The Great Curve
The world moves on a woman’s hips, says David Byrne, or maybe it was the Weymouths but we know what they are talking about. That taper, swell and taper is hypnotic, notoriously it is used in advertising and product design to subliminally trip primordial triggers. Is it no more than vestigal reproductive instincts? Science seems to demonstrate this geometric construct to be nearly a bedrock of reality; not quite as solid as the speed of light but close enough to earn the name Normal or Standard Deviation.
And it isn’t just solar intensity or SAT scores that follow this template. Like so many other aspects of finance and economics, a Standard Deviation is historically demonstrated in the relationship between tax rates and tax revenues.
This is the famous/notorious Laffer Curve, the basic foundation of Supply Side Economics. The X axis, along the bottom is your income tax rate. Obviously at a rate of 0% you collect no revenue. But at a rate of 100% you also collect nearly no revenue. The why of that seems plain but perhaps it is not. If there is a 100% rate on income, guess what? then there is NO income. If the taxpayer is going to earn no income from a certain professional action then they will not take that action and the income will never be realized either to that rich bastard or gub coffers. And this is not just theoretical. Those with longer memories may remember a rather bitter ditty for the Beatles, called The Taxman. When McCartney complains the taxman offers one for you nineteen for me, a 95% tax rate he was premature. The UK actually had some special rates for performers and other high earners that amounted to rates OVER 100%. This didn’t last long but not because of any principled case against it in British politics, rather it was found through hard experience that these nasty rates did not accomplish the goal of increasing Crown revenues but worse, drove high earners of all stripes to other shores. If you ever wondered why so many Brit-poppers at the highest levels become US citizens in their Golden Years, the burdensome tax structure that yet exists in Blighty is most of the reason.
So zero rates get us zero revenue. And 100%+ rates get us no revenue or even harm existing revenue. What is happening in between? Anyone who works with numbers can make a good guess. It is a bell curve. Revenue rises as rates rise, peaks and then declines. This is not a theory, it is an observation and it is one that obtains through other sorts of taxes like tariffs and sales taxes as well as commercial, non-coercive transactions like prices. If the goal of the Treasury is to maximize its revenue, even if there is NO other consideration like GDP growth or general prosperity or any of that claptrap, then they would still, rationally, want to set rates at the peak of the curve. Where that may be is imprecise and it probably moves marginally with other events but the highest revenues as a fraction of GDP have been reaped around the 30-35% mark.
Some will be more familiar with this concept through the sticky nickname given it by Bush the Elder in his primary struggle against Ronald Reagan. That, of course, is Voodoo Economics.
This gassy dismissal from Bush Pere has never left the national stage. We may hope that it was a cynical, tactical ploy and not the actual view of Bush Sr, especially as he served Reagan’s administration without public qualm on the actual fiscal policies, but who knows? In any case it is always Exhibit A in any pushback on Supply Side policies; a damaging Admission Against Interest from the demonic Republicans. Okay, this prominent spokesmodel is on the record, once and in a primary slugfest, dismissing the Laffer Curve and all its implications. Is that all there is?
Just about, yes. Can anyone dispute that at higher prices fewer goods are sold? Well, income taxes are the price of income. Increase the price and you will have less income. Lower the price and you will get more. Yes, this is the mechanism, hotly debated and derided, that Reagan claimed would “pay for” the tax cuts, meaning that they would not, on net, cost the gub money but MAKE it money. On the timeline this is what happened, not only from the Reagan tax cuts but also the Kennedy tax cuts and other historical instances of taxcutting. As the rates reduce we move to the left on The Great Curve, increasing the tax take because there is that elusive thing everyone now seeks; economic growth.
For the anti-Reagans, this is an insulting fraud. Everyone knows Reagan was just lucky. The economy was coming back…. it’s all cyclical, and he just happened to be the dude (or dud) in office. Generally assertions like this are not subject to serious testing, only serious screaming, but we are about to embark on a serious test of the existence, relevance and Greatness of the Laffer Curve.
