The Tax Debate and the Laffer Curve

[anvi]

In recent debt-ceiling/budget negotiations, the idea of cutting top marginal tax rates, with a view to growing the economy and thereby raising more revenue in the long term, gained a great deal of headway in Washington.  Obama and Boehner were close to a deal on a rate adjustment and the Gang of Six in the Senate proposed its own downward rate adjustment.  The debate about how to optimize revenue through tax policy will surely play a starring role in coming negotiations on the Joint Select Committee tasked with long-term budget outlays and in Congress as a whole thereafter.

As with all such issues these days, the debate about whether the Laffer Curve hypothesis gains revenue through lowering marginal rates seems to have only two sides.  One side (the supply-side, usually) cites evidence such as the 1920's downward tax adjustments, the 1980's Reagan tax cuts, and the downward marginal tax adjustments in Europe in the '80's and '90's.  Their estimates also point out that simply and mechanically raising marginal rates causes deadweight loss in the economy, and such loss not only reduces the net effect of raised revenues but eventually reduces them over time.  Opponents call the Laffer Curve a "myth" and conjecture that the marginal tax increases by FDR and Clinton demonstrated that such straightforward increases are better at both maximizing and optimizing government revenue.  They also argue that the effects of the Reagan tax cuts were distorted by increased government spending, and in any event that lowering marginal rates requires considerable amounts of time to recoup the lost revenues.

I have only read a few articles and papers about the Laffer Curve from different perspectives.  I am hardly an expert on taxes, but for those on the forum who have more knowledge than I do, I have a few questions.

--If the Laffer Curve is credible, then shouldn't we first determine on which side of the curve we are currently on with regard to optimized tax revenues before we make a downward rate adjustment, since if we are on the forward-sloping end of the curve, lowering rates would cost revenue?

--Given the ever-increasing costs of funding politically popular federal budget priorities, may not lowering marginal rates now incur some danger, given that there seems to be some agreement that lowering marginal rates requires some extended period of time for the economy to grow and thus for the government to recoup the lost revenue?  Wouldn't we be in danger of lowering our revenue at a time of increasing costs and thus only worsening our deficit woes?

--Would those who support rate adjustments according to the dictates of the Laffer Curve still support them if the Curve at current rates dictated the slight increase of marginal rates?  Or is the embrace of the Laffer Curve hypothesis merely a rationalization for lowering marginal rates regardless of the circumstances?

--Shouldn't we learn more about the credibility of the Laffer Curve hypothesis before staking so much on it in a time when the federal budget is facing a veritable crisis?

I realize that equally difficult questions can be raised of advocates of simply increasing the marginal rates, given that the change in economic behavior they would cause may have an adverse effect on economic growth and, in the long run, perhaps even government revenue collection itself.  But I'd like to be better informed of the actual likelihood of the Laffer effects of lowering marginal rates before myself fully buying the idea, or, even more importantly, before Congress signs off on it.

Any feedback is welcome.  Thanks.   

[J. J.]

--If the Laffer Curve is credible, then shouldn't we first determine on which side of the curve we are currently on with regard to optimized tax revenues before we make a downward rate adjustment, since if we are on the forward-sloping end of the curve, lowering rates would cost revenue?

I think this is the key point.  Many people in the early 80's were saying, "Art, you're right, in theory, but we're not at the peak."  The empirical data from the period tended to support that.

You also had two different factors when Laffer first proposed the theory.  The top Marginal Tax Bracket was 70% and tax brackets were not indexed for inflation.

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At some points this isn't true, but in 2011 I think it is.

One thing that you hinted is is that the same solution does not work in all situations.  Arguably a policy that had inflation as effect made no difference in 1935; in 1979, it would have been a disaster.  In 1981, a policy that had, as an effect, increased debt made no difference.  2011, it does.

That is why you hear me talking about income tax increases.  I doubt that the Laffer disincentive would be reached.

[anvi]

Thanks for the feedback, J.J.

I agree that the same economic measures obviously don't work in all situations.  Even if the Laffer Curve Hypothesis is correct, we need, as mentioned, to figure out where we currently are on the curve and do some fairly mathematically sophisticated estimates and projections in order to determine what sorts of rate adjustments are optimal.  If it is found that we are on the forward-sloping end of the curve an that an upward-adjustment would therefore be best, I think that would give the Hypothesis itself increased credibility.  If on the other hand it is agreed we're on the backward-sloping end of the curve, it may indeed make sense to adjust the rates downward.  But even in that case, we should also figure out how long it will take to recoup the initially lost revenues and then start generating more, because if, during whatever that time-lag is, our budget priorities coupled with rising costs force us to borrow more money, not only will our deficit woes worsen, but the effects of the Laffer Curve revenue projections may be distorted. 

