Laffer Curve
Dr. Roman von Ah
Financial Markets
Neither history nor economic research supports the thesis of self-financing tax cuts
Neither history nor economic research supports the thesis of self-financing tax cuts
Laffer Curve
President Donald Trump last month awarded Arthur Laffer - the father of the Laffer Curve and godfather of supply-side economic policy - with the Medal of Freedom, the highest honor possible for civilians.
Few economists have received the President's Medal of Freedom. Most of them could also boast a Nobel Prize in economics, and-unlike Laffer-all were recognized for their extensive, distinguished academic achievements or public service.
In its announcement, the White House called Laffer "one of the most influential economists in American history." It is true that several presidents have invoked his theories to defend sweeping tax law enactments, all in the name of economic growth. But whether Laffer increased public understanding of economics, helped strengthen the nation's economy, or had a positive impact on the well-being of the American people is very doubtful.
Laffer's ideas contain a grain of truth, in that tax cuts can lead to more economic activity. This is typically illustrated with the following train of thought: If the tax rate is 0%, then the government has no revenue. If the tax rate is 100%, then neither people nor firms have an incentive to operate. There must therefore be a critically high tax rate above which a reduction in this rate, via associated stronger economic growth, increases government tax revenues. [However, all economists agree that tax rates are far from this critical rate].
Laffer sold the country on the idea that tax cuts were magic. He claimed tax cuts would lead to so much investment and economic growth that they would end up generating at least as much government revenue as they cost. In other words, he said, tax cuts would pay for themselves.
The magical thinking sold to the American people was that tax cuts to the rich would improve the lives of the majority. Laffer's theory provided a foundation for supply-side economics and was illustrated by the Laffer Curve, which he drew on a napkin for then-White House Chief of Staff Dick Cheney in the 1970s.
Laffer Napkin
If the idea that tax cuts raise revenue seems counterintuitive, there's a good reason: It's not supported by economic research. And when this idea becomes the basis of government policy, it can have disastrous consequences.
We have seen these consequences play out in several U.S. administrations. President Ronald Reagan accepted the bait of the Laffer Curve. He convinced Congress to enact large tax cuts in 1981 and tax revenues fell. Despite the economic recovery after the 1981-82 recession, tax revenues did not rebound. As a result, Congress had to enact deep and painful spending cuts at the expense of all U.S. residents. To avoid even deeper cuts in programs such as Supplemental Nutrition Assistance and Medicaid, Congress forced President Reagan to accept tax increases. Reagan's tax cuts did not pay for themselves. Moreover, they led to a period of broad economic inequality that continues today.
If supply-side economics were valid, then consequently tax increases should reduce government revenues and increase deficits. But the tax policies enacted by President Bill Clinton and Congress in 1993-namely, an increase in tax rates on the wealthy coupled with modest spending cuts-not only raised additional revenue, but also followed an economic boom that boosted revenues so much that the United States saw its first federal budget surpluses in a quarter century. Tax increases, not cuts, boosted revenues.
After President George W. Bush's proposed massive tax cuts took effect in 2001, government revenues again fell and calls for spending cuts were made to address the self-inflicted problem. Analogous to President Reagan's tax cuts, it was primarily the wealthy who benefited from lower tax rates; and again, the tax cuts did not pay for themselves.
Then, in 2012 and 2013, Kansas Governor Sam Brownback, inspired by the Laffer Curve, signed a tax cut decree that was among the largest ever enacted by a state, along with significant spending cuts. Laffer was a paid consultant who lobbied hard for that plan. But the "experiment," as Brownback called it, was an economic disaster. In 2017, the Republican legislature overrode the governor's veto and the tax cuts were rolled back.
It's no wonder that "The Kansas City Star" put it in an editorial, "Recognizing Laffer devalues the president's prestigious award ["presidential medal of freedom"]."
Even as Laffer's experiment in Kansas was cut short, President Trump followed up. His tax cut package, the Tax Cuts and Jobs Act passed by Congress in 2017, continues Laffer's magical thinking. Again, the American people were asked to believe Laffer's promise that big tax cuts, mostly going to the wealthy, would spur growth and raise revenue so much that the federal government would not have to make painful spending cuts. In reality, this legislation added $164 billion to the 2018 budget deficit and will end up cumulatively generating more than a trillion dollars in deficits (source: Congressional Budget Office CBO estimates).
Why do these deficits matter? For two reasons. First, they show that the path to an economy with strong, stable, broad-based growth does not begin with tax cuts for the rich. Second, someone must ultimately foot the bill. The tax cuts benefited wealthy Americans (Laffer's supporters). Every time government revenues were lower because of these tax cuts, Americans were told they would have to tighten their belts, with curtailed investments in people and places. This undermines the economic security of the people, infrastructure, and efforts to increase the human capital of the American nation.
To ensure prosperity for all Americans, not just those at the top, policymakers must not ignore widely accepted economic research findings. The evidence is overwhelmingly against the efficacy of Laffer's ideas. A strong middle class with rising wages and the ability to purchase goods and services is the foundation for sustainable and broad-based growth. Getting there requires policies of higher wages and competition and the promotion of human capital development, not an increasingly unequal distribution of the economic pie.
Last month's Medal of Freedom ceremony was meant to mark the end of supply-side economics and the beginning of a new era in which economic policy is based on evidence, not magic.
* Source: This is a translated, edited and slightly expanded version of the article: "Neither History nor research supports supply-side economics", by Heather Boushey, of July 2, 2019.
