The Journal of Accounting and Management, Vol 6, No 1 (2016)

Considerations on the Laffer curve

Gina IOAN¹, Cătălin Angelo IOAN ²

Abstract: The article aims to determine the optimal level of tax burden in order to maximize the level of GDP. The value obtained from a regression analysis that followed the mathematical modeling of the Laffer curve is 17.39%

Keywords: Laffer curve, fiscal pressure

1 Introduction

Long before the known curve of the economist Arthur Laffer, we find on economic literature studies dedicated to the analysis of expenses, income and public debt of the state, supporting the idea that moderate taxes and non-oppressive quick production. We an mention here Jean Baptiste Colbert, David Hume, Adam Smith and many others.

Concerned about the individual utility and its measurement, Arsene Dupuit, for the same reason, expands its research to the utility of public work. Considered one of the pioneers of "welfare economics", he admits that social usefulness is measured by the amounts paid by taxpayers for public services provided . What we read in his article from 1844 “De l'utilité et de sa mesure”, “if a tax increase progressively from 0 to the point where it becomes prohibitive, its yield, at first zero, increases to reach a maximum, then start to fall to 0. For the state there are always two levels of fees that bring income: one below and another above the tax that brings maximum efficiency” and in article “Peáge” (1853) “there exist, for any or price, a certain level that brings the highest income[...] In determining the level of duties, there are two different positions. A company will pursue that level of fees ensures maximization of turnover [...] On the contrary, if the state manages a particular sector, will seek to minimize the level of fees. Or, as the fee is lower, the service is often used frequently” , also found in the article by Jude Wanniski “Taxes, Revenues and the Laffer Curve” (1978), this time also in a graphic transposition of the relationship between tax rates and tax revenues.

The ensure of a optimal and efficient tax system has been and remains an actual and complex problem at both theoretical and especially practical level. A fundamental problem which lies in the macroeconomic level, consist in effective economic policy mix which should support a sustainable economic growth and at the same time to attenuate business cycle fluctuations. The efficiency of the economic policy mix which we refer is given, mainly, from the conduct of monetary policy and fiscal, which together can lead to qualitative and quantitative changes in the economy.

A study on optimality of fiscal and monetary policy in the various neoclassical growth models revealed the following:

1. taxing capital income should be reduced progressively (toll higher at the beginning and almost zero on long term);

2. the tax rates on labor and consumption should be approximately constant;

3. monetary policy should aim and maintain interest rates near zero .

In this article we intend to examine the impact of fiscal policy on the Romanian economy during 2001-2014 and to determine also, using Laffer curve, an optimal tax level. The approach is complex, due to the fact that in the analyzed time series we find present the main stages of the economic cycle: growth (unsustainable), economic crisis over which overlapped phases of the electoral cycle. All they printed a strongly pro-cyclical fiscal policy.

The absence of toxic assets in the Romanian banking system (one of the main causes of the world economic crisis) was not enough for Romania to be avoided by recession. It was felt in the real economy downturn after a period of 8 years of artificial growth, also accompanied by the accumulation of macroeconomic imbalances: the current account deficit, budget deficit, public debt.

The main macroeconomic imbalances accumulated in Romania, the current account deficit and budget deficit generate a vulnerable economic system and, after the beginning of economic crisis took a difficult adjustment process. Although there have been periods of growth, they were not accompanied by structural reforms to print the growth process sustainable component.

Table 1

Source: INSSE, BNR

From the data above, we observe that the current account deficit widened in 2004-2008, when they occurred massive capital inflows. Unsustainability of the current account deficit is explained by the pro-cyclicality of fiscal policy. A prudent fiscal policy could mitigate some vulnerabilities (currency appreciation in nominal and real terms negative impact on external competitiveness) generated by massive capital inflows, on the understanding that often these large capital inflows followed by financial crisis¹.

The role of fiscal policy in economic and social terms, is one of great importance, especially in the current context characterized by instability when taxes are the main drivers that act as automatic stabilizers of economic growth to alleviate economic cycle fluctuations.

The role of automatic stabilizers is particularly important, contributing to smoothing the economic cycle and lowering GDP volatility. The mechanism is more effective in progressive tax systems. The role of these stabilizers is visible also in the flat tax system, such as Romania in 2004. The budget balance contribute through cyclical fluctuations automatically to smoothing fluctuations in economic activity:

1. stabilizers automatic reduce (without the intervention of policy makers) the amount by which the gross domestic product changes in response to a shock to the economy;

2. in the phase of economic boom, budget surpluses and vice-versa;

3. diminish the liquidity preference of the population during the economic boom and an increase in the recession;

4. stimulate aggregate demand when the economy is on the downward economic cycle and limit its expansion during the boom.

Table 2

* Own calculations based on data from NIS, World Bank

2. The relationship between tax revenues and fiscal pressure

Considering the data in from the table 2, we obtain the following dependence between tax revenues and fiscal pressure as is shown in figure 1.

We shall try to find a link between tax revenues (TR) and fiscal pressure (FP). Analyzing different regression curves, we find that a better approximation for this link is given by a second degree polynomial. Let therefore:

, a,b,cR

Let now: where (FP_i,TR_i)_i=1,...,n are given by the table 2 and n=14.

After the condition that dF=0 we find that:

and finally:

The regression is therefore:

Because FP= we find: .

We have now: , 0 therefore the function GDP is concave. But from this relations, GDP reach its maximum for GDP’=0 that is: FP_max= =17.39%.

Figure 1

.

2. Conclusions

Analysis of taxation from the period 2001-2014 reveals that on excessive taxation the real level of GDP decreases. It reaches a maximum (for data adjusted following regression analysis) at 17.39%. A high level of fiscal pressure generates a decrease in investment activity, so by default will have unwanted consequences in the medium and long term.

Figure 2

4. References

Chari V.V., Kehoe J.Patrick (1999), Optimal Fiscal and Monetary Policy, NBER, WP 6891

Chiang A.C. (1984), Fundamental Methods of Mathematical Economics, McGraw-Hill Inc.

Dolls M., Fuest C., Peichl A. (2009), Automatic Stabilizers and Economic Crisis: US vs. Europe, Institute for the Study of Labor, DP No. 4310, July

Dornbusch R., Fischer S., Startz R. (2007), Macroeconomics, Economica, Bucharest

Harrison M., Waldron P. (2011), Mathematics for Economics and Finance, Routledge

Ioan C.A., Ioan G. (2011), n-Microeconomics, Zigotto Publishing, Galati

Popescu Gh. (2004), The evolution of economic thought, Romanian Academy Press, Bucharest

Reinhart C., Reinhart. V. (2008), Capital Flow Bonanzas: An Encompassing View of the Past and Present, NBER Working Paper

Simon C.P., Blume L.E. (2010), Mathematics for Economists, W.W.Norton&Company

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