Give Back that PhD!

Charles Wheelan (PhD and all), has written article debunking one of the most outlandish ideas in economics. No, he hasn’t gone after somebody like Karl Marx and the labor theory of value. No, he hasn’t gone after the idea of anarcho-communism. Instead he has decided to go after the Laffer curve. Boy what a laffer…I hate that joke.

What I find absolutely amazing is all that is wrong with Wheelan’s article. Right off the bat Wheelan is wrong,

Economist Arthur Laffer made a very interesting supposition: If tax rates are high enough, then cutting taxes might actually generate more revenue for the government, or at least pay for themselves.

In a word, no. The reason that the Laffer curve is called the Laffer curve is that Arthur Laffer, according the the “legend” expressed the idea at a lunch (or dinner) on a napkin. Those present, I believe Jude Wanniski was one of people in attendance, were struck by the description and started calling it the “Laffer” curve. The name stuck.

However, the idea of the Laffer curve is far older than Laffer. I recall in an economics course somewhere one of my professors mentioning that John Maynard Keynes was aware of the concept. President John F. Kennedy basically described the concept when he proposed his tax cuts.

In short, it is a paradoxical truth that tax rates are too high today and tax revenues are too low and the soundest way to raise the revenues in the long run is to cut the rates now. The experience of a number of European countries and Japan have borne this out. This country’s own experience with tax reduction in 1954 has borne this out. And the reason is that only full employment can balance the budget, and tax reduction can pave the way to that employment. The purpose of cutting taxes now is not to incur a budget deficit, but to achieve the more prosperous, expanding economy which can bring a budget surplus.

According to Wikipedia, the Laffer curve was discussed in some form by,

  1. John Maynard Keynes,
  2. Frédéric Bastiat,
  3. Ibn Khaldun,
  4. Alexander Hamilton,
  5. The 19th century constitution of the Confederate States of America

The basic idea is quite sound. Here is a picture of an idealized Laffer curve. When the tax rate is 0%, it is axiomatic that the tax revenues will also be 0. Further, when the tax rate is 100% it can easily be derived from the axioms of neo-classical economics that tax revenue will also be 0. We also know that tax rates are bounded between 0 and 100% (or 1). Hence it follows that tax revenues will reach at least one peak inside the range of 0 and 1.

The idea is that chances are we are not going to be at the peak. Further, if we are to the “right” of the peak, then we can raise tax revenues by decreasing taxes. In fact, if we are to the right of the peak, then there exists another tax rate t* that is less than the current tax rate that will raise exactly the same amount of revenue.

Now, there are issues with the Laffer curve when formulating policy. The big problem is that we don’t know the shape of the curve, nor do we know what the maximum is. Hence it really isn’t much help in setting some sort of “optimal” tax rate in the sense of maximizing tax revenues. Further, if it happens that we are in fact to the “left” of the maximum then lowering the tax rate will only lower tax revenues.

And from here things just get worse for Dr. Wheelan,

But here’s the problem when we take Laffer’s theory and try to apply it in the U.S.: We don’t have a 99 percent marginal tax rate. Or 70 percent. Or even 50 percent. We start with low marginal tax rates relative to the rest of the developed world. (Yes, I understand that it may not feel that way after the check you wrote last month.)

Actually there have been periods when the marginal tax rate has been very high (link–pdf). Dr. Wheelan notes that cutting the top marginal tax rate from 36% to 33% isn’t a big deal. While he is likely correct, this isn’t a flaw with the idea of the Laffer curve. In fact, the good Dr. has already conceded that the theory is correct. Frankly, at that point how he can go on and try to make the case that this idea is hair-brained is indicative that perhaps the one who actually hair-brained is Dr. Wheelan.

Here is the nut of Dr. Wheelan’s argument,

So why does Laffer’s sketch on Dick Cheney’s cocktail napkin rank near the top of my list of bad economic ideas? Because, when applied to the U.S., it’s intellectually dishonest. The Laffer Curve offers the false promise that we can cut taxes without making any sacrifice on the spending side, and that’s simply not true. It’s the economic equivalent of arguing that you can lose weight by eating more.

