Mike Kimel at Angry Bear has several nice posts on the "Laffer Curve"
by Kenneth Thomas
(reposted from Middle Class Economist)
Mike Kimel at Angry Bear has several nice posts on the “Laffer Curve” that underlies much of conservative economic orthodoxy in this country. As you may know, Art Laffer famously claimed that at tax rates of 0 and 100%, you would get zero tax revenue, and that in between, there is an inverted U shaped curve, where taxes collected first increase as the tax rate goes up, then decrease as tax rates go higher still, back down to zero tax collected when the tax rate is 100%.
The Kimel post linked above was prompted by an economist at the American Enterprise Institute, Alan Viard, telling the New York Times that all economists know that when the top tax rate is 35%, cutting rates further will reduce tax revenue.
“The Reagan tax cuts, on the whole, reduced revenue,” he explains. “The Bush tax cuts clearly reduced revenue. There is no dispute among economists about that.”
Except, as Kimel points out, lots of conservative economists dispute this, including one who co-authored a paper with Viard! For his trouble, Kimel became the subject of a post at the AEI blog by James Pethokoukis, which started by completely misidentifying him and going downhill from there. For Kimel’s enjoyable takedown of this post, see here.
All this led me back to an earlier post of Kimel’s, where he makes an empirical estimate of the Laffer Curve, using U.S. data all the way back to 1929, the first year for which official U.S. data exists. I’ll spare you the technical details (see Kimel’s post), but here’s the bottom line: Laffer got it exactly backward, with tax revenue initially falling as tax rates increase, then rising after a further increase in rates. Here is Kimel’s estimate of the “true” Laffer curve:
Not only that, as one of Kimel’s commenters, Robert Waldmann points out, we actually have experience with a country having a top marginal rate over 100%, Sweden in the 1970s. Contrary to Laffer, not only was tax revenue not equal to zero, in 1975, Sweden’s tax revenue was 41.3% of gross domestic product! (OECD statistics, click on “data by theme,” then “public sector, taxation, and market regulation,” then “taxation,” then “revenue statistics – OECD member countries,” then “comparative tables”) 21.2% was central government revenue, i.e. excluding subnational government and social security. Either way, a long way from zero.
Not to belabor the point, but Viard was right about tax revenue after President Bush’s tax cuts. Here is the OECD data for the federal government, excluding Medicare, Medicaid and Social Security. First we see the effects of President Clinton’s tax increase, then President Bush’s tax cuts.
Year Tax/GDP
1992 10.7%
1993 11.0%
1994 11.3%
1995 11.7%
1996 12.2%
1997 12.7%
1998 13.1%
1999 13.2%
2000 13.5%
2001 12.5%
2002 10.4%
2003 9.8%
2004 10.0%
2005 11.2%
2006 11.9%
2007 11.9%
2008 10.4%
2009 8.4%
2010 9.1%
Source: OECD, directions as above for Sweden
Before you supply-siders get too excited about the increase in 2006 and 2007 to 11.9%, remember that the higher Clinton tax rates brought in more revenue for five straight years, 1996-2000.
Though many journalists get it wrong, chessplayers like myself know that “refute” means to conclusively disprove. And the Laffer Curve stands refuted.
crossposted with Middle Class Political Economist
And the Laffer Curve stands refuted.
Not by this post. Supply side theory is that, under certain conditions, reductions in tax rates will increase TOTAL tax reciepts. This misleading post uses a measurement of tax revenue AS A % Of GDP, which is not what the Laffer curve is about.
Now that we are on the real subject…..The Bush tax cuts were in 2003. Check out what happened to tax reciepts post tax cut: http://1.bp.blogspot.com/-XzSt66mxR0c/T4bGOL-eD3I/AAAAAAAABKM/0A1Up_3ujd0/s1600/FIGURE110.gif So “The Bush tax cuts clearly reduced revenue. There is no dispute among economists about that.” is also in error.
And the Laffer Curve stands refuted.
Not by this post. Supply side theory is that, under certain conditions, reductions in tax rates will increase TOTAL tax reciepts. This misleading post uses a measurement of tax revenue AS A % Of GDP, which is not what the Laffer curve is about.
Now that we are on the real subject…..The Bush tax cuts were in 2003. Check out what happened to tax reciepts post tax cut: http://1.bp.blogspot.com/-XzSt66mxR0c/T4bGOL-eD3I/AAAAAAAABKM/0A1Up_3ujd0/s1600/FIGURE110.gif So “The Bush tax cuts clearly reduced revenue. There is no dispute among economists about that.” is also in error.
