Developing A Supply-Side/

Public-Choice Synthesis
Supply-Side Fundamentals for Tax Reform
Presented at The Heritage Foundation
October 17, 2000

By
Lawrence A. Hunter
 CHART 1
Original Laffer Curve
100%
A
C
Tax Rate

D
B
0%
0%
Revenues
Chart 1: Art Laffer observed that there are two rates
at which the government gets no stuff for its taxing
efforts – Zero and 100 percent. He connected the
dots in between and the Laffer Curve was created.

Two fundamental considerations where taxes are

concerned:
What Stuff is taxed – i.e., what’s the tax base;
How much of the Stuff does the government
confiscate – i.e., what’ the tax rate;

The more Stuff is taxed, the less Stuff you get; and
The less Stuff is taxed, the more of it you get.
 CHART 2

A
Ym

C B
Y+

Y-
Output

0%
- rm
0% r r+
100%
Tax Rate
Chart 2: I don’t know why Art put the independent variable—the tax rate—along
the y axis, so I always reorient the curve so the tax rate is along the x axis where it
belongs.
Laffer’s observation was not new, indeed it is derivative of a fundamental
concept of economics—diminishing returns. In fact, the concept was well
understood by America’s Founding Fathers: Hamilton in Federalist # 22:
“It is a signal advantage of taxes on articles of consumption [what today are
called tariffs and sales and excise taxes] that they contain in their own nature a
security against excess. They prescribe their own limit, which cannot be
exceeded without defeating the end proposed--that is, an extension of the
revenue. When applied to this object, the saying is as just as it is witty that, ‘in
political arithmetic, two and two do not always make four.’ If duties are too
high, they lessen the consumption; the collection is eluded; and the product to
the treasury is not so great as when they are confined within proper and
moderate bounds. This forms a complete barrier against any material
oppression of the citizens by taxes of this class [i.e., indirect taxes], and is itself a
natural limitation of the power of imposing them.”
This analysis implies that if we decide to enact some version of a flat income tax
or a consumed income tax or a cash-flow tax collected like an income tax, which
are less sensitive to the tax rate, some “constitutional” rule would be more
important than if we opted for a national sales tax, which “contains in its own
nature a security against excess.”
 Laffer Curve is a fine heuristic, especially when the top tax rate is 70
percent as it was back in 1980. But, it doesn’t suffice to inform
comprehensive tax reform. Moreover, the Media and demand-siders
parodied the Laffer Curve to ridicule Reaganonomics. George Bush the
Elder called it Voodoo Economics and George W. has yet to say “we’re all
supply siders now.”
Supply-side economists played into their opponents’ hands by making a
fundamental mistake early on. Jude Wanniski, a former editorial writer at
the WSJ was supply-side economics’ chief propagandist and in a famous
article in 1978 in the Public Interest he made an heroic assumption:
“Revenues and Production are maximized at point E,” he contended. “It
is the task of the statesman to determine the location of point E, and
follow its variations as closely as possible.”
The reason Jude made this mistake is that he did not analyze the more
fundamental, underlying relationship between production/output and taxes.
As we will see in just a moment, the Laffer Curve is a derivative of this
relationship and completely determined by it. The relationship I am talking
about is the relationship between the tax base and the tax rate, not between
revenues and the tax rate.
 CHART 3
Rahn Curve
YMAX
1

