Refuting Reaganomics, Part 1 – Fantasy, the Laffer Curve, and “Supply Side” Ideology

(Return to the Contents Topics page.)

Like one of those Hollywood monsters that cannot be killed, the once-ridiculed Laffer Curve has again come back from the dead to haunt the current tax cut debate just in time for Halloween and the November elections.  Legend says the curve was scrawled on a napkin by Arthur Laffer for a luncheon audience that included Dick Cheney.   * * *

From that crude beginning the Laffer Curve went on to become the somewhat shaky underpinning of what became known as “supply-side economics,” the doctrine that also was known as Reaganomics for the President who relied on it, especially during his first term.  Since then the Laffer Curve has been gospel for a generation of conservative Republicans, the centerpiece in their long-standing campaign against taxes and big government. But many people saw those who still preached the Laffer Curve as irrelevant as someone who still believes the world is flat.  * * *

Meanwhile most Americans had forgotten the Laffer Curve the way people on Elm Street forget Freddie Krueger.  But the Laffer Curve is back with a vengeance; the nightmare on Wall Street.   – Liberalamerican,  The Laffer Curve Comes Back From the Dead,  October 8, 2010.

Introduction

There is a growing discussion of “supply-side economics,” a.k.a. “trickle-down economics” or “Reaganomics,” in the Reaganomics category on this blog.  In this post series, we combine an explanation and evaluation of the Laffer curve’s supply-side theory with a summary of our earlier discussions of Keynesian “demand-side” economics.

The Laffer curve is used to illustrate, and provide theoretical support for, the basic argument of supply-side economics, which in my words is this:

Freed from the shackles of taxation, financial investors and capitalists will increase their investments, creating economic growth for the benefit of everyone.  At high levels of taxation, everyone will lose incentive to work and work less.

The for last 28 years the Laffer curve has provided a symbol for this supply-side ideology, implying its theoretical legitimacy.  It has been used to market the core supply-side idea that if government tries to increase tax revenues by raising the top income tax rate, the tax increase itself will cause investment, productivity and income to decline, and government will end up collecting fewer total revenues.  This plausible-sounding theory has worked very well for Arthur Laffer, Milton Friedman, and the rest of the Chicago School of economics that created supply-side theory. It has enchanted and subjugated the Republican Party, led hundreds of politicians to sign Grover Norquist’s pledge never to raise taxes, and reduced the Obama Administration to an almost apologetic insistence that wealthy people ought to at least pay their “fair share” of taxes.

The theory has gained political acceptability, I would argue, because there is no obvious theoretical problem with the Laffer curve itself.  It actually purports to represent little more than the arithmetic truism that income tax revenues vary with the income tax rate. That makes it an ideal talisman for Reaganomics.

The supply-side theory supposedly illustrated and supported by the Laffer curve, however, is unsound. Beyond the arithmetic truism that (at any given income level) tax revenues vary with the tax rate, supply-side theory adds the assertions about dynamic economics contained in its basic argument, as stated above.

In effect, supply-side ideology piggy-backs on modern Keynesian economic theory by attempting to apply to very rich people a conclusion that is only true for ordinary, non-wealthy taxpayers.  The basic supply-side argument as I stated it above can be transformed into a true statement by simply changing the italicized words as follows:

Freed from the shackles of taxation, middle and working class consumers will increase their spending, creating economic growth for the benefit of everyone.  At high levels of taxation, people in lower income brackets will gain incentive to work and  work more.

Thus, everything depends on whose taxes we are talking about.  Wealthy people’s spending and consumption are not affected by income taxation nearly as much as are other people’s spending and consumption.  What economists call the “marginal propensity to consume,” that is the percentage of an increase in income that is spent, is much lower for very wealthy people than for everyone else.  What wealthy people actually do with most of their income and marginal income is save it, making it available for investment. Because of that, lowering taxes for them does not stimulate spending and consumption nearly as much as tax cuts for everybody else.

In its opposition to taxing the wealthy, therefore, supply-side ideology argues (as it must) that lowering the personal income taxes of the wealthy increases their incentive to invest, stimulating the economy and economic growth.  That claim creates the famous conflict between supply-side and demand-side theories, the former arguing that aggregate demand responds to increases in real investment, and the latter that investment responds to increases in aggregate demand.

The supply-side argument maintains, in effect, that cutting taxes on top incomes increases the economy’s marginal propensity to invest As explained in Part 3, this proposition is wrong:  The Keynesian argument that investment responds to aggregate demand is supported both factually and logically.  The economy’s incentive to invest is closely related to the level of incomes (GDP), not to income tax rates.

