Thursday, January 29, 2009

Laffer Curve Applied and Oil Rationing

The original article by Laffer in 2004 is much longer and investigates a great deal of the history of tax cuts in general and what is now known as the Laffer Curve. Its prehistory may be mature, but it was Arthur Laffer and importantly, Ronald Reagan who finally rewired finance ministers worldwide to understand the meaning of this curve as applied to public policy.

Historic resistance to this paradigm came from the simple inability of most of the population to intuit second order mathematics. A linear argument is always more beguiling even if it is the road to wrack and ruin, Its successful application has delivered twenty five years of sustained economic growth here and abroad, as well as government budget surpluses. It has only been halted because the bankers got drunk one night and listened to their greed and threw the regulatory governors away on the financial system, which was poorly structured to start with.

However, dear reader, understanding this curve and matching it to the current state of taxation policy will inform you as well as any finance minister of the future condition of the economy.

We have a progressive income tax system, and we have a series of turn over taxes. The latter responds directly to the ebb and flow of the economy, and recently in Canada’s case led directly to the ballooning of governmental revenues and the paying down of deficits for the first time almost in living memory.

However, the progressive nature of the income tax has led to tax creep as incomes have risen. This has also happened elsewhere, including the USA. That is why it is possible for politicians to offer tax cuts every couple of years or so.

To bail us out of the current disaster, the policy calls for strong deficit funding of present capital programs including bailouts and financial infrastructure recapitalization which is clearly falling into place just as fast as possible. It also calls a cut in taxation ahead of the expected economic rebound to give the economy the maximum running room. We can expect a rapid recovery of government revenue surpluses as the economy swings back into motion.

The Oil Problem

The problem we do not control is the price of oil which is draining liquidity out of the North American economy. Much of this is a massive tax on USA business that is not been repatriated in country and is instead sloshing around looking for a home and not all been directly reinvested. We have lived with a lot of this for a long time. What we cannot live with is volatility such as drained the blood out of the country last summer and accelerated the developing crash.

All solutions are ugly. The best solution is to put a ceiling on the amount of money that will be spent on foreign oil. That guarantees shortages and this must be coordinated with a simple rationing system that obviously gives supply priority to industry and transportation. Last on the list will be the private automobile for luxury driving.

A couple of important things happen though. There is a turn over price, becomes a defacto ceiling that everyone recognizes as the point of long term diminishing returns. It should make a run up such as was delivered last summer nearly impossible and certainly far more costly to sustain.

Much more importantly, American Industry will have no choice but to move heaven and earth to replace oil as a secure energy source. The gasoline car will make its exit from the mass market in a couple of years instead of slowly with lots of foot dragging.

And because the USA had so far to go, it becomes the global standard for solutions to the energy problem.

June 1, 2004

The Laffer Curve: Past, Present, and Future

by Arthur B. Laffer
Backgrounder #1765

The story of how the Laffer Curve got its name begins with a 1978 article by Jude Wanniski in The Public Interest entitled, "Taxes, Revenues, and the `Laffer Curve.'"
1 As recounted by Wanniski (associate editor of The Wall Street Journal at the time), in December 1974, he had dinner with me (then professor at the University of Chicago), Donald Rumsfeld (Chief of Staff to President Gerald Ford), and Dick Cheney (Rumsfeld's deputy and my former classmate at Yale) at the Two Continents Restaurant at the Washington Hotel in Washington, D.C. While discussing President Ford's "WIN" (Whip Inflation Now) proposal for tax increases, I supposedly grabbed my napkin and a pen and sketched a curve on the napkin illustrating the trade-off between tax rates and tax revenues. Wanniski named the trade-off "The Laffer Curve."

I personally do not remember the details of that evening, but Wanniski's version could well be true. I used the so-called Laffer Curve all the time in my classes and with anyone else who would listen to me to illustrate the trade-off between tax rates and tax revenues. My only question about Wanniski's version of the story is that the restaurant used cloth napkins and my mother had raised me not to desecrate nice things.

The Historical Origins of the Laffer Curve

The Laffer Curve, by the way, was not invented by me. For example, Ibn Khaldun, a 14th century Muslim philosopher, wrote in his work The Muqaddimah: "It should be known that at the beginning of the dynasty, taxation yields a large revenue from small assessments. At the end of the dynasty, taxation yields a small revenue from large assessments."

A more recent version (of incredible clarity) was written by John Maynard Keynes:

When, on the contrary, I show, a little elaborately, as in the ensuing chapter, that to create wealth will increase the national income and that a large proportion of any increase in the national income will accrue to an Exchequer, amongst whose largest outgoings is the payment of incomes to those who are unemployed and whose receipts are a proportion of the incomes of those who are occupied...

Nor should the argument seem strange that taxation may be so high as to defeat its object, and that, given sufficient time to gather the fruits, a reduction of taxation will run a better chance than an increase of balancing the budget. For to take the opposite view today is to resemble a manufacturer who, running at a loss, decides to raise his price, and when his declining sales increase the loss, wrapping himself in the rectitude of plain arithmetic, decides that prudence requires him to raise the price still more--and who, when at last his account is balanced with nought on both sides, is still found righteously declaring that it would have been the act of a gambler to reduce the price when you were already making a loss.