0.9 Output is maximized at Ymax with a tax rate of T1

0.8

0.7

0.6
Index of Output

0.5

0.4

0.3

0.2

0.1

0
0% T1 100%
Tax Rate
Output
Chart 3: I call this the Rahn Curve because when I first met Richard Rahn back at the
US Chamber of Commerce, he was always emphasizing that it was output that we
were seeking to maximize, not revenues, and he drew a version of this curve to make
the point. Over the past 15 years or so there has been considerable research on this
relationship, some by Richard. Richard always focused on spending rather than the
tax rate, but under a balanced budget constraint, they reduce to the same thing.
I have drawn an arbitrary Rahn Curve—notice there are no specific tax rates—and
the truth is, there exists an entire family of Rahn Curves depending upon
circumstances and the tax base.
Remember, Alexander Hamilton’s words. He was making the point about taxes on
consumption because he wanted to justify the constitutional provision
(apportionment) limiting the federal government’s ability to levy “direct” taxes, i.e.,
income and property taxes, over and above the natural constraint of the Laffer Curve.
In terms of a supply-side analysis, Hamilton would argue that where consumption
taxes are concerned, the Laffer Curve is narrow and skewed to the left, i.e., quite
sensitive to the rate at which consumption is taxed.
Whereas in the case of income taxes, it is more symmetric or even skewed to the
right and quite wide, i.e., not so sensitive to the tax rate, which makes them require
“constitutional” constraints to keep them within reason.
We will return to the implications of this insight in a moment, because this is one of
the most important considerations to think about regarding tax reform circa 2000. But
first, I want to show how the Laffer Curve is really derivative of the Rahn Curve.
 CHART 4
EXAMPLE 1
Output Maximized @ 13% Tax Rate Tax
Revenues Maximized @ 26% Tax Rate
1 100%

0.9 90%

0.8 80%

Maximizing Revenues Reduces Economic Output by 27%

0.7 70%

Revenue As Percent Output

0.6 60%
Index of Output

0.5 50%

0.4 40%

0.3 30%

0.2 20%

0.1 10%

0 0%
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
Tax Rate
Output Revenues
Chart 4 (Example 1). For any given Rahn Curve, the Laffer
Curve can be derived by multiplying every possible tax rate
times the amount of output determined by the Rahn Curve at that
rate. If you plot that curve, it will look like the red curve in
Example 1.
In this instance, I have drawn the Rahn Curve so that output is
maximized at a 13 percent tax rate, resulting in a revenue-
maximizing rate of 26 percent. (I assume that each marginal tax
dollar below the output-maximizing tax rate is spent efficiently
by the government, i.e., so as to yield the largest increase in
output. We will see why that is a reasonable assumption in a
minute and when inefficient “pork-barrel” spending is likely to
arise in a democracy.)
Example 1 also illustrates why Jude was wrong in his
conjecture that the revenue-maximizing tax rate is the point at
which production is maximized. Here maximizing revenues at a
tax rate of 26 percent reduces output by some 27 percent.
 CHART 5
EXAMPLE 2
Output Maximized @ 18% Tax Rate
1.1 Revenue Maximized @ 39 % Tax Rate 110%
Output-Maximizing Tax Rate Equals 18%
1.0 100%

0.9 Up to 25% Lost Economic Output Due to Excessive Tax Rates

90%

0.8 80%

Revenue As Percent Output

Index of Potential Output

Pure Rent Seeking

0.7 betw een Tax Rates of
70%
18% and 39%
0.6 60%

0.5 50%

0.4 40%
Revenue-Maximizing Tax Rate Equals 39%
0.3 30%

0.2 20%

0.1 10%

0.0 0%
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Tax Rate

Output Revenues
Chart 5 (Example 2). But, of course, depending upon the preferences of the
electorate and the nature of the tax base, the Rahn Curve might look quite different
than Example 1. In Example 2, for example, output is maximized at an 18 percent
tax rate, which yields a revenue-maximizing tax rate of 39 percent.
Notice how maximizing revenues at 39 percent in this example results in a 25
percent reduction in output.
Why is all of this important? Look at the range of tax rates between the output-
maximizing rate and the revenue-maximizing rate. In this range, all of the productive
and efficient ways government can spend tax revenue have been exhausted.
Beyond the tax rate that maximizes output, taxes can be raised but because the use
of the revenue cannot be put to the general welfare, only to the benefit of special
interests, politicians must play “pork-barrel” politics, i.e., increase taxes on a
minority of the population to bestow government goodies on a small majority or a
coalition of minorities. It is here that supply-side economics meets public choice
economics.
The range between these two maximizing tax rates creates a range for pure
rent seeking by politicians. Even though economic output is reduced by 25
percent in this example by raising tax rates from 18 percent to 39 percent, the
additional revenues that flow into the treasury in this range can be used to buy
votes.
This is the very essence of concentrated benefits (derived from government
spending financed by the revenues raised in this range) and diffuse costs (the lost
output that people do not directly observe that results in an overall lower standard of
living. And, the reduced standard of living is greater than the benefits concentrated
on favored constituencies.
 CHART 6
Demand For Taxable Output

