Last Saturday, the topic of the Bush tax-rate cuts stimulated a heated debate among a select group of financial analysts on the Fox News Channel. My ears perked up when Ben Stein, one of today’s more astute financial-market observers, stated that the Bush tax-rate cuts “unequivocally” did not pay for themselves. Huh?
Stein is an advocate of raising taxes on the “rich” to reduce the U.S. budget deficit, and he believes that the president’s reduction in personal income-tax rates on the so-called rich is a major contributor to the increased size of the budget deficit. Stein should know better. In the memorable movie Ferris Bueller’s Day Off, he played an economics teacher who explained the Laffer curve. But now it’s evident that Stein was merely reading his lines — simply, he seems to have no understanding of the incentive effects of lower tax rates.
Although I have not appeared in any movies, I interned under Arthur Laffer for four years, a period in which I discussed the implications of the Laffer curve with institutional investors across the United States. For the benefit of the critics of the Kennedy, Reagan, and Bush II tax-rate cuts, and their intended effects, I’ll here revisit the instructive tenets behind that curve.
There are two zones to the Laffer curve: prohibitive and normal. In the prohibitive zone, reductions in tax rates contribute to higher, not lower, tax collections. Conversely, when you raise taxes on individuals in this zone, you get lower, not higher, tax revenues.
So, if government administrators want to increase tax revenues from the rich, they should monitor the level of tax collections when tax rates are reduced on the rich. For example, if lower tax rates do not produce higher tax revenues, then the lower rates have fallen below the prohibitive zone.
Of course, the situation is quite the opposite today. Tax revenues — from the “rich” — have been surging, meaning marginal tax rates on the rich are still too high.
And here’s the irony of the situation: Reductions in tax rates have little effect on incentives for taxpayers who reside in the normal zone. Tax these people less, and higher tax revenues are not going to follow. So, in order to unequivocally make the argument that tax-rate cuts do not pay for themselves, you can only refer to taxpayers in the normal zone.
Don’t take my word for it. Listen to what Columbia University Professor (the real kind) Edmund Phelps had to say about solving the U.S. debt problem: “Over the last couple of decades, the federal government has virtually abolished taxation of a wide swath of people with smallish incomes. [Italics mine.] This was a mistake, because we need all the tax revenues we can get. It’s inefficient to have low marginal tax rates on low incomes, because people with upper middle incomes and high incomes get the same breaks, but they don’t get any incentive to work harder. What you want to do is give tax breaks that give people an incentive to earn income that would not otherwise be earned.”
Yikes, that sounds like a supply-sider! Incidentally, Professor Phelps won the Nobel Prize in economics this year.
1. Reducing tax rates on the rich increases tax revenues;
2. Raising tax rates on poor and middle-income earners increases tax revenues.
If the government seeks to maximize tax revenues in order to shrink the size of the budget deficit, it should implement numbers 1 and/or 2.
Now that is unequivocal!
– Thomas E. Nugent is executive vice president and chief investment officer of PlanMember Advisors, Inc., and principal of Victoria Capital Management, Inc.