Monday, July 16, 2007

Snapshots vs movies and corporate taxes 

I confess to being confused over all the fuss about the WSJ editorial regarding corporate tax rates and tax revenues. I agree that what the Journal calls a Laffer curve isn't one (take for instance Mark Thoma's redrawing or Max Sawicky's estimate, or the other links provided by Kieran Healy) -- but not for the reasons they express.

Laffer's argument is a dynamic one. Not in the sense that Laffer drew it -- the Laffer curve itself is a comparative static story: two tax rates in equilibrium should produce tax/gdp ratio of what? -- but underlying the story is a lifetime optimization problem. If presented with these (expected) tax rates over the rest of my life, when would be the smartest times for me to work and save and invest, and when would it be wisest for me to consume leisure?

The graph in the editorial is a snapshot of what an industrialized economy's corporate tax rate is right now and what its tax share is right now. It tells you nothing about when the tax rate was imposed and the stage at which the economy's adjustment to the new rate is right now. It doesn't tell you about administrative deadweight losses of tax collection systems between countries. It doesn't tell you the interplay of tax rates and R&D, which can be different in different countries. As one of my friends would say, "there's a whole lot of ceteris that just ain't paribus."

If you were going to make this analysis, time must be an explicit dimension. The effect of tax rates on tax takes is a long-run analysis. You need to see the movement of work effort and savings over time. You need a movie, not a snapshot. Unfortunately, newspapers are not good vehicles for dynamic analysis.

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