In short, it seems to me we need people to do some very good math in a a very unbiased way to determine whether upward or downward tax rate adjustments are appropriate for our situation before we commit ourselves to a ten-year long binding budget plan.  The fact that I don't know the answer to this question of what exactly to do with the rates is not surprising.  My big worry is that Congress doesn't rightly know at the moment either, and since they are under the gun to make decisions by the end of the year, I hope some very credible evidence and projections can be made so they can make an informed decision.

That's hoping for way too much from D.C. and the studies they commission, isn't it? 

[Torie]

Nobody knows just where the Laffer curve kicks in, and it probably depends. Few would contend that cutting rates from any "reasonable" level actually raises revenues  (and certainly would not raise revenues with a cut from current rates), but most would agree I think that a cut would generate some additional economic activity (and less tax avoidance and evasion), thereby mitigating the revenue loss. That is what the argument in Congress and elsewhere about "dynamic scoring" is all about.

There seems to be a consensus that cutting rates and deductions (so no net loss in revenues pre dynamic scoring), would enhance economic efficiency and revenues I think, because at the margin the tax on economic activity would be lower in an unbiased way, while the loss of deductions affects less activity at the margin, and is more of a subsidy for specific economic behavior, which itself causes economic distortions and inefficiency.

Make sense?  By the way, Laffer was a professor of mine. I was not impressed with his brain. Nice guy though. I have met him two or three times since. One of his peculiarities back when was he disliked floating exchange rates, and wanted them fixed. Now how free market is that?  My best friend in Business School co-wrote a WSJ article with Laffer on the subject.

[J. J.]

In regard to the Laffer curve itself, when he drew it (on a cocktail napkin) it was a standard bell curve.  I think that was the wrong assumption.  It might have more a skewed right side curve.  There is a disincentive, but it kicks in at higher rates.

[anvi]

Thanks Torie, as always, for the clarification.  I do suspect that a combination of deduction and loophole elimination combined with downward-adjusted rates would likely increase economic efficiency and enhance revenues in the long term, depending on what rates the margins were adjusted to.  But all the major examples of Laffer Curve effects from downward adjustments always strike me as simplistic, since there are a lot of economic dynamics at work in any given situation that make it unique.  

The downward rate adjustments are also very politically difficult for both sides.  If you combine them with deduction and loophole elimination, the Norquist crowd makes noise because they smell a net increase in upper-bracket taxation.  And if you adjust the rates downward, the Democratic base (not necessarily Democrats in the Senate) go wild because they just want to see the upper brackets increased.  So, in addition to the whole matter being a very tricky economic one, it's also a tough needle to thread politically.

Laffer was a prof. of yours, eh?  Well, I'm impressed, even though you seem less so.  Fixed exchange rates, huh?  Yeah, that really isn't a good idea; wow!

.....

J.J, yes, I think the papers I've read do suggest that the curve kicks in at the higher rates.  The bell-curve would in any case be misleading because it suggests far to static of an economic situation.  Even David Stockton, Reagan's first-term budget director, seemed suspicious of how literally top administration officials were assuming the Laffer Curve worked, especially in the face of increased government spending which distorted the effects of the curve anyway, even when bringing top rates down from 70%.

[opebo]

I don't dispute there being some validity to the Laffer curve at very high tax rate levels, but the missing link is this:

Without Keynesianism, in a neo-liberal economy, there is virtually no incentive to invest simply because there is little or not growth due to a dearth of demand.  We are seeing precisely this condition at present - extremely low (dangerously low) tax rates do nothing whatever to encourage investment because neo-liberal inequality leave us with an economy not worth investing in.

It is sheer idiocy for anyone to be talking about disincentives to investment due to taxes in an economy where 1) tax rates are a comically low level of 35%, and 2) huge amounts of capital are sitting idle because of a lack of demand.

[J. J.]

I don't dispute there being some validity to the Laffer curve at very high tax rate levels, but the missing link is this:

Without Keynesianism, in a neo-liberal economy, there is virtually no incentive to invest simply because there is little or not growth due to a dearth of demand.  We are seeing precisely this condition at present - extremely low (dangerously low) tax rates do nothing whatever to encourage investment because neo-liberal inequality leave us with an economy not worth investing in.

Oddly, you are right in certain situations, though not our current one.

[opebo]

Oddly, you are right in certain situations, though not our current one.

So, you're saying at the present we have plenty of demand and a high tax rate, J.J.?  Perhaps your cummerbund is too tight.

[J. J.]

Oddly, you are right in certain situations, though not our current one.

