and the junior senator from New York. In the fall of 1974, Rumsfeld and Cheney were looking for alternatives. Happy to oblige was Laffer, who pointed to a mandala sketched on a cocktail napkin--two perpendicular lines and an arc--as the answer to the complex problems plaguing the nation. The Laffer Curve, one of the icons of supply-side economics, was born (American Spectator, Jan/Feb 2002).

It has been said that one of the great advantages of the Laffer curve is that you can explain it to a congressman in half an hour and he can talk about it for six months. But jokes aside, since its arrival on the public scene literally hundreds of journal articles have analyzed, dissected, rejected, accepted, objected, executed, and rehabilitated the Laffer curve. But all this literature has one thing in common; it implicitly assumes a single-peaked Laffer curve. In most of these articles the underlying assumption is that tax revenue approaches zero when the (average) tax rate is either zero or close to 1 (100%), and at some intermediate tax rates there is one peak point where tax revenue is at its maximum. Moreover, the approach taken by the literature to the aggregate (macro) Laffer curve is similar to that of the individualistic (micro) Laffer curve.

All journal articles and all text books in microeconomics, macroeconomics and public finance that we are aware of take the one peak approach (e.g., Borgas (2000), Stiglitz (1999), pp. 699-700, Rosen (1998), pp. 383-384). (1) Moreover, most authors do not even bother to distinguish between the micro and the macro Laffer curves. The aggregate (macro) Laffer curve is a vertical summation of the individualistic Laffer curves of all heterogeneous individuals in the society (in terms of hourly wage rate) at each tax rate. We will show that even if each individualistic Laffer curve has one peak point, the aggregate (macro) economic Laffer curve is likely to have multi (or at least dual) peaks.

This is based on several assumptions which reflect the wage distribution and labor supply curve in most western countries.

The assumptions are as follows:

1. The wage distribution demonstrates a very high degree of inequality. The distribution is one-tailed asymmetric with a narrow margin approaching very high wage rates while most of the population has a comparatively low wage rate. Parenthetically, Chinhui, Murphy and Piece (1993) claim that historically the wage rate inequality has always existed and is increasing over time, especially over the last several decades. Their data shows that from 1969 to 1989 the real wage of the median "income earner" remained stable, whereas the 10th percentile fell by about 20%. However, the real wage rate of the 90th percentile rose during this period by more than 15%. More recent data such as the distribution of wages in the U.S. in 1997 (see Borjas, 2000) clearly shows this one-tailed asymmetric distribution. This evidence strengthens our argument that wages exhibit a one-tailed distribution as well as a high degree of inequality.

2. Each individual who earns a given hourly wage rate, has a peak point of tax payment at some tax rate, which is different for different individuals. For the low wage earner the peak tax rate is relatively low, and for the high wage earner the peak tax rate is relatively high. …

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