There is another arithmetic truism not illustrated by (but ignored and obscured by) the Laffer curve, namely, that for any given income tax rate, tax revenues vary with the amount of income (GDP).  The amount of income tax revenues collected by government is a function of both the level of income tax rates and the level of incomes (GDP) – and therein lies the fundamental problem with the Laffer curve.

The basic question is:  What stimulates growth in GDP?  The demonstrable truth is that supply-side policies suppress economic growth and lead to wild increases in income and wealth inequality, excessive wealth and incomes at the top, and recession and depression at the bottom.

In 1936 John Maynard Keynes wrote: “The outstanding faults of the economic society in which we live are its failure to provide for full employment and its arbitrary and inequitable distribution of wealth and incomes.” [1]  There has been much progress in economic theory since Keynes wrote those words, but his revolutionary observations about the role of aggregate demand in the economy changed economic thinking forever — and his “demand-side” approach and reasoning are as valid today as they were then.

The Dismal Science. . .

(Discovery Education)

Econophobes, worry not!  This will all be abundantly (and transparently) clear by the end of this post series.  Put on your thinking caps: We are about to sift through various explanations of the underlying concepts and supply-side theories associated with the Laffer curve.  Once we get into it, you will start having “Eureka!” moments, I assure you.

The Laffer Curve

The Laffer curve is based on the observation that government tax revenue will be zero when the marginal tax rate is zero, and the assertion that it will also be zero when the marginal rate is 100%.  In between these two extremes, it follows, there has to be a tax rate at which revenues are optimized.  As shown on the following version of the graph, the theory specifies that as the tax rate increases beyond an optimal point, a “prohibitive range” is reached at which further tax increases result in lower revenues:

In a recent article (The Laffer Curve: Past Present and Future, June 1, 2004), Laffer explains the theory behind the curve:

The basic idea behind the relationship between tax rates and tax revenues is that changes in tax rates have two effects on revenues: the arithmetic effect and the economic effect. The arithmetic effect is simply that if tax rates are lowered, tax revenues (per dollar of tax base) will be lowered by the amount of the decrease in the rate. The reverse is true for an increase in tax rates. The economic effect, however, recognizes the positive impact that lower tax rates have on work, output, and employment–and thereby the tax base–by providing incentives to increase these activities. Raising tax rates has the opposite economic effect by penalizing participation in the taxed activities. The arithmetic effect always works in the opposite direction from the economic effect. Therefore, when the economic and the arithmetic effects of tax-rate changes are combined, the consequences of the change in tax rates on total tax revenues are no longer quite so obvious.

Not so obvious, indeed: The Laffer curve itself provides only one hypothetical description of what the net effects might be over the whole range of tax rates, from 0%-100%.

In Don’t Knock the Laffer Curve (February 9, 2011), Hunter Baker argues that the Laffer curve is “undeniable” and “axiomatically true.”  In a couple of respects, it certainly is:

(1) It’s clearly true (a tautology) that when government does not tax income at all, it will get no income tax revenues.  Of course, this “zero rate” end of the curve is a little messy, for without any tax revenues you have no government (unless it prints all the money it needs), and that would be anarchy;

(2) It also seems more than likely (though not axiomatic) that if government attempts to take 100% of income from corporations and people, its efforts will break down.  This part is a bit more complicated: Society must always provide, somehow, for (at least) feeding, clothing and housing people, and if a corporation turns over all of its profits to government, that seems at first blush a bit like “nationalizing” the firm, so it’s not clear that the firm would collapse.  It’s not intuitive that at the 100% rate production and tax revenues actually fall all the way to zero, as that would be the point at which all taxable work and economic activity has ceased, implying anarchy, the collapse of the economy and all social institutions, and the death of the population.  That’s the really messy end of the curve;

(3) Assuming tax revenues are zero at both ends, it is axiomatic that there is a point somewhere on the curve where tax revenues are highest.

(4) In a paper (Supply-side Economics: “Voodoo Economics” or Lasting Contribution?) published in 2003 by Laffer Associates, Bruce Bartlett identifies another axiomatic characteristic of the curve:

The Laffer Curve implies that there is some point between zero and 100 percent that will maximize revenue. If rates are above this point—in the prohibitive range—then a tax rate reduction could theoretically raise revenue. A more important lesson of the Laffer Curve is that there are always two tax rates that will collect the same revenue—a high rate on a small base and a low rate on a large base.

