The Real Laffer Curve vs. Voodoo Economics

There are really two Laffer curves. There’s the real one, which actually is a curve, and there is a version of it frequently used by conservatives living in the imaginary world which so many current conservatives inhabit. Pretty much nobody likes to pay taxes and most of us would love to see taxes lower, but those in the reality based world also generally realize that currently our taxes are fairly low by historic standards. We also realize that, as much as we’d rather not pay them, taxes are a necessary evil. Many other conservatives don’t get beyond the point of wishing we don’t have to pay taxes and developing a set of principles of Voodoo Economics.

To conservatives who are divorced for reality, there is a simple solution to the problem of not wanting to pay taxes while simultaneously wanting to fund necessary government services. They claim that the Laffer Curve proves that we can cut taxes and the government will bring in more revenue.

This is certainly true under some circumstances. At some point high taxes will reduce motivation to create wealth, resulting in less money being earned to be taxed. High taxes can also increase the likelihood that money will be spent in various ways to shelter money for taxes. There have actually been times in which lowering taxes will bring in more revenue. The Laffer Curve shows that this is the case with high levels of taxation, but not all levels.

We are not currently in a situation where we can lower taxes and bring in more tax revenue. Bruce Bartlett, a former Reaganite who sees many of the problems in the current conservative movement, refers to this paper from The National Bureau of Economic Research. From their 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.

As Bartlett points out, this is not an argument that we should raise taxes, but “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.”

One of the problems with the mind set of many on the right is that they would see the issue as purely one of raising taxes, have a knee-jerk opposition, and then cite the Laffer Curve even though it does not support their case. The real issue is not a yes or no question as to whether we should raise taxes but whether we are receiving value for our money. In other words, I wouldn’t want to pay higher taxes for the war in Iraq (not that fighting it on credit was a good idea) but higher taxes to really do universal health care right would be worth considering.

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21 Comments

  1. 1
    Joe Markowitz says:

    The problem with a mindset that is totally focused on cutting taxes is that in the short run at least, cutting taxes just requires the government to borrow more money.  There is no real evidence that cutting taxes make the government smaller, at least where the government has the capacity to run a deficit.  Those who advocate cutting taxes should have the courage and the responsibility to explain where they would cut spending at the same time.  Otherwise they are not accomplishing anything other than adding to the government’s debt burden.

  2. 2
    Eclectic Radical says:

    “Those who advocate cutting taxes should have the courage and the responsibility to explain where they would cut spending at the same time.  Otherwise they are not accomplishing anything other than adding to the government’s debt burden.”
     
    They must also have the responsibility to explain (honestly) why the spending they are going to cut should be cut and how the slack should be picked up if the spending being cut funds something of practical value. Ideally, of course, the spending cut should not be of practical value.
     
    Impractical spending of questionable value can be very popular, however. A significant portion of the DC population was attached the city’s test school voucher program, despite the fact that the program was both too small to provide a signficant impact on the community and too underfunded to provide real school choice.  Many seniors have become very attached to their Medicare Advantage programs, despite the inferiority of the coverage to straight Medicare and the higher costs. At least one Florida Senator is resisting the Baucus bill because his constituents view the cutting of Medicare Advantage as a ‘Medicare cut.’
     
    It’s easy to promise to cut taxes and to do so, because tax cuts are popular. Spending cuts are much harder, because nearly every program one spends many on is very popular with someone. Even bad programs.
     

  3. 3
    Ben says:

    I’d welcome a land value tax, and other ecotaxes, and no taxes on productivity. Taxes at all levels reduce productivity, just when we’re on the left side of the curve, the lost productivity is not enough to offset the gain in revenue from the increase in tax rate.

  4. 4
    Ron Chusid says:

    “Taxes at all levels reduce productivity…”

    Have you ever actually owned a business? Taxes have zilch effect on my business productivity. Sure, if they were at confiscatory rates that would change things, but (while I would not like to see it) increasing my taxes another 10% would not cause me to be any less productive. If anything, I’d look for ways to increase profits to offset the higher taxes.

  5. 5
    Eclectic Radical says:

    “Have you ever actually owned a business? Taxes have zilch effect on my business productivity. Sure, if they were at confiscatory rates that would change things, but (while I would not like to see it) increasing my taxes another 10% would not cause me to be any less productive. If anything, I’d look for ways to increase profits to offset the higher taxes.”
     
    As an independent subcontractor in my field, I have to agree with Ron. My productivity is determined by the work I do, and the work I do is determined by how much work I feel like doing balanced against how much money I need to make… and of course, how good I am at my job against random obstacles to that job. Call that cynical and self-serving if you like, but that’s one of the reasons I liked the idea of owning my own business. My taxes don’t figure into the question at all. Does anyone like paying their taxes? Not really. In a properly administered system, however, taxes do not curtail productivity at all.
     
