Raising Taxes and Cutting Spending – Understanding the Laffer Curve

Please allow me to turn from discussions of investing and personal finance for a day and talk about macroeconomics.  Before you hit snooze or go back to Facebook, please indulge me and read a bit further as an understanding of the effect of tax laws on the deficit and the economy in general is useful both to the investor and the voter.

In the media the choices for cutting the enormous budget deficit, and eventually paying back the ginormous federal debt, are being widely reported as either cutting spending or raising taxes.  While cutting spending would no doubt lead to a reduction in the deficit, raising taxes would actually cause the deficit to increase if spending were left unchanged.  Here’s why.

A famous economist named Aurthur Laffer proposed an economic theory during the Reagan Presidency that eventually came to be known as the Laffer Curve.  The Laffer Curve basically says that, starting from zero tax rate, if taxes are increased incrementally government revenues would also increase, as would be expected.  At some point, however, tax rates would become so high that federal revenues would actually begin to decrease.  This is because:

1) People who start companies and grow businesses would have less incentive to grow their businesses.  This would both result in less taxes from them, since their incomes would be lower (they would be lying by the pool instead of working extra hours to grow their businesses), and because they would not build the extra factories, stores, restaurants, etc… that would hire people who would also pay income taxes and generate corporate income taxes with their purchases.

2) Those with high incomes, who usually have the ability to delay or offset income, would have more incentive to do so.  For example, a founder of a company who has most of his wealth in company stock could hold onto shares and take out a loan against them to make purchases rather than selling the shares and realizing the taxable capital gains.  This also causes companies to keep profits overseas rather than bringing them back into the country and paying taxes (a process called “repatiation”.

3) High earning individuals would have incentive to leave the country, taking their wealth and businesses with them.  These types of individuals tend to travel extensively, own homes in foreign countries, and have the ability to work from anywhere.  If taxes become to onerous, there would definitely those who would decide to make a vacation home in a foreign country a permanent residence.

This all means that, assuming we are currently above the equilibrium point, lowering taxes would actually cause federal revenues to increase, while raising taxes would actually cause them to decrease.  Because the deficit is:

Deficit = Income – Spending,     where Spending > Income,

lowering taxes would actually lower the deficit.  In doing so, it would also cause all kinds of economic output, because those making high incomes would see the value in expanding their businesses to make more money since the amount they would be keeping would justify the extra hours and hassle.  This also means an increase in the number of jobs.

To look at it another way, for the government, the economy is its investment portfolio (the government’s IRA).  Just as with an IRA, when one takes money out, the reduction in the balance of the account causes the rate of increase to decline.  The less one can withdraw, and the longer one can wait to make withdraws, the faster the account will increase in value.

In an IRA, one can withdraw funds at a certain rate and still see the value of the account increase.  For IRAs invested in stocks, this rate is around 10% per year.  In the government’s case, they can tax at a certain rate and still see the overall value (and revenue generation) of the economy increase.  

Businesses and individuals can pay taxes at a certain rate and still have enough capital to reinvest to grow their businesses, as well as have enough economic incentives to do so.  If they are taxed at too high a rate, however, they will no longer have the capital and incentives to grow their businesses, causing the economy to stagnate.  If taxed at a sufficiently high rate, they will start to close their businesses down or move to more tax friendly climates (see Manhattan for a case of taxes being too high, leading to flight of businesses).

So what does this mean for the investor?  Well, if taxes are being increased, expect economic activity to decrease.  Just as is the effect when the Federal Reserve raises interest rates, increases in taxes will generally cause stock prices to decline.  There is generally a lag, however, in that it takes time for the full effects to be felt, so the decline will generally follow 6 months to a year after the taxes are raised.  As the saying goes, “Don’t fight the Fed” and add to it “Don’t Ignore the Tax Man.”

Your investing questions are wanted.  Please send to vtsioriginal@yahoo.comor leave in a comment.

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Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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