The Limits to the Laffer Curve

Question: would you work 30% harder if you got a 233% pay raise? OK, how about 40% harder if you got a 67% pay raise? Very well, how about 13% harder for a 7.6% pay raise?

These questions illustrate the power of the Kennedy tax cuts, the mixed results of the first round of Reagan tax cuts, and the fiscal disaster which was the Bush tax cuts.

The Kennedy tax cuts took the top tax rate from 91% down to 70%, the take home rate for money in the top bracket went from 9% to 30%. 30/9 = 3.33, a 233% increase! Meanwhile, the government receipts on money in this bracket went down by factor of 70/91 = .77, a mere 23% decrease. For the government to break even, top tax bracket money had to increase by 91/70 = 1.3, a 30% increase.

For the first round of Reagan tax cuts, the top rate went from 70% to 50%. This increased the take home rate from 30% to 50%, a 67% increase. Nice, but not nearly as dramatic as the effect of the Kennedy cuts. The pain factor to the government, conversely, was higher: 50/70 = .71, a 29% loss. For growth to make up the loss, top bracket earners had to earn a factor of 70/50 = 1.4 times more, a 40% increase. People are still debating the effect of the Reagan cuts. Deficits exploded. Reagan himself signed some large tax increases into law in order to partially plug the leak. Then again, Reagan was in the process of winning the Cold War and Paul Volker was continuing the tight money policy in the midst of recession which cost Carter the election. We don’t have a controlled experiment, so the debate will continue.

For the Bush tax cuts, the top rate went from 39.6% down to 35%. The take home rate for those in the top bracket thus went from 60.4% to 65%. 65/60.4 = 1.076, a mere 7.6% increase. The pain factor to the government, however, was 35/39.6 = .884, an 11.6% loss. To make up for the loss, those in the upper bracket would need to increase their taxable income by a factor of 39.6/35 = 1.13, a 13% increase. My intuition tells me that this is a prescription for lost tax revenue. That’s intuition, not hard proof. Proof requires knowing people’s marginal desire for more money vs. leisure as a function of take home pay/income. It also requires knowledge of the cost of various tax avoidance maneuvers.

The only true proof is controlled experiment, which we do not have. But we do have some uncontrolled experimental data.

Tax Receipt Data

To get some feel for the effect of supply side tax cuts, I used the Bureau of Economic Analysis interactive data for Federal government receipts and expenditures. (You will have to click a few buttons from this link to generate the table I used. There is no direct link.) I put the data into a spreadsheet and added a column for yearly average Consumer Price index from the Bureau of Labor Statistics. I renormalized the columns (rows in the BEA tables) for “Current tax receipts” (does not include Social Security taxes) and “Net federal government saving.” (It is unclear what the difference is between “Net federal government saving” and “Net lending or net borrowing” is. I leave it up to the reader to dig up the difference.) The result is this chart:

Tax money flowed to the Treasury quite nicely after the Kennedy tax cuts. The Reagan years were far less impressive in this regard: a dip followed by a recovery to eventual net growth. Bush gave us a deeper dip in tax revenue followed by the Great Recession. Now look at the Clinton Years: a huge growth in tax receipts producing a momentary budget surplus. The Clinton tax increases do not disprove the Laffer Curve Theory – the top tax rates under Clinton were still lower than when Reagan took office – but they do suggest that Clinton came closer to the maximum of the Laffer Curve than we have had since the Bush tax cuts.

(Advocates of smaller government may take offense at my treating tax revenues to the Treasury as a good. I am sympathetic – to those who truly want smaller government. But surging the Cold War (Reagan) or fighting two wars in Asia and adding an entitlement (Bush) are not examples of smaller government. I leave it to the reader to decide the merits of these expensive policies. But if they were worth doing, they were worth high taxes to pay for them.)

Debt Reduction Requires Higher Taxes

When taxes are extremely high, tax cuts provide huge incentives with little cost to the government. We can expect supply-side tax cuts to work, and history appears to back up this assumption. As rates diminish, tax cuts cost the government more for each percentage point drop while providing less relative incentive for taxpayers to earn more. At some point tax rate cuts cost the government money. Clinton boosted the top tax rates, and we briefly experienced a budget surplus. Bush rolled back those tax increases and deficits ballooned. While this is not a controlled experiment by any means, both theory and data indicate that Clinton was closer to the Laffer Curve maximum than Bush was.

Republicans who call for yet further tax cuts are being irresponsible, as irresponsible as the liberals who call for stimulus programs. Without budget cuts in the Ron Paul wish list range, we need tax increases, not tax cuts. Yes, these increases should come more from loophole closures than rate increases, but maybe we should tax Warren Buffet more than his secretary.

This is not to say we have no opportunities for Supply Side magic. We’ll have a look at some special cases in a future article. But in general the low-hanging Supply Side fruit has been picked. To robotically call for further tax cuts in the face of ballooning deficits is to rely on Santa Claus to solve our economic problems.

It’s time to grow up. Santa Claus does not have room on his sleigh for all the dollars needed to balance the budget.