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Conservative Misapplications of the Laffer Curve

by | Jun 9, 2016 | Economy, Taxes

For the last four decades, a sizable phalanx of conservative thinkers has argued that government revenues can be increased by cutting tax rates. In reality, tax rate reductions have consistently failed to generate new revenue, both at the federal and state levels. Nonetheless, faith in the tax-cut-as-revenue-raiser dogma continues.

“Tax-cut-as-revenue-raiser” claims are rooted in the “Laffer curve,” named after economist Arthur Laffer, who popularized the graphical representation of one of the fundamental tenets of supply-side economics: zero public revenue will be generated when the income tax rate is zero and when the rate is 100 percent. It’s easy to understand how a zero tax rate generates zero revenue, but why is revenue zero at a 100 percent tax rate? Because at a 100 percent rate, there is no incentive for an individual to work or invest (or there is a powerful incentive to avoid taxation) because taxation eats up all the fruits of labor. The maximum amount of tax revenue is generated at a rate greater than zero but less than 100 percent.

Laffer Curve

The above chart shows a hypothetical Laffer curve at which the maximum amount of revenue is generated at a rate of 70 percent, represented by tm. (A comparison of various academic studies summarized in the New Palgrave Dictionary of Economics indicates a range of revenue maximizing tax rates that centers around 70 percent.) In this illustration, the revenue generated declines as tax rates surpass 70 percent, as work and investment is effectively discouraged. The precise shape of the Laffer curve—and the tax rate at which the maximum revenue is achieved—can vary, depending on the specifics of the tax being examined and the specific economic circumstances to which it is applied.

Economists have pointed out shortcomings of Laffer curve, including circumstances in which it does not apply; however, the logic behind the Laffer curve—that extremely high tax rates can be a disincentive to work and investment and hence destructive of the goal of generating tax revenue—is difficult to deny.

Tax cut proponents often predict that the increased work and investment stimulated by tax rate reductions will increase the level of economic activity, thus generating more tax revenue, despite the tax rate reduction. Conversely, they argue that tax rate increases will frequently bring in less revenue. If the fundamental logic behind the Laffer curve is basically sound, why are predictions that tax rate reductions will generate additional tax revenue (and that tax rate increases will generate less revenue) consistently wrong?

Predictions based on the Laffer curve of increased revenue resulting from tax rate reductions implicitly assume that the current tax rate is greater than the maximum revenue tax rate—in other words, the current tax rate is to the right of tm in the above graph. However, if the current tax rate is less than the maximum revenue tax rate (to the left of tm), a reduction in the tax rate will generate less revenue. For example, if the current tax rate is equal to tc in the above graph, any reduction in the tax rate will generate less tax revenue; conversely, any increase in tc will generate more revenue, unless the tax rate increase is so large that the rate surpasses tm, at which point tax revenue will begin to decline.

One of the few instances where a tax cut may have contributed to an increase in tax revenues was during the 1960s, when the Kennedy administration succeeded in lowering the top marginal tax rate from 90 percent to 70 percent. A 90 percent marginal rate was very possibly above the maximum revenue tax rate (i.e., to the right of tm)—and thus a reduction to this rate may have indeed contributed to an increase in tax revenue.

However, tax rates for the last several decades have been nowhere near the level of the early 1960s. The top federal income tax rate is currently 39.6 percent—less than half the top marginal rate at the beginning of the Kennedy administration. Even if we add state tax rates, the resulting rate remains well below the top marginal federal rate prior to the Kennedy rate cut. In short, income tax rates today generally are not high enough (i.e., are not above the maximum revenue tax rate, tm) to generate increased revenue as the result of a rate reduction.

This is the fundamental reason why state and federal tax cuts enacted in recent decades have failed to generate additional tax revenue. For example, the 1981 Reagan tax cuts led to a significant drop in federal tax revenue:

President Reagan argued that because of the effect depicted in the Laffer curve, the government could maintain expenditures, cut tax rates, and balance the budget. This was not the case. Government revenues fell sharply from levels that would have been realized without the tax cuts. (Principles of Economics, Karl E. Case & Ray C. Fair, 2007.)

Similarly, the Bush tax cuts of 2003 led to a large reduction in federal revenue and escalating deficits, according to a report from the Economic Policy Institute.

Meanwhile, tax rate increases enacted during the Clinton and Obama administrations not only increased federal tax revenue, but led to “a boom that eclipsed Reagan’s” in the case of the Clinton tax increase and “the best job growth since 1999” in the case of the Obama tax increase, according to Nobel laureate economist Paul Krugman.

At the state level, Kansas provides the most recent and perhaps starkest example of “tax-cut-as-revenue-raiser” predictions gone awry. In that state, conservative policymakers—with the urging of none other than Art Laffer himself—slashed taxes in August 2012 with the expectation that the resulting economic boom would buoy state revenues. What actually happened is summarized in a January 2015 Kansas City Star article:

Two-and-a-half years later [after the tax cuts], Kansas is staring at a budget crisis, with more than a billion dollar gap between revenues and expenses projected in the current and next budget years. The state is also experiencing a low private job growth rate, as well as a slow-growing economy.

Minnesota is not immune from anti-tax hysteria inspired by a misapplication of the Laffer curve, as demonstrated by the following admonition from the conservative Gopher State Politics Institute directed at the 2013 state income tax increase:

Have the Legislators and Governor ever heard of the Laffer Curve? That is when you tax people too much, resistance develops, the tax revenue line steepens and actually bends backwards bringing less revenue. Higher taxes do not mean greater tax revenues. When they are perceived as being too high and too much, revenues will decline not increase. We’re afraid Minnesota is at that juncture.

For the record, since enactment of the 2013 tax increases, state tax revenues have increased—and have generally met or surpassed the revenue projections made at the end of the 2013 legislative session.

The problem is not that the logic behind the Laffer curve is wrong. Rather, the problem is that a subset of conservatives has misapplied it. At both the federal and state levels, income tax rates are generally not above the maximum revenue tax rate; as a result, reductions in the rate will generate less—not more—revenue. Reasonable people can disagree about the merits of income tax rate reductions, but no one should assume that cutting these rates will increase government revenue.

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