Developing A Supply-Side/

Public-Choice Synthesis
Supply-Side Fundamentals for Tax Reform

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

D
B
0%
0%
Revenues
 CHART 2

A
Ym

C B
Y+

Y-
Output

0%
- rm
0% r r+
100%
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 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 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 6
Demand For Taxable Output

100%
Tax Rate

T1

Tax Revenue
Excess
Burden
0%
Taxable Output
 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 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 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 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
 DIAGRAM 1
OUTPUT CURVE

A
Ym

Y+ B

Y-
Output

0%
- rm
0% r r+
100%
(1 ) B y C o n jec tu r e : Rm > R'  R'  Rm

(2 ) F o r all r - , th e C o n je ctu re c le a rly is tru e sin c e b y d e fin itio n ( r m ) > (r - ) a n d

(Y m ) > (Y - ), w h ic h im p lie s (r m )(Y m ) > (r - )(Y - ), p ro v in g th a t R m > R - ,  r - . T h is fa c t is
e a sily se e n in D ia g ra m 1 . A s r - in cre a se s a b o v e 0 , Y - a lso in crea se s b u t still re m a in s
sm alle r th a n Y m , , an d th e rec ta n g le rep re se n tin g re v e n u es , Y - C r - 0 , re m a in s c o n ta in e d
w ith in Y m A r m 0 , th e rec ta n g le re p re sen tin g re v e n u es a t r m ,

(3 ) F o r all r + , it is n o t re a d ily d isc e rn a b le fro m D ia g ra m 1 w h e th e r th e C o n jec tu re is

tru e sin c e it is n o t o b v io u s w h e th e r th e in cre a se in re v e n u es d u e to a n in c re ase in th e ta x
rate — re p rese n te d b y th e a re a o f X B r + r m — e x c e e d s th e lo ss o f re v e n u es d u e to th e
d ec re ase in o u tp u t (ta x b as e)— re p rese n te d b y th e a re a o f Y m A X Y + . T h e re fo re , it is
n ec e ssa ry to d eriv e th e c o n d itio n s, if a n y , u n d er w h ic h th e c o n je c tu re h o ld s. T o e x p lo re
w h eth e r su c h c o n d itio n s e x ist, a n d if so w h a t th ey a re , rew rite e x p re ssio n (1 ) fo r R + a s:

(4 ) (r m )(Y m )  (r + )(Y + )

rm 
(5 ) R e arra n g in g term s Ym  Y
r
rm
(6 ) R e ca llin g th at Y m = 1  Y w h ich e sta b lish e s th e c o n d itio n fo r
r
th e C o n je ctu re to h o ld :

1
C o n d itio n : Y + < rm ,  r+.
r

L em m a: T h e rev e n u e -m a x im iz in g ra te w ill alw a y s b e g re a te r th a n th e o u tp u t-

m a x im iz in g ra te u n le ss o u tp u t is s u ffic ien tly se n sitiv e to c h a n g es o f th e ta x rate in th e
n eig h b o rh o o d o f th e o u tp u t-m ax im iz in g rate th a t th e d ec lin e in o u tp u t re su ltin g fro m
sm all in c re ase s o f th e ta x ra te ab o v e th e re v en u e-m a x im iz in g ra te e x c ee d s th e in c re a se in
rev e n u e g e n era te d b y raisin g th e tax rate a b o v e th e o u tp u t-m a x im izin g ra te .

P r o o f: T h e p ro o f th a t th e re v e n u e -m a x im iz in g ta x rate w ill n e v e r b e sm a lle r th an

th e o u tp u t-m ax im iz in g ra te is g iv en b y (2 ) a b o v e . T h e re m a in d e r o f th e p ro o f is b y
1
c o n stru ctio n . R e c o g n izin g th a t Y + = rm  e x p ress es Y + a s a p o w e r fu n c tio n o f r + w ith
r
a n e x p o n en t o f -1 a n d a n asy m p to te o f r m , th e C o n d itio n m ay b e illu s tra te d g ra p h ic a lly .
S e e D ia g ra m 2 .
 Output and Revenue Curves Satisfying the Conjecture