So, you're saying at the present we have plenty of demand and a high tax rate, J.J.?  Perhaps your cummerbund is too tight.

No. and I wear a vest.

I'm basically saying that an small income tax increase would have a negative effect on revenues.

[TeePee4Prez]

I don't dispute there being some validity to the Laffer curve at very high tax rate levels, but the missing link is this:

Without Keynesianism, in a neo-liberal economy, there is virtually no incentive to invest simply because there is little or not growth due to a dearth of demand.  We are seeing precisely this condition at present - extremely low (dangerously low) tax rates do nothing whatever to encourage investment because neo-liberal inequality leave us with an economy not worth investing in.

It is sheer idiocy for anyone to be talking about disincentives to investment due to taxes in an economy where 1) tax rates are a comically low level of 35%, and 2) huge amounts of capital are sitting idle because of a lack of demand.

I've even toyed with the idea of a Intangible Property Tax for cash/bank accounts over a certain amoun with credits offset by hiring employees or making capital investments.  Any thoughts?

[Nichlemn]

--Would those who support rate adjustments according to the dictates of the Laffer Curve still support them if the Curve at current rates dictated the slight increase of marginal rates?  Or is the embrace of the Laffer Curve hypothesis merely a rationalization for lowering marginal rates regardless of the circumstances?

The Laffer Curve doesn't dictate anything. If you believe that tax revenues should be maximised, then sure. But that is a highly questionable objective - it means you would support a tax hike that raised revenue by $1 even if it caused an additional $1,000,000 in deadweight losses. The tax maximising level is a very conservative measure of what the top tax rate should be - a point beyond which there should be little controversy over cutting taxes (assuming agreement of where it is, which is not likely to be the case in practice). Below it, you no longer have a "free lunch", but the lunch starts out cheap.

[J. J.]

I don't dispute there being some validity to the Laffer curve at very high tax rate levels, but the missing link is this:

Without Keynesianism, in a neo-liberal economy, there is virtually no incentive to invest simply because there is little or not growth due to a dearth of demand.  We are seeing precisely this condition at present - extremely low (dangerously low) tax rates do nothing whatever to encourage investment because neo-liberal inequality leave us with an economy not worth investing in.

It is sheer idiocy for anyone to be talking about disincentives to investment due to taxes in an economy where 1) tax rates are a comically low level of 35%, and 2) huge amounts of capital are sitting idle because of a lack of demand.

I've even toyed with the idea of a Intangible Property Tax for cash/bank accounts over a certain amoun with credits offset by hiring employees or making capital investments.  Any thoughts?

It would completely destroy the economy, even worse that it is now.

Cut capital gains, toss Obamacare, remover newer environmental regulations, cut bot entitlements and defense spending and raise income taxes across the board.  Eliminate the loopholes in corporate taxes, make it a lower rate.  Do however consider a tax on undistributed corporate profits.

[anvi]

The Laffer Curve doesn't dictate anything. If you believe that tax revenues should be maximised, then sure. But that is a highly questionable objective - it means you would support a tax hike that raised revenue by $1 even if it caused an additional $1,000,000 in deadweight losses. The tax maximising level is a very conservative measure of what the top tax rate should be - a point beyond which there should be little controversy over cutting taxes (assuming agreement of where it is, which is not likely to be the case in practice). Below it, you no longer have a "free lunch", but the lunch starts out cheap.

It's of course a good point that tax maximization shouldn't be mistaken for optimization, and the goal should be to optimize revenue.  But the Laffer Curve does figure in such discussions too.

[opebo]

Cut capital gains, toss Obamacare, remover newer environmental regulations, cut bot entitlements and defense spending and raise income taxes across the board.  Eliminate the loopholes in corporate taxes, make it a lower rate. 

Why would repeating the same mistakes which brought us back to 1929 again be a good idea?

[anvi]

I've even toyed with the idea of a Intangible Property Tax for cash/bank accounts over a certain amoun with credits offset by hiring employees or making capital investments.  Any thoughts?

Wouldn't companies with large holdings just move them around?  But I like the sentiment; just waiting around for new sources of demand to pop up while we trap ourselves in a diminished production and hiring stagnation seems dumb.  If the economy continues to worsen or if Europe pulls us down, it may be necessary to reverse course for a while and take more stimulative measures.

[J. J.]

Cut capital gains, toss Obamacare, remover newer environmental regulations, cut bot entitlements and defense spending and raise income taxes across the board.  Eliminate the loopholes in corporate taxes, make it a lower rate. 

Why would repeating the same mistakes which brought us back to 1929 again be a good idea?

