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Introduction

With the fear that debt-to-GDP levels are widely becoming unsustainable across the developed world, many governments are reacting by instituting or debating sizable austerity measures. New research shows that tax increases will not have a sizable effect on lowering debt levels. The bulk of austerity must come from spending cuts if debt levels are to be lowered.

The Laffer Curve

Noted supply-side economist Arthur Laffer postulated that tax receipts and tax rates do not have a linear relationship. Instead of higher taxes always leading to more revenues, higher taxes act as a disincentive for utilized labor and can actually result in lower tax receipts.

As tax rates increase, disposable income falls. This causes some workers to experience a phenomenon in which they see their total disposable income being worth less to them than the required effort needed to generate that income. In other words, workers prefer leisure -- or simply not working -- versus putting in the effort to make the lower disposable income level.

The simplest example is a 100% tax rate. Since workers would take home nothing, there is no incentive to work. Thus, government tax revenues would actually be $0 even though the tax rate is at its maximum point.

This model showing the relationship between tax revenues and tax receipts became known as the Laffer Curve.


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There must be a point where tax rates maximize tax revenues. Therefore, in terms of tax policy, the main concern has always been where on the curve the tax rate is currently set and whether that point is optimal for revenue gains and economic growth.

In today's economic environment, many developed countries are actively seeking ways to lower their debt loads. This has led to an additional concern. Even though a country could increase taxes and receive higher revenues, the steepness (or flatness) of the curve before reaching the peak could make it socially prohibitive to raise taxes.


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For example, the country with the blue Laffer Curve will receive maximum revenue that is slightly higher than the country with the black curve. However, the slope of the blue country's curve is so much flatter that the revenue gain from a comparative increase in taxes is really small. Thus, the gain from raising taxes may not be enough to offset the social problems that could ensue.

A Comparison of U.S. and European Laffer Curves

New research from Trabandt of the Board of Governors at the Federal Reserve and Uhlig of the University of Chicago (2012) utilizes the Laffer Curve and gives insight into how much further the U.S. and 14 key European Union countries can increase their tax rates, based on 2010 data, before experiencing a decline in revenue.

In all cases, each country has the potential to gain more tax revenue through higher taxes. The amount that taxes can be raised and the potential size of the revenue gain, however, is drastically different among countries.

Country

Tax Increases (%)

Just Labor

Tax Increases (%)

Just Capital

Tax Increases (%)

Labor/Capital Jointly

Revenue Growth
(% of GDP)
United States 27.9 8.8 28.1 7.4
Austria 4.7 2.8 5.5 2.2
Belgium 4.0 0.1 4.1 1.8
Denmark 0.3 0.4 1.0 0.6
Finland 1.6 1.0 1.9 0.9
France 4.6 0.7 4.6 1.9
Germany 14.9 6.1 15.7 5.2
Greece 14.2 7.8 15.6 4.8
Ireland 21.5 12.2 25.9 8.3
Italy 7.3 1.1 7.3 2.8
Netherlands 6.6 4.4 8.6 3.4
Portugal 15.4 4.6 15.6 5.2
Spain 10.3 5.4 11.4 3.9
Sweden 3.3 0.0 3.5 1.7
United Kingdom 8.6 0.7 8.8 3.4

Source: Trabandt and Uhlig (2012)

In the U.S., for example, the government can raise taxes on labor by 27.9%, on capital by 8.8%, or vary them jointly by 28.1% to achieve maximum revenue. As a percentage of 2010 GDP, however, revenue would increase by only 7.4%.

In Europe, Denmark and Finland have nearly reached their maximum level of revenue. Increasing taxes by even 2.0% from current levels would result in lower revenues.

Most of the PIIGS (Portugal, Italy, Ireland, Greece, and Spain) can increase their taxes considerably before experiencing a decline in revenue. However, the amount of money that can be raised from taxes is quite small when compared to their current debt situations.

For example, Greece can jointly increase its taxes on labor and capital by 15.6%, but this will only result in a 4.8% increase in revenue as a percentage of 2010 GDP. Spain can increase its taxes by 11.4%, but will only receive a 3.9% boost to revenue as a percentage of GDP.

Cutting Debt through Tax Increases


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The chart above illustrates the potential revenue that can be raised by increasing a tax rate from its 2010 implicit level to its maximum rate. As can be seen, countries carrying elevated debt-to-GDP levels have flat Laffer Curves.

This leads us to believe that reducing debt levels, especially for the PIIGS, cannot be accomplished through raising taxes alone. Even after maximizing revenue through higher taxes, there is no way that the Greece and Italy will see their debt-to-GDP levels fall below the 60% required by the Maastricht Treaty.


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Quite simply, there is not enough potential revenue available to push debt ratios much lower through higher tax rates.