    All of the countries championed by the right for their cutting of corporate tax rates in the last decade have income taxes expontentially higher than American income taxes. Income taxes in South Africa and Ireland make Americans’ tax rates look like nothing by comparison. The most productive period of the American economy, the 1950s, was also the most highly taxed era of American history. The gap between the salary of the CEO and the wages of the working man was smaller than it had ever been, and the highest marginal tax rate was 90%.
     
    Yes, there were economic factors besides taxes that made the 1950s so productive, but high taxes clearly did not lower productivity. Tax cuts will most stimulate productivity in hard economic times, but this is based on the premise that taxes are at a ‘normal level’ during good times. American taxes have been artificially low (and getting lower) since Reagan.
     

  6. 6
    Michael Bristol says:

    » The Real Laffer Curve vs. Voodoo Economics Liberal Values http://bit.ly/vntSX

  7. 7
    taxtracker says:

    » The Real Laffer Curve vs. Voodoo Economics Liberal Values http://bit.ly/vntSX

  8. 8
    Ben says:

    Data is not the plural of anecdote

  9. 9
    Ben says:

    And about the 50′s, how do you know that? How do you know that if taxes were lower, productivity wouldn’t have been higher? And, how do you figure it was the most “productive?”

  10. 10
    Ron Chusid says:

    Maybe the 50′s would have been even more productive with lower taxes. That might be why Kennedy lowered taxes.

  11. 11
    Michael Bristol says:

    » The Real Laffer Curve vs. Voodoo Economics Liberal Values http://bit.ly/vntSX

  12. 12
    Eclectic Radical says:

    “Maybe the 50’s would have been even more productive with lower taxes. That might be why Kennedy lowered taxes.”
     
    It may have been, but the Kennedy tax cuts did obviously increase productivity. Indeed, through Kennedy’s term and the first year of Johnson’s term, the economy got enough worse that there were what some conservatives gleefully called ‘bread riots’ in small towns in the Midwest and Rocky Mountain states just before the mid-term elections in Johnson’s presidency. Republicans were swept into Congress because of the perception that Kennedy and Johnson had ‘ruined’ the economy.
     
    I’m not blaming Kennedy’s tax cuts for the downturn (though the Kennedy-Johnson downturn was still a period of impressive growth, just not as impressive as the 1950s) anymore than I am giving the high taxes of the Eisenhower years credit for prosperity. I’m simply noting that tax policy is not the magic tinker-toy that makes the economy do what you want it to do.
     
    Economic performance is based on factors largely outside the government’s control, and the influence of tax policy on those factors is nil. The greatest influence of tax cuts is their increase of the purchasing power they give to the lower and middle brackets. When people who normally budget very strictly can afford to buy more, it can stimulate the economy if they choose to do so. This, combined with the increased employment provided by infrastructure spending and investment in the private sector, is why deficit spending can work to offset a depression in the short term.
     
    Reagan’s tax cuts in the 1980s may have been a very good thing, because taxes were still very nearly at the same rate they had been under JFK and Johnson and the economic factors that made the 1950s so blindingly successful no longer existed. So the Reagan tax cuts probably did increase productivity… but Reagan found he had to reverse some of his tax cuts for budgetary reasons when the economy came round again.
     
    Thanks to W. Bush, taxes are now as artificially low as they were artificially high when Reagan took office. The standard tax-cut strategy in a recession may not work, because of how the rates have already been bottomed out. Cutting spending during a recession is never a good idea, but neither is raising taxes. It puts us in a very difficult situation, economically speaking.
     

  13. 13
    Ben says:

    “in the short term”
    That’s a big qualifier. Caffeine provides you energy…in the short term. Steroids bulk up your muscles…in the short term. Eventually it takes its toll and you end up in a worse situation. Same with deficit spending. Jobs is not the goal of an economy; anyone can do jobs, including Stalin. Jobs are a means to an end, and that end is higher living standards. We don’t just want people having jobs, we want people having jobs that increase living standards. The market, assuming internalized costs and benefits, is far better at this than any central planner. No one individual or group can aggregate the subjective happiness of everyone. Only individuals can do that for themselves
    I’ll make a prediction now: the auto companies are going to end up in a far worse situation than before Cash for Clunkers. I hope and pray I’m wrong, but I don’t think I am. The auto industry overexpanded in the boom and we’d be better off if capital moved elsewhere. Instead, Cash for Clunkers kept capital there, and moved more in, away from more productive uses. It’s not sustainable.

