Notes: The New York Times on the Laffer Curve:
Posted by DeLong at May 24, 2003 03:22 PM | TrackBackhttp://www.nytimes.com/2003/05/18/business/yourmoney/18VIEW.html?fta=y
May 18, 2003
Name That Tune About Tax Cuts
By DAVID E. ROSENBAUM
WASHINGTON
ONE of the most enduring political images of the last generation is the one of Arthur Laffer, an obscure economist from the University of Southern California, scribbling a parabola on a cocktail napkin one night in the late 1970's to illustrate how tax cuts would lead to more government revenue, not less.
The Laffer Curve became the basis of a whole political movement. Prominent politicians like Jack F. Kemp, then a Republican congressman from Buffalo, bought the theory. Then Ronald Reagan adopted it, and it became the justification for the main plank of his 1980 campaign for president (in the face of the elder George Bush's ridicule that it was "voodoo economics"). After Mr. Reagan was elected, he rammed through Congress in 1981 a tax cut that was then the biggest ever, and his staff produced forecasts showing that within a few years, the budget would be balanced.
Of course, the budget deficits mushroomed. In economics circles, the idea that tax cuts would pay for themselves was never widely held and was mostly abandoned by the late 1980's. Supply-side economists, as they call themselves, argued instead the much less provocative point that budget forecasters should take into account the view, accepted by nearly all economists, that the revenue lost from $1 in tax cuts would be somewhat less than $1 because of economic growth generated by lower taxes.
But that is far too sophisticated for a political sound bite. To this day, either directly or indirectly, conservative Republican politicians leave the impression that taxes can be lowered with no effect on the deficit.
At almost every stop as he tours the country to promote his tax-cut plan, George W. Bush makes the two-step argument that the way to deal with the budget deficit is to make the economy grow, and that the way to make the economy grow is to cut taxes.
His staff is more direct. In a television interview last weekend, Treasury Secretary John W. Snow was asked about studies showing that the Bush plan would lead to a rising deficit. "Well, it's actually going to be lower," Mr. Snow declared, "because none of those studies have factored in the feedback cycle ? that is, as the economy grows and gets stronger, more people are at work; there are more government receipts."
George Stephanopoulos, the ABC News moderator, said, "That sounds like supply side."
Mr. Snow replied, "The truth is, a growing economy leads to more government revenues, not the other way around."
Over the years, the accepted practice at the Office of Management and Budget and in Congress has been to assume that the government's revenue loss from a tax cut would be equal to the size of the tax cut. It was not that the revenue estimators believed that there would be no revenue effect from the economic stimulus of a tax reduction. It was that the disagreement was so vast over how much the effect would be.
This galled the many Republicans and conservative economists who believe that lower taxes are the solution, whatever the problem. So, this year, Representative Bill Thomas of California, the chairman of the Ways and Means Committee, ordered the Joint Committee on Taxation, Congress's expert tax staff, to project how much additional revenue would be produced by the stimulus from the tax bill the House approved this month.
THE tax staff is highly professional. But it answers to the Republican majority, and Democrats braced for an extravagant projection that would put them on the defensive as the plan moved through Congress. Instead, the report now circulating around Congress estimates that the "revenue feedback" from the House bill would range from 5.8 to 27.5 percent in the first five years and from 2.6 to 23.4 percent over the full 10 years covered by the bill.
"Eventually," the staff found, "the effects of increasing the deficit will outweigh the positive effects of the tax policy."
In other words, the economic return would be so small that even in the short term, the deficit would grow by at least three-quarters of the size of the tax cut and probably more.
Mr. Thomas's reaction was surprising. The study proves that the bill "stimulates the economy, creates jobs, brings more revenue back to the federal government," he declared during the House debate. "That's what this bill is all about," he added.
Democrats were amused at his attempt to paint a pretty picture on a spoiled canvas. Actually, declared Representative Charles B. Rangel of New York, the top Democrat on the Ways and Means Committee, the report "should dissipate the pie-in-sky mirage that tax cuts will dramatically grow the economy and pay for themselves."
