The Laffer Curve, Part I Jude Wanniski June 24, 2006

In today's SSU lesson, Jude Wanniski introduces the Laffer Curve, which basically demonstrates the law of diminishing returns applied to tax policy. Along the Laffer Curve there are always two rates of taxation that produce the same amount of revenue, with the exception being where the rate is optimum. The concepts as Jude discusses them, are fairly straightforward. Still, as Jude wrote, "there have been tens of millions of words written about the Laffer Curve since I first watched Laffer scribble it on a cocktail napkin to demonstrate the idea for Vice President Dick Cheney, when Cheney was deputy chief-of-staff to President Gerald Ford in December 1974. But almost everything written has been wrong…" 

Polyconomics Staff

To: Students of Supply-Side University
From: Jude Wanniski
Re: Taxes, Revenues and the Laffer Curve
Date: 2/11/2005

In studying public finance, there is nothing more important than an appreciation of the Laffer Curve. Nothing. Empires have been built on the wisdom of a few men who understood the law of diminishing returns as it applies to tax policy. Caesar Augustus understood. Napoleon understood. The architects of the Byzantine Empire understood. So did the Founding Fathers of the United States. The temporary, but sharp decline of the U.S. economy in the 1970s was the result of the failure of our political leaders to realize the law of diminishing returns was eroding the economy in a new and different way. The tax rates themselves were constant, but because of the inflation that began to take hold in 1967 when the U.S. commitment to a dollar/gold standard began to waver, real rates of taxation were rising and had passed the point of diminishing returns. We were inflating our way up the progressive tax schedules of the income-tax code.

Robert Mundell and Arthur Laffer were the first economists on earth to realize that basic fact and to predict the bad things that followed. The law of diminishing returns simply means that once you pass a certain point in anything you do that seems pleasurable, the pleasure diminishes. Eat ice cream to a point and the pleasure in eating more diminishes rapidly. Raise tax rates too high and commerce will be stifled to the point that tax revenues will decline. At that point a reduction in tax rates will stimulate commerce and revenues will rise.

This is all the Laffer Curve demonstrates. As early as 1972, Art Laffer explained to me that there always are two rates of taxation that will produce the same revenue, one 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 rates of taxation. When I met Robert Mundell in May 1974, he elaborated on this concept by teaching me that if a government were in the high range of the tax rate, it could lower the rate safely even though the aggregate revenue immediately declines -- as long as the economy grows faster and produces more revenue than the level predicted by the static assumption of no behavioral change.

Keynesian demand-siders will argue that any reduction in taxes will produce this result, including rebates on taxes already paid. In the supply-side model, only certain kinds of tax cuts will have positive supply effects. Tax rebates, of the kind passed in 2001 by the Bush administration, have no supply-side effects, and in fact were designed by the President's chief economic counselor, a conservative Keynesian, Lawrence Lindsey. The tax cuts passed this spring were correctly designed, reducing unnecessarily high tax rates on capital, which is why the stock market has been rising since mid-March when the first signs of the legislation taking shape began to appear.

Mundell has argued the deficit could increase if tax rates swollen by inflation were cut, and 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 grew faster because of the incentives of the lower rate, perhaps revenues would only fall by 8% or 9% in the fiscal year ahead. By this analysis, he said, the revenue difference at least would have to be sufficient to pay the interest on the bonds the government would float to cover the temporary 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 that 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. There have been tens of millions of words written about the Laffer Curve since I first watched Laffer scribble it on a cocktail napkin to demonstrate the idea for Vice President Dick Cheney, when Cheney was deputy chief-of-staff to President Gerald Ford in December 1974. Almost everything written has been wrong, in that reporters or critics of the Curve thought it showed an immediate response, where there would be no deficit increase in the 12 months following the cut.

I still get mail from serious people who tell me "Supply-side economics is a fraud," because the Reagan tax cuts led to budget deficits. The deficits themselves caused economic growth because of demand-side Keynesian effects, they say, but the deficits would have to be paid down in future years with higher taxes. This would be true if the deficits were accompanied by higher interest rates, but interest rates declined as the Reagan tax cuts took effect and the deficits swelled. That combination led me to predict that as the lower tax rates would steadily increase the rate of economic growth over several fiscal years, the budget deficits would turn to surpluses.

