Thursday, February 27, 2003

Fiscal Policy in Three Graphs-I'm assuming most of my readers have heard of the Laffer Curve, but it's a good place to start a fiscal policy discussion. [My apologies in advance for the crudeness of the graphs] The basic premise is that if you raise taxes past a certain point, tax revenue will decline. The logical extreme is where you have an 100% tax rate; no one would work and thus there's no tax revenue. If you back off on the tax rate, people will be interested in working and you'll actually raise some revenue. Thus, there should be a point where we maximize tax revenue. If I could apply my elasticity teachings, there'll be a point where the tax rate increase is smaller than the percentage change in taxable income. Above that point, our tax revenue graph is elastic (revenue drops as you raise the "price"), and the government should cut taxes. However, maximizing revenue might not be what we're after. Let's look at wealth as a function of the tax rate. We'll need a certain amount of government to maximize wealth; a solid military, a judiciary and a police force and some basic infrastructure. How much infrastructure is a good question. Also, a certain amount of welfare might be in the wealth-maximizing mix as riot insurance to keep the poor from getting restless. However, we'll hit some point where government programs aren't helping to create wealth. That tax rate will be well to the left of the Laffer Curve's peak. However, is wealth what we're trying to maximize? We might be better suited to maximizing the commonweal, maximizing our collective utility. Let's bring in a third graph of aggregate utility as a function of the tax rate. Below is a copy of my graph-it doesn't seem to be as clear in Blogger as it does in the original file.

This utility curve hits its maximum somewhere between the wealth curve and the Laffer curve. As government spending (and the taxes needed to support it) grows past that point of maximizing wealth, we're now in the business of wealth transference, giving aid to the poor while taxing the more affluent. For a time, that transfer of wealth will reduce wealth (since taxpayers now have the cost of leisure go down and will not work as much) but increase utility, since the poor person's getting more joytrons out of the spending that rich guy is losing. However, there comes a point where that wealth transference becomes counter-productive. That point will come when the lost marginal utility from the taxes, both from the lost utility from the taxpayers and the slowing down of the economy from lack of hard work and investment from taxpayers, overwhelms the marginal utility of the government spending. At that point, aggregate utility jumps the shark and heads downhill. The question before the Peanut Gallery is whether we're on the right slope of the Utility Curve and a tax cut would aid aggregate utility. I would say yes. This is the first of a number of macroecon posts that might be the starting point of a book. [update 5:45PM-thanks to a comment from Nathan Mates, I've converted the BMP file to a JPG file ; it should load smoother. I'm a newbie at graphics]

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