Laffer Curve and Corporate Tax Rates: Time to Revisit?

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Laffer Curve and Corporate Tax Rates: Time to Revisit?
Image source: Pixabay

Laffer Curve and Corporate Tax Rates: Time to Revisit?

Twitter is serendipitous to me.  I don’t track it all day long, or I would never get anything done.  Usually, I keep it off, unless I am sending off tweets.  But I accidentally saw a tweet from Cardiff Garcia of FT Alphaville. regarding a presentation done by Brad DeLong.  Here it is:

CardiffGarcia Cardiff Garcia 1 May

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This slide from @delong‘s presentation made me belly-laugh (via http://bit.ly/ZmqeKq ): pic.twitter.com/beZcJs8Rwk

So I looked, and here is what I found:

BJNC6Y_CYAAB2Of.png large Laffer Curve

I looked at it and said, “Huh, yeah, whoever did this was a total hack.  Totally arbitrary curve drawing.”  But then I thought a little more.  “If I estimated a quadratic equation (parabola) what would it look like versus the data?”

So I took the points and eyeball estimated the values, and dropped them into an Excel spreadsheet, and ran the regression.  Turns out that both DeLong and the Wall Street Journal, and those they relied on were wrong.  Remember that the horizontal axis is marginal corporate tax rate, and the vertical axis is corporate taxes received as a percentage of GDP.

delong comment_30011_image001

At a 5% level of significance, the equation is not significant, and the coefficients are not significant, though they are close.  The signs all go the right way, and the intercept is near zero.  That said, the prob-value for the equation as a whole (F test), is 6.5%, not far from the 5% threshold, so it looks like there is some validity to the idea that as marginal corporate tax rates rise, so do corporate taxes as a percentage of GDP, until the taxes get too high.

Only one data point of the above analysis, Norway, is statistically significant, with an error 3+ standard deviations versus the model.  Norway is different, with its huge sovereign wealth fund, so what happens to the model if we exclude it, and re-run the model?

delong comment_3027_image001

Under these conditions, at a 5% level of significance, the equation is significant, with a prob-value of 1.4%, and all but one of the coefficients are significant, and the coefficient on the squared term has a prob value of 11.6%.  The signs all go the right way, and the intercept is near zero.  It looks like there is some validity to the idea that as marginal corporate tax rates rise, so do corporate taxes as a percentage of GDP, until the taxes get too high.

I didn’t test anything else.  With both equations we learn two ideas:

  • The tax take tops out at a 30% marginal rate
  • You don’t give up much if you set the marginal rate at 20%

Now, this is a cursory analysis on a limited data set.  But the idea that corporations start to go elsewhere when tax rates get too high is a reasonable hypothesis.  The WSJ analysis was a joke, but so was DeLong’s dismissal of the data. I’m no great fan of the idea of the Laffer Curve, never have been, but this was the first time I gained some sympathy for the idea.  So, be wary who you listen to, study statistics and their limitations, and generally, be skeptical, but not cynical.  There is truth out there, we just need to find it.

PS — If anyone wants me to publish the detailed statistics, I will, but I omitted them because they make most of my readers’ eyes glaze over.

By David Merkel, CFA of alephblog

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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