Because:

A.  Those are not the same policies.

2.  This in not 1929.

[All Along The Watchtower]

I don't think the Laffer Curve is nearly as relevant when the top marginal tax rate is not 70 percent, but 35 percent.

[opebo]

Cut capital gains, toss Obamacare, remover newer environmental regulations, cut bot entitlements and defense spending and raise income taxes across the board.  Eliminate the loopholes in corporate taxes, make it a lower rate. 

Why would repeating the same mistakes which brought us back to 1929 again be a good idea?

Because:

A.  Those are not the same policies.

2.  This in not 1929.

A.  Afraid they are, J.J.  Just more concentrationist neo-liberal madness.

2. 1929 was caused by capitalism, just as all panics are including the current.  Easily fixed by Keynesian redistribution, but you're prescribing the opposite.

[J. J.]

Cut capital gains, toss Obamacare, remover newer environmental regulations, cut bot entitlements and defense spending and raise income taxes across the board.  Eliminate the loopholes in corporate taxes, make it a lower rate. 

Why would repeating the same mistakes which brought us back to 1929 again be a good idea?

Because:

A.  Those are not the same policies.

2.  This in not 1929.

A.  Afraid they are, J.J.  Just more concentrationist neo-liberal madness.

2. 1929 was caused by capitalism, just as all panics are including the current.  Easily fixed by Keynesian redistribution, but you're prescribing the opposite.

The 1929 recession was caused by debt; what helped it become the Great Depression was Smoot-Hawley.

The difference today is a lot of the debt is government debt, something there wasn't a lot of in 1929.

[opebo]

The 1929 recession was caused by debt; what helped it become the Great Depression was Smoot-Hawley.

The difference today is a lot of the debt is government debt, something there wasn't a lot of in 1929.

Oh my gosh you are one ass-backwards mofo.

[J. J.]

The 1929 recession was caused by debt; what helped it become the Great Depression was Smoot-Hawley.

The difference today is a lot of the debt is government debt, something there wasn't a lot of in 1929.

Oh my gosh you are one ass-backwards mofo.

Try reading economics texts, you might learn something,  People were leveraged and couldn't meet the margin calls.  That was the proximate cause of the crash.

(That's also why I sold off silver coins just before Black Thursday.)

[Verily]

The 1929 recession was caused by debt; what helped it become the Great Depression was Smoot-Hawley.

The difference today is a lot of the debt is government debt, something there wasn't a lot of in 1929.

Oh my gosh you are one ass-backwards mofo.

Try reading economics texts, you might learn something, unless the pox has entirely rotted you brain.  People were leveraged and couldn't meet the margin calls.  That was the proximate cause of the crash.

(That's also why I sold off silver coins just before Black Thursday.)

People, i.e., not the government. They are not at all the same, nor is their debt. This recession was also caused by debt. Debt belonging to the people in the form of mortgages. Mortgages and government debt are, once again, not remotely the same.

[J. J.]

The 1929 recession was caused by debt; what helped it become the Great Depression was Smoot-Hawley.

The difference today is a lot of the debt is government debt, something there wasn't a lot of in 1929.

Oh my gosh you are one ass-backwards mofo.

Try reading economics texts, you might learn something, unless the pox has entirely rotted you brain.  People were leveraged and couldn't meet the margin calls.  That was the proximate cause of the crash.

(That's also why I sold off silver coins just before Black Thursday.)

People, i.e., not the government. They are not at all the same, nor is their debt. This recession was also caused by debt. Debt belonging to the people in the form of mortgages. Mortgages and government debt are, once again, not remotely the same.

There is a difference in debt, but this recession is being caused, to some extent to government financing.  Even from a Keynesian viewpoint, we might have hit the "Keynesian Endpoint."

[t_host1]

I don't dispute there being some validity to the Laffer curve at very high tax rate levels, but the missing link is this:

Without Keynesianism, in a neo-liberal economy, there is virtually no incentive to invest simply because there is little or not growth due to a dearth of demand.  We are seeing precisely this condition at present - extremely low (dangerously low) tax rates do nothing whatever to encourage investment because neo-liberal inequality leave us with an economy not worth investing in.

It is sheer idiocy for anyone to be talking about disincentives to investment due to taxes in an economy where 1) tax rates are a comically low level of 35%, and 2) huge amounts of capital are sitting idle because of a lack of demand.

 true, there is cash stashed, because, when it is earn it has value. However, your not even close when you say that there is no "demand" for it. Much worst than those trolls out and about, there is an incurable disease called Progressive-Keynesianism, at it's core, a liberal democarat. It's existence can only be maintain, much like a tumor needing blood, is by the confiscation and consumption of that earn stashed cash.