The Laffer Curve: Will Tax Cuts Pay for Themselves? : The Freeman : Foundation for Economic Education

The Laffer Curve: Will Tax Cuts Pay for Themselves? : The Freeman : Foundation for Economic Education

As someone who worked for Laffer (in 2006–07), I thought I would clarify some of the misconceptions that leftist progressives and even many libertarians have about supply-side economics and the Reagan years.

In my view, Laffer’s biggest contribution to policy debates was to show the ambiguity in the terms “tax cut” and “tax hike.” In his own writings, Laffer would always distinguish between a tax rate reduction and a drop in tax revenues. If the analyst adopts a static model of the economy, and assumes households and businesses act the same regardless of tax rates, then the two ways of speaking are identical. In debates over government policy, people typically rely on the static approach. For example, they refer to a “tax cut of $x billion” or say that the president’s proposal would “raise taxes by $x billion over 10 years.” Laffer’s insight demonstrates that the world is a far more complicated place.

If people respond to incentives — as they always do — then changes in the tax rate and tax revenues may be quite different, and can even go in opposite directions. For example, when it comes to the personal income tax, did the Reagan administration “cut taxes”? Well, tax rates certainly fell sharply: the top personal income tax rate went from 70 percent in 1980 down to 28 percent by 1988. However, during the Reagan years, tax receipts went up — from $599 billion in fiscal year 1981 to $991 billion in FY 1989 (in historical dollars), an annualized growth rate of 6.5 percent. It’s definitely true that the federal debt mushroomed under Reagan’s tenure. In my view, this is one of the failures of Reagan’s “conservative” and “small government” legacy. However, it is ludicrous that critics deride his “tax cuts for the rich” as the source of the deficits; total federal outlays went from $678 billion in FY 1981 to $1,144 billion in FY 1989, for an annualized growth rate of 6.8 percent. Over the whole period, therefore, total federal tax receipts grew by a cumulative 65 percent while total outlays grew 69 percent. The problem with “Reaganomics” wasn’t that it “starved the beast” of revenue, but rather that the federal government let spending grow faster than tax receipts.

Of course, my discussion above relies on what has become known as the “Laffer curve,” which is the source of both confusion and ridicule among economists and pundits alike. The Laffer curve epitomizes the distinction between tax rates and total receipts by plotting them against each other. The two endpoints are easy enough to calculate. At a tax rate of 0 percent, the government will collect $0 in tax receipts. However, at a tax rate of 100 percent, the government will also collect (virtually) $0 in total receipts, because people will either stop generating income, or they will operate in the black market and fail to report their income to the IRS.

Between these extremes, the government will collect positive revenue. If we assume a smooth curve, then there is a tax rate — greater than 0 percent but smaller than 100 percent — that maximizes total tax revenues. This has been dubbed the “Laffer point” by some, but the title may sow seeds of confusion. In neither his scholarly nor his popular writings did Laffer ever argue that this point is optimal. (You can read about it at the Laffer Center website if you don’t believe me.) Rather, his modest point was simply to underscore the trade-offs involved. Clearly, it made no sense to set tax rates above the inflection point on the Laffer curve, because then the government would not only cripple economic growth, but also forfeit potential tax revenue.

In other words, the only rhetorical significance of the “Laffer point” would be to convince all sides in the policy debate that surely tax rates should be reduced at least to that level, because doing so would allow citizens to keep more after-tax income while also allowing the government to increase its revenue. To repeat, the purpose for this rhetorical point wasn’t that Laffer himself was holding up “more government spending” as a goal; it was instead to avoid truly absurd rates of taxation that were counterproductive even from the perspective of big-government liberals.

Critics like to deride the Laffer curve as “voodoo economics” by pointing to counterexamples, say of tax rate reductions that didn’t increase total revenue, or by pointing to tax rate hikes that brought in more revenue. But these possibilities were contained in the original Laffer curve itself. Specifically, if the tax rate starts below the inflection point, then a tax rate reduction will shrink receipts, while a tax rate hike will increase receipts. Laffer never drew his curve with the inflection point hovering above 1 percent, so how in the world did critics get the idea that Laffer thought “tax cuts always pay for themselves”? Did the critics think Laffer couldn’t read his own curve?

Now what Laffer did stress — and I can speak with authority here, because at his firm I had occasion to read plenty of his old papers going back to the early 1980s — is that a tax rate reduction would have a smaller impact on tax receipts than a “static” scoring analysis would indicate. So, for example, if California cut its marginal personal income tax rates across the board by one percentage point, the drop in total tax receipts would be smaller than one percent. The increase in economic activity would not only increase the base of the personal income tax, but it would also increase receipts from sales taxes, property taxes, and so on. Depending on how onerous the initial tax rate was, it was even theoretically possible that the drop in revenue would be negative — meaning that total tax receipts would actually increase — but that was never a blanket prediction of the Laffer approach.

Let me close with one last analytical twist I learned while working for Laffer. When it comes to assessing the incentives from a tax rate change, you need to look at the after-tax return on the margin from additional activity. For example, at first it might seem as if a tax rate hike from 10 percent to 20 percent is a bigger deal than a hike of 90 percent to 95 percent, because the first hike is a 10-percentage-point increase and a doubling of the rate, while the second hike is a 5-percentage-point increase and a comparable jump in the proportion. Yet, if someone is considering investing in a project that will pay $1,000, in the first scenario his after-tax return goes from $900 to $800, while in the second scenario it goes from $100 down to $50. The measured rate of after-tax return has been cut in half in the second scenario, while it only fell about 12 percent in the first scenario.

The Reagan years were certainly not a textbook model of small government and fiscal conservatism, but the derision of the theoretical apparatus of supply-side economics — and of the Laffer curve in particular — is misplaced. The point here was and is a simple one, yet to this day it is routinely ignored in policy debates.