Thursday, June 09, 2016

The Laffer Tic

by Neil H. Buchanan

Everyone would like to find win-win solutions to problems.  If there is no pain associated with a policy proposal, there is likely to be no political opposition, and the proponents of such policies can claim to have found a way to make everyone happy.

In budgetary policy circles, one supposedly win-win idea that simply will not die is the notion that cutting tax rates will paradoxically lead to increased tax revenues.  Widely known as the Laffer Curve, this everyone-gets-a-puppy-and-rides-on-a-rainbow promise has been around for the last four decades, tempting generations of Republican politicians to try to update old-fashioned trickle-down economics to be sold to a gullible public.

It is impossible to write about taxes in the U.S. without bumping up against Laffer-inspired claims.  Two years ago, I wrote a column and a blog post directly discussing "why Laffer lingers."  One explanation is that there is always a new generation of wide-eyed young people who have not yet figured out that this particular cure-all is and always has been pure snake oil.

I apologize to those readers who have until now never been exposed to the Laffer mythology, because I am about to put an end to your blissful ignorance.  But because of the ongoing damage to public policy that Laffer's minions have caused, I must take a moment here to run through the basic theory-oid behind the push for cutting taxes at all times and in all places, even though it has been repeatedly disproved in the real world.

We start with two simple observations.  If you set the tax rate at zero percent, you will obviously collect no revenue.  And if you set the tax rate at 100%, you will also collect no revenue.  (Actually, you might collect a bit of revenue from people who are happy to carry on a taxable activity for free, but we can ignore those as isolated examples.)

But if tax revenues are zero at rates of 0% and 100%, then revenues will be positive at other rates, which means that there must be some range of rates at the high end where tax revenue falls toward zero as rates rise toward 100%.  And here is the pseudo-genius conclusion: There must be some range of tax rates within which cutting rates will increase revenues.

As far as it goes, that must be true, with a huge question mark over where the magic range of tax rates might be.  But what is the economic explanation for this?  Proponents of the theory claim that reduced tax rates encourage economic activity, which increases the amount of income that is subject to taxation, which means that even lower rates can lead to higher revenues.

Note that this happy conclusion requires not only that tax cuts induce higher economic activity but that the increase in such activity is so large that it numerically dominates the reduction in tax revenues that necessarily follows from imposing lower tax rates.

This is, in other words, ultimately an empirical inquiry.  And the empirical results have been quite unkind to the tax-cuts-pay-for-themselves crowd, as I will explain momentarily.

Why am I thinking about this question now?  I actually was inspired by an unexpected exchange during the question-and-answer period after a public talk that I delivered last month in Auckland, New Zealand.  I had not actually intended to talk about the Laffer nonsense during that speech, but at one point I was trying to explain how Donald Trump's version of magical thinking differs from that of other Republicans.

I said something like this: "It used to be that even an ill-informed politician would try to offer some logical chain of cause and effect, explaining how his policy ideas would make the world better off."  Sorting through various possible examples in my mind, I suddenly thought of the Laffer mantra: "For example, a politician might say that cutting taxes will increase economic activity, which will increase tax revenue by more than enough to make up for the lower tax rates."

I then added: "Of course, that theory has been proven to be wrong over and over again, but at least it purports to be an explanation.  Trump, on the other hand, never bothers with an explanation.  He simply skips to the end: 'Trust me, it will be great.'  In fact, he not only dispenses with a step-by-step explanation, but he frequently does not even bother to tell us what the policy is that will make things great again."

An earnest young man wanted to ask the first question during Q-and-A.  I anticipated a question about the chances of Trump winning, or about tax policy under Hillary Clinton if she wins, which were much more central to the overall purpose of my talk.  To my surprise, however, the questioner wanted to know why I was rejecting the Laffer Curve, which he was sure was the absolute truth.

I explained that decades of evidence in the U.S. overwhelmingly failed to support the Laffer Curve, so much so that even the Treasury Department under George W. Bush publicly acknowledged that tax cuts do not pay for themselves.  I also noted the recent public experiment in Kansas, where the Republican governor followed Laffer's advice to cut taxes in an effort to prove once and for all that this was really not snake oil.  Budgetary disaster ensued, so much so that even fellow Republicans in the state have been pushing the governor to give up the ghost.

To my surprise, the questioner pursued me out the door after the lecture was over, insisting (politely, but with great intensity) that I had to admit that the theory could be true.  I said again that we do know the end points of the curve, but everything else is subject to empirical testing, and those tests are not kind to Laffer.  He then said, "Well, what do you say about the French experiment with super-high tax rates?"  Is there finally an example on the pro-Laffer side of the ledger -- not from the U.S., perhaps, but at least something to which the tax cutters can point?  There is not.

In 2012, the nominally Socialist government of French President Francois Hollande adopted a top marginal tax rate of 75% on annual incomes above one million euros (roughly $1.25 million at the time).  The government then abandoned that policy as of the end of 2014, after protests from right-leaning economists in France that the country was becoming "Cuba without the sun" and other similarly-deep criticisms.

As my questioner in New Zealand indicated, this short-lived French policy has been viewed as great vindication on the political right, both in France and in the U.S.  A quick Google search of "France Laffer" brings forth multiple hits from the usual run of right-wing websites and think tanks in the U.S., all triumphantly claiming that the French experience validates Laffer -- and claiming also that France's travails debunk Thomas Piketty, the French economist who claims that higher rates are a good idea in advanced countries.

Interestingly, The Guardian (which is not at all a part of the right-wing media echo chamber) fed into the right-wing story about France's tax controversy.  Its news article in 2014 announcing the death of the "supertax" said that the Hollande government was "forced" to drop the top rates, because the revenues being collected were lower than forecast.  Yet the article never actually produced evidence supporting the Laffer Curve, reporting only that the tax revenues were less than expected, not that tax collections went down.

