Is the Laffer Curve Flat?

• In Event: Tax Policy, Compliance, and Fiscal Capacity

Abstract

A revenue-maximizing top tax rate results from the trade-off between revenue gains from a higher tax rate and revenue losses from behavioral responses along a Laffer curve. The literature on revenue-maximizing top tax rates, however, has ignored critical policy implications by focusing only on revenue-maximizing top rates, relying on simplified tax functions, and usually overlooking relevant tax interactions. We show that a more accurate and realistic depiction of the tax code fundamentally alters the shape of the estimated Laffer curve, the implied revenue-maximizing top rate, and potential revenue gains from increasing the top tax rate. This has three implications. First, Laffer curves are relatively flat—thus even substantial changes in the top rate around the revenue-maximizing rate have only modest effects on total tax revenues. Second, we show that simplified tax functions fail to correctly account for income tax bases, which can profoundly distort policy conclusions. Laffer curves estimated using more realistic tax representations are flatter, suggesting less potential revenue from a top rate increase and a lower revenue-maximizing top rate. Finally, we show that interactions of federal individual income taxes with other taxes suggest even flatter Laffer curves. Instead of raising more tax revenue by adjusting top tax rates, we highlight that the relevant policy tradeoff is between equity and efficiency.

Authors

• Rachel Moore, Joint Committee on Taxation

• Brandon Pecoraro, Joint Committee on Taxation

• David Splinter, Joint Committee on Taxation