Actually, the Bush tax cuts were in 2001 and 2003. Did you forget the first round of cuts? Many of the 2003 cuts simply accelerated thw 2001 cuts.
Here is what two Heritage analysts, clearly working from a supply-side perspective, said about the 2001 tax cut: “Under President Bush’s plan, an average family of four’s inflation-adjusted disposable income would increase by $4,544 in fiscal year (FY) 2011, and the national debt would effectively be paid off by FY 2010.” (http://origin.heritage.org/research/reports/2001/04/the-economic-impact-of-president-bushs-tax-relief-plan via Wikipedia http://en.wikipedia.org/wiki/Economic_Growth_and_Tax_Relief_Reconciliation_Act_of_2001). We both know that didn’t happen. I would ask you, if tax cuts are so great for the economy, why did the Bush tax cuts of 2001 and 2003 not prevent the worst recession since the 1930s?
If you want to look at revenue only, tell me what to make of this: Over President Reagan’s time in office, individual income tax revenue increased from $285.9 billion in 1981 to $445.7 billion in 1989 (http://www.cbo.gov/sites/default/files/cbofiles/ftpdocs/120xx/doc12039/01-26_fy2011outlook.pdf, Table E-3), an increase of 56%. During President Clinton’s administration, when tax rates were raised, invididual income tax revenue went from $509.7 billion to $994.3 billion in 2001, an increase of 95%. Moreover, regardless of what Laffer said, raw numbers do not make good measures. If GDP grows, there is also a need for increased government spending, what with greater population and all, So we should look at this explanation from the Wikipedia article on the Laffer curve and compare it to what happened to deficits: “Laffer presented the curve as a pedagogical device to show that, in some circumstances, a reduction in tax rates will actually increase government revenue and not need to be offset by decreased government spending or increased borrowing.” But the budget deficit (Table E-1) grew from $73.9 billion in 1981 to $205.4 billion in 1989 (and would have been even bigger without the 1986 tax increases). By slowing the growth of tax revenue, the Reagan tax cuts did require increased borrowing. Spending grew faster than revenue, and we know that growth in GDP increases spending. That’s why revenue/GDP is the right measure, and what I’ve shown also explains why Kimel uses all the data since 1929 rather than cherry-picking some particular period that supports his view.
Household composition?
I think we should give Viard credit for more subtlety than Mike has done. When Viard says there is no disagreement among economists that the tax cuts of recent decades have reduced revenue, he is tacitly saying that anyone who disagrees is not an economist. That, I think, is a pretty good rule of thumb.
By the way, I think we need to recognize that, whatever Laffer may have said, the correct argument is not that a marginal rate over 100% would produce zero revenue overall. The logically correct formulation is either than a blanket 100% tax rate would produce no revenue, or that a marginal 100% tax rate would produce no revenue at the margin. Vast amounts of income would be taxed at less than a 100% marginal rate in any progressive system, and so would produce revenue. The logic of Laffer’s argument was that private taxable activity would stop if government confiscated all income. That implies a blanket 100% tax rate, not just a 100% marginal rate.
I suppose I am agreeing with sammy, which troubles me. In my defense, I can only say that I make the distinction between marginal and total tax rates for the purpose of logic, not ideology. Laffer’s observation is trivial to actual tax policy discussion. The reality, as Kimel shows (as have others) is that in the real workd, the Laffer argument is irrelevant. Anyone who argues otherwise is, to be polite about it, not an economist.
Sammy,
I’m not sure what your graph shows (or is meant to show). That nominal income grows? I think everybody knew that. If you want to make it meaningful you have to take the log, and convert it to real values.
Kenneth,
That’s why revenue/GDP is the right measure,
Laffer doesn’t even mention revenue/GDP, so it is NOT the right measure. In fact, since the mechanism for increased tax reciepts includes faster GDP growth, it is not even reasonable to expect the ratio to go up.
Sammy,
I would say that the Laffer Curve is an irrelevant measure and is more appropriately referred to as the Laugher Curve.
If we accept that Laffer based his argument on the notion that GDP would grow faster under lower tax rates, then the evidence shows he was wrong. As Kimel has shown (as have others), lower rates do not result in faster growth.
In fact, though, Laffer’s original argument was merely to start from two extreme “zero” conditions – no taxes means no revenue and complete confiscation of private income would lead to an end to efforts to earn taxable income, so no revenue – and then conclude that moving away from the extremes would produce some revenue and progressively more the further from either “zero” condition rate moved. Laffer may believe that lower taxes produces faster growth, but that was not the insight he claimed to offer with the cocktail-napkin curve. It is not unreasonable to expect the ratio to go up, given Laffer’s own argument. Neo-Lafferists can make all the claims they want, but Laffer’s cocktail-napkin argument was dead simple, purely based on the notion that some conditions produce no revenue, so that moving away from those conditions would logically produce more.
