Pareidolia in economics

Via Cosmic Variance, we learn of the complex statistical analysis presented here, originally from the Wall Street Journal and based on work from the American Enterprise Institute.

The curve labeled the "Laffer curve" is not meant to make you "laff," it is actually an example of the psychological phenomenon known as pareidolia. More famous examples include the ability to see Jesus in burnt tortillas, or the name of Allah in the swirls of an ice cream cone. In this case, the AEI has discovered their own mythical ideal in the data on tax revenue and tax rates.

The Laffer curve is the theoretical underpinning of supply-side economics. It shows tax revenue rising with tax rates until some point at which taxes become so onerous that people prefer not to make money rather than pay more in taxes.

Economists agree that some such relationship must exist – it would be pointless to do any work at all if you were taxed at 100%, after all. The premise of supply siders is that the rate at which tax revenue reaches its maximum is somewhere pretty close to current tax rates, while real economists tend to think the maximum would occur somewhere far beyond current tax rates, and that it is silly to think (as the Bush administration has claimed many times) that cutting tax rates would raise tax revenue.

As Sean points out at Cosmic Variance, the Laffer curve here appears to have been drawn using the sophisticated statistical tools provided by M$ Paint. A simple linear regression through the data shows an upward trend, with no basis for fitting quadratic models. Apparently Norway is also in the wrong place, and in the right place, would simply make the upward trend stronger (Norway has high taxes on oil and gas extraction, a fact included in the tax revenue axis but not in the tax rates axis. Really.).

Humans have a remarkable ability to find patterns where they don't exist, and indeed to force patterns that we see to meet those expectations. The tools of statistics and the scientific process are powerful checks on the excesses of "common sense," and the Wall Street Journal editorial board would do well to rely more on the latter and less on the former.