More Evidence Against the Laffer Curve
Brad DeLong uses his blog to publish more honesty from Bruce Bartlett:
But how likely is it that the Laffer curve is causing revenues to rise, as opposed to normal operation of the business cycle? Not much, in my opinion. First of all, the Laffer curve came to prominence during a period when the top tax rate on dividends was 70 percent and the rate on long-term capital gains was 40 percent. Economist Arthur Laffer correctly pointed out that a 100 percent tax rate would raise no revenue and that rates close to this would reduce revenue below what a lower rate would bring in. Given the tax rates in existence, it was plausible to argue that a reduction in the top rate and capital gains tax would raise revenue. However, when President Bush took office, the top rate on dividends was down to 39.6 percent and the rate on long-term capital gains was just 20 percent—far below the rates Ronald Reagan inherited. It is very implausible that these rates were in the “prohibitive” range of the Laffer curve, such that a rate reduction would raise revenue. But even if we grant the theory, how likely is it that the recent rise in revenue owes anything to this effect? Again, not much. The fact is that it is only in very exceptional circumstances that there would even be the possibility of a tax cut that would so stimulate growth that it would pay for itself. Even the Bush Administration admits this. The 2003 Economic Report of the President (pp. 57-58) says, “Although the economy grows in response to tax reductions…it is unlikely to grow so much that lost tax revenue is completely recovered by the higher level of economic activity.” Recent academic research suggests that feedback effects would offset only a fraction of the static revenue loss, that which would result from no effect on consumption or incentives. A 2004 study by Harvard economists N. Gregory Mankiw and Larry Weinzierl found that a cut in taxes on capital might recoup 17 of the static revenue loss in the first three years and a cut in taxes on labor could recoup 13 percent. Mankiw served as chairman of the Council of Economic Advisers under President Bush. A study by the Congressional Budget Office in December 2005 found that a tax rate cut would recoup at most 20 percent of the static revenue loss in the first five years. Overall federal revenues are just barely back to where they were five years ago in nominal terms.
In the comment box of Brad’s post, we see a link to Evidence on the High-Income Laffer Curve from Six Decades of Tax Reform written by Austan Goolsbee in 1999:
This paper has used evidence from seven different tax changes since 1922 to examine the evidence in support of the high-income Laffer curve and the New Tax Responsiveness Literature … While that work emphasizes the potential importance of behavioral responses to marginal tax rates, the results in this paper suggest that the evidence on which those conclusions are based—evidence from the 1980s—is atypical in the historical experience. Using the same methods that NTR authors have used for the 1980s, the elasticities of taxable income calculated for other tax changes seem to be much more modest with several indistinguishable from zero. This is true in the aggregate cross-sectional tax return data as well as in panel data on executive compensation. The largest estimates of the taxable income elasticity from all of the previous historical periods is lower than the smallest estimates of the elasticity in the literature based on the 1980s. Given the importance of the behavioral response to taxation, it is my hope that this will stimulate further research on the topic using data outside of conventional tax returns in the 1980s and 1990s. The notion that governments could raise more money by cutting rates is, indeed, a glorious idea. It would permit a Pareto improvement of the most enjoyable kind. Unfortunately for all of us, the data from the historical record suggest that it is unlikely to be true at anything like today’s marginal tax rates. It seems that, for now at least, we will have to keep paying for our tax cuts the old fashioned way.