This “axiomatic” observation enticingly suggests that lower tax rates are better, because the lower rate has associated with it a larger income “base” of taxable income, implying that  society and the economy would be better off at the lower of the two rates.  With this observation, though, comes acknowledgment that tax revenue varies with total income (tax base) as well as with the tax rate.  Importantly, as income varies, so does the level of aggregate demand.  Note that the level of aggregate incomes (the tax base) is nowhere represented on the curve.

Measuring the Laffer Curve

What might a real Laffer curve look like?  Why, twenty-eight years after its invention, are we still looking at hypothetical Laffer curves?   What data must we use to try to estimate a tax rate that produces optimal tax revenue?  And where might that optimal revenue point be on a typical Laffer curve?

(Pam’s Clipart)

Normally, empirical questions like these would beg for econometric investigation.  But, as Liberalamerican reports, Laffer himself testified that a Laffer curve cannot be measured:

Of course the problem is precisely delineating the shaded area and “A,” “B,” and “D.” Laffer himself declined to do this in testimony over the Kemp-Roth tax cut bill:

SENATOR  PACKWOOD:  Now, let’s go back to finding this optimum again, because obviously, if indeed you can define it and we can arrive at it …
MR. LAFFER:  I cannot measure it frankly, but I can describe  to you what the characteristics of  it are; yes, sir.

Indeed, the Laffer curve cannot be statistically measured, and here’s the problem:

There is no such thing as a real Laffer curve!  

A Laffer curve can exist only as an “illustration” of a hypothesis.  The arithmetic effect Laffer identifies (Revenue = Rate x Base), for any given tax base, can never be more than a single point on a hypothetical curve, because the  amount of income tax revenue is a function of both the tax rate and the tax base, and the Laffer curve specifies revenue as a function only of the tax rate.  Thus it cannot show (or predict) any dynamic change in the tax base (income) over time.  Once a tax change affects the level of income, we have shifted to a new, hypothetical and illustrative, curve!

This renders the Laffer curve useless, even for illustrative purposes, for the so-called “prohibitive range” would likely never exist under dynamic, real world conditions, with a  functionally progressive income tax schedule.  (As will be discussed in Part 3, increasing taxes on the rich and keeping them low for everyone else will greatly stimulate growth and investment.)

Unfortunately, the indeterminate nature of the Laffer curve leads supply-side advocates to argue pretty much indiscriminately that any tax increase will cause a decline in tax revenues, and vice versa. That’s a major supply-side overreach, for even if we assume arguendo the validity of supply-side ideology, the Laffer curve does specify (axiomatically) a “prohibitive range,” and at any point below that range tax increases always increase tax revenues, and vice versa.  

Revenues declined when Bush cut the top income tax rate from 40% to 35%, so the top rate was below the “prohibitive range” hypothesized by the theoretical Laffer curve, and reversal of the Bush tax cut would therefore increase revenues.  Nonetheless, supply-siders continue to argue (e.g., The Truth About the Bush Tax Cuts, February 7, 2012) that reversing the Bush tax cuts will not produce more revenues.

Such claims can never be anything more than ideologically driven propaganda.  The Laffer curve only partially accounts for reality, and has no economic significance.

Supply-Side Behavioral Theory

With reference to the above Laffer curve, Investopedia (2003) emphasizes that the “arithmetic effect” is always greater than the “economic effect” at the low end of the curve, and vice versa:

The curve suggests that, as taxes increase from low levels, tax revenue collected by the government also increases. It also shows that tax rates increasing after a certain point (T*) would cause people not to work as hard or not at all, thereby reducing tax revenue.

Eventually, if tax rates reached 100% (the far right of the curve), then all people would choose not to work because everything they earned would go to the government. * * * [P]oint T*. . . is the point at which the government collects [the] maximum amount of tax revenue while people continue to work hard.

This curve doesn’t “show” that tax increases cause people not to work hard, it presumes that they do:  I am aware of no empirical evidence supporting this theory of individual behavior.  Hunter Baker’s discussion of the proposition that the incentive to work is inversely related to the tax rate is symptomatic of the problem:

You can increase taxes to some optimum point where you will continue to get more revenue up to the point where increased taxation becomes counterproductive because it causes people to reduce their effort. We observed this phenomenon actually occurring in the United States when we had ultra-high marginal tax rates. Various types of earners curtailed their effort once they hit the magic level at which they would begin to pay the highest rates. They preferred to put off additional activity until the next year. Famously, the detective novels about Nero Wolfe mentioned his tendency to take a few months off at the end of the year because of the top rates of taxation.

Unfortunately, his only citation is to a fictional character, Nero Wolfe!  I note that he at least appropriately limits this theory to rich people, and asserts only a tendency to delay (not reduce) work.