I think the debate is no longer whether we are on the downward sloping part of the Laffer curve. Democrats and experience have defeated soundly this particular notion. We know we are on the upward sloping part. I think that Democrats have to show that the part of the Laffer Curve that we are on is not only upward sloping, but also very steep.
The Bushies, and I think Mankiw, have been arguing in effect that we are on a rather flat part of the Laffer Curve that is slightly upward sloping. This allows them to act like supply-siders but avoid looking like cranks for believing that tax cuts actually increase revenues. Therefore, whenever Democrats ask a Bush economist whether we're on the downward sloping part, the Bushy can shield himself from looking like a crank by claiming that tax cuts will be significantly *but not completely* offset by growth.
I think Democrats have defeated the hypothesis that we are on the downward sloping part of the Laffer Curve. But this new version of supply-side economics that we are on a flat slightly upward sloping part is allowing supply-side prescriptions to make a comeback. This new slightly moderated version must be debunked too so that we can kill the Laffer Curve for good.
Posted by: Bobby on May 28, 2003 05:53 AMI'm not so sure the Laffer Curve is vulnerable to death. The insight behind Laffer's silly claims for the benefits of tax cuts is valid. There is a tax rate above which economic activity is discouraged and ahead of which tax avoidance reduces the effectiveness of higher tax rates in generating revenue. There is a level of revenue collection so low as to hold goverment activity below the level that is needed to foster growth. I have the impression (from a long time ago) that it has been difficult to get a very good handle on the impact of taxes anywhere between the two extremes - and it is pretty clear that most OECD countries' tax rates are not approaching either extreme. Has there been any progress on estimating tax and spending effects in the middle fo the range? US rates are not particularly high among OECD members, after all.
Posted by: K Harris on May 28, 2003 07:06 AMWhile on the subject of the Laffer Curve, I note with some trepidation that the Curve has escaped the strict confines of economic debate. If Brad doesn’t already know, he will surely be pleased to be enlightened – the Laffer Curve is now a bedrock notion in anthropological economics and political history. The “brilliant economist Arthur Laffer” what “on a larger scale … may be the most important economic law of political history. “ It’s true. Look right here:
http://szabo.best.vwh.net/shell.html#The Spoils of War
You are right that the concept is a valid one, just not relevant to the U.S. right now. I should have said that we should aim for its death from the standpoint of political debate in the United States . . . that is unless extreme leftists take over and create a tax policy that makes it relevant, but this won't be any time soon. :)
Posted by: Bobby on May 28, 2003 08:05 AMThe Democrats may have won the debate with the economists but not with the ideologues. Remember that Mankiw and company have been exiled from the WH proper. The point Rosenbaum makes very well is that GOP supply siders like Thomas and Mr. Bush do not listen to their own GOP economists, or if they do are unable to comprehend what is being said.
Mr. Bush is correct that the way to deal with the deficit is to grow the economy. After all, that is how the budget eventually came into balance in the 1990s. But a thriving economy will not balance the budget if the government does not collect the necessary percentage. The trick is to find the proper balance between economic stimulation and revenue collection. The Democrats and the GOP place that balance at different levels of taxation. The Rosenbaum column does a good job of reporting that the economists think the revenue collection will be too low.
Mr. Bush is not correct on his second point, that his particular tax cut will fill the bill for stimulating the economy. Mr. Bush is of the mistaken impression that all tax cuts will have the same economic effect. Not so. It matters greatly who gets the additional money as to how much is invested and spent immediately to help the economy. In the mind of the GOP, Mr. Cheney voting for the government to put a $300,000 tax rebate in his pocket is the same as giving $100 to the lowest 3000 wage earners. It won't be spent the same way.
Posted by: bakho on May 28, 2003 09:13 AMThe shape of an ad hoc curve is not the issue here. The real issue is whether a tax cut not funded by any reduction in government spending increases or decreases economic growth. If the tax cut is even partially consumed, the impact on savings and investment is clear - they decline. So how can this increase growth (unless the labor supply curve is much more elastic than most of the empirical evidence suggests)?
