David R. Henderson  

More on Supply-Side Economics

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On yesterday's post, Bob Murphy asks:

David, what exactly do you mean by saying tax rate cuts didn't increase revenues? Tax revenues did in fact go up (eventually), right?
So I assume you mean they didn't go up more than we would have predicted in the absence of the tax rate cut.
But then we get into a really complicated alternate universe. For example, what if the economy didn't grow nearly as much in the 1980s if Reagan had kept marginal income tax rates really high?
I am presumably biased since I worked for Arthur Laffer and saw dozens of his papers making (what appeared to be) very persuasive cases that the Laffer Curve is alive and well.

What I meant was that tax revenues were lower than otherwise, that is, lower than they would have been. The best study I know of this is Larry Lindsey's book, The Growth Experiment. The academic article on which a major part of this book is based is his article in 1987 in the Journal of Public Economics. It's gated and Elsevier is charging an outrageous price for it. But the bottom line is this sentence from the Abstract:
Comparison of this baseline [his term for Bob Murphy's alternate universe] with actual tax return data shows that at least one-sixth, and probably one-quarter, of the revenue ascribable to the rate reductions was recouped by changes in taxpayer behavior.

I agree that the Laffer Curve is alive and well. It has to be correct. That is, at a zero tax rate, tax revenues would be zero and at a 100% tax rate, perfectly enforced, tax revenues would be zero. When the rate rises from zero, revenues rise from zero. Voila: a Laffer Curve. The real question is where we are on the Laffer Curve. Larry did find, by the way, that the cut in the top income tax rate from 70% to 50% did generate higher revenue than otherwise. So the highest-income people were in the prohibitive region of the Laffer Curve.

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COMMENTS (11 to date)
N. writes:

That's fine, but immaterial if one's aims are to punitively punish the rich for being rich.

fundamentalist writes:
Larry did find, by the way, that the cut in the top income tax rate from 70% to 50% did generate higher revenue than otherwise.

I don't get it. If a reduction from 70 to 50% generated higher revenue, then "

what exactly do you mean by saying tax rate cuts didn't increase revenues?
"? since wealthy people pay most of the taxes, there must have been a substantial increase in revenue.

one-quarter, of the revenue ascribable to the rate reductions was recouped by changes in taxpayer behavior.
I'm not certain what he meant, but it seems like he is saying that the Laffer curve worked because people changed their behavior, which is exactly what the Laffer curve predicts.

Still, as Henderson points out, that doesn't mean we are still on the negative slove side of the curve. Based on the failure of Bush II's tax cuts, we are now at the top or to the left of the top of the curve on the upward slope. Tax cuts don't work forever.

Still, I have seen impressive research that shows the optimum total tax (federal, state and local) to be around 25% of GDP, about twice what we have today. Cutting all taxes in half could generate twice the growth in real gdp, but it still might reduce tax revenue.

Chris Koresko writes:

When I read arguments about where we are on the Laffer curve, it sometimes seems as if people are forgetting that maximum tax revenues may not be a good thing. Isn't maximizing public well-being, which is presumably more correlated with economic growth than with tax revenues, a more sensible goal?

Tom Dougherty writes:

If someone could get the data then this could be cleared up. But going on memory, which might be faulty, didn't income tax revenues go down after the marginal rate reductions? And wasn't there a huge tax increase in the early 80s to pay for social security that caused tax revenues to increase? My point being that although tax revenues went up this was due to an increase in payroll taxes and not due to the income tax rate reductions.

And wasn't the argument regarding income tax rate reductions paying for themselves was that although the income tax revenues would decrease they would not decrease as much as static analysis would suggest because of the additional economic activity generated by the lower marginal rates.

David R. Henderson writes:

fundamentalist, Chris Koresko, and Tom Dougherty,
Virtually all of your questions are answered in Lindsey's book.

Nick writes:

Mankiw did some work in this area which can be found here

His quote on the subject was something to the effect of: Tax cuts aren't a free lunch, but the lunch is cheaper than you might think.

English Professor writes:

Years ago I clipped a page from the NYT with a graph of tax receipts from 1980 to 1993 (NYT, national ed., March 19, 1993, p. A9). I assume these are gross receipts, including corporate tax, payroll tax, etc. Here are the gross figures:

1980: 517b
1981: 599b
1982: 618b
1983: 600b
1984: 666b
1985: 734b
1986: 769b
1987: 854b
1988: 909b
1989: 991b
1990: 1,031b

You can see the drop for 1983. I don't recall when the SocSec reform increased revenues from the payroll tax. I also assume that these figures are NOT corrected for inflation.

