Ask The Economist: Why Elasticity Means Soaking the Rich Won’t Work
In the history of civilization, income tax policies designed primarily to soak the rich have always failed. Why? Because of a basic concept of economics called elasticity. Imagine the price of gas goes up by $4 per gallon (to say, the European price). If you routinely buy 20 gallons of fuel a week for your “fun” car (maybe a BMW M3 or Chevy Corvette), would you, after this price hike, be likely to add an extra $80 a week to the coffers of the gas company? The answer is, of course, no. You observe the price of gas going up and cut your consumption.
The percent change in the quantity demanded for a good or service following a change in its price is called its price elasticity of demand. The same applies to supply. As the price received by suppliers of a good increases, they tend to supply more of the good to the market. The change in supply with a change in price is called the elasticity of supply. This holds both for a sales tax or an income tax—the income tax being the price you pay for the “privilege” of working. If governments tax a good higher, less of it is demanded. If you tax labor higher (by taxing income at a greater or graduated rate), you get less of it in the market.
Thus, tax revenues will begin to plateau with increasing tax rates and will eventually start declining. This phenomenon, known as the “Laffer Curve,” was first articulated by Economist Arthur Laffer.
Hopefully, now you understand elasticity, even if (some of) your elected representatives do not.
—Abir Mandal, PhD Candidate, Clemson University Department of Economics and Palmetto Policy Forum Summer Fellow