Refuting Reaganomics, Part 2 – The Laffer Curve, Growth, and Inequality

(Return to the Contents Topics page.)

(Sunshine State News)

In the United States, trickle-down theory’s insistence that a more progressive tax structure would compromise economic growth has long blocked attempts to provide valued public services. Thus, although every other industrial country provides universal health coverage, trickle-down theorists insist that the wealthiest country on earth cannot afford to do so.

Low- and middle-income families are not the only ones who have been harmed by our inability to provide valued public services. For example, rich and poor alike would benefit from an expansion of the Energy Department’s program to secure stockpiles of nuclear materials that remain poorly guarded in the former Soviet Union. Instead, the Bush administration has cut this program, even as terrorists actively seek to acquire nuclear weaponry. * * *

The rich are where the money is. Many top earners would willingly pay higher taxes for public services that promise high value. Yet trickle-down theory, which is supported neither by theory nor evidence, continues to stand in the way. This theory is ripe for abandonment. —  Robert H. Frank,  (April 12, 2007)

Introduction

Much thanks to Robert Frank for pointing out that “trickle-down” economics (a.k.a. “Reaganomics” or “supply-side” economics) “is supported neither by theory nor evidence.” As discussed frequently in this blog, the evidence has been piling up that during the last 30 years “trickle-down” policies have resulted in an accelerating increase in wealth and income inequality, economic depression for the bottom 90%, and the imperilment of America’s economic future.

This trend and its social implications are nicely summarized and documented in  Chuck Collins’ new book, “99 to 1: How Wealth Inequality is Wrecking the World and What We Can Do about It”.  This is an important book, succinctly written (only 124 pages), that every American should read.  As Collins’ book, in all likelihood, was in preparation last September, the Occupy Wall Street movement began, and suddenly the slogan “We are the 99%!” entered the public consciousness.  The topic of income and wealth inequality became a major part of the national conversation, and the supply of “Tax the Rich” signs and bumper stickers mushroomed.  Understandably, broad public understanding of economic issues and taxation remains low, but people are increasingly able to answer the “What’s wrong with this picture?” question.

Last June, according to a  Gallup Poll, two-thirds of people with annual incomes of $75,000 and over opposed “redistributing wealth” by imposing “heavy” taxes on the rich; incredibly, one-third of people making less than $30,000/year also opposed increased taxes on the rich.  This may have reflected the way the question was framed, but I believe it also shows a heavy influence on poor people of the “trickle-down” propaganda peddled by mainstream media.  By September, a Harrison Group  survey of people making more than $100,000/year showed considerably more support for taxing the rich. As Reuters reported:

Nearly half of those polled approved of income tax increases on discretionary household incomes of $500,000 or more annually … For those earning $1 million or more annually, 65 percent of respondents said they would support income tax increases.  Only 23 percent of respondents said they support tax increases for households making $250,000 a year.

An article (The Case for Raising Top Tax Rates) in Tuesday’s (3/27/2012) New York Times  reported that one-third of households earning more than $250,000/year now agree that their taxes are too low.  Support for taxing the rich is steadily (if gradually) rising; still, two-thirds of people making $250,000/year or more evidently still oppose higher taxes on top incomes.  In support of still lower taxes for themselves and their corporations, the very rich have rallied behind trickle-down Reaganomics with a slogan of their own: “Don’t Tax the Job Creators.”  The battle lines are drawn, and with the truly draconian long-term budget plan recently introduced (March 20, 2012) by Republican Congressman Paul Ryan, much more attention is now being paid to Reaganomics.

In this series of posts, we are reviewing the supply-side ideology of Reaganomics, and contrasting it with Keynesian demand-side theory.  Here in Part 2 we are continuing the review of the theoretical basis for the Laffer Curve started in Part 1. The recent New York Times article The Case for Raising Top Tax Rates is linked to some very important recent econometric studies that (1) disprove the Laffer curve’s specification and (2) show that the tax reductions for the rich have been a major cause of the growing inequality.  I’ll refer to these studies below in connection, mainly, with the first point.

