Things both Crazy and Stupid, The Laffer Curve
Anthony C. Bernardo
I’m reading this book, “How Not to be Wrong: The Power of Mathematical Thinking” by Jordan Ellenberg, and one of the early examples of nonlinear thinking presented is the Laffer Curve. For those that don’t know it, Arthur Laffer, a world renowned supply side economist, predicted that under some circumstances increasing the tax rate will result in a decrease in tax collection. That sounds counter intuitive, even stupid, and maybe even crazy. How can that be; an increase results in a decrease?
Even more strange is the reverse: a decrease results in an increase. Applied by supply side politicians, they come up with the policy that a decrease in tax rate will result in an increase in government revenue. Everybody’s Happy; right?
The theory is reputedly to have been presented by Arthur Laffer to Dick Cheney in around 1976 at dinner on the back of a napkin, and theoretically, it could make sense. If the government imposes a tax rate of 0%, then there will obviously not be any collection of tax revenue; it will be zero. But here’s the hairy part; it also states that if the government imposes a tax rate of 100%, then there will also be no collection of tax rate; it will also be zero because under such unfair circumstances, no one will work.
So on the right side of the peak, if we reduce tax rates, tax revenue will go up. Wow! This is a wonderful theory. Every one’s tax rate goes down, the government’s collection of tax revenue goes up, the deficit and debt goes down, services are maintained, Social Security is saved, Medicare/Medicaid is saved – if the politicians keep it, our military spending can be increased to insure our security and Dr. Pangloss is coming to dinner. As stated in that famous scene from the movie “Independence Day” –“well, not exactly”. The key word is exactly because no one knows exactly where the peak of the revenue curve is and at which tax rate it occurs, and that’s if you buy the theory in the first place. Is the peak at 10%, 15% 35%, 50%, 70%, who knows? When questioned, Mr. Laffer himself doesn’t know.
So one could reasonably ask of what use is this theory or is this theory correct, but for a moment, let’s suppose the theory is correct: if we are on the right side of the peak of the curve, a decrease in tax rate will result in an increase in tax revenue.
President Ronald Reagan used the theory of this curve to reduce taxes in his first term. Either he was convinced the country’s tax rates were in fact on the right side of the curve, or someone told him they were. He may also not have totally understood, but let’s say he did. President George W. Bush, or more likely Vice President Dick Cheney who originally was presented the theory by Mr. Laffer in 1976, also utilized the Laffer curve to justify a reduction of taxes, promptly wiping out the surplus created by Clinton/Gingrich.
The Laffer theory has in fact been the basis of Republican tax reduction policy for 40 years. It’s resulted in massive deficits under both the Reagan and W. Bush administrations. As a percent of GDP, the deficits under Reagan and H.W. Bush went from around 35% to around 60-65%. President Reagan saw the problem and did eventually raise taxes; so did President Bush. We all know that a surplus was created under the Clinton Presidency and Gingrich House, reducing the debt to GDP ratio to under 60% using a more traditional economic theory that increasing tax rates increases tax revenue, but the The George W. Bush administration again instituted Laffer economics and the debt to GDP ratio rose to about 80-85%.
We had 20 years of application of Laffer’s theory with results that, if anything, totally disproved it. Debt and deficits have soared due to insufficient tax revenue generated and needed to support the country’s social and defense programs.
But that’s history; why bring it up now? It may be discredited, it may not, but it’s history. It’s not important anymore. Well it is important, because one of Republican candidate Donald Trump’s economic advisors is none other than Arthur Laffer. Now, this is a world renowned economist, and I’m an engineer by education and a retired business man, so what do I know vs. a world renowned economist. Well I know that by Mr. Laffer’s own admission, no one knows where the peak of the revenue collected and it’s corresponding tax rate is on the curve.
