How does tax policy affect government revenues? This is the latest subject of debate in the nation’s capital after the ubiquitous Iraqi conflict. The debate is important because it can influence the degree to which the government is willing to help the economy through increased deficit spending. The basis for disagreement is over how should the deficit grow — through increased government spending or lower government tax revenues triggered by lower government tax rates.
Supply-side economists have encouraged the tax-cutting strategy because of their belief in the idea that lower marginal tax rates will trigger incentives to produce. These incentives will foster higher output and an ultimate increase in government tax revenues. The bottom line, according to supply-siders, is that tax cuts ultimately pay for themselves. As a result, supply-siders pushed to incorporate this relationship — otherwise known as dynamic scoring — within budget forecasting,
Ever since the Reagan tax cuts of the 1980s, the debate has raged over the plausibility of such a theory.
The Congressional Budget Office (CBO) disregarded any attempt to introduce the idea that incentives impact tax revenues. When developing their annual budget forecasts, the CBO would use static scoring — the theory that increased tax rates produced higher tax revenues and lower tax rates produced lower tax revenues. There was no room for individual responses to changes in the tax rate. Supply-siders were relieved recently when congressional leaders appointed an avowed advocate of dynamic scoring as the director of the CBO — Douglas Holtz-Eakin.
When the new head of the CBO subjected the president’s budget proposal to dynamic scoring, his scorecard suggested that some aspects of the president’s plan would speed up the economy and other aspects would slow it down. Unfortunately, for supply-siders, the bottom line was that the prospective impact on the economy of these tax proposals was small and in no case would the Bush tax cut pay for itself over the next ten years.
A recent article in the Wall Street Journal authored by Alan Murray attempted to undermine the whole idea of dynamic scoring based on these findings. Murray’s conclusion: ‘”But it [the debate] ended last week — with a whimper.” Murray’s “whimper” conclusion was based on the following premise: “The problem with Mr. Laffer’s graph [According to lore, Arthur Laffer sketched a curve on a cocktail napkin suggesting that a cut in income taxes could provide such a spark to the economy that government revenues would rise, not fall. The free lunch was born.] . . . was that it had no numbers on the axes. How much would growth be boosted? At what level of taxation would tax cuts become self-financing?
There they go again. Time and time again students of the fiscal debate are served partial analysis leading to erroneous conclusions. The problem with Murray’s analysis? It is simply wrong.
The Laffer Curve does not suggest that a cut in income taxes can provide a spark to the economy. The Laffer Curve simply represents the constellation of all tax revenues that can occur at varying levels of taxation. If properly drawn and analyzed, it reflects the fact that there are two tax rates that can produce the same level of revenues.
In the extreme, a 100% tax rate produces zero revenues and a 0% tax rate produces the same. If you lower tax rates from the higher tax level, revenues will increase; if you lower them from the lower tax level, they will decrease.
For example, when President Kennedy lowered the highest marginal tax rate from 92% to 70%, increasing after-tax income by almost 300%, do you think more people worked harder (and produced a tax windfall) at a 70% tax rate or at a 92% rate?
Similarly, a reduction in the capital-gains tax from 20% to 15% will have a lot less of an impact because the incentives are increased by only 6%. The reason the Beatles lived in New York City in the early 1980s was that the highest marginal tax rate in England was 98%. Does anybody in his or her right mind believe that people would work at the same level of output to keep just 2% of their earnings? The migration of foreign movie stars and athletes from high-taxed countries to low-taxed countries answers that question.
The challenge for politicians and economists is to figure out what tax rates produce the maximum tax revenues. The difficulty is that we may all have different thresholds for working, saving, and investing. So the identification of the perfect tax rate is an imperfect science.
Holtz-Eakin confirmed how difficult the process is. He said it took 35 government analysts a month and a half to get through the president’s budget proposal. This is something that Laffer understood when he drew the Laffer Curve “without any numbers on the axes.” Laffer was the economist for the Office of Management and Budget under President Nixon. His napkin came to the same conclusion that 35 analysts at CBO came to after a month and a half of hard work.
Alan Murray needs a refresher course in supply-side economics.
— Tom Nugent is Executive Vice President & Chief Investment Officer of PlanMember Advisors, Inc., and an investment consultant for Wealth Management Services of South Carolina.