  14. 14
    Eclectic Radical says:

    ‘That’s a big qualifier. Caffeine provides you energy…in the short term. Steroids bulk up your muscles…in the short term. Eventually it takes its toll and you end up in a worse situation.’
     
    Economists who advocate funded debt and deficit spending don’t advocate long term deficit spending. Long term deficit spending is an invention of Republicans who want to cut taxes ‘permanently’ without cutting spending at all and have no place to get the money but borrow. When Ronald Reagan took office, the national debt was at around 800 billion. This sounds high at first hearing, but was offset by the fact that the US was the world’s largest public creditor was owed far more than owing. When Reagan left office the debt was around 3 trillion and the use was the world’s largest debtor nation.
     
    ‘Jobs are a means to an end, and that end is higher living standards. We don’t just want people having jobs, we want people having jobs that increase living standards. The market, assuming internalized costs and benefits, is far better at this than any central planner.’
     
    This is one of the major ‘errors’ of the right. I put ‘errors’ in quotes because I believe the majority of the people using such rhetoric know better. Stimulus/intervention is not about central planning. It is about taking necessary action during a crisis. The people who advocate tax cuts and deficit spending during economic emergency also advocate restoring taxes to a normal level and saving money to pay down the debt in times of prosperity.
     
    Unchecked, unregulated, unpoliced market activity does not result in higher living standards. It results in massive inequities in wealth which then result in massive inequities in freedom. History has proven this repeatedly in every situation resembling the ‘absolutely free market’ advocated by classical liberals. If higher standards of life are the goal, then significantly lowered standards of living for a large number of people is clearly a market failure even in times of economic ‘prosperity.’
     

  15. 15
    Ben says:

    About deficit spending and caffeine, I wasn’t particularly meaning long term. But, what happens when people take caffeine? They get a high, then crash to lower than before. That’s like boom and bust. Do it one time, or many, it happens each time. A person then has 2 choices: let the crash run its course, get the junk out of the system, and get back to normal. Or, drink even more caffeine and get another false high, and the cycle repeats. Inflationary policy has that same effect: false high, worse low.
    I happen to be a fan of Hyman Minsky’s <a href=”http://www.answers.com/main/ntquery?s=hyman+minsky&gwp=13#Understanding_Minsky.27s_Financial_Instability_Hypothesis”>Financial Instability Hypothesis</a>, and the <a href=”http://www.slideshare.net/fredypariapaza/capitalbased-macroeconomics”>Austrian Business Cycle Theory</a> is just one way it happens.
    What’s the one thing socialists and Republicans have in common? They both seem to agree with what capitalism consists of, just disagree about whether it’s a good thing. I’m not willing to surrender capitalism to those who have corrupted the term (read: Republicans and therefore socialists). I’m not calling you a socalist, I’m just pointing something out.
    Also, I’m not a right-winger and I despise Reagan’s legacy.
    You can take a read at my Was That Capitalism? referring to the Bush years: http://freedomdemocrats.org/node/3512 we’re essentially taking meat, poisoning it with all these chemicals, antibiotics, and hormones, then blaming meat.
    “It is about taking necessary action during a crisis”
    Define necessary.
    Markets have failures the government needs to correct, but many failures are due to intervention. When confronted with a failure, it usually centers around the following 2 things: incentives, and information. Incentives being whether costs and benefits are fully internalized and how easy entry and exit is, information being whether all parties have the same information. The best way is to fix those things.
    You say pure lasseisz faire results in inequities of freedom. Not saying you’re wrong, but name one historical situation where that has occurred.
    Also, I thought I’d point out <a href=”http://www.answers.com/main/ntquery?s=public+choice+theory&gwp=13″>public choice theory</a>

  16. 16
    Eclectic Radical says:

    ‘You say pure lasseisz faire results in inequities of freedom. Not saying you’re wrong, but name one historical situation where that has occurred.’
    The Second Industrial Revolution, just prior to the American Civil War, led to a huge explosion of utterly unregulated capitalism in the US and the UK.  The Liberal governments of the UK, who had embraced Adam Smith, opposed regulation of business. Because skilled adult male employees were expensive and machine manufacture did not require skilled craftsman, the new factories hired young boys and teenage girls over the skilled adult male workforce whenever possible. This led to crushing levels of adult unemployment and poverty, children were forced to work themselves to death to support their families on substandard wages while their fathers were frequently unable to find work at all. The British economy was ‘stronger’ than ever before, but living standards plummeted, the child mortality rate soared and huge inequities between rich and poor led to a massive increase in the crime rate. Rather than take steps to regulate capitalism run amok, the Liberals (representing the interests of the capitalists) instead passed the Poor Act and established the Treadmill, effectively criminalizing the working classes. One can call the Poor Act ‘statism’, but the circumstances that led to its ‘necessity’ were brought about by laissez faire capitalism and it was chosen because it was supposedly the government course least ‘intrusive’ to same. A lack of proper government regulation of business practices led to a national crisis of poverty and crime. A government committed to a ‘hands off’ policy toward business then reacted to that crisis with draconian measures toward its victims that deprived a massive portion of the citizenry of the basic freedoms that capitalism was supposed to ensure. It was seen as a violation of proper capitalism to pass a child labor law.
     