The phenomenon is accepted when it is seen in the microeconomic world of the private firm. The bond market assesses a corporation's bond floatation by examining the uses to which the funds will be deployed. If it believes the issue will produce a positive return on investment (ROI), the interest rate on the bond will be favorable, and the corporation's other debt may even trade up in the secondary market. There is no reason why government bond finance should not be treated the same way, especially when the bonds are being issued explicitly to finance tax cuts.

Conservatives fear such daring by governments because they worry governments routinely will go into debt for "investments" that have no chance of producing a positive return. Fed Chairman Alan Greenspan is in that position, always arguing that spending cuts take precedence over tax cuts. But even Greenspan will support a cut in the capital gains tax without offsetting spending cuts. This is because he believes that any cut in the capital gains tax will produce a positive ROI for the nation. The reason is the capital gains tax is the most destructive of all taxes, in that even at 1% it immediately reduces the willingness of the market to finance equity investments. Tax rates on ordinary income can run up to higher levels in order to finance government spending. But in order to get a capital gain, an individual has to pay taxes on ordinary income and invest some portion of what remains, hoping the investment increases in value. Greenspan told me years ago this is a direct tax on the nation's standard of living and he would never hesitate to cut it, even down to zero.

With a few exceptions, liberal Democrats have opposed the Laffer Curve concept, rejecting the idea that high tax rates could be cut and thus produce more revenues for liberal spending programs. This is because they are reluctant to concede that the economy can expand at the expense of government, especially if the result is a widening of the gap between high incomes and low incomes. A former Democratic Speaker of the House of Representatives once told me over a pleasant lunch that he conceded a lower capital gains tax would cause the economy to expand, but said he had to oppose it because it would lead to greater "unfairness" in incomes. In other words, everyone would get wealthier, but the rich would get richer, faster. Even this is false. Lowering the tax rate on capital elicits more capital from the economic system, with the difference made available to those who can only hope to become rich by having access to capital and credit.

In this sense, President John F. Kennedy was a "supply-sider," arguing for lower tax rates on incomes and capital gains. In presenting his tax package in 1962, he argued "a rising tide lifts all boats." By contrast, his brother Edward "Ted" Kennedy, the Senator from Massachusetts, rejects those supply-side arguments and insists on government spending as the route to greater economic welfare. Tax the rich and spend the revenues on the non-rich.

This approach also can have positive economic effects, as long as the spending programs have a positive return on investment. After WWII, the GI bill that subsidized college tuition for veterans, for example, almost certainly had positive supply effects. On the other hand, the welfare spending of the Great Society had negative returns in requiring there be no "man in the house" for a family to receive welfare checks. This had the effect of destroying black families when unemployed fathers abandoned their families so they would be eligible for welfare. To be consistent, supply-siders have to accept the fact that government programs that have positive returns deserve to be supported, even if it would mean raising taxes. In the early Reagan years, I supported an increase in the federal gasoline tax, on the grounds that inflation had reduced the purchasing power of the specific five-cent tax. Revenues were insufficient to repair the national highway system, I argued, and the costs of commerce were climbing as potholes tore up the tires of cars and trucks. In the debates since 2001, I did criticize the Bush/Lindsey tax rebates and supported selective parts of the Democratic spending agenda.

It is important to note that when policymakers or political leaders examine a tax structure, looking for places to raise or lower taxes, they must analyze each one individually. When the federal budget was throwing off big surpluses prior to 2001, every politician had a pet tax he or she wanted to cut. The cultural conservatives wanted to fix the marriage-tax penalty, for example, on the theory that it encourages mates to remain outside wedlock. Others wanted to use the surpluses to finance a bigger earned-income tax credit, which gives workers extra cash if they earn less than the lowest income-tax bracket. There are all sorts of tax credits offered to one group or the other, to foster bigger families, or bigger charities, or to subsidize cultural activities. Generally speaking, these have negative effects on economic growth and because they do, their enactment would cause interest rates to rise. That is, they are poor investments for the federal government to be making. In the remainder of this semester, we will spend considerable time on the themes and variations of the Laffer Curve. Next week I plan to run an essay I wrote as an adaptation of Chapter Six of my 1978 book, The Way the World Works, which discusses in detail the Curve as it is pictured above.