Joshua Rauh, an economist at Stanford University and a senior fellow with the Hoover Institution, has co-authored an important study of the effects on revenues of a major increase in marginal tax rates in California. In 2012, Californians voted to increase the top marginal tax rate from the then-high 9.3 percent to rates ranging from 10.3 percent to 12.3 percent. Add in the pre-existing 1-percentage-point extra tax on people making over $1 million a year, and you get rates ranging from 10.3 percent to 13.3 percent.
Rauh and co-author Ryan Shyu of Stanford’s Graduate School of Business find that of the extra revenue the state government would have raised if high-income people had gone on with business as usual, 55.6 percent was lost over the first three years of the higher taxes. That was due to people leaving the state and to the high-income “stayers” making less income than otherwise in response to the higher tax rates. The effects were even larger in the last of the three years the economists studied. That makes sense because the longer the taxes were in force, the more time people had to adjust.
The Laffer Curve in California is alive and well. Which is more than can be said for California.
These are the closing paragraphs of David R. Henderson, “California’s Laffer Curve,” IPI TaxBytes, October 25, 2022. Read the whole thing, which is not long.
READER COMMENTS
robc
Oct 27 2022 at 8:49am
There is one mistake I always seen made with regard to the Laffer Curve and you made it in the article too.
That is to treat the taxes independently.
For example: Lets say we have a federal income tax cut. And federal income tax revenue goes down by $1B dollars. Someone would say, “see, we were still below the peak of the laffer curve, the tax cut led to less revenue.”
But that isn’t the whole story. Because FICA revenue went up $400M. And state income tax revenues went up $300M. And excise tax revenues went up $100M. And state/local sales tax revenues went up $300M. And property tax revenues went up $100M.
So the net change in this example is +$200M in tax revenue due to the tax cut. But the effect isn’t seen in the revenue of the tax actually cut.
I don’t think you can treat the taxes independently. It is total tax burden that matters.
Knut P. Heen
Oct 27 2022 at 10:27am
The main problem with the Laffer curve is the assumption that it is a good idea to maximize tax revenue in the first place.
The Heen curve has utility on the y-axis and the curve is monotonically decreasing at an increasing rate as the tax rate increases. The politicians have too much money and we have too little money.
robc
Oct 27 2022 at 10:59am
I don’t think that assumption is true. What is clear, though, is that it is a bad idea to be on the backside of the curve. No good can come from that.
David Henderson
Oct 27 2022 at 11:50am
You write:
That’s not true. There’s no value judgment in the Laffer curve. It’s simply a relationship between tax rates and tax revenues. Indeed, when you’re close to the peak, the incremental deadweight loss is a multiple of the incremental revenue raised. (I think what I just said is true: I don’t have time to show it here.) That’s why, in an article I wrote for Contemporary Policy Issues, I said that the Laffer curve is a way of making deadweight loss understandable to non-economists. The editor insisted that I cut that sentence.
David Seltzer
Oct 27 2022 at 3:12pm
David, “Indeed, when you’re close to the peak, the incremental deadweight loss is a multiple of the incremental revenue raised.” I think you are correct. If we look at a marginal increase in tax revenue, the rectangle between the demand and supply curves increases incrementally which increases the area of Harberger’s DWL Triangle. I could be wrong.
Daniel
Oct 27 2022 at 10:44am
A few things we learn from the study:
1. The VAST majority of the windfall tax revenue dissipation is due to the intensive margin (i.e., behavioral responses encapsulated in observed income) rather than the extensive margin (i.e., out-migration).
2. With a headline windfall tax revenue dissipation estimate of 55.6%, California is on the left side of the Laffer Curve. In other words, increasing tax rates still increases tax revenue, despite those behavioral responses.
3. The dissipation effect increases over time, though I wonder to what extent that is a mechanical function of income (and therefore taxes, and therefore the dissipation estimate) compounding over time vs. actually more or more sophisticated behavioral adjustments. Even the authors themselves are cautious about claiming this inference with much confidence.
robc
Oct 27 2022 at 11:04am
I am not sure your #2 is correct, see my example in the post above. The dissipation is only in CA tax revenue. If you also include the effect on federal income tax revenue and FICA revenue (and etc) from CA, it is possible the losses from those are greater than the dissipated gain in CA revenue.
