Magazine | October 31, 2011, Issue

Four-Point Plan for Failure

The president would tax work and subsidize unemployment

I believe in evolution, but when I was asked whether schools in my home state of Tennessee should be allowed to teach creationism, I answered: “Why not? They teach Keynesian economics, don’t they?”

Deeply held beliefs are persistent, even when they’re wrong. Judging from Pres. Barack Obama’s most recent jobs plan, it is clear that the president is choosing complex error over simple truth. As a former tenured professor at the University of Chicago, I am especially dismayed that our nation’s president, also a former faculty member at the University of Chicago, continues to advocate a policy that over the past five years has by all accounts been demonstrated to be a comprehensive failure. The historical record is convincing, and, beyond that, the president’s policies enjoy no theoretical credibility, either. His agenda is simply a formula for government gone wild.

In essence his plan has four parts: 1) a temporary reduction in the payroll-tax rate; 2) a temporary extension of unemployment benefits to 99 weeks; 3) additional deficit-financed stimulus spending; and 4) higher tax rates on “the rich,” whom the president erroneously defines in terms of income rather than wealth.

Let’s deal with these in order, beginning with the payroll-tax cut. While all taxes have incentive effects of one form or another, a payroll tax is one of the least harmful. The key to an efficient tax system is to have a low tax rate on a broad tax base. Under such a tax, people will have the least incentive to avoid taxable income or evade taxes, and they will have the smallest number of places in which to hide their income.

Because our payroll tax drops dramatically at a little over $100,000 of earned income, the people most strongly affected by it tend not to be the economy’s decision makers. Decision makers more often are those who earn well over $100,000 per year and whose income is disproportionately in the form of capital gains or dividends. Most payroll taxes are “inframarginal,” i.e., they don’t enter into people’s choices about whether to work or not to work. As taxes go, the payroll tax is a big revenue raiser and one of the least damaging to work incentives. So cutting it is a poor choice if jobs are the objective.

So is extending unemployment benefits. For years, the Department of Agriculture has paid farmers not to grow food — and those farmers did indeed grow less food. It’s elementary: Pay people to do something, and they’ll do it. Pay them not to do something, and they won’t. President Obama proposes to pay people not to work for nearly two years. This will not create jobs. It is undeniable that the long-term unemployed need help, but the help they need is a job, not a steady stream of other people’s money. I know of no research that shows anything other than a positive relationship between unemployment benefits and the number of people unemployed.

Additional deficit spending won’t create jobs, either. One big debate among macroeconomists of the past 75 years is whether deficit-financed stimulus spending creates or destroys jobs. From an empirical standpoint, the neat thing about the past five years is that we have carried out a huge national experiment aimed at testing that very proposition. But first the logic.

Proponents of deficit-financed stimulus spending argue that the recipients of government money will spend part of the funds they receive, thereby creating jobs and income. Those people with the new jobs and higher incomes in turn will spend more, creating even more jobs and even higher incomes, and the process will continue to cascade down the line. The additional spending resulting from one dollar of higher income is called the “marginal propensity to consume,” and the increase in income resulting from each dollar of additional government-deficit-financed stimulus spending is called the “multiplier,” which equals 1 / [1 minus the marginal propensity to consume]. And that’s pretty much their argument.

The other skeptics and I don’t get it. When government gives people command over real resources — through deficit-financed stimulus spending — it has to take those resources from somebody else. It’s a double-entry accounting and economic system: debits and credits. The government doesn’t create resources; it only redistributes resources. The tooth fairy does not work on the Treasury staff. While those who receive government benefits may spend more, those from whom the resources are taken will spend less. As my former colleague Milton Friedman said, “There ain’t no such thing as a free lunch.” The stimulus resulting from the recipients is exactly offset by the de-stimulus of the payers. Logically, there can be no stimulus from stimulus spending.

#page#For those of you who enjoy delving into the weeds of economic theory, the rejection of the logic of stimulus spending comes from what is called the Slutsky equation. The Slutsky equation organizes all changes in taxes or deficit-financed stimulus spending into a substitution effect and an income effect. As shown in the previous paragraph, the sum of all income effects resulting from stimulus spending is always zero. The substitution effects, however, don’t cancel out like the income effects: They aggregate. By taking resources from those who produce and giving resources to those who don’t produce, government reduces the incentives to work for both parties. Output, employment, and production will fall.

Given this logic, the evidence from the experiment of the past five years is just as you would expect. By miles and miles, the U.S. has had its single worst recovery since the Great Depression. The only reason our current recovery isn’t as bad as the Great Depression’s recovery is that back in the 1930s they passed even more Obama-style policies than we have. Under both Republican and Democratic administrations, our government raised the highest income-tax rate from 25 percent to 79 percent between 1929 and 1939 and imposed the single highest tax on traded products in our nation’s history.

But now Obama wants to raise taxes, with his so-called Buffett Rule. What is unclear in President Obama’s position is whether he believes raising tax rates on the rich will raise overall tax revenues, reduce income disparity, reduce wealth differences, or all of the above.

On the first point, raising tax rates in the highest income-tax brackets will not increase tax revenues. Anyone who has studied actual tax collections by tax bracket knows that whenever the highest tax rates have been raised, tax revenues from the top 1 percent of income earners have fallen. Whenever the highest tax rates have been lowered, tax revenues from the highest income earners have risen. And sometimes those revenue increases from the top 1 percent of income earners were huge, as was the case in the 1920s, after the Kennedy tax cuts in the 1960s, and after the Reagan tax cuts in the 1980s.

Low tax revenues from higher tax rates on the rich shouldn’t surprise anyone, because the highest earners have access to lawyers, accountants, deferred-income specialists, congressmen, and senators. They can also change the volume of their income, the location of their income, the timing of their income, and the composition of their income to minimize taxes. And, being the people they are, they are very adept at getting things done.

On the second point, taxing higher earners does nothing to help lower earners. About 50 percent of Americans pay no federal income tax while the other 50 percent do — and the president accuses the taxpaying group of not paying its fair share. Some people call that the politics of class warfare, but it’s really just the politics of envy. It’s also counterproductive.

President Obama could, if he were so inclined, aim for a more even distribution of wealth by proposing a one-time, 50 percent wealth tax on all wealth exceeding $1 billion and on all gifts from people who are worth $1 billion or more. But then Warren Buffett would actually have to pay more in taxes, rather than posture as the conscience of billionaires everywhere.

So, President Obama is still without a credible jobs plan. His first step in developing one should be to realize that if workers are taxed more, and non-workers paid more, then there will be fewer workers and more non-workers. This science may be dismal, but it is predictable.

– Mr. Laffer, chairman of Laffer Associates, is co-author, with Stephen Moore, of Return to Prosperity: How America Can Regain Its Economic Superpower Status.

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