Guest Post by Arpit Gupta: The Laffer Curve

by Arpit Gupta

In a Bloomberg View column, Betsey Stevenson and Justin Wolfers suggest a hidden consensus among economists, pointing to a Chicago Booth survey on the Laffer Curve:

 

How about the oft-cited Republican claim that tax cuts will boost the economy so much that they will pay for themselves? It’s an idea born as a sketch on a restaurant napkin by conservative economist Art Laffer. Perhaps when the top tax rate was 91 percent, the idea was plausible. Today, it’s a fantasy. The Booth poll couldn’t find a single economist who believed that cutting taxes today will lead to higher government revenue – even if we lower only the top tax rate.

 

Austan Goolsbee takes a strong stance on this issue:

Moon landing was real. Evolution exists. Tax cuts lose revenue. The reasearch has shown this a thousand times. Enough already.

Though the question focused on whether US tax revenues would be higher in five years if tax rates were reduced, it’s worth looking at other evidence. Chicago economist Harald Uhlig found that Swedish labor taxes were on the wrong side of the Laffer curve, as were capital taxes in many European countries — suggesting that higher revenues could be raised by cutting those taxes.

The UK also recently ran an experiment in Laffer Curves by hiking income taxes on top earners to 50%. Evidence suggests that the measure raised very little, if any, revenue. Some of the decrease reflects temporary tax avoidance strategies, but other mechanisms by which tax revenue may fall — emigration and lower labor supply — will likely increase in the future.  

Though it does seem unlikely that US income tax rates are on the wrong side of the Laffer Curve over a five year window; the British evidence suggests that Laffer-style effects do happen in the real world, and it’s premature to take Goolsbee’s stance that this issue is as simple as the moon landing. Academic research by Emmanuel Saez and Jonathan Gruber has estimated that the tax rates corresponding to the top of the Laffer Curve is 52% — not much higher than the current top marginal income rate taking into account state, local, and other taxes. Other researchers disagree and this issue remains unsettled. But regardless of where the highest feasible rate is, all researchers agree that the closer taxes get to the top rate, the less money the government brings in for a given tax increase; and the rate of tax distortions increases as we get close to the Laffer Curve limit.

It’s also important to keep in mind what John Cochrane refers to as the “dynamic Laffer Curve” — the fact that even if taxes raise revenue, they may hurt GDP and so hike the Debt/GDP ratio. 35% of economists polled in the Chicago survey suggested that higher taxes lowered GDP, while 9% said that higher taxes raised GDP. If higher taxes reduce GDP more than they reduce debt levels, that worsens the overall government fiscal position. When you consider the future government balance sheet more than five years out, people have more time to respond to tax increases in ways that will further diminish reported tax revenue, and the picture looks bleaker still.

Stevenson and Wolfers conclude with a partisan stance:

 Angry Republicans have pushed their representatives to adopt positions that are at odds with the best of modern economic thinking… Right now, millions of people are suffering due to high unemployment. Our textbooks are filled with possible solutions. Instead of debating them seriously, congressional Republicans are blocking even those policy proposals that strike most economists as uncontroversial.

Alas, the economics is as contestable as the politics. Reading through the posted comments of the economists above reveals an ongoing debate in which many reasonable people worry about the effects of higher tax rates on growth and the fiscal balance. 

The Agenda

NRO’s domestic-policy blog, by Reihan Salam.