During the public controversy in France, the actor Gerard Depardieu very publicly moved a half mile over the border from France into Belgium, in order to avoid paying French taxes.  This feeds into the same meme in the U.S. that claims that rich Americans are moving from high-tax states to low-tax states, which turns out to be nothing more than the hyping of anecdotes.  In fact, careful empirical analysis has shown that America's rich people are not mimicking Depardieu.

But what if they did?  Although I have not met Piketty personally, I find it hard to imagine that he would claim that no one ever crossed a border for tax reasons -- and certainly not a border dividing countries that speak the same language, are in the same economic union, have passport-free travel, and so on.  But the question is again an empirical one.  Belgium also has no capital gains tax, yet there are plenty of rich people who have stayed in France during all of the years when it was supposedly tax-foolish to do so.

More importantly, border crossing is not the story that Laffer's acolytes really want to tell.  As I described above, this is not supposed to be about race-to-the-bottom tax competition.  It is supposed to be an uplifting story about how job-creating entrepreneurs will be so thrilled by reduced tax rates that they will create more wealth for everyone, with the resulting high incomes more than making up for the lower tax rates that induced their heroic efforts.

After all, if the problem with high tax rates is merely tax competition among jurisdictions, then this simply says that it is important either to coordinate among nations and states to make border-jumping useless, or -- Heaven forfend!! -- to adopt the dreaded World Government that the lunatic right has been railing about for decades.  It is certainly not an argument for lower tax rates as a win-win policy.

Even so, there will apparently always be a nervous tic on the right that automatically connects tax cuts with increased tax revenues.  But that tic is not symmetric on the left.  Is every tax increase a good idea?  Of course not, and no sensible person on the left would ever say so.  The search for good policy choices is always about sensibly assessing evidence.

So this is yet another area where the evidence has spoken, yet only one side of the ideological divide has listened.  Move over, climate change and evolution!


barcrunchsub said...

I've always wondered why Republicans always seem to be the proponents of the Laffer Curve. If Republicans are champions of smaller (less) government, wouldn't they be proponents of a tax rate that is somewhat less than the optimal point on the Laffer Curve? Less money coming into government would control the growth of that government, and having citizens keep more of their own money means more freedom, unlock entrepreneurial zeal, etc.

CJColucci said...

It's not obvious to me that at 100% rates tax revenue will be essentially (a few oddballs aside) zero. The government doesn't just eat money, it provides services, more or less well. If the government taxes all my money and gives me services that I might otherwise have had to buy with after-tax income, don't I still have some incentive to work in order to fund a government that gives me stuff? (I assume a government could minimize free-rider problems by not providing services to persons who don't pay taxes on their incomes.)

Neil H. Buchanan said...

My thanks to both barcrunchsub and CJColucci. Both of your comments are excellent and help to clarify my thinking.

Greg said...

I'll accept that at 100% the number isn't zero, but I think there is a steep curve in that direction as tax rates approach 100%. However, you're right that the value of services provided by government has to be considered.

In a no-tax climate, individuals get more if they do more, but carry significant risks. The most obvious example in a no-tax environment is that there is no police force. As a result, crime is often more profitable than production, resulting in an overall societal loss of production.

As taxes go up, crime can be better controlled, and more individuals will be willing to work. Now the problems become things like healthcare. People leave the workforce (and even die) because they don't have enough money to deal with emergencies that arise.

As taxes go up more, the government is able to spread out some risk, essentially providing insurance to society. This helps get people back into the work force. We're still on the rising edge of production.

At some point, government services start to become close to "enough to live on" and some people will choose to work less, or even to leave the work force, because they feel that the increased opportunity is not outweighed by the increased income. Interestingly, I suspect this inflection point has more to do with the level of government services than it has to do with the amount of taxes collected. If I need $1000 to feed my family and have a 50% tax rate, I work as long as it takes to earn the $2000. That could be LONGER due to increasing tax rates (increasing production) unless the government is providing a significant amount of that money in the form of government services.

At some point, the government services will be enough for most people to live "comfortably" without working. That's where the trouble arises. This is when it gets difficult to find someone to take out the trash. Some people will continue to work because they value the increase in income, but many will choose not to. This choice is part of why high tax rates on the rich are not as devastating as on the poor. Rich people are people who highly value the increase in income, and are willing to work extra to get it (ignoring other issues with wealth, and being incredibly optimistic.) This is true even if they get a smaller portion of that increase. (At some point, working to lobby for lower tax rates becomes more effective than contributing to production, but that's another issue.)

The real problem with this last point is that the government is also going to have a hard time providing services. How do you convince someone to write government checks when you can't offer them anything of value?

Interestingly, the inflection point for maximum production could be quite high. Consider a government where everyone gets paid enough for basic food and clothing, but working gets you enough to pay for luxuries like TV, better food, better clothes, or automobiles instead of bus fare? Will people work more because they now have a stable home life and can see the value of the luxuries, or less because they are not struggling for existence? I don't actually know. Given how our economy has primarily been driven by "luxury" goods for a long time, I wouldn't be surprised if working for luxuries rather than necessities was actually a better motivator.

Certainly paying for services (roads, education, research, etc.) that overall increase net production is a good investment, and worth raising taxes for. This is why there's almost no way that the US is anywhere near the "tax reduction is a win" part of the Laffer curve. The ultra-high French tax rate is probably a clear case of the "lobbying for lower taxes is more effective than increasing production" issue, and that does have some bearing on the Laffer curve as a whole. Unfortunately, for the ultra-rich that may nearly always be a win, even in the US with our relatively low tax rates.