Monday, February 18, 2008

Laffering All the Way

[This is something of a distillation of some discussions from Mark Thoma's Economist's View Blog].

The Laffer Curve is one of the greatest scams of all time. Really. "Please send me your bank account number so I can transfer $50 million in gold to your account" isn't even in the running compared to the Laffer Scam, though the Ponzi scheme might give it a run for the money.

The idea that you can somehow increase tax revenues by cutting tax rates is as seductive as 25% at no risk, though, isn't it? And it's so simple you can explain it to a child, using just the famous bar napkin:

Let's let the Wikipedia supply the basic, simple explanation:

"The curve is most understandable at both extremes of income taxation—zero percent and one-hundred percent—where the government collects no revenue. At one extreme, a 0% tax rate means the government's revenue is, of course, zero. At the other extreme, where there is a 100% tax rate, the government collects zero revenue because (in a "rational" economic model) taxpayers presumably change their behavior in response to the tax rate: either they have no incentive to work or they avoid paying taxes, so the government collects 100% of nothing."

Martin Gardner, in a famous Scientific American article, gave a satirical "neo-Laffer Curve," supposedly to show how fatuous Laffer's arguments were (Gardner's graph is rotated, with tax rates being on the y axis, and revenues on the x axis; the Wikipedia has a redrawn version in the same orientation as Laffer's original):

When I read Gardner's original article I was really pissed, because Gardner's graph fails on basic mathematical terms. A squiggle like Gardner drew isn't a function! So Gardner, the epitome of the punctilious math-head, let himself slide into a basic math error, simply because he was so annoyed with Laffer.

Moreover, he missed the most important mistake in Laffer's analysis. It is simply not true that a 100% tax rate generates no revenue, even in "rational" economics models, because there is no such thing as 100% compliance, among other things.

Consider the illegal drug trade. The criminal and RICO proscriptions on illegal drugs amount to a tax rate that is actually greater than 100%; there have been RICO prosecutions where people's houses and all their financial assets have been seized for a fairly small quantity of drugs, far less than the sale value of the drugs themselves. That's a greater than 100% excise tax. Yet the drug trade continues. Furthermore, various law enforcement agencies obtain substantial funding from RICO seizures, and a number of venues actually have excise tax laws on illegal drugs.

Hey, wait, no fair! exclaim the supply-side enthusiasts. We're only talking about the effects of capital gains taxation on investment and economic growth here. Or they'll claim that it's the effects of high marginal income tax rates on incentives to work or labor specialization.

Well, let's take that last one, which one might think would have a germ of truth to it. I remember a story from the Reader's Digest "Life in these United States" feature from many years ago. How many years ago will become apparent.
A man saw his neighbor out cleaning the leaves from his gutters, The man asked his neighbor why he didn't hire someone to do it, as the neighbor was an affluent professional.

"Well," the neighbor replied, "It would cost at least $10 to hire someone to clean my gutters, and I'm in the 90% tax bracket. So that means I'd have to earn $100 to get that much money after taxes. For $100, I'll do it myself."

It's possible to argue that cleaning gutters was an inefficient use of this man's time. And certainly his forgoing the hiring of it deprived the economic statistics of at least the $10 wage exchange, and possibly the extra hour or of the high income fellow's labor that he'd have surely worked if his marginal tax rate were less (I'm being sarcastic here, in case anyone is in doubt). But there are worse ways of spending a bit of time on the weekend than getting some exercise and seeing the neighborhood from a different viewpoint, to say nothing of the incidental inspection of the roof.

The point here is that even at 90% marginal tax rates, tax revenue was collected, it was not negligible, and the behavioral changes created by the "distortion" weren't necessarily always bad. People do not only work for money; if that were the only motivation in the world, I wouldn't be writing this, would I?

Moreover, by concentrating exclusively on monetary incentives, people tend to devalue the other incentives to labor, such as pride of workmanship and simple civic responsibility. The idea that a 100% tax rate results in zero labor implies that there is no volunteer labor—ever. This is the fallacy of Econ 101 Management.

