Tax Increases Will Not Solve The Debt Problems

May 31, 2012 9:43 AM ETDIA, SPY26 Comments
Jeffrey Rosen profile picture
Jeffrey Rosen


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.

(Click to enlarge)

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

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Jeffrey Rosen profile picture

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