Here we go again, econophobes, so put your thinking caps (courtesy of Discovery Education) back on!

To begin, it may help to set forth my conceptual framework for evaluating economic concepts and issues. Broadly speaking, there are three main factors involved in the macroeconomic evaluation of Reaganomics:

(1) Taxation: How incomes are taxed affects economic growth and the degree of inequality;

(2) Growth: Economic growth is determined by the level of real incomes and aggregate demand for goods and services, and by the level of investment;

(3) Inequality: The level of income and wealth inequality is closely related to taxation, and it heavily affects the levels of aggregate demand and investment. 

The difference between supply-side and demand-side economics lies in their assertions about causal relationships between investment and demand.  There are two aspects to the investment issues as posed by supply-side argument: (1) The first is the claim purportedly illustrated by the Laffer curve that taxing the rich reduces their incentive to invest (and, consequently, investment); (2) The second is the broader, macroeconomic claim that growth is reduced when you tax the rich.  The first assertion is addressed here, and the second in the next post in this series.

Summary of Part 1

In “Refuting Reaganomics, Part 1 – Fantasy, the Laffer Curve, and Supply-Side Ideology,” we reviewed the basic ideas behind Laffer curve theory and began discussing the theoretical and factual support for it, finding:

1. The Laffer curve merely illustrates the unsubstantiated idea that there is a “prohibitive range” above the optimal tax rate within which attempts to raise more revenue by raising taxes will instead cause tax revenue to decline as people cut back on their work and income sufficiently to offset the arithmetic revenue-producing effect of any tax rate increase;

2. There is no evidence or credible basis for the claim that people will reduce their work in response to a tax rate increase to the point that after-tax income declines, and certainly not to the further point that the total tax revenue declines. People at the lower end of the income ladder will take more jobs, pool their resources and work harder, as necessary to make ends meet, and people at the top of the income ladder have so much wealth that they don’t need to work;

3. The illustrative Laffer curve obscures the fact that tax revenue is a function of both the tax rate and aggregate income (the tax base).  The dynamic effect of a tax rate change is to change the tax base, so any tax rate change shifts the total revenue point (“T” on the above curve) onto another equally “illustrative” and fictitious curve;

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

The Lack of  Empirical Support 

I have found no empirical evidence and virtually no reasoning to support the idea that people won’t work as hard when their incomes are taxed more heavily.  The only idea I found is that people might stop working near the end of the year if they were about to move into a higher tax bracket, and that point was only supported anecdotally.  Hunter Brown cited a fictional character, Nero Wolff, to illustrate the point, and Arthur Laffer curiously argued that Ronald Reagan stopped making movies near the end of the year so that his income would not decline.

The only other behavioral example I found was Arthur Laffer’s assertion that the principle of the Laffer curve is supported by investors selling capital assets to avoid the impact of an increase in the capital gains tax.  Although such transfers of asset ownership would no doubt affect sellers’ personal incomes and income tax obligations, real levels of work or investment are not affected by these asset transfers.

I cannot emphasize too strongly that there is no empirical or logical basis for any asserted taxophobic behaviors of individuals that would, in their collective effect, support the macroeconomic notion, as Bruce Bartlett puts it (apparently as a proffered restatement of  “Say’s law”), that “economic policy should be more concerned with the production of goods and services than with the stimulation of demand.” (Supply-side Economics: “Voodoo Economics” or Lasting Contribution?)  There simply is nothing offered by supply-side theorists to show that the holders of capital wealth must be coaxed by tax reductions into investing in the production of goods and services.  As Warren Buffet (August 14, 2011) puts it: “People invest to make money, and potential taxes have never scared them off.” Thus, people with money always have an incentive to (profitably) invest.

