During a White House meeting with Dick Cheney and Donald Rumsfeld in 1974, Arthur Laffer, a newly minted economics Ph.D. from Stanford University, sketched on a paper napkin a simple parabola which he believed perfectly captured the relationship between marginal tax rates and government tax receipts. Supply-side economics and the modern Republican Party were born.
Supply-side economics, the belief that the key to maximizing economic growth lies in cutting marginal tax rates, was always too simple and rustic for academic macroeconomists. Laffer and other supply-siders built their careers in insulated right-wing think tanks and periodicals — far removed from the peer-reviewed world of academia. Faith in the power of tax cuts to deliver America from the evils of unemployment and sluggish growth never had a home in the ivy tower. And to this day, there are literally no supply-side economists in tenure at any major American university.
So if supply-side economics lacks the rigorous, well documented and well researched theoretical backbone that only thorough academic debate can provide, what about Laffer’s scrawled graph is so intellectually persuasive for the right? This exploration of the underpinnings of the Laffer curve is best undergone by entertaining two simple questions on public policy.
First, if the government was to set marginal tax rates at zero percent, how much revenue would the government take in? A softball question: If there’s no tax, then the government collects no taxes, so there’s zero tax revenue.
Second, how much revenue would be collected if marginal tax rates were set at 100 percent? Intuitively, most would say that all income would go to the feds in tax revenue, but why get out of bed and head to work in the morning if all your wages are gobbled up by faceless bureaucrats? Clearly, there is no incentive to punch the clock if your income is eaten whole by the gluttonous maw of the IRS. Thus, a marginal tax rate of 100 percent will leave federal coffers untouched and empty as the populace leave their workplaces unattended.
From this we can construct the basic graphical shape of the Laffer curve. We begin by putting tax rates on the horizontal axis and tax revenue on the vertical axis, with zeros at tax rates of zero percent and 100 percent since the government collects no revenue at these rates. So, if neither of those rates maximize government receipts, the revenue-maximizing tax rate must be plotted somewhere between these two extremes. By connecting these three points, we get a smooth curve and, like magic, the Laffer curve is sitting before us on our graphing paper. In terms of public policy, the implications of the Laffer curve are also straightforward. If tax rates are to the left of the maximum tax revenue point we can hike them to increase tax revenue, and if tax rates are to the right of this point we can cut them to accomplish the same. A correct theory, albeit an uninteresting one, is that real controversy is not with the Laffer curve itself, but rather with the “Laffer hypothesis.”
Laffer used his parabola to make two suppositions about the economy. First, the United States was far to the right of the tax rate that maximizes revenue, and second, the optimal tax rate is close to zero percent. The policy implication was, and still is, immensely appealing to conservatives. If Laffer is correct, the federal government can drastically cut income tax rates while simultaneously producing a deluge of federal tax receipts. Laffer also claimed that these cuts would produce sweeping economic growth as workers increase their productivity in response to higher effective incomes. Math may not be sexy to Republicans, but a proposal which succinctly vilifies Big Government certainly is.
Taking Laffer at his word, former President Ronald Reagan cut the top marginal tax rate from 70 percent to 28 percent. But rather than creating a revenue bonanza, the federal debt reached a historical high of $2.85 trillion — a threefold increase in the tab left by the Carter administration. While there was a tepid increase in tax revenue, when extraneous factors that automatically raise tax receipts are factored out, the tax rate change had a neutral or negative impact on revenue growth, as detailed by the Center on Budget and Policy Priorities.
But what of Reagan’s impressive growth record? Per capita GDP increased at an average annual rate of 3.4 percent during Reagan’s years, but two confounding variables make it extremely difficult for tax cuts to be credited as the proprietary source of the 1980s boom. First, much of that growth is attributable to the economy making up for lost time after bottoming out during the 1981-1982 recession at an unemployment rate of 10 percent. In the business cycle, deeper slumps make for headier booms, so Reagan benefitted from a rising tide of economic activity entirely outside of his control. Second, throughout this period, Federal Reserve Chairman Paul Volcker, after raising the federal funds rate to a sickening high of 20 percent to squash stagflation, progressively cut interest rates throughout the 1980s, increasing investment spending and buoying economic growth. Moreover, supply-side economics’ ingredients for growth, higher labor productivity and a greater national savings rate never materialized. Labor productivity grew slower under Reagan than it did under Carter, and the national savings rate fell from 7.8 percent of GDP to 4.8 percent by the close of Reagan’s term.
So the question becomes if tax cuts weren’t a magic bullet in the 1980s — no productivity boom, no savings and no tax revenue — then what are the odds that they’ll be beneficial in 2013 under a tax regime which is much more lenient than the one which faced Reagan?
When Paul Ryan and Rand Paul crow about the virtues of slashing tax rates, they have in the back of their minds Arthur Laffer’s total misunderstanding of his own invention. In other words, treat economists and policymakers who cling to the supply-side doctrine with the same respect owed to a chemist who thinks that phlogiston creates fire.
Ryan Dau is an LSA freshman.