The same is true in the U.S. Increasing taxes will only bring the debt-to-GDP ratio down 7.4 percentage points from its 2010 level.

Substantial declines in debt-to-GDP will only come from spending cuts.

Minsky Moment

Trabandt and Uhlig took the results a step further and calculated the point at which debt levels become unsustainable, otherwise known as the "Minsky Moment."

Hyman Minsky theorized that as long as cash flows -- in this case tax receipts -- are large enough to support interest payments on the debt, then a debt level is sustainable. Once the interest rate exceeds cash flow, there is no way to support the debt and default is inevitable.

The "Minsky Moment" is the real interest rate level that the country can pay if it allocates all of the revenue gain from increased taxes to interest payments. That interest rate was then compared to the implicit real interest rate (i.e., the interest paid on the average maturity of all outstanding debt) to see which countries have unsustainable debt loads.

This assumes a base revenue level that is equal to the tax receipts received in 2010. If an economy experiences a negative (positive) shock to GDP, tax revenues will decrease (increase) in-line with the new GDP trend. The severity of the shock will dictate the shortfall (bonus) to tax revenues.

Country

Maximum Real Interest Rate

Real Interest Rate 2010

Real Interest Rate 2012

United States

12.0% - 15.6%

2.0%

0.7%

Austria

7.1%

2.2%

1.6%

Belgium

5.9%

1.8%

0.3%

Denmark

5.3%

0.3%

2.2%

Finland

5.8%

2.1%

-0.9%

France

6.4%

2.3%

1.7%

Germany

10.3%

2.9%

1.3%

Greece

7.4%

2.6%

2.9%

Ireland

12.7%

7.1%

2.8%

Italy

6.4%

3.6%

1.3%

Netherlands

9.4%

2.1%

-0.4%

Portugal

9.5%

2.6%

3.7%

Spain

10.5%

3.2%

0.8%

Sweden

8.2%

0.8%

0.5%

United Kingdom

8.3%

1.5%

0.9%

Source: Trabandt and Uhlig (2012), European Commission: Economic and Financial Affairs, Treasury Direct, Briefing Research

Absent the economy entering a severe recession, the U.S. has a long way to go before it reaches its "Minsky Moment." Depending on how the national debt is calculated for the U.S. -- harmonized cross-country or total held by the public -- real interest rates are sustainable until they reach 12.0% or 15.6%. While that may seem like a large variance, the Treasury paid an average real interest of just 1.99% in 2010. The average real interest rate has fallen to just 0.65% in Q1 2012.

Surprisingly, the PIIGS are not in danger of surpassing their "Minsky Moment." This is due to the fact that the PIIGS have the ability to raise their taxes considerably before reaching the peak of the Laffer Curve. Thus, there is ample room to keep paying higher interest rates even if it is not enough to dent their overall debt loads.

The question then is: "If Portugal, Ireland, and Greece have not surpassed their 'Minsky Moment,' why did they need bailouts?"

The reason has to do with the dynamism of the economic situation. Portugal, Ireland, and Greece were ill-equipped to pay their short-term debt if revenues suddenly declined, which is what happened during the "Great Recession." Even though an increase in taxes would have allowed these countries to continue making their interest payments, they were unable to raise taxes fast enough to offset the abrupt shortfall in baseline tax revenues and meet their obligations.

In the case of Greece, a default became inevitable even though it technically did not reach its "Minsky Moment."

Conclusion

As debt-to-GDP levels continue to rise, the need for austerity is finally being discussed among many governments in developed countries. There are two methods for reducing debt: increasing taxes or cutting spending.

The Laffer Curve model clearly shows that tax increases alone cannot lower debt-to-GDP levels significantly. The bulk of austerity must come from spending cuts.

That does not mean, however, that spending cuts need to be implemented immediately to prevent a default.

Barring a sudden and protracted recession that severely curtails tax receipts, neither the U.S. nor any of the EU countries that were evaluated is in imminent danger of facing unsustainable interest rates. While it will not offer much help in lowering the debt, countries have the ability to raise taxes to meet obligated interest payments.

Obviously a lot has transpired over the last couple of years, especially among the PIIGS, that makes it difficult to believe that current interest rates are sustainable. That, however, is because the focus is on market rates and not time-of-issue rates.

Newly issued debt, which would require countries to pay the current elevated market yields, accounts for a small fraction of the overall debt load. Thus, longer-dated paper that countries issued prior to when default fears entered the lexicon has kept overall interest payments well below current market rates. That is why countries are paying current real interest rates that are beneath their "Minsky Moment."

There is still time for discussion on what spending cuts should be implemented to produce meaningful debt relief.

Sources

Source: Tax Increases Will Not Solve The Debt Problems