A companion argument is made that if the rich and their corporations are overtaxed, they will lack sufficient wealth to invest in economic growth.  However, there has been no shortage of investment funds for the top 1% and their corporations. As reported on this blog (Growth of Inequality of Wealth: 1979-2007), the top 1% has increased its percentage of financial wealth over three decades from 20.5% in 1979 to 33.8% in 2007, a percentage gain equivalent to almost $9 trillion.  Clearly, the top 1% has not been overtaxed.

Beyond these points, Arthur Laffer (e.g., The Laffer Curve: Past Present and Future) and his associate Bruce Bartlett, mainly present arguments for supply-side economics based on quotations from philosophers that mostly preceded the development of modern economics (such as John-Baptiste Say, 1767-1832) and claims about the effects of 20th Century tax cuts. These points — including Laffer’s argument from a Keynes quotation — will be reviewed in the next post on Keynesian “demand-side” economics.

What About the Laffer Curve?

However, what Bartlett says about the Laffer curve must be addressed here:

Although it is only one aspect of supply-side economics, the Laffer Curve has come to represent what it was all about, in the minds of most people. It simply makes the indisputably true point that neither a zero percent tax rate nor a 100 percent tax rate collect any revenue; the former because there is no tax and the latter because no one will earn taxable income, knowing that the government will confiscate all of it.

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.

Obviously, there are massive problems with translating a pedagogic device like the Laffer Curve into something that will predict the actual impact on revenues of any particular tax change. Whether something like the 1981 Reagan tax cut would raise revenue and over what period of time could only be answered by careful empirical analysis.  No such analysis was ever done. Every official document and statement ever released by the Reagan Administration made clear that the 1981 tax cut would lose large revenues. Moreover, its estimates were comparable to those of independent analysts such as the Congressional Budget Office.

In the words of Bill Niskanen, a member of the Council of Economic Advisers under President Reagan, “Supply-side economics…. does not conclude that a general reduction in tax rates would increase tax revenues, nor did any government economist or budget projection by the Reagan Administration ever make that claim.”  Nevertheless, the charge continues to be made that the American people were deluded into thinking that the 1981 tax cut would not increase the federal deficit. The rest of this paper tries to answer the question of what the supply-siders really thought about the effect of tax changes on revenues, what were their sources of information and inspiration, and whether their work was based on serious analysis or built on the quicksand of wishful thinking. (Emphasis added.)

Unfortunately, this “pedagogic device” has been extremely misleading.  It doesn’t, as Bartlett cautiously puts it, merely suggest that a tax rate reduction could theoretically raise revenue when a tax is in the prohibitive range.  It specifies, axiomatically, that it will do so — all the way down to the optimum rate!

The “massive problems” Bartlett concedes in trying to use the Laffer curve to “predict the actual impact on revenues of any particular tax change” effectively admits its invalidity, or at least its uselessness.  But it has been repeatedly used to support lower top tax rates that have caused rampant inequality over three decades.  People continue to argue that the 1981 tax cut did not effectively increase the federal deficit (See, e.g., JEC Report, April, 1996, and Laffer, June 1, 2004). Today’s crop of supply-side Republicans essentially presume that any tax rate (including, incredibly, the 15% capital gains rate that applies to the majority of the income of the ultra-rich top .1%) is so high as to be in the prohibitive range, and that more tax cuts for the rich will not adversely affect the federal budget.  Some “pedagogic device”!

The Laffer Curve is the Wrong Curve

In The Laffer Curve: Past Present and Future, June 1, 2004, where Arthur Laffer describes the basic supply-side theory, he says:

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 economic effect . . . 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. (Emphasis added)

And Bruce Bartlett, as quoted above, maintains 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.” (Emphasis added)

Despite being presented as truisms, these are assertions of fact, and both of them therefore could be wrong.  The Laffer curve represents aggregate tax revenue, based on only one set of assumptions about human behavior.  If the only assumption we make, however, is that some people among those with the highest incomes will, like Hunter Baker [2], elect to stop working when they reach a 90% tax bracket, we have a completely different curve.  An illustrative “Baker curve” would look something like this: 

Both curves are illustrative only, pedagogic devices, because they have been drawn to show the hypothesis of the author.  They are examples of art, not science.  In my “Baker curve,”  there is no prohibitive range, reflecting the assumption that wealthy people paying taxes at the top rate will not decide to earn less money as the tax rate approaches 90%.