Theory Basics

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.

Figure 1 is a graphic illustration of the concept of the Laffer Curve--not the exact levels of taxation corresponding to specific levels of revenues. At a tax rate of 0 percent, the government would collect no tax revenues, no matter how large the tax base. Likewise, at a tax rate of 100 percent, the government would also collect no tax revenues because no one would willingly work for an after-tax wage of zero (i.e., there would be no tax base). Between these two extremes there are two tax rates that will collect the same amount of revenue: a high tax rate on a small tax base and a low tax rate on a large tax base.

The Laffer Curve itself does not say whether a tax cut will raise or lower revenues. Revenue responses to a tax rate change will depend upon the tax system in place, the time period being considered, the ease of movement into underground activities, the level of tax rates already in place, the prevalence of legal and accounting-driven tax loopholes, and the proclivities of the productive factors. If the existing tax rate is too high--in the "prohibitive range" shown above--then a tax-rate cut would result in increased tax revenues. The economic effect of the tax cut would outweigh the arithmetic effect of the tax cut.

Moving from total tax revenues to budgets, there is one expenditure effect in addition to the two effects that tax-rate changes have on revenues. Because tax cuts create an incentive to increase output, employment, and production, they also help balance the budget by reducing means-tested government expenditures. A faster-growing economy means lower unemployment and higher incomes, resulting in reduced unemployment benefits and other social welfare programs.

Over the past 100 years, there have been three major periods of tax-rate cuts in the U.S.: the Harding-Coolidge cuts of the mid-1920s; the Kennedy cuts of the mid-1960s; and the Reagan cuts of the early 1980s. Each of these periods of tax cuts was remarkably successful as measured by virtually any public policy metric.

Prior to discussing and measuring these three major periods of U.S. tax cuts, three critical points should be made regarding the size, timing, and location of tax cuts.

Size of Tax Cuts

People do not work, consume, or invest to pay taxes. They work and invest to earn after-tax income, and they consume to get the best buys after tax. Therefore, people are not concerned per se with taxes, but with after-tax results. Taxes and after-tax results are very similar, but have crucial differences.

Using the Kennedy tax cuts of the mid-1960s as our example, it is easy to show that identical percentage tax cuts, when and where tax rates are high, are far larger than when and where tax rates are low. When President John F. Kennedy took office in 1961, the highest federal marginal tax rate was 91 percent and the lowest was 20 percent. By earning $1.00 pretax, the highest-bracket income earner would receive $0.09 after tax (the incentive), while the lowest-bracket income earner would receive $0.80 after tax. These after-tax earnings were the relative after-tax incentives to earn the same amount ($1.00) pretax.

By 1965, after the Kennedy tax cuts were fully effective, the highest federal marginal tax rate had been lowered to 70 percent (a drop of 23 percent--or 21 percentage points on a base of 91 percent) and the lowest tax rate was dropped to 14 percent (30 percent lower). Thus, by earning $1.00 pretax, a person in the highest tax bracket would receive $0.30 after tax, or a 233 percent increase from the $0.09 after-tax earned when the tax rate was 91 percent. A person in the lowest tax bracket would receive $0.86 after tax or a 7.5 percent increase from the $0.80 earned when the tax rate was 20 percent.

Putting this all together, the increase in incentives in the highest tax bracket was a whopping 233 percent for a 23 percent cut in tax rates (a ten-to-one benefit/cost ratio) while the increase in incentives in the lowest tax bracket was a mere 7.5 percent for a 30 percent cut in rates--a one-to-four benefit/cost ratio. The lessons here are simple: The higher tax rates are, the greater will be the economic (supply-side) impact of a given percentage reduction in tax rates. Likewise, under a progressive tax structure, an equal across-the-board percentage reduction in tax rates should have its greatest impact in the highest tax bracket and its least impact in the lowest tax bracket.

Timing of Tax Cuts
The second, and equally important, concept of tax cuts concerns the timing of those cuts. In their quest to earn after-tax income, people can change not only how much they work, but when they work, when they invest, and when they spend. Lower expected tax rates in the future will reduce taxable economic activity in the present as people try to shift activity out of the relatively higher-taxed present into the relatively lower-taxed future. People tend not to shop at a store a week before that store has its well-advertised discount sale. Likewise, in the periods before legislated tax cuts take effect, people will defer income and then realize that income when tax rates have fallen to their fullest extent. It has always amazed me how tax cuts do not work until they actually take effect.

When assessing the impact of tax legislation, it is imperative to start the measurement of the tax-cut period after all the tax cuts have been put into effect. As will be obvious when we look at the three major tax-cut periods--and even more so when we look at capital gains tax cuts--timing is essential.

Location of Tax Cuts

As a final point, people can also choose where they earn their after-tax income, where they invest their money, and where they spend their money. Regional and country differences in various tax rates matter.

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