Monday, May 08, 2006

Debunking a would-be debunker of the Laffer Curve

Don Luskin said that people had asked him to comment on this rubbish that purports to critique the Laffer Curve. My friend Charlie had alerted me to it, but I hadn't had time to blog about it.

Don simply replied, "Well... I already have." The link there is to a speech he recently gave, and it's a zinger through and through. You really have to read the whole thing.

Wheelan and other critics of the Laffer Curve often use a strawman, pointing out that a tax cut doesn't necessarily pay for itself:
If Laffer were right, lower taxes would never require any spending sacrifice. We could pay a mere one percent of our income in taxes and still fund all of our government spending -- and maybe more! Do you think that's really possible?
Or they'll use the tactic of the flawed analogy:
Whether it's tax policy or dieting, you can't have your cake and lose weight, too, which is why America currently has huge deficits and a lot of fat people.
Neither of these are what we supply-siders say, and I bet he knows it. Never have we argued that any tax cut automatically pays for itself. The very shape of the curve tells us that. But supply-siders emphasize economic growth first, balanced budgets second. That's why, though the economics professor who influenced me the most is an Austrian, I count myself among the supply-siders. It was supply-siders like Jack Kemp and Alan Reynolds, and our friend Steve Conover, who showed me that deficits are not a worry if the economy grows faster. Call it an investment in ourselves. That's not to say all deficit spending is fine, for heaven knows both parties are wasting untold sums, but if spending exceeds revenues, it's better for government to borrow than raise taxes.

What we also say is that if you're to the right of the optimal tax rate t*, you can definitely cut taxes to get more revenue. I add that if you're so far to the right, you can cut taxes so that even if you fall below maximum revenue, you can still get more revenue than before because you were taxing too much. (Image borrowed from Wikipedia.)

We have had four Presidents who followed this simple game plan. Three were Republican, and one was a Democrat who today would be shunned by his own party. (I've touched on this when debunking Ted Rall's stupid claim that tax cuts never worked.) Technically there were five presidents, four of whom were Republican, if you want to count Warren Harding's presidency of just two years. However, the bulk of the tax cuts and their effects occurred during Calvin Coolidge's presidency.

Dr. Burt Folsom noted that with Andrew Mellon as Treasury Secretary, the top federal income tax rate was cut from 73% in 1921 to 24% in 1929. By 1925, Calvin Coolidge and Congress had lowered the maximum to 25%, which spurred the prosperity of the Roaring Twenties. Combined with truly prudent Congressional spending, the national debt actually decreased for several years. This lasted until the Fed severely started cutting the money supply (eventually by a third), Congress enacted the Hawley-Smoot Tariff of 1930, and Herbert Hoover started wrecking the economy (before FDR) by heavy borrowing to finance useless public works programs.

Congress passed Kennedy's proposed tax cut after his death, in February 1964. If you look at Table 1 of the CBO's historical budget data, federal tax revenues were growing anemically from 1962 to 1965, then they had started jumping. (Jack Kemp wrote extensively on this back in 2003.) Kennedy knew exactly what he was doing. Someone asked why he was cutting taxes, and he reportedly replied, "To raise revenue. Didn't you take Economics 101?" (I recall that anecdote from Greg Mankiw's introductory economics textbook, which we used in Macro I.)

Ronald Reagan, of course, slashed taxes to begin an era of unprecented, sustainable economic growth that has experienced only two (quite mild) downturns. At his funeral, George H.W. Bush tearfully eulogized, "As his vice president for eight years, I learned more from Ronald Reagan than from anyone I encountered in all my years of public life." It's a shame he didn't learn supply-side economics too. Bush had campaigned for the GOP nomination and called Reagan's across-the-board tax cut proposal "voodoo economics." After eight years under Reagan, he never came around. In 1990, he worked with Congress to raise taxes. It completely failed in its objective to balance the budget, and in the compromise Bush demanded that Congress would control spending.

On an aside, it just goes to show that a Democrat's only promise you can really trust when he says he'll raise taxes. Mondale said in 1984, "Mr. Reagan will raise taxes, and so will I. He won't tell you. I just did." Bruce Bartlett correctly wrote that Reagan raised some taxes, but which ones, and by how much? If government raises one of my taxes by $1, but I get a $100 cut elsewhere, well, I consider that a tax cut. Except for Social Security (a necessity of the pyramid scheme because people are getting far more than they pay in), none of Reagan's "tax increases" were on income or capital gains. They were also extremely miniscule compared to the real cut in income taxes: a top rate of 70% in 1981 slashed to 28% in 1986. Anti-supply-siders still won't admit how that facilitated federal tax revenue growth during Reagan's terms from $600 billion to over $900 billion. That's 33% growth despite the top tax rate being cut by 60%.

George W. Bush's tax cuts have not had as big an effect as Mellon's, Kennedy's or Reagan's, it's true. As Don explained to me one night when we met for drinks, you won't have as much of a boost when cutting the top rate from 39.6% to 35% as when cutting it from 70% to 28%. The recovery from the 2001 recession didn't seem that hot because the recession wasn't that bad (France would call 6% unemployment a "boom"), and for the same reason the tax cuts' economic jolt won't be as apparent when we compare it to several years of relatively good economic health. But look again at Don's speech and its history of what's happened since 2003, once President Bush got the real tax cut package passed. Don characteristically emphasizes capital gains tax cuts, and with good reason, because they encourage the wealthy to invest -- creating jobs for everyone.

I'll certainly admit that federal tax revenues dropped after Bush's 2001 tax cuts, but Congress increased spending by far more than the lost revenues. Bush's tax cuts are not to blame for the deficits. Federal revenues fell $138 billion from 2001 to 2002, but federal spending increased by $148 billion. Revenues fell $71 billion from 2002 to 2003, but spending increased by $149 billion. Revenues increased $98 billion from 2003 to 2004, but spending increased by $133 billion. The good news is that from 2004 to 2005, revenues increased by $274 billion, and spending increased by "only" $179 billion. Congress needed to cut spending, not reverse the tax cuts.

So in short, "Charles Wheelan, Ph.D." (his doctorate is in "public policy") doesn't know what he's talking about. Then again, what do you expect from a guy who thinks Greg Mankiw is still "the current Bush Administration's top economist"? I bet that's news to Edward Lazear.

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Anonymous Anonymous said...

What do you think of my thoughts on the Laffer curve. I posted that a long time ago, but I did my best to try to explain a different curve: the one that compares economic growth to tax rates, which I think is much more important.

Monday, May 08, 2006 8:05:00 AM  
Blogger Josh said...

Excellent. A great refutation of the straw man arguments used by the left.

Monday, May 08, 2006 10:53:00 AM  
Anonymous Anonymous said...

a couple comments from a non-economist:

1. I didn't really think that your argument contradicted the original 'anti-laffer' argument. You both make valid points
2. In your opinion what is the maximizing revenue point in terms of income tax rate? If it is a moving target how much does it fluctuate. PS. i realize these questions may be idiotic

Saturday, May 13, 2006 11:24:00 AM  
Anonymous Anonymous said...

I have a new column on this

Thursday, June 15, 2006 7:30:00 PM  

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