100%
Tax Rate

T1

Tax Revenue
Excess
Burden
0%
Taxable Output
Chart 6. Larry Lindsey illustrated why this is the case with the concept of the “excess
burden of taxation.” Larry Lindsey explained the relationship depicted in the Rahn
Curve in a conventional micro-economic analysis in which he focused on the “excess
burden” of taxation. The excess burden of a tax is the loss in the taxpayer’s well-being
above and beyond the taxes he pays; there is no offsetting gain to the government from
the loss in taxpayer well being resulting from having to pay the taxes.
Along the x axis is pre-tax income. The diagonal line determines for any given tax
rate along the y axis, how much pre-tax income an individual will demand. At no tax,
the individual will demand, i.e., work to earn, Y1 income, and the government will
receive no tax revenue.
It the government institutes a tax at a tax rate of T1 the individual’s demand for pretax
income will fall to Y2, and the government will raise (T1 x Y1) in tax revenue (the rate
times the base), which is illustrated by the rectangle. But notice, the little triangle
represents a loss in income that is neither picked up in tax revenue by the government
nor in after-tax income by the individual.
Larry also used this framework to argue that Jude was wrong in his assertion that the
revenue-maximizing rate maximizes production. But Larry did not draw out the
implications of his observations on excess burden nor did he seem to comprehend the
nature of the Rahn Curve. In fact, he contented himself with showing that the marginal
excess burden of raising an additional dollar of revenue approaches infinity as the tax
rate gets close to the revenue-maximizing rate. I’ll return to this at the end of my
presentation.
 CHART 7
EXAMPLE 3
Output Maximized @ 33 Percent Tax Rate
Tax Revenues Maximized @ 60 Percent
1.0 100%

0.9 90%

0.8 80%

0.7 70%

Revenue As Percent Output

0.6 60%
Index of Output

0.5 50%

0.4 40%

0.3 30%

0.2 20%

0.1 10%

0.0 0%
0.0% 10.0% 20.0% 30.0% 40.0% 50.0% 60.0% 70.0% 80.0% 90.0% 100.0%

Output Revenues
Chart 7. Finally, in Example 3, output is maximized at a 33
percent tax rate, with a revenue-maximizing rate of 60 percent.

What might account for such a relationship? Jude makes the

point that when a nation is at war, it may be quite willing to
maximize output at a very high tax rate. Korea after WWII comes
to mind as to why the public tolerated the top tax rate remaining
at 70 percent. And, we also should not over look the fact that the
American welfare state based on rent seeking began to take hold
in the 1950s.
 CHART 8
Derived Laffer Curve
Output Maximized @ 33% Tax Rate

100.0%

90.0%

80.0%

70.0%

60.0% E = Revenue Maximizing Rate of 60%

Tax Rate

50.0%

40.0%

30.0%

20.0%

10.0%

0.0%
0.0% 10.0% 20.0% 30.0% 40.0% 50.0% 60.0% 70.0% 80.0% 90.0% 100.0%
Revenues As Percent Output
 Chart 8. I have just thrown this chart in to illustrate that the
derived Laffer Curve looks like one would expect.

Now, before going any further, I want to discuss an

important fact that has been overlooked by supply-side
economists. In fact, I would state it as a basic theorem of
political economy that can go a long way to integrating
supply side economics and public choice economics.

