Sunday, December 19, 2010

Tail of Two Ideologies - The Laffer Curve

The Republican fiscal ideology is wrapped in something called “supply side economics”.  The concept is based on the concept that individuals work harder when they can keep more of what they earn.  As individuals work harder, the increase in work results in additional jobs.   It is somewhat reminiscent of Adam Smith and his views on self-interest. 

This idea has been taken further.  From a national perspective, there is an optimum tax rate that is low enough to motivate workers while generating the maximum tax revenues to the government.   This curve that theoretically identifies the optimum tax is called the Laffer Curve.

There are some who may confuse the Laffer Curve with supply side economics.  They are related but not the same.  First, let’s discuss supply side economics.

There are several events that supply-siders cite when advocating lower income tax rates.  One is when President Kennedy lowered the highest tax rate from 91% to 70%, and the second is when President Reagan lowered the highest rate from 70% to 30%.  Both actions are credited with causing long economic recoveries for their times.  By lowering tax rates, the economies grew and tax revenues grew.  Unfortunately, government expenditures grew as well, and deficits continued. 

This most recent downturn in the economy occurred just as the census was happening, which was a prelude to Congressional reapportionment among the states.   A recent study compared states that will be adding to their Congressional representation with those that are losing Congressional seats.  The states losing seats are high tax states and have the average of their personal income tax rates is 6.05%, and those gaining seats have average rates of 2.8%. There is the view that when a state lowers taxes, it basically draws economic resources from neighboring states.  In other words, people walk, or even vote, with their feet. 
So, Texas and Virginia are growing state economies and California is not.  These experiences do not necessarily support the idea that lower tax rates create more economic growth.  These states are really drawing businesses from other states, and the situation does not support the argument that businesses within these states are growing by themselves due to lower rates.

These are the main arguments that supply-siders cite when stating their case.  However, one of them, namely Arthur Laffer, in the early 80’s fascinated President Reagan with what has come to be known as the Laffer Curve.  This says that tax revenues will increase as rates increase up to a point, after which as rates increase, tax revenues will fall.  Supply-siders are left with the question of where is this optimum point in the tax rate structure? 

Well, I know of one mainline economic textbook that says that the theory sounds great, but there is no evidence that supports the curve.  Supply-siders cite Kennedy and Reagan, but leave out Clinton, who took Reagan’s highest rate and raised it back up to 39%.  G.W. Bush lowered it to 35%, and we had good economies under both.  Now, Obama wanted to raise it back up to the Clinton rate, and the supply-siders became upset again.  The problem is that they have no data upon which to argue their point. 

And when a group argues a theoretical point without the data, they are being ideological.  Hence, the classification of the Laffer Curve as ideology.

1 comment:

  1. This blogpost was pretty informative. Dan Mitchell of the Cato Institute has a pretty cool lecture series on the Laffer Curve. You might want to check it out. Here it is (in 3 parts):