Senator Kent Conrad of North Dakota badgered Henry Paulson, nominee for secretary of the Treasury, at Paulson’s confirmation hearing this week. Conrad — armed with poster-sized exhibits of economic misinformation and isolated quotes from the current and prior chairmen of the Federal Reserve — tried to lure the nominee into admitting that tax cuts don’t pay for themselves. Paulson, demonstrating that he is not only a financial heavyweight but an agile debater when among undereducated politicians, focused on the impact of tax cuts on the economy in 2001, and gave credit to President Bush’s first tax cuts for moving the economy out of recession and into expansion. Nice job, Henry!
The assumption that tax cuts don’t pay for themselves is a central tenet of the Democratic party, and also leads to the party’s objection to the president’s tax cuts of 2001 and 2003. Since this belief is so important to Democrats (they rail against any type of tax cuts), it is crucial to take a closer look at the role tax cuts play in “paying for themselves.”
First of all, let’s make the important distinction between tax cuts and tax-rate cuts. Obviously, tax cuts do not pay for themselves. If you reduce the taxes that I pay, I’ll say thank you and that’s it. No effect on my behavior. The president’s tax rebate of 2001 is an example of a one-time transfer to consumers that had little, if any, impact on incentives. On the other hand, cutting tax rates can have dynamic effects that will generate additional tax revenues. In other words, tax-rate cuts can indeed pay for themselves.
So why is the debate between Republicans who believe tax-rate cuts pay for themselves, and Democrats who say they don’t, so acrimonious?
The answer lies in a closer examination of the Laffer curve.
Arthur Laffer, the well-known supply-side economist, has demonstrated that cutting tax rates can produce higher, not lower, revenues. Using the graphical presentation shown below, Laffer analyzed the relationship between tax rates and tax revenues. As noted in the exhibit, there are two tax rates (at points A and A*) that can produce the same revenues. However, if tax rates are lowered from A*, revenues go up, not down. Therefore, lowering any tax rate in the prohibitive zone will produce higher tax revenues.
The missing piece to this puzzle is that incentives matter. When tax rates in the prohibitive zone are lowered, people (or corporations) may very well be willing to pay more taxes, since doing so could be a net positive versus the costs of not paying those taxes.
On the other hand, lowering tax rates from point A will, in fact, produce lower tax revenues. The reason is that lower tax revenues produced by lower tax rates cannot be offset by increased incentives to pay taxes. When tax-rate cuts reduce rates in the normal zone, government tax revenues will decline. (Note: The Laffer curve is a pedagogic device that has a variety of shapes for different circumstances. The shape is subject to how individuals and companies respond to incentives.)
So, can tax-rate cuts pay for themselves? The Laffer curve clearly demonstrates that cutting tax rates that are in the prohibitive zone will pay for themselves, while lowering tax rates in the normal zone will not. If Democrats understood this concept, it would be logical to assume that they would be for lower tax rates in the prohibitive zone and higher tax rates in the normal zone.
The next time we have a debate over whether or not tax cuts pay for themselves, some well-educated Republican should take a page from Sen. Conrad and use this exhibit to demonstrate the real relationship between tax rates and tax revenues.
– Thomas E. Nugent is executive vice president and chief investment officer of PlanMember Advisors, Inc., and principal of Victoria Capital Management, Inc.