As pointed out above, I had argued that the Laffer curve does not exist in reality, concluding that tax revenue could not be statistically estimated over the entire range of potential top income tax rates.  I was wrong!

An Econometric Breakthrough

This curve reflects groundbreaking (and in my view Nobel-Prize quality) work by Anthony B. Atkinson and Andrew Leigh, issued in a study (The Distribution of Top Incomes in Five Anglo-Saxon Countries over the Twentieth Century) released in May, 2010.  They are a part of a small group of talented economists who have shown (among other things) that the top income tax rate can be significantly raised.  See also, Taxing the 1%: Why the top tax rate could be over 80%, a report (12/8/2011) by Thomas Piketty, Emmanuel Saez, and Stefanie Stantcheva, a report that reflects equally significant and exhaustingly thorough work.

The work of Piketty and Saez lies behind nearly all of our current knowledge on income inequality in the United States.  I became aware of these two reports when I found them linked on-line in the article The Case for Raising Top Tax Rates in Tuesday’s (3/27/2012) New York Times.

I will discuss these studies in more detail in my next post in this series, along with my discussion of Keynesian demand-side macroeconomics.  In the meantime, interested readers should go to pp. 28-29, 39, and 44 of the Atkinson/Leigh report.  The graph reflects the consolidated income distribution data for the top 1% for Australia, Canada, New Zealand, the United Kingdom, and the United States.  They find:

Using our estimates of the elasticity of the top 1 percentile group share to the top marginal tax rate, we can estimate revenue hills for the Anglo-Saxon countries. In Figure 9, we 29 show estimated revenue hills for two cases, in which the elasticity of the top percentile group share with respect to the after-tax share is 1.2, and in which the elasticity is 1.6. In our specification, the revenue-maximizing tax rate is simply the inverse of the elasticity (see Appendix C for proof). Thus if the elasticity is 1.2, the revenue-maximizing tax rate will be 83 percent (1/1.2), while if the elasticity is 1.6, the revenue-maximizing tax rate will be 63 percent (1/1.6). This suggests that in all five Anglo-Saxon countries, the tax rate paid by the top percentile group in the early-2000s was well below the revenue-maximizing point (i.e., on the correct side of the Laffer Curve).

[Let me translate that into plainer English: The higher the degree to which a reduction in the top tax rate results in greater income inequality, the more the relationship between the top tax rate and total tax revenues looks like the “Brown curve” instead of the dome-shaped “Laffer curve,” and the more the “prohibitive range” specified by the Laffer curve is smaller and less troublesome than specified by the dome-shaped version. – 3/31/2012]

At first blush, it appears that these economists have advanced what we might call “the economics of inequality” with an apparently new approach to specifying the relationship between inequality and taxation.  One thing is clear, they have demonstrated that the world is not as depicted in the Laffer curve.  In so doing, they have demolished the shaky foundation of the supply-side ideology that has, over the last thirty years, led human societies to the brink of economic ruin.

How amazing it is that such little things, like a taxophobic idea and a Laffer curve, could make such a big difference!

JMH – 3/30/2012 (ed. 3/31/2012)

________

[1] “99 to 1: How Wealth Inequality is Wrecking the World and What We Can Do about It”, by Chuck Collins, Barrett-Koehler, 2012, p. 66.

[2] Much thanks to Hunter Baker for commenting on the first post in this series, in response to being cited there.  He makes the not unreasonable assertion that a 90% marginal rate might be too much for many people, who might by the time they reach a 90% top rate have already obtained sufficient income to satisfy their needs and desires.

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