Is The Laffer Curve a Joke?

An article I read recently suggested that President Donald Trump’s tax plan was based on his understanding of the Laffer Curve.  At the risk of boring some of you I decided it was worth the effort to explain what this means since tax reform is high on the GOP agenda in September.

Dr. Arthur Laffer holds a PhD in economics and was the chief economist in President Nixon’s Office of Management and Budget from 1970 to 1972.  As the story goes, Laffer was having dinner with President Gerald Ford’s top advisors, Dick Cheney and Don Rumsfeld, in 1974 when the U.S. economy was in recession.  At the time the top income tax rate was 70 percent.  Laffer was counseling Cheney and Rumsfeld that the top federal tax rates were too high and that high taxes were stifling economic growth.  To emphasize his point, he drew a crude graph on a napkin that I believe looked something like graph from the Laffer Center depicted here.

LafferCurve-graphicLaffer’s purpose was to show that as the top tax rate goes up it initially increases revenue but at the tip of the curve economic growth is stifled and revenues begin to go down.  At a 100 percent tax rate no revenue would be collected because there would be no incentive to work.  This is obviously false since the top tax rate during 1952 and 1953 was 92 percent and lots of people were still working and paying taxes, even the very rich who were subject to that rate.

The key question was — and still is — at what top tax rate is revenue maximized without discouraging productivity and investment?  As far as I know Laffer did not suggest what the optimum tax rate would be at the time, although his symmetrical curve would seem to indicate that revenues would be maximized at a top tax rate of around 50%.  Today the top rate is 39.6 percent.

Devotees of the Laffer Curve use it to show that tax cuts stimulate economic growth and tax increases suppress economic growth.  The Laffer Curve has even been used to support a theory that tax cuts actually pay for themselves by creating strong economic growth.   In fact Treasury Secretary Steve Mnuchin claimed that Trump’s plan would do that.

In 1981 Dr. Laffer became a member of President Ronald Reagan’s Economic Policy Advisory Board and remained in that position for eight years.  It was during Reagan’s tenure that “supply-side economics” became the prevailing economic theory in the Reagan administration.  And Laffer was its champion.

No doubt Laffer influenced Reagan’s first big tax cut in 1981 that reduced the top rate from 70 percent to 50 percent. Then Reagan’s 1986 tax reform brought the top rate down to 28 percent in 1988.  This reform was designed to be revenue neutral so it collected the same amount of revenue as when the top tax rate was 50 percent.  Although rates came down significantly, this reform is not considered to have been a tax cut.

Dr. Laffer now runs Arduin, Laffer & Moore Econometrics (ALME), an organization that does consulting and studies for mostly Republican led states like Kansas and North Carolina.  Typically these studies suggest that if a state eliminates its personal and corporate income tax systems and replaces them with a much higher consumption (sales) tax, the state’s economy will boom.  Of course, a sales tax puts the greatest burden on middle to lower income wage earners and the elderly on fixed incomes.

The study that ALME did for North Carolina in 2012 was entitled, “More Jobs, Bigger Paychecks,” It recommended a consumption tax based system.  In January 2013 the Institute on Taxation and Economic Policy published a report that concluded the ALME study for North Carolina “relies on an economic analysis that is fundamentally flawed to the point of making it entirely useless.”

Kansas Republican Governor Sam Brownback relied heavily on Dr. Laffer’s advice when he and the Republican controlled legislature passed a massive tax cut in 2012.  But instead of stimulating strong growth, tax revenues plummeted and huge spending cuts became necessary.  To this day the Kansas economy has not kept pace with its neighboring states.  In short, the Kansas tax cuts were a disaster.

Here are a couple of other data points on tax cuts:  President John Kennedy reduced the top tax rate from 90 percent down to 70 percent (enacted in 1964 after his death).  This tax cut was by some measurements larger than Reagan’s 1981 cut but Kennedy is rarely mentioned as a tax cutter, nor is his tax cut touted as having spurred economic growth.

President George W. Bush engineered large tax cuts in 2001 and 2003 that were also larger than Reagan’s in some respects.  But his eight years in office ended in the Great Recession and he had the worst job creation record, on record, according to the Wall Street Journal.

There is nothing simple about tax policy, either in theory or in practice.  But in my opinion the Laffer curve is entirely too simplistic to be useful.  It focuses on the top tax rate when in truth the top rate is just one factor in tax policy as Reagan’s 1986 tax reform demonstrates.  So I would not conclude that the Laffer curve is a joke; I just don’t think it has much relevance in today’s economy and Republicans shouldn’t claim that it does.

