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The Laffer Curve Revisited

15 Sep 2009
Posted by Bruce Bartlett

According to a new study, the U.S. is well down on the lower half of the Laffer curve, meaning that taxes could be increased substantially before the backward bending side of the curve is reached.  This is not an argument for raising taxes, only an argument against a common right-wing argument against raising taxes; i.e., that no net additional revenue would be collected if tax rates are raised because of a Laffer curve effect.

How Far Are We from the Slippery Slope? The Laffer Curve Revisited

Mathias Trabandt and Harald Uhlig

NBER Working Paper No. 15343 (September 2009)

Abstract: We characterize the Laffer curves for labor taxation and capital income taxation quantitatively for the US, the EU-14 and individual European countries by comparing the balanced growth paths of a neoclassical growth model featuring ”constant Frisch elasticity” (CFE) preferences. We derive properties of CFE preferences. We provide new tax rate data. For benchmark parameters, we find that the US can increase tax revenues by 30% by raising labor taxes and 6% by raising capital income taxes. For the EU-14 we obtain 8% and 1%. Denmark and Sweden are on the wrong side of the Laffer curve for capital income taxation.

http://www.nber.org/papers/w15343

In 2007 (with a few updates

In 2007 (with a few updates in 2008) I compiled what I think is still the most thorough compilation of comments by prominent conservative economists on this topic, all debunking that right-wing myth (I included links to original sources). See http://swordscrossed.org/node/1671

(You're in there, Bruce)

I didn't bother with commentary from anyone who could be seen as a partisan of the left, since my objective was and is to use that list to disabuse conservatives of this myth, and many of them would reflexively dismiss anything from a left-of-center source.


Yes, but

It's true that reputable conservative economists know better. But they very seldom will engage in political debate on this topic.  They look the other way when Republican politicians assert that all tax cuts raise revenue and all tax increases lose revenue. They don't wish to be inundated by comments from right wing trolls seeking enforce conformity on this issue or have their conservative bona fides questioned. I know that every time I explain why we must raise the tax/GDP ratio I always get numerous comments from people saying I am an idiot because there is some kind of law that say revenues will always equal about 18% of GDP regardless of what the rate is and assertions that we are always on the upper end of the Laffer curve no matter how obvious it is that we aren't etc.  It's tiresome to feel that you are making no progress whatsoever, but I just keep plugging away.


I hear ya'. I've been trying

I hear ya'. I've been trying to disabuse folks on the right of that myth for years (as my compilation and post at that link indicates), and a couple of years ago I even fought that battle for a few months on Redstate.com until they banned me (under a blatantly absurd pretext, since they never admit they ban people for presenting legitimate challenges to their hyperpartisan talking points).

Although a couple of individuals came around at least to a large degree, most essentially called me "insane" and a "lefty troll" and trotted out that absurd argument that revenues went up after the Kennedy, Reagan and Bush tax cuts, even after I explained that you can't even establish a correlation without considering what generally happens to revenues when taxes are not cut or are even increased -- which is that they revenues generally go up, simply because GDP is usually growing. So, as I explained, the question, in the years following a tax cut, is not "Are revenues (even in real terms) higher than before?" but rather "Are they (likely) higher or lower than they would have been without the tax cut?" (i.e., "Is it likely that they expanded the tax base enough to fully offset (and then some) the reductions in tax rates?"). And I linked to my compilation of prominent conservatives -- folks on their "side", all debunking their myth that revenues are higher than they would be without tax cuts. Their response was to mock my reference to those economists as asking them to "believe some economist, not [their] own lyin' eyes". After all, they'd insist, "No one knows a counter-factual" (what would have happened without a tax cut), and "Have revenues or have they not increased since the Bush tax cuts?" (this was 2007)

Unfortunately, we live in an age in which many people are increasingly seeking out, uncritically accepting, and reflexively and fiercely defending whatever it is that they want to believe, helped along by media and politicians who largely cause and capitalize upon this mindset and behavior.


Supply Side Economics

In my new book I try to distill what is right about SSE from what is wrong.  It won't satisfy anyone, I'm sure.  Those on the left think it was always BS and my efforts to explain why it worked in the early 1980s will fall on deaf ears.  But I also argue that much of what passes for SSE today is wrong, which will upset those on the right.  I don't understand why everyone on both sides seems to think that their beliefs must be applicable under all circumstances.  What is wrong with saying that an idea may be applicable under one set of circumstances and wrong in another?


