Pre-Laffer Assumption - Tax Revenue Increases Proportionally With the Tax Rate

Here’s the second of two posts inspired by the super-committee’s failure to report any results just before Thanksgiving. Committee members did report that differences over tax reform and tax rates blocked progress on a budget package members of both parties could back. The interesting thing about this debate is that the media did not come to grips with the logic that underlies disagreements about tax reform and tax rates. Republicans believe that lowering tax rates will increase tax revenues, or at least leave revenues largely unchanged. The surest way to reduce revenues, they believe, is to raise rates. Democrats believe the opposite: the surest way to raise revenues is to increase tax rates. A reduction in tax rates equals a reduction in tax revenues for Democrats.

The Laffer curve underlies the Republicans’ logic about tax rates and revenues. A single straight line proceeding up and to the right underlies the Democrats’ logic. I have not surveyed the economic literature on this question, and I have to say I would not have that much confidence in economists’ findings if I did. Usually findings in the academic journals find their way into public debate, especially if they are compelling or if they agree with one or another political position. No findings about the Laffer curve or the single straight line have emerged in public debates about taxes. You’d almost think these two models about the relationship between tax rates and revenues don’t exist. These irreconcilable models drive our public debate on this subject, yet we don’t acknowledge them.

The Republicans want to lower rates, whatever the impact on revenues. The Democrats want to raise revenue, whatever the impact on rates. Interestingly, the two parties don’t even agree about whether current tax rates are high or not. Democrats look at income tax rates, and argue that they are historically low. No doubt about that: you go back to the fifties and you’ll see marginal income tax rates so high they would make your hair stand on end. The Republicans look at the overall tax burden that business firms and workers carry, and they see a proportion of money going to governments that is way above the twenty-five percent that has historically marked the threshold between healthy economies and troubled ones.

Classic Laffer Curve - Maximum Tax Revenue Occurs When the Tax Rate is Fifty Percent

Republicans want to get us back down to twenty-five percent. Democrats respond that citizens would never tolerate the deficits and benefit cuts that would accompany tax rates that low. In fact, American citizens have tolerated fairly high tax rates in exchange for public benefits. The Tea Party has said, no more. The Democratic party, especially with health care reform, said yes, more – more benefits and more taxes to support them.

Let’s take a closer look at the Laffer curve. Reagan and his revolutionaries embraced Laffer’s logic. The Democrats laughed at it, then ridiculed it. The Kennedy tax cuts in the early 1960s did in fact increase federal tax revenues, however, so ridicule and laughter do not make the Democrats’ case so well. If they want to assault this model, they should do so with some logical rigor. Clear evidence about the relationship between tax rates and revenues is in fact not that easy to collect. We have a lot of governments, a lot of tax revenue streams, a lot of rates, and a long period of history to study. The empirical side of this question is not simple.

Laffer’s logic is simple and compelling. Let’s consider one tax rate and one revenue stream. Think of it as a sales tax on beans if that helps. We know that when the tax rate is zero, revenue is zero. We know that when the tax rate is one hundred percent, revenue is zero. No one in private business would produce, buy, or sell beans if the government took all the proceeds. Lastly, we know that when the tax rate is between zero and one hundred percent, revenue from the tax is some positive number. Therefore the relationship between the tax rate and tax revenue between zero and one hundred had to look like an upside down bowl. Or maybe a two-humped camel. Or perhaps a gun barrel. It could even look like a steady line up and to the right, until it drops back down to zero at 99.9 percent.

Alternate Laffer Curve - Maximum Tax Revenue Occurs When the Tax Rate is Seventy Percent

That tells you something. The logic behind the Laffer curve is compelling, but we don’t actually know the shape of the curve. Collecting real data to discover its shape is devilishly difficult. You know that’s so because if it were easy and the findings were conclusive, someone in the Republican party would have those findings translated into talking points and we would never hear the end of it. We don’t even know if the shape of the curve depends on what kind of tax we’re talking about. The same person who might buy a house where property taxes are high might quit working if the income tax rate is high, or might quit investing if the capital gains tax rate is high.

Let’s say we can figure out the actual shape of the curve, form fitted to take into account the variations that may exist among different taxes. Suppose revenues max out at a twenty-five percent rate, and decline after that. The Republicans are in heaven. Now suppose revenues max out at seventy-five percent, then decline as you move toward one hundred percent. Now the Democrats are loving it. That shape gives them much more room to pile on benefits and pay for them. You know that Republicans will oppose a rate that goes much above thirty percent, no matter how much revenue it raises. If you try to take their money, they’ll say Taxed Enough Already.

If the Democrats are wrong about their line that goes steadily up and to the right – that is, if revenues go down when we increase taxes – we make a big mistake if we raise rates in the current situation. If the Republicans are wrong about the Laffer curve – that is, if revenues actually do continue to increase when you increase the rate – they may have some ‘splaining to do. I think revenues probably do peak when local, state, and federal governments’ total take is about twenty-five percent. After that taxes begin to eat away at productive activity. Right now we are so far above a twenty-five percent total I don’t care to contemplate it.

Kindergartner's Laffer Curve - Layman's Best Guess About Tax Revenues for Rates Between Zero and One Hundred Percent

It’s just a gut feeling, though. I can’t show that twenty-five percent is the magic number for the total tax rate. Nor can I show how much revenue we are sacrificing because the total tax rate has crept up toward fifty percent over these many years. We know that employers have willingly shed workers in order to shed the financial burden of keeping them on, even though cutting employees generally means cutting profits as well. We know that small businesses have difficulty starting up and expanding in an environment where hiring new workers is so expensive. We can’t measure the amount of economic activity we forego because the total tax rate is so high. We can only lower the rate to see what happens.

We know from a few decades of experience that we are not going to see lower tax rates. We hear about the Bush tax cuts again and again, but that is one modest, temporary reduction in one tax. If you focus on one thing, you wind up distracted from other things. To add up the total tax burden in our economy is one depressing exercise. I stopped doing it a long time ago. The total take by local, state, and federal governments has not subsided since I stopped.

If you feel the super-committee let us down, consider this idea. We are going to have to proceed on principle here. Neither party can persuade the other based on convincing data about the relationship between tax rates and revenues. Even if you consciously rule out the complexity one encounters in arguments about taxes, you cannot sufficiently simplify the arguments in this case if you try to collect comprehensive data. You cannot hold other variables constant when you try to measure the impact of rate reductions or increases on revenues. Because taxes operate in such a complex environment, conclusions you draw about the relationship between rates and revenues are open to challenge from some quarter.

Consequently people eventually have to choose between small government with low taxes, or large government with high taxes. We could go for something in between, but no one is talking about compromise right now. From the 1930s on, we have embraced government benefits. We haven’t felt so comfortable about the cost, but we have consistently settled for gradually increasing taxes in order to pay for public benefits. Ask anyone who has voted for a bond issue to fund a local library or a new school, knowing how much it will add to property taxes in the near term. People are willing to pay.

Until now. The tax revolt has begun. The revolt comes when we have big government deficits at all levels. The deficits make people anxious. We want to address them, but we’re not sure how. We want our leaders to address them, and they clearly don’t know how. We need better leaders and better discussions. Where we’ll find better leaders is open to question. Meantime, we can improve our discussions if we’re more explicit about the mental models we use to analyze tax issues.