For the past few weeks I’ve been talking a lot about government spending and taxes. Last week (click here to read), I discussed how not all tax breaks pay for themselves.

As you could imagine, I got a slew of insults from diehard conservatives telling me there was simply no way that could ever be true. Still, not one person showed me any evidence that the Bush tax cuts paid for themselves.

I also got a bunch of e-mails from people who admitted that cutting taxes while increasing spending is simply a crapshoot.

Take John R., for example, who said:

While I believe the Bush cuts did generate an amazing revenue increase and that had spending been constrained we wouldn’t be in this mess, they did not pay for themselves (apart from the cap gains cut). Nice work, based on facts and figures, not preconceived answers. Thanks.

But one of the more interesting e-mails came from reader Curt D., who said:

I definitely like your articles. But the question still and always will remain, what is the correct tax rate? Trust me - if tax rates are at 100%, I will not be working. Why turn over 100% of my income when I still have expenses? So I think we can agree that a tax rate of 0% results in zero revenue to the government and a tax rate of 100% will result in zero revenue to the government. So what percentage will maximize government tax revenue? And is this the appropriate level of taxation to maximize the potential of the people who actually pay taxes? Two competing goals, no? Thanks for listening,

Well, Curt, you bring up an interesting question. And it’s a question that politicians have been haggling with since taxation first began.

To find the “perfect” tax rate, let me introduce you to something called the Laffer Curve.

As you can see, on one side of the curve, you have a zero-percent tax rate that would result in no revenue. Likewise, a 100-percent tax rate would also result in zero (or little) revenue.

So for government to maximize the revenue they receive in taxes, they have to find the perfect tax rate – one that maximizes government revenue by getting everyone who avoids paying taxes to actually pay them.

This curve is central to the conservative right, which believes that lowering taxes will increase revenue. But of course they fail to realize that lowering taxes too much actually cuts government revenue (and increases inflation).

Now, finding the perfect tax rate isn’t easy. At any given time, there are thousands of different factors that go into exactly why people avoid paying taxes or why revenues drop.

How can this curve possibly account for all of those different factors? It can’t. For this curve to truly optimize government revenues, it would have to be on a sliding scale (similar to interest rates).

When economic activity slows down, the tax rate drops so that people have more money to spend in an economic downturn. But as soon as economic activity starts picking up, the tax rate rises to help control the money supply, recover any lost revenue, and maximize government revenue.

In essence, tax rates would be closely pegged to interest rates.

What this accomplishes is a fluid and flexible taxation system that’s in sync with the supply and demand fundamentals of the economy.

You see, the problem with the Laffer Curve is that there’s no real flexibility or fluidity to it. Tax rates stay the same for years and years before they finally change. But the economy has been changing that entire time.

All the factors that keep a person from paying taxes change over time. Yet for some reason, they would still get taxed based on yesterday’s economy.

Now this system isn’t something that’s easy to implement. Every employer would have to go along with the tax changes. And then there’s the question as to how often these taxes change. And who would control these tax rates? Certainly not our overspending, time wasting Congress.

In short, finding the perfect tax rate is nearly impossible. It would take a lot of experimentation. And even if we found today’s proper tax rate, it doesn’t mean it would stay the same tomorrow.

That’s why I’m all about eliminating income taxes altogether and replacing them with a progressive consumption tax.

The reason why I like this system is because it encourages saving (which is something the government doesn’t want you to do). And since it encourages savings, it would also encourage capital formation (building new plants), increased productivity, and economic activity.

This would eliminate the thousands of various tax breaks littered in our defunct, broken-down taxation system. It would decrease government spending (since the IRS would be significantly downsized), and it would maximize government revenue.

Plus, it would make it harder for government to raise taxes to extreme levels. Alexander Hamilton realized that hundreds of years ago when he said, “It is a signal advantage of taxes on articles of consumption 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.”

Hmm, a taxation system that CLEARLY discourages raising taxes? Sounds like a good system to me!

Next week I’m going to cover government spending and its role in everything from what you invest in to what you eat.