As the federal rates are well above the CA rates, I could see losses in federal revenue exceeding the gains in CA revenue.
robc
Oct 27 2022 at 11:14am
Following up, since the federal high earner rate is about 3x the CA rate, for every dollar of revenue CA is losing over expectation, Fed revenue is being reduced by 3 dollars. That puts the net past the peak of the curve. It isn’t that 13% is past the peak, it is that 13% + 37% is past the peak of the curve.
robc
Oct 27 2022 at 12:03pm
More following up, one of the easiest ways for the states to raise revenue, is to get a Federal income tax cut. Regardless of where you are on the curve, that will result in more state income tax revenue. This is yet another reason the direct election of Senators is bad. Prior to the 17th amendment, the states could put pressure on their senators to help out the states.
Dylan
Oct 27 2022 at 1:21pm
Isn’t that only true for income that goes away, but not true for incomes that move to a different state? I haven’t read the paper to see the breakdown they estimate for the movers vs. the stayers.
robc
Oct 27 2022 at 3:20pm
Dylan,
Yes, you are correct. According to Daniel in his #1, it is mostly due to stayers, movers are a small part, so it doesn’t affect my analysis much. But that would make a difference in some cases.
Dylan
Oct 27 2022 at 5:43pm
Thanks Rob, missed that from Daniel’s first post.
I need to read the paper, but I have to say I have a natural skepticism on studies like this that try to suss out difficult to observe phenomenon, even if directionally the results go the way we’d expect.
robc
Oct 27 2022 at 3:32pm
My calculation…for every $10 of CA income taxed at the highest level, they were expecting to receive an extra 30 cents in revenue, but instead got only 13.38 cents. And the federal revenue decreased by 47 cents.
If I did the math correctly, there was about a 12.5% reduction in income at that level to cause the 55% dissipation.
TMC
Oct 27 2022 at 5:11pm
Related, but a little off topic – some hardcore libertarians would say ‘all taxes are theft’. I think it is reasonable to say after a certain point, they are theft. What would that point be to you? I’d put it at 30% for me.
robc
Oct 28 2022 at 8:32am
From a deontological perspective, it is the method that matters, not the amount. For me, most taxing methods are immoral, so the hardcore libertarians are mostly right. I agree with Henry George, the only moral tax is the land value tax.
So a Single Land Tax split between all levels of government would raise maybe 1/3rd of current tax revenue levels. It might be closer to 1/4th. I am totally fine with shrinking the government down to that size.
It might even be a bit larger than the “nightwatchman” state that some libertarians call for.
Andrew_FL
Oct 28 2022 at 2:07pm
You contradict yourself, a land value tax is not collected in a deontologically different way from any other tax.
I prefer the formulation of President Coolidge.
“The collection of any taxes which are not absolutely required, which do not beyond reasonable doubt contribute to the public welfare, is only a species of legalized larceny.”
robc
Oct 30 2022 at 11:07am
No contradiction. I said nothing about collection. Income tax, sales tax, even most property tax are taxing production.
Land Value Tax taxes ownership of natural resources. There is no natural law theory of property rights that I accept, so land ownership is a useful fiction. In this I agree with Mises and George. Any value to land is due to its existence or, primarily, production of other people — neighboring property, roads, etc. The owner of an empty lot in Manhattan didnt create its value, the history of Manhattan did. This includes the state, as much as I hate to admit it. I see nothing immoral about taxing away the rents of undeveloped land value. The perfect use of that money would be to collect it all together and divide by 7 billion people. But letting a localish government have it is a reasonable 2nd best.
Johnson85
Oct 28 2022 at 12:33pm
I think an easy, hard line rule is anytime government(s) makes more than you for an hour of your time, that’s theft. I’d personally put the line for immorality at well lower than 50%.
To me, if we converted as much as possible to use taxes (e.g., tolls where ever they make sense; I’d actually prefer a mileage tax except I don’t think there is a way to effectively calculate it without way too much government intrusion) and then kept the rest down to around 14.3%, I think that’d be fine. Basically the equivalent of 1 day a week is taken for other people. Assuming some of that is not wasted and actually is spent on things that benefit the public (e.g., law enforcement) and the rest is wasted and/or spent on transfer payments, that seems reasonable.
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