Republicans Have the Last Laugh About Laffer

“W

ith the election season coming into the home stretch, the cry of ‘Tax cuts for the rich!’ is ringing out across the land from Democrats desperate to regain power in Washington. Like many other political slogans, its popularity depends on slippery words and sloppy thinking.” –Economist Thomas Sowell, Ph.D., in the 2004 election season.

The Congressional Budget Office (CBO) has proclaimed flourishing federal revenues, up approximately $206 billion from this point last year, and there is speculation in the White House that figure will be up to $250 billion by the end of the year.[i] That nine-month increase represented the second-highest growth rate (13%) in the past twenty-five years;[ii] four to five times the inflation rate.[iii] Amid an ever-gloomy economic prognosis from liberal economists since the Bush tax cuts, why are we seeing tax revenues soar? Republicans are quick to take credit with their 2001 and 2003 tax cuts, and, in part at least, rightfully so. Democrats simply point out that tax receipts are barely back to 2000 levels, claim the long-term situation is dismal, and quickly shift over to the obvious fact that there’s still a significant deficit.[iv]

There are two questions everyone is asking. Why on earth would revenues be soaring after tax cuts? And, how could a deficit actually get trimmed in a Congress spending more on pork-barrel projects than Richard Branson spends on space trips? In order to answer the first question, we need to look at an economic theory regarding the effect of tax rates on tax revenues called the “Laffer Curve.” Named after one of Reagan’s economic advisors who popularized the idea in America, Dr. Arthur B. Laffer, the curve doesn’t actually say if tax rate cuts will or will not increase revenue. Rather, it explains there are two consequences of tax rates, arithmetic and economic.[v] The arithmetic effect is simply the revenue in taxes per dollar received. The economic effect, however, is the crux of the conservatives’ idea. It takes into account spurred economic productivity of lower taxes. As is obvious, with supplementary post-tax capital, people can invest, save, hire, and purchase more than without such economic benefits. As long as the income tax rate is in the “prohibitive zone,” or higher than what will maximize economic productivity and revenue, the government can cut rates without significant losses to receipts. Evidence suggests in some circumstances revenues can even increase after cuts.

The arithmetic and economic effects will always be opposite, according to the theory. Ideally the economic effect would cancel out the impact of the arithmetic effect, allowing significantly lowered taxes (improving the economy) without sacrificing significant tax receipts. There are three major historical examples to consider in an analysis: the supply-side tax cuts under John F. Kennedy, the rate cuts under Ronald Reagan, and George Bush’s 2001 & 2003 rate cuts.

At the onset of the Kennedy Administration, the highest tax bracket had a well established 91% personal income tax rate, a peak of the steady climb to fund WWII and social income redistribution programs. In other words, a businessman in the top tax bracket would profit nine cents on every dollar earned. If he or she were to invest that remaining 9%, they would not only pay personal tax on the original acquisition, but also corporate income tax prior to a surplus being collected, and personal income tax on that surplus. Undoubtedly, economic stimulus lags significantly under such an anti-business atmosphere. In a 1963 White House Economic Report, the Kennedy Administration made its position clear:

“Tax reduction thus sets off a process that can bring gains for everyone, gains won by marshalling resources that would otherwise stand idle--workers without jobs and farm and factory capacity without markets. Yet many taxpayers seemed prepared to deny the nation the fruits of tax reduction because they question the financial soundness of reducing taxes when the federal budget is already in deficit. Let me make clear why, in today's economy, fiscal prudence and responsibility call for tax reduction even if it temporarily enlarged the federal deficit--why reducing taxes is the best way open to us to increase revenues.”[vi]

Posthumously, in 1965 Kennedy’s vision was fulfilled. Congress enacted substantial tax rate cuts. Not only was there more money in American’s pockets,[vii] resulting in the incentive to trade, hire, and invest bolstered; but also something happened that surprised many. Federal income tax (FIT) revenue jumped. From 1961 to 1964, the mean increase in FIT revenue was 2.1%. From 1965 to 1969, the mean increase in FIT revenue was a whopping 8.6%, well above the CBO projections.[viii] US Department of Commerce statistics, demonstrated by the Heritage Foundation, clearly show significantly higher real GDP growth and significantly lower unemployment after the cuts.[ix] This left many critics scrambling to reformulate arguments.

