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We know that taxes (and borrowing) always rises to match expenditures. In other words, it is naïve to expect a government to commit suicide by lowering expenditures and therefore taxes. The reason is simple, lower expenditure = less votes = loss of jobs for politicians. Therefore politicians are always on the look for the “sweet spot” of taxation, this is, the taxation rate that will enable them to collect the maximum amount of money from us.

If you feel that you are being squeezed like a lemon, it’s because you are!

Today we are going to take a look at what’s called the Laffer curve and its effects on your standard of living.

Politicians only care about maximizing spending. For this, they need to get money from somewhere. They have only three options: print, borrow or tax.

Printing at the levels required to sustain large, continuous spending is suicidal because it leads to hyperinflation and the destruction of all economic activity. We have seen this in our lesson Senseless Inflation And Interest Rates. Economic destruction = losing votes and this means they lose their jobs. So, usually, printing is limited.

Borrowing is a “victimless” crime since government debts are never paid. All that’s paid are the interests. These interests are paid from taxes, but for as long as the total interest rate costs are low, politicians can spend much more than what’s collected by taxes. So, borrowing is a favorite bloodless sport for politicians…. Until interest payments become too large affecting politician’s spending capacity = less votes = losing their job. So, borrowing has limits.

Taxation, on the other hand, is a blood sport. People are trapped inside a geographical location (region, province, municipality, state, you name it). Therefore politicians can and do extract blood from you. And so the question becomes how much blood (money) can they extract? What is the absolute maximum? Remember that for as long as they keep spending, even if the economy drops, they will keep their jobs.

Therefore, they are not concerned about the “optimal tax rate”, this is, the tax rate that will minimize economic impact (as if such a tax rate would exist…. but we digress…). They are concerned with the optimization of revenue collection. In other words, what do they have to do to get the maximum amount of money from us.

Enter the Laffer curve. This curve (as you can see below) indicates that the amount of money that can be robbed from your pocket has a maximum.  If the tax rate is below the maximum, it can be raised and more money will be collected. If it is over the maximum, and it is raised, then less money will be collected.

The general idea is that low taxation levels are a nuisance for people and therefore they will keep paying them. It is easier to pay than to face prosecution for tax evasion.  At high taxation levels, the amount of money stolen from your pocket is such that it severely affect your standards of living. At this point, tax evasion is a necessity and people choose their well-being over government’s greed and therefore collected money drops. This effect can be seen in the curve below.

 

Laffer Curve

 

Of course, nobody knows for sure what the actual curve looks like, even if one actually exists. There are many models (theoretical) and very little actual data. Locations of the Optimum Taxation Level vary from about 30% to 70%!!! Yes, you are not dreaming. Some people tolerate 70% of their money being stolen by the government!!!! If you are interested in the technical details, there is convenient summary in Wikipedia Laffer.

What we are concerned with, are other parameters; ones that are never thought of, but are of vital importance to your standards of living. The question that lingers in the air is always the same: what happens to the economy as we travel the Laffer curve? For that, we need to add economic activity to the curve. See below.

 

Laffer Curve and Economic Activity

 

As we can see, when the tax rate is Zero, the economic activity is maximum. From that point on, it drops, drops and then drops some more. This makes sense because the government is removing productive money from the system and spending it in non-productive activities. The economic activity drops quite rapidly. This also make sense, since once money enters the production cycle, it creates wealth, which in terms creates more capital which in turn creates more wealth and so on. In other words, the capital multiplies in a production cycle. If we remove capital from this cycle (as the government does with taxes) this multiplication does not happen.

As we approach the Optimum Taxation Level, economic activity seems to remain constant. This is so because the top of the curve is more or less flat. This means that a little to the left or to the right of the Optimum Tax Rate add or removes very little money from the production cycle. Therefore, the economy is not affected too much. However as we pass the Optimum Tax Rate towards 100%, we notice that although the amount of money collected drops, the economy keeps dropping! How is this possible?

What we would expect is that as we pass the Optimum Taxation Level, less money is removed from the production cycle and therefore the economy should surge. But that is not the case. The reason why the economy never recovers is because of all the inefficiencies built into the system by the tax process.

Imagine a country where tax is 70%. When you finally get your profit, would you rather invest it in this country or smuggle it out and invest it somewhere else where the tax is much lower? Tax evasion is not neutral. Tax evasion removes capital from an inefficient production cycle (i.e. high tax) and moves it into an efficient one (i.e. low tax). Therefore, the economy never recovers!!!

The last element that we need to take a look at, is what happens with votes. This is the critical parameter that nobody ever looks at. However, the goal of all politicians is to stay in power. They can only do so if they can buy sufficient votes. And so they play a simple game: they extract the maximum amount of money from “rich” people because it is politically correct (see Those Bastards the rich people) and give it to the poorest people. The equation is simple, they are buying the largest number of votes possible. In order to do so, they buy them where they are cheap.

Remember, a vote is a vote regardless of where it comes from. And so, taking let’s say a million euros from one “rich” person (one vote against) and building a library or improving a school or increasing welfare buys them 100 votes. Therefore the loss/gain is one against one hundredth. That’s why the y do it.

 

Laffer Curve, Economic Activity and Votes

 

As we can see in the picture above, this is how this game is played.

When taxation is low, politicians can buy very little votes. As taxation increases, more votes can be bought, until this quantity remains more or less constant (the Optimum Taxation Level). Passed this point, politicians have a problem. We have seen the lesson Taxed to death No just into slavery and in several others, that politicians need to keep spending just to stay in power. They need to keep outdoing other politicians and themselves because the voters get used to something and then they take it for granted. Worse, they actually spend their welfare money! Remember, human beings are differential machines; we are good at noticing differences, but we are not so good at noticing absolute values. No politician was ever elected to anything by declaring that things will remain the same if this person is elected!

And so, passed the Optimum Taxation Level, politicians need to increase spending, otherwise the number of votes starts to decrease. You can see this in the graph above in green. But now, they have a problem. They can borrow, but eventually this will impact revenue levels (they need to pay interest on the borrowed money) or they can print (but this will rise inflation a lot which will kill the economy and lower their revenue levels) or they can try to increase taxation (which will decrease revenue levels). In other words, they are doomed no matter what they do. And what do they do? They increase taxation levels. Why do they do this? Remember those people with badges and guns we talked about in several other lessons? Well.. they are there to make sure you pay.  They create automated systems of payment whereby taxes are deducted “at source” as economists love to say. What does this mean? That every single person or company selling any product or service becomes part of the taxation machine. And so we have Value Added Taxes, and Bank Transaction Taxes and Gasoline Taxes and Stamp Taxes and Paycheck Taxes and so on and on. They make it impossible for you to evade taxes. And so yes, they push past the Optimum Taxation Level to the right, as far as to the right as they can to try to stay in power.

Of course, all they achieve is to kill the economy and lower everyone's standards of living, not surprisingly.

This is precisely why as Absolute Austro-Libertarians we say that the only taxation level that makes sense in ZERO.

This is why every time you are taxed you feel like a lemon. Because you are!

These are the rules of the game. Now you know them. Now you are aware of them. It is up to you to make something about it; and no, just voting somebody else won’t do. You know that already. Now it is up to you. Do something or keep being squeezed. Your choice.

Note: please see the Glossary if you are unfamiliar with certain words.

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