Ever since Time magazine selected supply-side economist Arthur Laffer as one of the hundred greatest minds of the 20th century, economists, authors, and media commentators have attempted to define supply-side economics and the Laffer curve. As with any second-hand explanation of an “idea,” there are often distortions and misunderstandings. So, to be sure the record is straight on the origin and meaning of the Laffer curve, here’s the inside scoop.
At a dinner in 1974, Dr. Arthur Laffer met with Donald Rumsfeld, the current secretary of Defense, and Jude Wanniski, a journalist for the Wall Street Journal. The purpose of the meeting was to discuss President Ford’s proposal to increase taxes in order to stop inflation. [I remember President Ford’s economic summit at that time and even have the memento given out — a little red WIN button that stood for “Whip Inflation Now.”] During dinner at the Washington Hotel restaurant, Laffer sketched the now-famous Laffer curve on a napkin to illustrate his concept of the relationship between tax rates and tax revenues. Wanniski described that meeting and what he first termed the Laffer curve in an article for The Public Interest.
The Laffer curve is a unique pedagogical device that captures the important role of incentives in a free economy. The application of the curve to the structure of the tax system allows for a visual representation of what happens when taxpayers respond to disincentives to pay taxes: Tax revenues fall when tax rates are high.
Using the example of taxes, the act of lowering or raising tax rates has two revenue effects: the arithmetic effect and the economic effect. The arithmetic (or static) effect is obvious: When you raise tax rates, you get more tax revenue. The economic or dynamic effect recognizes that, at certain high levels of taxation, people will not work, save, or invest. In the extreme, a zero tax rate produces no revenues and a 100 percent tax rate is likely to produce minimal revenues.
The principal of the Laffer curve is present in virtually every business decision where the overall objective is to maximize profitability through the determination of setting prices consistent with the ability and desire of the consumer to buy. Setting prices too high produces a shortfall in sales and revenues while setting prices too low produces a shortfall in profits.
The parabolic shape of the Laffer curve demonstrates that there is no one exact point or tax rate that changes incentives. However, there are at least two tax rates that will produce the same tax revenue (points A and A* in the graph below). At lower tax rates there is little resistance to paying tax, but as tax rates rise, each of us reaches a point where we take actions that will reduce our exposure to these higher tax rates.
As mentioned earlier, some notions of the Laffer curve, which is at the heart of supply-side economics, are a little different. For instance, Chris Rohmann, author of A World Of Ideas — a so-called dictionary of “important theories, concepts, beliefs, and thinkers” — describes the Laffer curve in terms of a pot belly. “As the ‘belly’ (tax rate) grows, revenues increase; but when the tax rate gets too high, people are discouraged from making the extra effort to generate more wealth to spend, save, or invest and are more inclined to use legal loopholes or false claims to avoid paying taxes, so the ‘belly’ of tax revenue begins to diminish.”
The “belly” (or outline of the Laffer curve) doesn’t get bigger. There are points along the outline of the “belly” that represent a mix of tax rates and tax revenues. There are two distinct partitions of the Laffer curve; one is the normal range and one is the prohibitive range. When in the prohibitive range, higher tax rates produce lower — not higher — tax revenues. The relationship between these two variables is a plot point on the curve and is not the shrinkage of the “belly.”
Continuing with the above as an example of people getting the Laffer curve wrong, Rohmann revisits history and appears to have acquired limited knowledge of the effects of the Laffer curve on tax revenues in the 1980s. He writes,
The Laffer curve was used to justify large tax cuts in the early 1980s, when President Reagan’s economic advisors were convinced that tax rates had passed the optimal level. But tax revenues fell rather than increasing, and this failure to achieve the predicted outcome contributed to a perception of the Laffer curve as simplistic and unreliable.
According to a number of subsequent studies, tax revenues collected from individuals in the higher tax brackets expanded dramatically in the 1980s while tax revenues from people in the normal zone fell, as was to be expected. According to the Internal Revenue Service, the share of total federal income taxes paid by just the top 1 percent of taxpayers (ranked by adjusted gross income) rose from 19 percent to 33 percent between 1980 and 1997. The top 25 percent of taxpayers increased their share from 73 percent to 82 percent.
The effective tax rate on those with high incomes is substantially lower today than it was when their share of total income taxes was much smaller. In 1980, the effective tax rate on the top 1 percent of taxpayers was 34.5 percent. In 1990, the rate fell to 23 percent. In other words, lower effective tax rates appear to have produced higher tax revenues.
According to the Treasury Department, marginal tax rates on the wealthy are down dramatically. In 1981, the top federal income-tax rate was 70 percent. Today it is 35 percent. Looked at in another way, the retention rate — the rate of income that individuals keep after taxes — went from 30 percent to 65 percent, an increase of well-over 100 percent since 1981.
Rohmann goes on to identify what he calls a “corollary hypothesis,” the so called trickle-down theory, where greater spending and investing power unleashed by tax cuts for those at the top of the economic ladder eventually “trickles down” in the form of increased employment, benefiting all of society. The term “trickle down” is a derogatory term invented by detractors of supply-side ideas. An appropriate description of the effects of supply-side policies was captured by John F. Kennedy in reference to the importance of economic growth in driving up the well-being of all Americans. Said JFK, “a rising tide raises all boats.”
As you can see, some perceptions of the Laffer curve are simplistic and unreliable. But the truth is that the curve represents a simple explanation of the way the world works, simple in the sense that people respond to incentives, high tax rates being one potential disincentive to work, save, and invest. “Unreliable,” however, is an obviously inaccurate characterization of incentive-based economics by those who would adhere to other, more complicated economic theories.
– Thomas E. Nugent is executive vice president and chief investment officer of PlanMember Advisors, Inc. and chief investment officer for Victoria Capital Management, Inc.