Zsolt Becsi
Economic Review, Vol. 85, No. 3, 2000
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Any number of U.S. politicians owe their success to emphasizing tax cutting. According to logic, voters are opting for fewer government services or for changes in the mix of services rendered. It is at this point that things become complicated, however, because what happens to expenditures influences how much revenue a government needs to collect. The author of this article observes that a good place to start in understanding the impacts of tax policy is with what is popularly known as the Laffer curve. This curve became famous early in the 1980s when tax rates fell but tax revenues did not rise as the curve predicted, and the United States resorted to deficit spending. This article examines the macroeconomic and conceptual issues that may have made a difference.
Because most analyses of the Laffer curve occur in a static framework that has proved inadequate, this analysis presents a simple dynamic model useful for analyzing the long-run effects of tax policies. The model also can easily be extended to analyze the disposition of government revenues and the consequent effects on national income.
It turns out that how the government spends its tax revenues "on consumption, investment, or transfers" is important for understanding the Laffer curve. In fact, a different Laffer curve is associated with the different ways revenues are spent, and it is important to know which curve one is operating on when designing tax policies.
September 2000