Memo To: Students of Supply-Side University
From: Jude Wanniski
Re: Taxes, Revenues and the "Laffer Curve"
As early as 1972, soon after he left the Nixon administration and returned to the University of Chicago to teach economics, Art Laffer explained to me that there always are two rates of taxation that will produce the same revenue. One is at a higher level of national production and one at a lower level. The only exception is if you are at exactly the point where the rate is optimum, which means revenues will fall if you raise or lower them. When I met Robert Mundell in May 1974, he elaborated on this concept by teaching me that if a government is in the high range of the tax rate, it can lower the rate safely even though the aggregate revenue immediately declines -- as long as the economy grows faster and produces more revenue than predicted by assuming no behavioral change.
Mundell, who was awarded the Nobel Prize in economics last year, said the deficit could increase under this condition, yet interest rates on government bonds would decline! In other words, if the rate is cut by 10%, the static prediction would be that revenues would fall by 10%. If the economy were to grow faster because of the incentives of the lower rate, perhaps revenues would fall only by 8% or 9%. By this analysis, he said, the revenue difference would at least have to be sufficient to pay the interest on the bonds the government would float to cover the revenue shortfall. In this sense, the government would be investing in the productive potential of the people, betting that they would respond to the lower rate in a way that would produce a permanent return on that investment. It was this insight which enabled me to see, where others did not, that the Reagan tax cuts, although accompanied by an increase in the deficit, also were accompanied by falling interest rates.
The lesson this week is basic, one that I’ve used in previous semesters at SSU. Because the Laffer Curve got such widespread attention when it was used in Ronald Reagan’s 1980 campaign, in support of his vow to cut tax rates by 30%, it is often assumed that “supply-side economics” is ONLY about the Laffer Curve. Economists who don’t know any better (and many who do) argue that supply-side economics failed because the lower rates were supposed to have produced a higher revenue level but instead produced massive budget deficits. They never have tackled the Mundellian argument that lower tax rates only would have to produce a sufficient increase in economic activity so that revenues from that increase would be higher than the interest payments on the bonds needed to finance the temporary shortfall.
Over time, the dynamic effects of the Laffer Curve have produced the much higher level of economic activity we enjoy today as well as the budget surpluses about which the two presidential candidates now are arguing. Both candidates, Vice President Gore and Governor George W. Bush, are ignoring the dynamics of tax policy, chiefly because of the assumption that the economy need grow no faster than it is. This leads to non-economic, political options: Use the surpluses to increase government spending -- either on news programs or to buy back government bonds issued when the budget was in deficit, or to return the surpluses to the taxpayers. There is no economics involved in this kind of debate, which is why Bush will remain on the defensive throughout the campaign -- as his program seems to benefit the rich for no good reason while Vice President Gore’s program is designed to benefit everyone who is not rich. When assessed in a Laffer Curve framework, as we will see in next week’s lesson, the Bush plan does have some dynamic effects because some of its elements would invite a higher level of economic activity. The Gore plan invites a lower level of economic activity as it simply transfers wealth from those who have it to others who do not. There is nothing wrong with proposing such transfers. Governments exist to tax and spend and the spending may, if properly placed, produce a higher return for society over time. The spending argument is harder to make on economic grounds.
This week, the essay is one I wrote as an adaptation of Chapter Six of my 1978 book, The Way the World Works. We have learned a lot since 1978, but there is nothing in the following treatment of the subject that I would retract. It also serves as a foundation for where we will go in future weeks. Next week I hope to have an exercise that examines the Bush and Gore plans in some detail.