Oh, and one more think. Kenneth did not make a claim about what Laffer said. He made a claim about the analytically correct measure. Laffer may be the sine qua non for cultists, but the rest of us need to keep in mind what legitimate reasoning looks like. That appears to be what Kenneth is doing. Making up a condition (adherence to Laffer) and insisting that Kenneth meet that condition suggests sammy doesn’t really have much substance on his side.
Oh, and one more thing. Kenneth did not make a claim about what Laffer said. He made a claim about the analytically correct measure. Laffer may be the sine qua non for cultists, but the rest of us need to keep in mind what legitimate reasoning looks like. That appears to be what Kenneth is doing. Making up a condition (adherence to Laffer) and insisting that Kenneth meet that condition suggests sammy doesn’t really have much substance on his side.
The entire problem with the Laffer Curve is that it is based on the idea that the type of government which is collecting these taxes is the type which is pocketing some of the revenue collected. We have never had such a government in this country.
Once the idea that none of the tax revenue collected is being pocketed enters the equation, Laffer’s entire presentation becomes nothing more than a mental exercise of “what if”. What if I were a king and I took all the money as taxes to me. Would it benefit me or would I be better off letting the subjects keep some of it.
After all, Laffer was a libertarian.
kharrris
i would argue that a 100% tax rate would NOT produce no revenue. under a perfectly “communist” system, one could imagine that all income is given to the “state” (church?) to be redistributed according to need. even if the citizens were not perfect communists, or christians, they wold still be better off to produce and wait for the government redistribution, than to just sulk and sit on their hands as we are often told the rich will do if their tax rate increases even marginally.
note i am not arguing that this would be a good way to run the world, just that the “100% tax leads to no revenue” argument is not only not logical, it isn’t even likely.
I would agree with this, and I am also fairly sure that when Sweden’s marginal rate was over 100%, it still collected some tax at the margin (kharris’ second reformulation of Laffer).
Becker
yes, i think that is a more reasonable interpretation than the one i suggested.
nevertheless it should still be apparent that the “fact” that there is a point above which collecting taxes might be counterproductive does not lead to the conclusion… as it has for all practical purposes in this country… that all taxes are bad, taxes can never be raised, or lower taxes are the solution for everything, under all circumstances.
and this, i am afraid, is Sammy’s real argument, and we waste our own time arguing with it on its terms.
IF the deficit is a problem, we need to raise taxes. we would need to do this even if it led to “less growth”… if for no other reason than it cannot be shown that all that “growth” is good for us. a little targeted spending by the government will do us more good than some vague “growth is good” increased spending on casinos and swooshes by the people who have more money than they know how to spend, even for their own good.
You are assuming a particular system. Systems matter. Laffer did not assume that system. He assumed a market system. Given his assumption, his conclusion is not unreasonable.
I agree with you there Colberly. The over riding issue in the discussion of taxes is the successful persuasion that taxes in general are bad. This was successful because other than here and like blogs, the benefit from what taxes purchase is never put into the equation.
The full due diligence that a business would make when determining a suggested idea to be turned into action is never part of the tax discussion. It’s, to use the concept of double entry accounting, only presenting one side of the ledger.
Daniel and Coberly,
I am arguing in favor of reducing tax rates that will result in MORE tax collected here. I am in favor of growth, prosperity, taxes and freedom. (Note the word “taxes” there).
What other system than a market system am I discussing? Sweden was and is a market economy, and that was true even when it’s top marginal tax rate was 100%.
kharris
assuming a market system, laffers conclusion is not unreasonable… it is tautological. if you collect 100% of “income” as taxes, there is nothing left to market.
no doubt this is a profound result.
sammy
that’s good to hear. personally i hate taxes. just can’t live without em.
the problem with what you are in favor of, is so is everybody. the question is whether lower tax rates will result in either “more taxes collected” or “more growth” or “a better life for the people.”
I think that at current rates the answer is no.
and,
i don’t find it difficult to imagine a market system in which the tax rate for some reason, for some taxes, for some time, is set at 100%… and I can’t see any reason why this would result in zero revenue, at least for that time, those taxes, and that reason.
Well, I’m pleased that you have an imagination. I have one, too, and I imagine a different outcome. No doubt your imagination is more profound, at least as you imagine it.
This is just juvenile. Laffer was talking about overall taxation rates, not top marginal rates.