Wait a minute! Does that mean that the tax policy of the Republican Party is based on a theory that has no quantitative measures, and that its application has historically always resulted in major deficit increases? Well yes. Well that’s just plain crazy: crazy and stupid. President George H. W. Bush called it “voodoo economics” in his president campaign against Ronald Reagan in 1980. For a time, he apparently thought similarly, and maybe always did throughout his terms as Vice President. His reward for raising taxes because of deepening deficits, despite his “read my lips, no new taxes” statement, was lack of support by the anti-tax crowd in the Republican Party, and a loss to Bill Clinton in 1992. That result alone guaranteed that any subsequent nominee of the Republican Party better advocate lower tax rates if they expect support from the anti-tax wing.
But now, let’s examine the theory itself. I buy that if the tax rate is 0% there will be no collection of taxes and no revenue to operate the government. I think we can all agree to that. Zero times anything is zero. We’ll leave open for now whether such policy could ever occur in a major civilized coherent society that is only 12 -14 hours away from physically being half way around the world, or 12-14 milliseconds from a tweet from half way around the world. It’s the other side of the curve that’s a real logic problem for me: at a tax rate of 100% the government will also collect zero revenue in taxes. The most common reason presented is that this will occur because no one will choose to work, but I’m sure there are others and more elegant ones. Does that really make any sense?
Would not the possible outcomes also include that some would work “off the books” so to speak, and keep their cash. Of course they would be quickly found out if they spent it. (If you’ve seen the movie “Goodfellows”, don’t buy your girlfriend the fur coat). But more seriously, if the government collected 100% of wages in taxes, they would run a major budget surplus guaranteeing a major tax refund to everyone that paid taxes. That refund could be instituted immediately or each month or week to provide a healthy wage to everyone. The government could quickly pay down the debt – if GDP and debt are both 20 trillion dollars, as they now are, paying down the debt would take one year, with much sacrifice. . Even if it took 5 years, that’s OK. The global economic implications, including the value of the dollar, could be disastrous, but who knows? We’re talking theory here, not any justification or intent to implement.
The most likely outcome is that if the tax rate were 100% of earnings, there would still be loopholes in the code to enable deductions, credits, special situations and the like to allow people to keep a lot of their money. Cutting to the chase, I’m saying that a 100% tax rate will not result in 0 revenue, but 100% revenue for the government and the laws would necessitate that the money was returned in some form as it is today whether it be expanded Social Security, expanded Medical, expanded security etc. It’s like giving your broker money to invest for you, only the investment is the social order.
I could expand on this but let me state up front, this sound like socialism. So, the 100% tax rate end of the curve is actually socialism, with the government distributing the money collected in taxes according to some formula which allows operation of the government and the services provided, while returning some fair quantity to the tax payers. It’s clear that this will not happen in the United States, or anywhere without rebellion. I will propose that the right side of the Laffer curve does have an end point that’s above zero in revenue collected, but no one knows what that amount is although some graduate student thesis could come up with a plausible scenario.
I’d also propose that mixing an unrealistic scenario on either extreme side of the Laffer curve with mathematical principle that anything multiplied by zero equals zero, and then applying economic policy based on that, is very dangerous ground.
But what about the expansion of business and the additional revenue collected because more business will be started in the United States if the tax rates are lower? May happen, may not, but history has shown that we can’t make it up on volume. Sufficient new business tax revenue has not overcome the revenue loss attributable to the reduced tax rate if history has any validity. But, no doubt there will be a benefit for business owners, whether proprietors or stockholders, and investors resulting from the tax rate reductions.
So we have a questionable economic theory, which requires impossible scenarios, exemplified with an unknown quantitative equation in the form of a curve where no one knows the coordinate values along that curve, and we have the candidate of a major party running for President of the United States about to use that theory, even after it’s been proven wrong through application over 20 years by three other Presidents, and always with the same result – massive deficits and increasing debt
Now that is the epitome of both stupid and crazy. . If it were funny, I’d call it the Laugher curve, but who’s laughing?