Bruce, I look forward to your

Bruce,

I look forward to your book. And by the way, much credit is due you for having the onions to write Imposter and in general to speak the truth rather than being one of the far-too-many professional partisan panderers who make a living by just telling their hyperpartisan audiences what they want to hear, under the guise of good-faith expert analysis. I know you took a lot of flak for that, and I assume that, at least so far, it's been a financial net loss for you, or at the very least was a substantial financial and career risk you didn't have to take.

As for SSE blowhards today, I think there are some will concede that not ALL tax cuts will increase revenues in ALL circumstances, but they still contend that such is the rule rather than the exception that it is. And while the left should acknowledge that there can indeed be supply side effects (incremental GDP and revenue feedback effects that partially offset the cost calculated by static scoring), the blowhards on the right often use the static vs. dynamic scoring distinction as a straw man as part of their assertion that "tax cuts pay for themselves (and more!)". And yes, they do tend to lump into SSE any tax cut of any sort (if that's to what you were alluding re: "what passes for SSE today").

As a note, all the comments of economists I compiled and almost all other commentary I've seen addresses taxation of individual income (labor or investment), but I haven't seen much analysis of Laffer Curve dynamics for corporate income (other than partisan rhetoric and cherry-picked anecdotal data that doesn't control for other variables or make international comparisons appropriate for inferences regarding U.S. federal taxation). I've been told that part of the problem is the greater complexity of corporate taxation -- the greater variance between the tax rate and the actual tax paid by a corporation. If you know of any studies or commentary (or have your own), please let me know.


Extend the laffer curve

Every supply side tax cut has been packaged with a middle class tax cut that has reduced rates on the middle class to well below the peak. So there is plenty of room to increase tax receipts, if necessary, by raising middle class taxes, a VAT, or other consumption taxes.

We may be able to increase capital income tax receipts somewhat, but that is not optimal. It is a mathematical fact that the Laffer Curve has zero slope at the peak. At the peak, a slight tax increase will collect a slightly higher rate of slightly smaller capital markets to collect the same amount of taxes. But because capital markets are smaller, interest rates will increase. By cutting taxes from the peak, private capital increases and interest rates and debt costs decrease and government spending becomes more affordable. (which is why starve-the-beast does not work) Every supply side tax cut has been followed by decreasing interest rates. We need to consider an extended Laffer Curve of total tax and bond receipts at given tax and interest rates.

We don't maximize growth by maximizing tax receipts. Supply side economics is simple. When you cut taxes on producers of goods and services (supply) they produce more goods and services for consumers. The increased return of producers increases the size (supply) of credit and capital markets. This makes public and private debt more affordable so products can be better distributed to consumers.


TDM, You may be overlooking

TDM,

You may be overlooking the fact that incremental public debt from tax cuts (1) must be paid back at some point, (2) means more debt to service (more debt on which to pay interest), and (3) places upward pressure on interest rates (due to both demand for capital -- "crowding out" -- and greater preceived risk of monetization/inflation).


The more you tax

The most basic SSE principal is the more you tax anything the less of it you get. Too many "fiscal conservatives" get fooled into thinking since "deficits crowd out private capital" the more you tax private capital the more you reduce the deficit and the more private capital you end up with. Nothing crowds out private capital more than taxes on private capital. Increasing taxes on private capital reduces private capital by the amount of the tax, increases the deadweight losses of the tax, reduces net capital inflows, and reduces savings and investment and increases consumption. Taxes shrink private capital by far more than is saved on interest on the debt, and interest rates increase.

Total credit markets and demand for treasury securities have been increasing rapidly. If investors get worried about the debt then cut government consumption or raise taxes on private consumption.


TDM, So do you think the key

TDM,

So do you think the key to our prosperity, in the face of an unsustainable long-term fiscal imbalance, is to cut taxes, and if so, how much, and why would you stop cutting taxes at any point?

Are you saying that such tax cuts would be good for our economy over the long term even without spending cuts amounting to a large portion of the static revenue loss from the tax cuts? Or are you only saying tax cuts would be good if largely offset by spending cuts?




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