§Theorem: Under reasonable circumstances, the revenue-

maximizing tax rate always exceeds the output-maximizing tax rate.
 CHART 9
Revenue-Maximizing Tax Rate
Exceeds Output-Maximizing Tax Rate
1
Even With Output Extremely Sensitive To Tax Rate 100%

0.9 90%

0.8 80%

0.7 70%

Revenue As Percent Output

0.6 60%
Index of Output

0.5 50%

0.4 40%

0.3 30%

0.2 20%

0.1 10%

0 0%
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
Tax Rate

Output Revenues
Chart 9. The proposition to disprove is Jude’s
Conjecture (he stated it as a theorem) that production is
maximized at the revenue-maximizing tax rate. I won’t
go into the details of the proof of this proposition but
inspecting a couple of graphs gives you the insight you
need. In this example, it is obvious how even with a
very steep output curve with a very low output-
maximizing tax rate—10 percent—the revenue-
maximizing rate is still higher—17 percent in this case.
 CHART 10

Revenue-Maximizing Tax Rate Exceeds

1 Output-Maximizing Tax Rate Even With Output- 100%

Maximizing Rate Skewed Unrealistically to Right

0.9 90%

0.8 80%

0.7 70%

Revenue As Percent Output

0.6 60%
Index of Output

0.5 50%

0.4 40%

0.3 30%

0.2 20%

0.1 10%

0 0%
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
Tax Rate

Output Revenues
Chart 10. At the other extreme, even with the output
curve skewed far to the right and an extraordinarily high
output-maximizing tax rate (about 91 percent), the
revenue-maximizing rate is still higher (93 percent).

The following slides present the formal proof of the

theorem and the implications that flow from it.
CHART 11
CHART 12
 In order for the revenue-maximizing tax rate to equal the output-
maximizing rate, Y+ must lie beneath and to the left of the graph,  r+.

In Diagram 2, the thick red line graphing the power function Y+ = is

the envelope that establishes the boundary on the family of all possible
output curves satisfying the condition required for the Conjecture to be
true.

The thin red [horizontal] solid line below this envelope is the graph of
the revenue [Laffer] curve generated by it, which means that the red line
traces out the boundary on the family of all possible revenue [Laffer]
curves that satisfy the condition making the Conjecture true. Notice
from the depiction of the Laffer Curve boundary that the output curve
synonymous with the boundary condition does not itself satisfy the
Condition of the Conjecture since in the case of the boundary, R+ = Rm,
 r+, which violates (1).
 Diagram 2 establishes the relationship between output and revenue that
is required for the output-maximizing and the revenue-maximizing tax
rates to be the same. The Condition an output function must satisfy to
meet the terms of the Conjecture demands that output be hyper-sensitive
to changes in the tax rate near the output-maximizing rate. This is
verified by the fact that a power function with an exponent of -1 has a
infinitely negative first derivative at its asymptote (rm in this case), which
means output falls dramatically for small increases in the tax rate above
the output-maximizing rate.

The thick blue dashed line in Diagram 2 represents one arbitrary output
function that satisfies the conditions of the Conjecture, and it’s
associated Laffer Curve is depicted by the thin blue gray line below it.
Notice that the revenue-maximizing tax rate lies on a cusp of the Laffer
Curve.

The practical implications of this result are enormous.

Lemma: If Yi  Ym then ri  , r j  ri   r j  rm and r j  ri  , where “ r j  ri ”
means r j dominates ri through a unanimous coalition, i.e., a unanimous coalition will
always be willing to increase the tax rate to from ri  to r j in order to enjoy the additional
output.

Proof: By assumption 0 < ri   r j < 1.0

Hence ri Yi   Yi  and r jY j  Y j

Subtracting   
r jY j  ri Yi   Y j  Yi  
which is to say the increase in tax revenues is less than the increase in output generated
by raising the tax rate from ri  to r j . Consequently, raising the tax rate under this
circumstance generates surplus new output over and above what is required to
compensate all taxpayers for the additional tax liability they incur when the tax rate is
raised. Which is another way of saying that raising the tax rate from ri  to r j is a
Pareto-superior move to which everyone would consent.