No Dr. Wheelan, the idea isn’t dishonest just like the idea that demand falls as prices increase isn’t dishonest. What is dishonest is how the idea is used or more accurately misused by some. To Dr. Wheelan the idea itself is bad; how it is used is irrelevant. I find this view to be anti-intellectual and something I’d expect from a primitive savage, not somebody with a PhD.

FILED UNDER: Economics and Business, , , , ,
Steve Verdon
About Steve Verdon
Steve has a B.A. in Economics from the University of California, Los Angeles and attended graduate school at The George Washington University, leaving school shortly before staring work on his dissertation when his first child was born. He works in the energy industry and prior to that worked at the Bureau of Labor Statistics in the Division of Price Index and Number Research. He joined the staff at OTB in November 2004.

Comments

  1. John Burgess says:

    Academia eats its young…

  2. MrGone says:

    The most recent analysis of the lower tax/lower higher revenue debate. It shows that while in theory, laffer should work, in practice it appears to have the opposite effect. The government ends up spending more.

    http://www.washingtonpost.com/wp-dyn/content/article/2006/05/07/AR2006050700924.html

  3. Steve Verdon says:

    Mr. Gone,

    The problem I have with articles like that is that the Laffer curve says nothing about spending. A broader theory that incorporates expectations, incentives and the Laffer curve might provide such explanations.

  4. yetanotherjohn says:

    You raised some of the key points on Laffer’s curve, but there are more.

    Nothing says the curve is fixed. The response to taxes predicts changes in perception and behavior. Raising the tax rate to 100% only produces 0 taxes if the people stop working (which is the logical thing to do overtly, though not starving would actually move them to find non-taxable ways to support themselves).

    Further, there is nothing that says the curve must be smooth and uniform. It would make sense that as you get to either end an incremental change in tax rate would have less effect than a the same magnitude change in the middle. Or to put it another way, a move between 90% and 99% would likely to have little change as few would find it worthwhile to work at 90%. A change from 10% to 1% would have a huge impact on taxes raised, but likely would not spur many to enter the market. But the same 9% change in either direction from say 50% tax rate would likely have a much larger impact on encouraging or discouraging people to labor at tax producing work (and of course tax revenues).

    Third, the arguments that tax cuts don’t pay for them selves tend to hold GDP growth constant and ignore other real world events like what is happening in other countries. If you think of taxes in terms of percent of GDP confiscated for spending by the government, then changes in the tax rate will have a short term impact on the amount of GDP confiscated. But it is likely to also have a medium and long range change on the growth of the GDP. So taking 9% of a GDP of 12 trillion will bring in more revenue than taking 10% of a GDP of 10 trillion.

  5. Tano says:

    I think you are doing an unfair hit job on Whelan. He understands the Curve perfectly well. His objections are to its use by the right – which comes with the unshaken and unquestioned assumption that we are permanently on the right side of the curve, and that therefore, reducing taxes will ALWAYS lead to increased revenues.

    While few might actually spell out such a claim explictly, that is the effect of listenting to republican discussion of this issue. Whenever tax cutting is the topic of debate, there is a reflexive appeal to the LC to “prove” to those “idiotic libruls” that lowering rates is, obviously, the wise thing to do. Never in history has any republican tried to articulate a reason for believeing that we are on the right side of the curve. And the empirical evidence (lowered revenues following tax cuts) that demonstrates that we probably have been on the left side of the curve for some time, is ignored.

    Of course there are more problems. THe curve, as admitted here, is a theroretical idealization. We have no idea if the real world relationships follow such a simple curve. And also, of course, the situation is dynamic. And there are a huge number of factors which effect acutal revenue yields, or effect economic growth.

    As an absurdly simplified graphic meant to illustrate a valid theoretical relationship, but used in an utterly dishonest and unprincipled manner to support flawed policies, I think it does qualify as one of the worst ideas in the politico-economic arena.

  6. Another big problem with the Laffer curve argument is that is premised on the belief that the primary goal of tax policy ought to be to maximize government revenue, a premise that should turn the stomach of anyone who believes in limited government.

  7. floyd says:

    if one dollar was collected by each taxing body each week, it would be barely worth going to work.federal tax rates are important, but real estate tax has made property ownership obselete.why does it cost more to govern the average family than it takes for them to live decently.government today simply costs more than it is worth. especially public schools.