A similar scenario unfolded in the Presidency of Ronald Reagan. He had long asserted that small-business owners, companies, and everyday workers where damaged by absurdly heavy income taxes. August 1981 marked the time when one of Reagan’s legacies was signed into law. The Economic Recovery Tax Act (ERTA) hacked off a quarter of the marginal earned income tax rates across the board. The economy under Jimmy Carter was faltering, being in the midst of the inflation explosion of the 1970s, growing unemployment, and real GDP growth that had stalled to 0.9%. Starting at 1983 (when Dr. Laffer claims the “bulk of the cuts” were in place) the choked economy began to see exceedingly high real GDP growth (a jump from 0.9% to 4.8%), and what had been shrinking returns turned into growing revenue.[x] Reagan’s supply-side economics created 18.6 million new jobs in the 1980s, and provided an economic stability that hadn’t been seen for a notable time. Once again, the evidence strongly points toward positive fiscal ramifications from tax cuts.

Hence, we’re back where we started- the George W. Bush tax cuts. Before noting our current situation, it is worth noting that President Bill Clinton had significant tax rate increases for upper brackets in 1993. The effects of this hike were felt in foreign trade, among other things. As the Institute for Policy Innovation noted in 2002, “The Clinton tax reform of 1993, which increased progressivity of personal income tax rates, raised marginal rates and the tax wedge American goods and services must suffer in increasingly competitive world markets. The New Economy information market boom has masked the growing competitive disadvantage of the United States in the far larger Old Economy markets, as witnessed by the balance of trade hemorrhage.”[xi]

Congruent with the anticipation of Laffer-style economists, we’re seeing a similar impact from the Bush tax cuts that were seen with the Kennedy and Reagan cuts. The GDP growth in the 2003 third quarter was the best since Reagan left office. Since the cuts, unemployment has plummeted (now at historically pleasing levels), and business investments are doing well.[xii] That leaves the problem liberals relentlessly demean as the curse of “tax cuts for the rich”— fear of tax receipts nose-diving. As The Wall Street Journal remarked, “For all of fiscal 2005, revenues rose by $274 billion, or 15%. We should add that CBO itself failed to anticipate this revenue boom…. Maybe its economists should rethink their models.” The Journal went on to point out that revenues as a share of the economy are now anticipated to be above the modern historical average this year.

Though the prime objection is that the long term is bleak, the economic effect of the Laffer Curve should kick in for the long-term—as long as tax rates don’t increase. Some indications show we may still be in the prohibitive zone, as rates are still considerably higher than during Reagan’s administration.[xiii] Democrats opposing making these beneficial cuts permanent claim they dislike tax hikes, they merely advocate the reversal of tax cuts. Anyone with the IQ of a pencil knows that means tax rates would be higher than what they are today.

It appears Bush may in fact come through on at least one of his campaign promises, the idea that he would “cut the deficit in half.” Democrats may indeed be correct when they object to the White House deficit predictions, claiming they were inflated to come through on the nearly forgotten promise. Nonetheless, the booming economy, likely bolstered by tax cuts, has provided steady deficit reduction since the all-time high of 2004. The national deficit and debt still remain as ominous behemoths of economic terror. Non-defense spending across the board, particularly pork-barrel projects, must be extensively reduced to have an acceptable budget. Beneficial as they may be, tax cuts aren’t an alternative to genuine tax reform. America still needs to adopt the Fair Tax or the Flat Tax to have a long-term tax solution. For the time being, the tax cuts stand as a sign of economic freedom for the American people, a boost to the business world, and stable or increased revenue for the government. Perhaps Dr. Sowell was right, and those incessantly chanting about “tax cuts for the rich” should come up with a November slogan that isn’t based on sloppy thinking.

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[i] Edmund L. Andrews, “Surprising Jump In Tax Revenues Is Curbing Federal Deficit,” The New York Times, July 8, 2006

[ii] Ibid

[iii] “Revenues Rising,” The Wall Street Journal editorial, July 12, 2006

[iv] See, e.g.: Center for Budget and Policy Priorities, “Claim that tax cuts pay for themselves is too good to be true,” updated July 12, 2006

[v] Arthur B. Laffer, Ph.D., “The Laffer Curve: Past, Present, and Future,” The Heritage Foundation, June 1, 2004

[vi] Ibid

[vii] David Hartman, “Does Progressive Taxation Redistribute Income,” Institute For Policy Innovation Center for Tax Analysis, February 12, 2002

[viii] See note 5

[ix] US Dept. Comm. economic stats for 1960-1968 in Heritage Foundation graphic illustration: http://www.heritage.org/Research/Taxes/images/58872464.gif

[x] US Dept. Comm. Economic stats for 1978-1986, showed in Heritage Foundation graphic:

http://www.heritage.org/Research/Taxes/images/table7.gif

[xi] See note 7

[xii] Daniel J. Mitchell, Ph.D., “Taxes: Facts and Figures,” Heritage Foundation, Issues 2006

[xiii] Thomas E. Nugent (executive vice president and chief investment officer of PlanMember Advisors, Inc.), “It’s tax cut time, once again,” National Review Online, July 14, 2006