0.9

0.8 + +
Y = (rm)(1/r )
0.7

0.6
Output

0.5
+ +
0.4
Y < (rm)(1/r )

0.3

0.2

0.1

0
0% 10% rm 20% 30% 40% 50% 60% 70% 80% 90% 100%
Tax Rate
In o rd e r fo r th e re v e n u e -m a x im iz in g ta x ra te to e q u a l th e o u tp u t-m a x im iz in g ra te , Y +
1
m u s t lie b e n e a th a n d to th e le f t o f th e g r a p h o f rm  ,  r + . I n D ia g r a m 2 , th e th ic k r e d
r
+ 1
lin e g r a p h in g th e p o w e r fu n c tio n Y = rm  is th e e n v e lo p e th a t e s ta b lis h e s th e
r
b o u n d a ry o n th e fa m ily o f a ll p o s s ib le o u tp u t c u rv e s s a tis fy in g th e c o n d itio n re q u ire d
fo r th e C o n je c tu re to b e tru e .
T h e th in re d [h o riz o n ta l] s o lid lin e b e lo w th is e n v e lo p e is th e g ra p h o f th e re v e n u e
[L a ffe r] c u rv e g e n e ra te d b y it, w h ic h m e a n s th a t th e re d lin e tra c e s o u t th e b o u n d a ry o n
th e fa m ily o f a ll p o s s ib le re v e n u e [ L a ffe r] c u rv e s th a t s a tis fy th e c o n d itio n m a k in g th e
C o n je c tu re tru e . N o tic e fro m th e d e p ic tio n o f th e L a ffe r C u rv e b o u n d a ry th a t th e
o u tp u t c u rv e s y n o n y m o u s w ith th e b o u n d a ry c o n d itio n d o e s n o t its e lf s a tis fy th e
C o n d itio n o f th e C o n je c tu re s in c e in th e c a s e o f th e b o u n d a ry , R + = R m ,  r+ , w h ic h
v io la te s (1 ).

D ia g ra m 2 e s ta b lis h e s th e re la tio n s h ip b e tw e e n o u tp u t a n d re v e n u e th a t is re q u ire d fo r

th e o u tp u t-m a x im iz in g a n d th e re v e n u e -m a x im iz in g ta x ra te s to b e th e s a m e . T h e
C o n d itio n a n o u tp u t fu n c tio n m u s t s a tis fy to m e e t th e te rm s o f th e C o n je c tu re d e m a n d s
th a t o u tp u t b e h y p e r-s e n s itiv e to c h a n g e s in th e ta x ra te n e a r th e o u tp u t-m a x im iz in g
ra te . T h is is v e rifie d b y th e fa c t th a t a p o w e r fu n c tio n w ith a n e x p o n e n t o f -1 h a s a
in fin ite ly n e g a tiv e firs t d e riv a tiv e a t its a s y m p to te ( rm in th is c a s e ), w h ic h m e a n s o u tp u t
fa lls d ra m a tic a lly fo r s m a ll in c re a s e s in th e ta x ra te a b o v e th e o u tp u t-m a x im iz in g ra te .

T h e th ic k b lu e d a s h e d lin e in D ia g ra m 2 re p re s e n ts o n e a rb itra ry o u tp u t fu n c tio n

  1 
 Y  r m  2  t h a t s a t i s f i e s t h e c o n d i t i o n s o f t h e C o n j e c t u r e , a n d i t ’ s a s s o c i a t e d
 (r ) 
L a ffe r C u rv e is d e p ic te d b y th e th in b lu e g ra y lin e b e lo w it. N o tic e th a t th e re v e n u e -
m a x im iz in g ta x ra te lie s o n a c u s p o f th e L a ffe r C u rv e .

T h e p ra c tic a l im p lic a tio n s o f th is re s u lt a re e n o rm o u s .

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 11
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 12
Demand For Taxable Output

100%
Tax Rate

T1
Burden
Tax Revenue Tax Deficiency
Revenue
0%
0% 100%
Taxable Output
 CHART 13
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