What I found most interesting was reading Charles Rangel's letter before I read Bill Thomas's letter. Rangel suggested something simple: read the JCT report before one reads the spin machine writings. So I did. Then reading Bill Thomas's letter made me laugh as Chairman Thomas completed misrepresented what the JCT report really said.
Posted by: Hal McClure on May 28, 2003 12:21 PMThe Laffer curve is valid, because indeed a high-enough tax rate will suppress the economy enough to reduce revenues when the two are multiplied together. But it is easy to slop around the issue for political reasons if you don't get a mathematical grip on it. There is a way to do so, but the hard part is getting the formula right - not using it. Let's be simple and say:
R = E*T
where R is revenue, E is "the economy" as taxable income, and T is tax rate. We need to show E as a function of R and other things, so *lets suppose*
E = E'(1 - kT), where E' is what E would be without taxes, and k is a constant of action of T (if k = 1, then dropping T by 1% *point* increases increases E by 1% *point*. That's the idea that you get your money back: all the extra proportional savings are economic growth: ie. drop 20 to 19% tax rate provides new E of 81/80 times the previous value.)
Hence, E = E'(T - kT^2), and the derivative
dR/dT = E'(1 - 2kT)
Solve for zero, the break-even "flat" point, and you get
T = 1/2k.
In the diagrams I remember seeing, the curve flattened out at about 28%, meaning k ~ 2. That would mean a surprising gain for the economy, since dropping rates would give twice the growth just "put back in their pockets." Another critical take on the curve idea: if consumers etc, have more money in their pockets, isn't that demand going to raise prices some - offsetting some practical economic gain? I would think k < 1.
~NB
Posted by: Neil Bates on May 29, 2003 11:54 AMThe Laffer curve is valid, because indeed a high-enough tax rate will suppress the economy enough to reduce revenues when the two are multiplied together. But it is easy to slop around the issue for political reasons if you don't get a mathematical grip on it. There is a way to do so, but the hard part is getting the formula right - not using it. Let's be simple and say:
R = E*T
where R is revenue, E is "the economy" as taxable income, and T is tax rate. We need to show E as a function of R and other things, so *lets suppose*
E = E'(1 - kT), where E' is what E would be without taxes, and k is a constant of action of T (if k = 1, then dropping T by 1% *point* increases increases E by 1% *point*. That's the idea that you get your money back: all the extra proportional savings are economic growth: ie. drop 20 to 19% tax rate provides new E of 81/80 times the previous value.)
Hence, E = E'(T - kT^2), and the derivative
dR/dT = E'(1 - 2kT)
Solve for zero, the break-even "flat" point, and you get
T = 1/2k.
In the diagrams I remember seeing, the curve flattened out at about 28%, meaning k ~ 2. That would mean a surprising gain for the economy, since dropping rates would give twice the growth just "put back in their pockets." Another critical take on the curve idea: if consumers etc, have more money in their pockets, isn't that demand going to raise prices some - offsetting some practical economic gain? I would think k < 1.
~NB
Posted by: Neil Bates on May 29, 2003 12:06 PMHere's the skinny: Washington politicians (meaning the spendthrifts of BOTH PARTIES in CONGRESS) are addicted to our tax dollars like a teeny-bopper is to X-Box games, like a programmer is to caffinated soda and like a spendaholic is to Visa/MasterCard.
The deficits of the 1980's and the deficits of today are a direct result of OVERSPENDING. Give politicians ONE dollar, and they will spend AT LEAST $10.
The only reasonable response can be to BREAK their addiction by cutting it off @ the source > that is TAX CUTS >
MARGINAL (lower rates)
WIDE (all wage earners)
DEEP (more than just a few percentage points) And PERMANENT (no phase-outs/sun-downs).
As a society, we do NOT permit convicted bank robbers to work @ a teller station in a bank. Therefore, voters and taxpayers should treat politicians @ the local, state and national level accordingly.
EOM