As for capital gains taxes, well, the effective tax rate on investment in the old Soviet Union was 100%, as the Soviet government owned everything. It's quite true that the USSR did not have a particularly vibrant economy, but it did still have an economy. The government's effective "tax revenues" on invested capital were not zero. It was just that the government was the primary source of investment capital. And please don't anyone try to tell me that we don't have government capital investment in this country. Even ignoring basic infrastructure investment, we have a lot of government investment, from tax credits to outright subsidy and demonstration projects. It's just that most of these investments eventually wind up turning into private wealth, which, as it happens, is what happened eventually to a lot of the wealth that was created in the old USSR, once communism fell and "privatization" began. Then there is the case of the city that built a big baseball stadium so a certain future President could make some money on his investment in a baseball franchise. That was public investment in a private enterprise, no?

But let's say that we're still on the question of would a 100% capital gains tax yield no return. The answer is still yes. If someone wanted to sell their house in order to move to another house, and they had a capital gain on the sale of their house, would they refuse to sell, staying forever in the same house? Some would, but many would not. Many moves are not a matter of choice. They might try to balance the sale vs purchase to render a zero capital gain, but they would not always be successful, and there would be some revenue collected.

The fact is that it is very difficult to come up with realistic scenarios where a 100% tax rate generates zero revenue. The most basic assumption of the Laffer Curve is simply wrong.

Now you may think that I'm spending more time than I should attacking the basic premises and logic of the Laffer Curve and Supply Side Economics. Perhaps I am. Certainly SSE has failed every reasonable empirical test. In every case since the Reagan Administration, tax cuts have caused reductions in tax revenues, and the tax increases that have occurred since then never created the economic contractions that Supply Siders predicted.

Empiricism is tricky stuff, however, and the snake oil salesmen have been peddling the idea that when taxes are cut, all that need happen is for tax revenues to eventually reach what they had been before the cuts—which will generally happen in any economy that is growing over time. Eventually absolute revenues manage to increase, so long as the Supply-Siders don't actually wreck the entire economy, which they haven't managed to do—yet. In any case, such perversions of empiricism damand that a more fundamental attack be made.

The effect of squeezing revenues and increasing "defense" spending (which is to say, paying for wars and military contractor profiteering) over the past 6 years has been to deprive the nation of the investments that governments need to make, on infrastructure, regulatory oversight, education, and all the things that Movement Conservatives hate, because they don't fit into the basically feudal worldview that drives their actions.

And scams like the Laffer Curve need to be attacked at their roots, otherwise they grow back, like a thorny bush of carrion flowers, smelling like rotting meat to attract the flies that it needs to pollinate. And I'm no longer in the mood to cede these twits a single point. I'm no longer willing to give them even an inch.


black dog barking said...

The effect of squeezing revenues and increasing "defense" spending (which is to say, paying for wars and military contractor profiteering) over the past 6 years has been to deprive the nation of the investments that governments need to make, on infrastructure, regulatory oversight, education,…

Last regime change, 2001, the incoming administration was handed an operating budget surplus. Their particular strain of idealogue had long bloviated that government should not be competing with business for capital and they'd been handed their wish. They immediately put the federal government back in the borrowing business, first with tax cuts, then with the aforementioned military and quasi-military spending. Nothing puts the fear stains in a banker's shorts like a bank full of money leaking interest and no treasury bonds to buy.

James Killus said...

Treasury bonds are a promise of a future "transfer payment," the collecting of tax money in order to pay it to some individual or institution. It's interesting how Movement Conservatives are so very good at smelling out transfer payments when they involve putting money into lower and middle income hands. They're really very poor at noticing tranfer payments when they transfer money into high income pockets. Perhaps they suffer from some sort of perceptual difficulty.

Nancy Lebovitz said...

It occurs to me that I've never seen a way of telling where you are on the Laffer curve. Even if the premise is plausible (and it still looks plausible to me), if you aren't in the range where cutting taxes increases government revenue, then cutting taxes will decrease revenue.

James Killus said...

Well, every tax cut in the past 30 years has decreased revenue, while tax increases have increased revenue, so that might be a clue.

The biggest problem is that some things that were called tax "cuts" like the 1986 Reagan changes, actually expanded the tax base (and that one actually eliminated the capital gains preferences for a while), so while some marginal rates got cut, many others went up.

Generally speaking, the "tax revolt" of the past several decades has actually been an attack on the legitimacy of the Federal government, and government generally, for reasons that I strongly suspect are other than economic. Of course, it's much easier to undermine the legitimacy of government when you are the government, so the Bush administration has been a rip roaring success when viewed in that light.

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