 

About eeldav

I am a retired corporate attorney who has lived in both Europe and Asia. While working my responsibilities took me to over 40 countries in Europe, the Middle East, Africa and Asia.
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7 Responses to Is The Laffer Curve a Joke?

  1. Philip Rakita says:

    Too many confuse “top tax rate”, sometimes called the “marginal tax rate” with the plain old “tax rate”, which is (total taxes paid)/(total income taxed). It’s remarkable that during the Eisenhower and Kennedy years the high (90+%) marginal rate did not stifle our economy or discourage high income people from working harder. Sure, they got to keep less than 10 cents from that final dollar they earned, but if you look at their overall tax rate it was a good deal less than that. Moreover, high marginal rates are one way of reallocating resources and reducing inequality. [Cf. “The Broken Ladder” by Keith Payne and Thomas Piketty’s “Capital in the 21st Century.”]

    The so-called Laffer Curve is merely an intellectual trick, used by the Rentier capitalists and those politicians beholden to them and their spokesmen to justify tax cuts for the wealthy and benefit cuts for everyone else.

    Laffer may be a Ph.D. in Economics but his theory is taken from the Betty Crocker, lickety-split school of economic cookbooks. Sounds great, tastes awful.

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  2. Tim Sheeran says:

    Mr. Rakita has it right in my view tho the Laffler curve must be attractive to Trump as it looks so simple and is easy to grasp. DT likes easy to grasp….

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    • Philip Rakita says:

      Trump aside, it’s the other so-called serious Republicans who embrace this fantasy. Take the Speaker of the House (Ryan) or the Governor of Kansas (Brownback). They both are viewed as serious, thoughtful politicians by their followers and, sad to say, too much of the media. They’re charlatans, empty suits, trying to sell us a pig in a poke. Baloney.

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  3. jan partin says:

    Let’s hope we’ve learned from the Kansas fiasco and wiser minds prevail – some Republicans are not rolling over in spite of Trump’s threats.

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    • Philip Rakita says:

      I, too, want to be an optimist. But I’ve lived long enough to have learned not to count on good will and intelligence to carry the day. Yes, I think the “Kansas fiasco” has something to teach all of us. But those who most need to learn the lesson are not listening. They’re standing there with their fingers in their ears yelling “Na, Na, Na.” As our benighted president would say, “Sad.”

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  4. Ken Walker says:

    The CURVE is nothing more than an intellectual concept to demonstrate a relationship between working more and the discouragement of that behavior because working more only pays the Government. I know an Attorney who once worked rather hard until about early July. He then would go away on vacation until middle September. He would return and work mostly pro-bono and service his existing clients until the first of the year. When tax changes went into effect he altered his schedule accordingly.
    The major defect in the current tax plan is not the Corporate Tax rate alone but also the endless number of loop hole deductions which bring the actual effective rate to something much lower.
    We need to stop using the tax code to favor special interests who contribute to politicians campaign funds. This behavior only adds invisibility to the tax code so we all wonder who is getting some special deal we cannot gets for ourselves.
    It appear the Republicans will agree to tax cuts without any offsetting revenue upticks. We simply have to stop this and recognize we cannot have costly social programs or defense spending and simply keep adding to the national debt. What if the Chinese stop buying our bonds??

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  5. Philip Rakita says:

    I totally agree with your comment, “We need to stop using the tax code to favor special interests who contribute to politicians’ campaign funds.” I just don’t know HOW to do it. Personally, I take advantage of the “mortgage interest deduction” loophole and also the “state income tax” offset deduction. Why? Because they’re in the tax code and I’m allowed to do it. Change the tax code and I’ll change my behavior (and pay off my mortgage).

    As you correctly point out, “Republicans will agree to tax cuts without any offsetting revenue upticks.” THAT is a recipe for fiscal disaster. We can fill pages debating the benefits of “costly social programs or defense spending” but it seems clear to me that there needs to be a decent level of public financing for shared benefits, whether those be the National Parks or school lunches to hungry kids or more tanks for the generals.

    Adjusted for population growth and GDP growth, the National Debt as a percentage of GDP is only now approaching the levels it was during the FDR and Truman presidencies.

    As for China, they hold 8% of our national debt, compared with the Social Security Trust Fund (16%) and the Federal Reserve (12%). The Japanese hold 7%. Should we be worried about them? [ http://www.factcheck.org/2013/11/who-holds-our-debt/ ]

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