I have read Lindsey's book and admire his work. But it seemed to me to be overly generous to the pre-tax-reform status quo: that is, (if I remember correctly) Lindsey estimated the baseline (old economy) tax revenues for each post-reform year. That is, he projected how much income the OLD tax rates would generate if they were applied to the income from the NEW (i.e., post-reform) economy. But the old tax rates would have damped the economic activity somewhat, so the estimates for the take from the old tax structure are overblown. That suggests that the cuts would have had an even greater effect than he could demonstrate. And I suspect that over the long haul--that is, if you carried it all the way into the Clinton years, even with the Bush and Clinton tax increases--the dynamic effects of the cuts did much more good than even his analysis suggests.

Henry writes:

The problem with the way the Laffer Curve was sold is that it could be painted as a failure if tax revenues did not increase, even in situations which most people would label as "increased social welfare".

For instance, tax revenues could decrease, but the people affected by the marginal spending cuts may have seen their after-tax incomes rise due to the tax cuts and/or additional economic growth they resulted in.

A weaker result might be some people being very slightly worse off monetary wise, but others are made much better off. I do not think most people would believe in a Rawlsian (maximin) social welfare function - they probably put some weighting on the welfare of the rich.

Ted Craig writes:

"Larry did find, by the way, that the cut in the top income tax rate from 70% to 50% did generate higher revenue than otherwise."

Andrew Mellon made this argument to Congress 75 years ago.

Bob Murphy writes:

Andrew Mellon made this argument to Congress 75 years ago.

I can't tell if you're being ironic or just plainly stating a fact. But you're right, they cut income tax rates in the 1920s, and (eventually) tax revenue went way up while Coolidge had budget surpluses every year of his administrations.

I give the chart in this paper.

Note that this isn't decisive. One could argue for example that it was Fed policy that (a) caused a stock market bubble and (b) pumped up tax revenues in the late 1920s.

But as my comment with David was meant to reinforce, I want to make sure everyone knows that in an absolute sense, tax receipts DID go up after the Reagan tax rate cuts. There are a lot of people who blame the "Reagan deficits" on his "tax giveaways to the rich," which reinforces the idea that total tax receipts were lower in 1988 than in 1981 which is obviously wrong.

One last thing: David is right that whether or not revenues increased after the Reagan tax cuts, the "Laffer Curve" per se would be valid. I apologize for contributing to that misconception.

Believe it or not, Laffer NEVER said that every tax rate cut leads to an increase in revenue. I had thought he said that too, but believe me I went through dozens of his papers (for other purposes) and never saw him saying that.

His main point (as someone mentioned above) was always that the possible drop in revenue would always be less than the static analysis would indicate, and in some cases could even be negative (i.e. revenues could go up).

I will have to defer to your endorsement of the book, David, but I have seen other econometric tests and I think their model of economic growth is wrong. In other words I think they downplay the retarding effects of high tax rates, which means their baseline estimates of tax receipts are too high.

joe calhoun writes:

I'll go one better than Ted Craig. John C. Calhoun described the "Laffer Curve" when he argued against a tariff bill on the floor of the Senate August 5th, 1842:
"On all articles on which duties can be imposed, there is a point in the rate of duties which may be called the maximum point of revenue-that is, a point at which the greatest amount of revenue would be raised. If it be elevated above that, the importation of the article would fall off more rapidly than the duty would be raised; and, if depressed below it, the reverse effect would follow: that is, the duty would decrease more rapidly than the importation would increase. If the duty be raised above that point, it is manifest that all the intermediate space between the maximum point and that to which it may be raised, would be purely protective, and not at all for revenue. Another rule remains to be laid down, drawn from the facts just stated, still more important than the preceding, as far as the point under consideration is involved. It results from the facts stated, that any given amount of duty, other than the maximum, may be collected on any article, by two distinct rates of duty-the one above the maximum point, and the other below it. The lower is the revenue rate, and the higher the protective; and all the intermediate is purely protective, whatever it be called, and involves, to that extent, the principle of prohibition, as perfectly as if raised so high as to exclude importation totally."

There are plenty of examples that go back to ancient times but it's too late to dig them out now. The idea of the Laffer Curve is very, very old.

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