The Supply Siders assumed we were on the right-hand slope of the curve. If we can move rates down, they surmised, revenues will increase, and so they did whether due to these actions or no. Obama is about to move us (or just allow us to fall, more his style) down the DESCENDING slope of the curve that predicts that higher rates not only will fail to produce proportionate revenue improvements but will collapse revenue. And the beauty is that he need do absolutely nothing to set this in motion. One of the most putrid legacies of the late and unlamented Bush the Younger is those Bush Tax Cuts, universally rebuked in media and academe. These were so controvertial, even with a Republican Congress, that they were enacted only with a sunsetting clause. These rates, which were those in place when we had four percent growth and five percent unemployment, will automatically be raised to their previous level come January 1st, 2011.
Now, neither Obama, Pelosi or any other Democrat will call this a tax hike. No no no no no. This is a repeal of an unjust and irresponsible tax CUT! Okay, let us abandon the semantic ground. That doesn’t change one damn thing mathematically. That doesn’t change the fact that those lucky enough to HAVE legit jobs with 401ks, overtime and witholding will see their checks pruned right after next New Year. That isn’t me, by the way. One mystery not yet answered is whether those lower earners who were completely relieved of income tax liability by the Bush pallate of tax cuts will be re-encumbered but they haven’t been excluded so almost certainly they will. Electoral tactics and ideology aside, is this genius politics? Genius economics?
We shall see but The Great Curve has proven to be just about indestructible up to now. Perhaps it will be more amenable to persuasion going forward.
Hope.
Latest posts by Ken Watson (Posts)
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I think there’s a huge blind spot in discussion of the Laffer Curve that misses a point far more important than current government revenues — tax rates & their effect on growth.
The Laffer Curve is a static analysis about tax rates in the very immediate future. But the more important effect is growth rate. If a $10T economy in a high-tax environment grows at 3% per year, and the economy in a low tax environment grows at 5% per year, 100 years down the road the 3% growth will give you a $160T economy while the 5% growth will give you a $640T economy (assuming my math isn’t off). A tax rate of 1/4th the size is needed to return the same revenues when the economy is 4 times larger.
If taxes & regulations inhibit growth, they are doing far worse damage than any short-term drop in revenues. They’re reducing the standard of living of our grandchildren and great-grandchildren by WIDE margins.
Thanks for that insight, Brad. Nothing I would dissagree with there but I generally try to approach these things on their own terms which offers targets fat and numerous enough. In this case, the alleged REAL reason for allowing taxes to automatically rise is to gain more, admittedly much needed funds for the gub. It will fail even on this limited yardstick and as your observations indicate, cause yet greater harm in the long term but hey, once Thunderdome is on the schedule you might as well get there as soon as possible. Thanks for reading and commenting.
Actually, I think the assumption that we’re on the right side of the curve is suspect.
Note the difference between the bell curve of revenue vs. rate offered in this post, and the downward-sloping curve of growth vs. rate in the post I linked in my comment (disregard actual shapes of the curves at this point — the key is that one peaks somewhere in the center, while mine peaks at the left).
It’s entirely possible that we’re on the left slope of the Laffer Curve, so that reducing taxes will result in a reduction in government revenues. However, that would move us to a faster growth portion of my curve, meaning that over, say, the next decade we’ll “grow our way out” of the smaller revenues.
The Laffer curve is a static analysis that doesn’t take economic growth into consideration. There is no evidence to believe we’re currently on the left slope of that curve. Work is only mildly elastic, and if I know I will earn, say, $200 of work for my marginal next hour of work, a tax rate that reduces that to $190 may not make a big enough difference to my decision that it reduces overall government revenue.
The curve of growth vs. rate doesn’t peak in the center, though. It peaks on the left, at low tax rates.
If we want to have a debate about taxes, we need to make it clear that we can choose higher revenue now and lower growth over time [which leads to lower revenue over time], or lower revenue now and higher growth over time [which leads to higher revenue over time].
But just assuming that we’re on the right side of the curve, the Laffer Curve would state that an immediate cut in taxes would result in an IMMEDIATE rise in revenues. I just don’t think it’s borne out in practice.
That is a vital question: which slope we are on right now. And if we ARE on the left side, yes, the increased rates will increase revenue. Lab quality results are not possible, it seems, unless we can breed some ants to bid on derivatives, but as you say, this is the static analysis element of Supply Side. Growth effects are quite important and perpetually ignored, as in the CBOs static scoring of these matters, or perverted. The anti-Reagan, anti-Laffer arguments presume that cyclic growth mitigated the disastrous policies of that time enough to grow dramatically. Whether these effects are immediate or not depends on how well and how many people see it coming. As always, we shall see.