Tuesday, June 24, 2008

Taxes, Part 3-The Laffer Curve and Goldilocks

I'm a supply-sider. That means (among other things), that JFK's tax cuts in the 1960s, Reagan's tax cuts in the 1980s, and (to a lesser extent), Bush's tax cut of 2003 all stimulated the economy. The result, put simply, is that the government took a smaller slice of a bigger pie. In all three cases, total revenue eventually went up. I know that Clinton raised rates in the 1990s and the pie got bigger then, too. But I tend to give most of the credit for that incredible economic boom to this little invention called the internet... I believe that the Clinton growth happened in spite of the tax hikes, certainly not because of them. However, just because I think these three tax cuts "worked," it does not logically follow that EVERY future tax cut would work the same. The reason why can be found in the Laffer Curve.

The Laffer Curve (above) is the supply-side model in simple form. What it basically says is that at 0% tax, there is 0% revenue. And at 100% tax, there is a 100% disincentive to go to work, so there's also 0% revenue. On the bottom (unshaded) part of the curve, raising tax rates increases revenue. On the top (shaded) half, raising taxes actually has a negative effect on revenues, as at that level the disincentives to work, or the incentives to shelter income, cheat on taxes, move business offshore, turn down overtime, or other natural reaction to confiscatory rates "shrinks the pie." So, in theory, when top rates were 90% under JFK and he slashed them to 70%, the resulting increase in revenue was due to the fact that we were on the top side of the curve. Same thing with Reagan's cut from 70% top rates down to 28% (which gradually climbed back to 39% under Clinton). Bush's cut from 39% down to 35% produced a less-dramatic effect, not only because the cut was less, but because that rate is (presumably) further out toward the right side of the curve.

The trick is, we don't know where exactly that rightmost part of the curve lies at which revenue is maximized. It could be 35% (in which case we're perfect already). It could be lower. It could be higher. Again, I know that's supply-side heresy, but if we cut taxes to the point that revenue goes DOWN, then we may be making moral or political sense, but we're not making economic sense. It does NOT naturally follow that every rate cut is a good thing... or else the perfect tax rate would devolve to zero, at which point we have no revenue, either, and therefore no interstates or army. But, on the other hand, raising a rate just because some folks want to play class-envy games is only a good idea if it can be done without shrinking the pie and having the opposite effect of what is intended. And notice that none of this addresses other factors, like what is the maximum "fair" rate (I have already posited that in my mind, an effective rate of 33% is about where I'd stop... which may be achieved with a higher top marginal rate). Also, this doesn't address other issues like the child tax credit, the home interest deduction, or the elimination of the "marriage penalty," all of which are concerned with other factors besides revenue.

So, anyway, my point with regard to this upcoming election is this. McCain promises to make the Bush tax cuts permanent. (If that doesn't happen, they'll expire in 2010. This will result in a tax increase for almost everybody who pays taxes.) Obama says he wants to eliminate the $102,000 cap on social security taxes and also go back to the old Clinton rates. But Obama has already said he'd exmpt the folks making $102-250k from the first, and I'll bet a dollar to a doughnut that he'd find a way to raise the top rates without messing too badly with the folks in the lower brackets whose votes he needs. I oppose that, as it gets that top bracket into effective rates of over my "magic number" of a third, and also as I think that probably moves us into the area of shrinking the economy. My advice would be to stand pat on rates. They are awfully close to "Goldilocks" rates right now. Maybe undertake some reforms that help the "little guy" whose FICA bill is higher than his income taxes, like increasing the child tax credit and having it also count against FICA tax. But generally, I'd say that politicians should apply their own version of the Hippocratic Oath: "first, do no harm."


bekster said...

Wow. That was a lot to read, especially with all of the links.

This issue does seem a little hard to figure out, like looking at an image inside of a prism. You can look at it from many different angles and at each angle it looks different. Still, Obama's plan does strike me as a [not well thought out] ploy to get votes. (Yeah, I know, that comes as a big surprise.) I have some other thoughts (and questions) that I will share with you later, but the bottom line (to me) is that there needs to be incentive for [rich] people to earn MORE money, but also enough "freedom" (less tax oppression) for [poor to middle-class] people to be able to invest what they do have to earn more money. Overly taxing poorer people would just discourage them and make it harder for them to get ahead, and overly taxing richer people would take away their incentive to produce more taxable income, BUT it does make sense that, proportionally, those with more money would get taxed more aggressively than those with less money.

Your Laffer Curve makes a lot of sense. However, it focuses on the amount of "revenue" brought in. (According to the chart, taxing less brings in less revenue, and that is assumed to be a problem.) Really, I think the government should focus on better managing the revenues it already gets.

I cannot believe that Pete has not already commented.

Goode Design said...

Yeah, Becky beat me to the punch! I'm actually just catching up!

First off, Becky said: "Still, Obama's plan does strike me as a [not well thought out] ploy to get votes." Y'know... it would be great if the general populous could figure this out. However, the Obama cheerleaders aren't thinkers either.

I have become an advocate for a Consumption Tax (Federal Sales Tax). Some say that a consumption tax then removes the benefit for Charitable Giving. Well, 2 points on that: 1. I'm sure our government could come up with something. 2. Is that why we give?

As for an optimum INCOME tax rate, I think I'm for the lower, the better. If we stick with an income tax model, then the solutions that present themselves:
1. Reduce government spending
Let's cut the fat and pork-barrel policy. Let's start a program where we wean farmers and the ilk from subsidized living.
2. Let's get creative with Gov't Income
The government could lease out public lands (interstate medians & right of ways) for farming & cultivating Cash Crops.
3. Be counter intuitive.
I've found that Giving is a great way to see increase grow. What IFF, and it's a big "if..." What if our nation decided to GIVE 10% of all total revenues to a handful of notable causes. (aids in Africa, feeding the hungry, etc.) What If a nation actually tithed. Okay, I'm even making it less of a Faith giving, and turn the national tithe into a Charitable Gift.

As Becky said, taxes are a political football. A ploy to get people to vote. No electable politician wants a Fair tax nor a national sales tax... it wouldn't be good for their image. Obama needs the lower income levels to think it's not FAIR that they're not rich and that it's the government's job to help them get there. The first time one of them sticks their head above the status quo, the taxes on the rich now hit them squarely in the face.

I believe it's immoral to tax our incomes. Tax what we spend! That's fine! But don't tax our backs.

Larry, is there any way to find out what the government is actually SPENDING our tax dollars on?

MichaelPolutta said...

You said, "but if we cut taxes to the point that revenue goes DOWN, then we may be making moral or political sense, but we're not making economic sense."

I may be reading into (or just plain misreading) what you said, but taking you literally would imply that maximizing tax revenue makes economic sense. I do not agree with this position as a foundational principle at all. What makes the most economic sense to me is to have the government get only what is required to do the job the government has been assigned by our Constitution, and to leave the rest of the country's money in the hands of those who earn/generate it. My personal opinion is that the government has taken on so many roles that do not have any precedence or permission from the founding documents (or any legitimate extension thereof) to the point that there is WAY too much Fabian Socialism in our representative republic for my taste.

I am also a big supporter of consumption taxes instead of income taxes. If only...

Goode Design said...

"...to have the government get only what is required to do the job the government has been assigned by our Constitution..."

Unfortunately, this is like asking a fox how many eggs are in your hen house.