    Charles Dickens wrote about this a little. Maybe you’ve heard of some of the books?
     
    After the American Civil War, as the US became a truly capitalist and industrialist nation for the first time, laissez faire policies came to dominate the economic policies of the now dominant Republican Party. The ‘hands off’ approach to business led to results somewhat similar to those in the UK. During what is now generally called ‘the Gilded Age’, the US was richer than it ever been before. It’s economy grew as it had never grown… and huge inequities between the capitalist class and the working classes led to the widest gulf between rich and poor in American history. Government refusal to regulate business practices or draft fair labor laws led to systematic oppression of employees who were very near indentured servants. The commitment to laissez faire gave the first American corporations the power to hire private armies to kill employees who dared complain. The wealth and influence of these corporations led to widespread corruption throughout state and local governments as business used the power of the paycheck to dominate political questions in their own interest. Again, child labor ran rampant. Living standards plummeted and crime rates skyrocketed. The first ‘organized crime’ rackets began to coalescein New York and Chicago in the form of the Irish street gangs, who worked hand in hand with business to police workers (read terrorize) and with politicians to organize (read rig) the vote.
     
    In both cases, the solution began with government actions. In the UK, the Conservative Party (so ironic, now) passed the first Child Labor Law in England. They also established the first meaningful industrial regulations and standards. A group of disaffected Liberals, calling themselves the Radicals, introduced proposals for more humane welfare reforms. As some of these began to pass, standards of living rose and some of the worst abuses were somewhat ameliorated. Though the rates of economic growth slowed somewhat, standards of living went up and adult unemployment went down. Crime rates fell as well.
     
    In the United States, the ‘progessive Republicans’ like Robert LaFollette Sr and Teddy Roosevelt began to reform some of the worst abuses of corporate power. As president, Teddy began to ‘bust the trusts’ and William Howard Taft and Woodrow Wilson did an even better job of it… though the post-WWI ‘Return to Normalcy’ would delay real recovery until after WWII as the return to ‘hands off’ policies toward business led to fresh management-labor violence and the speculation craze that caused the Great Depression.
     
     

  17. 17
    Ben says:

    That’s much information. I don’t consider corporations capitalism, they are anti-capitalism. They’re purely creatures of the state

  18. 18
    Eclectic Radical says:

    ‘That’s much information. I don’t consider corporations capitalism, they are anti-capitalism. They’re purely creatures of the state.’
     
    Ummm, no. Corporations are exactly what Smith was talking about when he wrote ‘The Wealth of Nations.’ Business supported by capital and run by professional directors on behalf of investors. The pure expression of capitalism as Smith intended it.
     
    Mind you, I’m pretty sure he intended directors to genuinely be professionals, rather than a leisure class of idlers whose seats on boards were ways for superannuated executives and celebrities to get paid a salary without doing any work. So it clearly hasn’t worked out the way he intended.
     
    Again, however, the corporation is the very model of what Smith meant by ‘capitalism.’ People supply the capital through investment and the businessmen do the business on their behalf and pay them a return for their investment. The fact that investment is a now a tool by which corporationsd= gull the public is entirely the result of the natural degeneration of human institutions over time.
     
    During the period I described, however, corporations were precisely what Smith wrote about in ‘Wealth of Nations’ and were still run by professionals on behalf of the capitalist class Smith had envisioned. Writing that period off by waving one’s hand at what one believes corporations to be now and dismissing it as ‘anti-capitalist’ doesn’t change the facts of laissez faire in action.
     

  19. 19
    Eclectic Radical says:

    As a note, I’m familiar with public choice theory.
     
    If the economists who devised it studied businesspeople in the same light, under the same assumptions, they would have very different views.
     

  20. 20
    Ben says:

    Economists often do. They often don’t study government officials in that light. As for corporations, limited liability is certainly anti-capitalist and creation of the state.

  21. 21
    Eclectic Radical says:

    That depends on whom you ask. There are those who would have you believe that the whole idea of liability is anti-capitalist and should be done away with.
     
    That said, I agree with you that limited liability and other modern conventions of corporatism are not truly capitalist. But the LLC hadn’t been thought up yet in the period of time I was describing.

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