Arthur Laffer (February 10, 2011) advances a similar argument: “Reagan knew from personal experience in making movies that once he was in the highest tax bracket, he’d stop making movies for the rest of the year. In other words, a lower tax rate could increase revenues” (Emphasis added).

No evidence is cited that this is a real phenomenon, even in the anecdotal Reagan case. Worse, Laffer is simply wrong in claiming that “a lower tax rate could increase revenues.” Here, he forgets his own distinction between the “arithmetic” and “economic” effects of tax rate changes: It’s clear that Reagan, despite moving into a higher tax bracket, would always have had (apart from changes in deductions) more after-tax income whenever he increased his pre-tax income, because he would always have been taxed at less than 100%.

We are given no reason to believe that to stop working would be a rational response to a tax bracket change: so why would Reagan stop working?  Delaying work has an opportunity cost.  The Wolfe/Reagan example is all I’ve found on this point, and it seems far-fetched and invalid.  Beyond that, the idea that people’s work slacks off as their taxes increase is fundamentally counter-intuitive:

(1) One would expect working people, especially in low-income brackets, to work harder (more hours) if their taxes are increased in order to maintain their levels of after-tax income.  Take, for example, the historical case of medieval peasants (2012), struggling to grow crops at a subsistence level. The 10% tithe imposed by the landowners could break them, especially if next season’s crop was jeopardized.  With survival at stake, higher taxes would have forced serfs to work even harder (assuming they weren’t already working as hard as they could).  Similarly, low-income Americans have often worked longer hours or taken additional jobs as their incomes have declined. There certainly would be no tendency to “take a few months off at the end of the year”;

(2) Very wealthy people, in theory, should not be much affected by a tax increase. Multi-millionaires and billionaires that work are doing so because they want to, not because they have to, so an income tax increase shouldn’t have much effect on how much they work. They do not work for the income they get through capital gains, except insofar as they manage their portfolios, and they presumably will try to maximize their capital gains regardless of the level at which capital gains are taxed.

Capital Gains 

Significantly, Warren Buffet (August 14, 2011), who contends that millionaires are under-taxed, flatly rejects supply-side Reaganomics:

“I have yet to see anyone — not even when capital gains rates were 39.9 percent in 1976-77 — shy away from a sensible investment because of the tax rate on the potential gain. People invest to make money, and potential taxes have never scared them off.”

Laffer, in The Laffer Curve: Past Present and Future (June 1, 2004), also talks about investor behavior in connection with capital gains taxes:

The Laffer Curve and the Capital Gains Tax

Changes in the capital gains maximum tax rate provide a unique opportunity to study the effects of taxation on taxpayer behavior. Taxation of capital gains is different from taxation of most other sources of income because people have more control over the timing of the realization of capital gains (i.e., when the gains are actually taxed).

The historical data on changes in the capital gains tax rate show an incredibly consistent pattern. Just after a capital gains tax-rate cut, there is a surge in revenues: Just after a capital gains tax-rate increase, revenues take a dive. As would also be expected, just before a capital gains tax-rate cut there is a sharp decline in revenues: Just before a tax-rate increase there is an increase in revenues. Timing really does matter. 

This all makes total sense. If an investor could choose when to realize capital gains for tax purposes, the investor would clearly realize capital gains before tax rates are raised. No one wants to pay higher taxes.

Here, incredibly, Laffer purports to associate taxes on capital gains with the hypothetical Laffer curve, but discusses a matter that has nothing to do with the Laffer curve!  Laffer himself, in the same article, specified that the Laffer curve illustrates the theory that “lower tax rates have a positive impact on levels of work, output, and employment.”  He refers here, however, only to attempts to sell assets for the highest after-tax net gain.  Sales of assets are merely transfers of ownership, and have nothing to do with changes in “work, output, and employment.”

Summary and Conclusions

The introduction to this post laid out the framework in which Reaganomics supply-side ideology contrasts with modern demand-side economics.

We found that the Laffer curve is merely an illustration of the idea that there is a “prohibitive range” above an optimal amount of tax revenue, within which attempts to raise more revenue by raising taxes will cause tax revenue to decline because the tax increase itself will cause people to cut back on work, reducing the tax base.  Although the Laffer curve has been providing symbolic support in the supply-side campaign of the very wealthy to keep taxes low,

1.  It obscures the fact that tax revenue is a function of both the tax rate and aggregate income (the tax base); accordingly for any given tax base, there exists only a single point on a fictitious, hypothetical curve showing the amount of tax revenue produced by a specified tax rate;

2. Accordingly, real Laffer “curves” cannot be measured, and do not even exist; the use of “illustrative” curves serves only to spread misinformation;

3. There is no credible basis, in any event, to support the claims that people will reduce their incomes as tax rates increase, much less to the degree that tax revenues would actually decline.

