ECON-002 Lecture Notes - Lecture 13: Laffer Curve, Capital Accumulation

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27 Mar 2017
February 28th, 2017
If the government cuts taxes, will government tax revenues rise?
Cutting non-entitlement spending and military spending does not solve the long-term problem
Theory: The “Laffer Curve”
If tax rate = 0%, government will not
collect revenue
If tax rate = 0%, government will not
collect revenue
For low tax rates, tax revenue will increase. For high rates, revenue will degrease. What goes up must
come down.
What happens when rates are too high:
1. work is discouraged
2. saving is discouraged
3. tax evasion
When taxes are cut:
1. work is encouraged
-for people who are currently employed
-for people not currently in labor force
2. saving is encouraged
-encouraging savings leads to more capital accumulation over the long run, leading to more
3. reduced tax avoidance and tax evasion
Ronald Reagan famously noted that tax cuts increase revenues
However, in a poll of economists, they believe:
-cutting tax rates is no way to reduce deficit
-economists do not believe cutting taxes is good
How do economists explain this, then?
1. Kennedy’s proposal under Johnson’s administration in 1964. Five years later, revenues had risen
by 79%
2. Reagan tax cut in 1981 (the biggest one). Five years later, revenues had gone up by 22%
3. Bush tax cuts in 2001 and 2003. But 5 years after 2003 is 2008, when tax revenues fall due to the
recession. So, not to bias our analysis, instead of the 5th year after the tax cut went into effect
(2008), there is the peak revenue in 2007. 5 years later, revenues had gone up by 17%
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