The revenue-maximizing rate is necessarily greater than the output-maximizing rate

unless output is so sensitive to the tax rate that output falls off so precipitously when the
tax rate moves slightly above the output-maximizing tax rate. In other words, unless the
revenue increase generated by an increase in the tax rate is overcome by a decline in
output resulting from the higher tax burden, it will always be possible to increase
revenues at the expense of output.
 CHART 13
Static versus Dynamic Output/Revenue Model

100% 100%

90% 90%

80% 80%

70% 18.2% Tax Rate 70%

Revenue As Percent Output

Revenue As Percent Output

Reduction from
55% to 45%
60% 60%

50% 18.2% Static Revenue Loss 50%

9.5% Dynamic Revenue Loss

40% 40%

30% 30%

20% 20%

10% 10%

0% 0%
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
Tax Rate

Output Static Output Static Revenue Revenues

Chart 13. We now can examine Dynamic v. Static revenue estimating. In this chart, the
green dashed horizontal line across the top represents the Rahn Curve under the basic
assumption of static revenue estimating, namely that output remains unaffected by a change
in the tax rate. The pink diagonal line represents the degenerate case of the Laffer Curve
under this assumption. Revenue is determined by multiplying the tax rate, whatever it may
be, times the constant output. Notice, revenues are zero at a zero tax rate and 100 percent of
output at a 100 percent tax rate.
Superimposed on the static Rahn Curve is a dynamic Rahn Curve—the turquoise dashed
curve—and its derivative Laffer Curve—the solid red line.
Notice what happens in each case if the tax rate is reduced 18.2 percent, from 55 percent
to 45 percent. Under static revenue methodology assumption—that output is unaffected by
tax rates—revenue falls proportionately by 18.2 percent. In dynamic case, I have
intentionally chosen an instance where the tax rate reduction takes place on the up side of
the Laffer Curve. Therefore, revenues do in fact decline when the tax rate is reduced, but
notice that because output also is declining with a rising tax rate, though not as fast as
revenues, the revenue loss from the tax rate reduction is roughly half that estimated under
the static assumption.
Indeed, I would argue that what happened after the 1986 tax reform was that we altered
the tax based in an inefficient manner—raising capital gains tax rates and lengthening
depreciation schedules—and lowered the rate sufficiently that given the new tax base it was
below the revenue-maximizing rate but still considerably above the output-maximizing rate.
The 1986 reform effort left the tax rate in the rent-seeking range and points out the dangers
of trading off lower rates in exchange for damaging the base. It sets us up for a perfect “bait
and switch” routine, which is exactly what happened under George Bush the Elder and Bill
Clinton. We got stuck with the ill-defined tax base and the rates were raised back toward
the revenue-maximizing point.
 CHART 14
Demand For Taxable Output

100%
Tax Rate

T1
Burden
Tax Revenue Tax Deficiency
Revenue
0%
0% 100%
Taxable Output
Chart 14. I have adapted Larry’s graphic demonstration to apply
to a dynamic Rahn Curve to illustrate that below the output-
maximizing point, it is possible to get a consensus on tax
increases and why once the tax rate exceeds the output-
maximizing point, rent seeking sets in with a vengeance. In
micro-economic terms, this depiction of the Rahn Curve
represents a backward sloping demand curve.

Larry had focused on the Excess Burden of a Tax. But there is

also a symmetric concept on the up-side of the Rahn Curve in
which there is an absolute loss to taxpayers over and above the
revenue lost to government when the tax rate is set below the
output-maximizing rate. I’ve called it the “Burden Deficiency.”
 CHART 15
Effect of a Tax Rate Increase on Burden Deficiency and Excess Burden

100% Burden Deficiency @ Tax Rate T1 = (L + M + N + O)

Burden Deficiency @ Tax Rate T2 = (M + N + O)
Excess Burden @ Tax Rate T3 = (P + O)
Excess Burden @ Tax Rate T4 = (P + O + C + B + N)

TRev -Max
T4
Tax Rate

A
C
T3

TOutput-Max
B P

T2
J
T1 O
L M N

0%
O1 O2 O4 O3
0% 100%
Taxable Output and Revenues

Output Revenues
Chart 15. This chart combines the concept of excess burden and
burden deficiency in the same graphic, complete with a Laffer
Curve.