We also saw a disturbing tendency on the part of three supply-side advocates to base conclusions on anecdotes and sloppy reasoning.  This is a feature of the kind of propaganda that is aimed at an uninformed and gullible audience.  It is not real economics, and it does a disservice to the field of disciplined economic inquiry. In Parts 2 and 3 we will see more of this use of non-economic reasoning by “authority,” including an incorrect attempt by Laffer to suggest that Keynes himself was, somehow, a closet supply-side theorist!

In Part 2 we will focus especially on the pernicious notions that low taxes (for the rich) encourage investment, and that high taxes cause investment to decline:  Supply-side advocates have provided no reason at all to believe that when rich people increase their financial wealth their additional savings will be invested any way other than according to the actual, real world, marginal propensity to invest.

Part 3 will show how the economic history of the last thirty years affirms demand-side theory and provides conclusive disproof of Reaganomics.  We will explain why the economy tanks after massive tax cuts to the rich, such as the Bush tax cut, and show how the Republican long-term budget plan recently introduced in Congress by Paul Ryan (March 20, 2012) will result in still further declines in aggregate income and investment.

No one should be surprised at projections that the federal deficit will rise another $4 trillion or so under the Ryan plan, or that the richest rich people in the American top 1% will take several more trillion dollars from the bottom 99%.  In fact, it’s not clear that either the economy or the federal government can survive such a plan.

Shocked?  Don’t be.  Reaganomics trickle-down “theory” is pure fantasy.

JMH – 3/24/2012 (rev. 3/26/2012)

___

[1] John Maynard Keynes, The General Theory of Employment, Interest, and Money, first printing 1935, Harvest/Harcourt, Inc., 1953, 1964 ed., 1991 printing, p. 372; See Keynesian Economics, Wikipedia, for brief descriptions of Keynes’ theories.

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9 Responses to Refuting Reaganomics, Part 1 – Fantasy, the Laffer Curve, and “Supply Side” Ideology

  1. Hunter Baker says:

    I cited Nero Wolfe because he was part of the pop culture, but anecdotally the effect reached down to people like IBM salesmen! Who would ever choose to work past the point of a 90% marginal rate? Not me.

  2. vorfahrt says:

    Wow, this is all too complicated for me. Why don’t we go back to the basics (and you mentioned this in earlier posts already):
    1. Investment depends on demand
    2. Demand comes mostly from the middle class
    3. Middle class incomes have badly diverged from GDP growth over the last 30 years and gone negative in real terms for about 15 years
    No demand = no investment, as can be seen at near-zero interest rates. All the capital in the world cannot be invested due to lack of demand. What do we need now? – Stimulate demand, demand, demand. This is the key going forward.

    • Thanks for checking in, and well said: The concepts clearly are not too complicated for you. You’ll soon get my more direct and summary statement when I sum up the first 4 parts – soon!

      • Hunter Baker says:

        It may be too complicated. It is by no means certain that stimulating demand is the key to creating growth in the economy. The supply side view is surely vindicated to some degree by the Reagan economy. Well before that, you could find many economists arguing that the stock of capital goods were the key to growth.

      • What is your basis for thinking that capitalists need more money? There is no shortage today of capital goods or investment funds for more capital investment. Any semblance of economic scarcity has vanished. These are depression conditions, with excess capital and labor everywhere, and low and declining consumer demand. So I must strenuously disagree: It is certain that stimulating demand is needed, and badly. Unfortunately, that’s what government is for; and anti-government ideologues are putting more people out of work while planning to eliminate safety net programs, while making people who are already very rich even richer. Even less demand, and even more surplus capital.

      • Hunter Baker says:

        No, what government is for is creating a stable and predictable system of rules and enforcement so that people can enjoy meaningful freedom.

      • Hunter, like it or not government is part of the economy. The “predictable system of rules” you mention must include sufficient regulation, at the very minimum, to prevent the demise of the economy. Without economic opportunity, there is no such thing as freedom.

      • Hunter Baker says:

        I think I agree with what you just wrote, but I don’t think stimulating or creating demand is necessarily part of what it means to have “sufficient regulation.”

        I’m not a pure laissez-faire guy. For example, as a person who grew up in the Tennessee Valley, I understand the incredible value of the TVA and NASA in terms of developing the economy of my region. For that matter, look at the tremendous value of the interstate highway system. But those are very different things from stimulating demand by pushing out dollars to consumers year after year and you are left with something to show for it.

      • Please see my last post, Part 4 of this series.

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