The field of economics fully developed scientifically in the 20th century. The names John Maynard Keynes, Milton Friedman, and Friedrich Hayek come to mind. However, one additional man became the one most referenced in the last part of the 20th century and continues as such today. That man is Arthur Laffer. The Joint Committee on Taxation of the U.S. Congress recently released a report telling us Laffer is even more accurate than previously thought.
Laffer became famous upon his recognition as adviser to President Ronald Reagan before and after the 1980 election. Laffer has a top-notch pedigree, including degrees from Yale and a Ph.D. in economics from Stanford. He then spent time at the University of Chicago. He was a colleague of Friedman, among others, while at Chicago.
Most people associate Laffer with Reagan, but he became notable in 1974 when presenting his thoughts to Dick Cheney and Donald Rumsfeld as part of the Ford administration. It was then that he drew his famous thought on a napkin to illustrate his beliefs about government’s raising tax rates.
The bell curve drawing was named the “Laffer curve” by Jude Wanniski, who was sitting in on the meeting. The legend was thus born, and the Laffer curve has become one of the most discussed economic ideas related to government levels of taxation. Ronald Reagan used it as his basis for the Reagan tax cuts in 1981 and 1986.
The simple idea of the proposal is that higher tax rates are ineffective in creating revenue. Lowering marginal tax rates increases government revenues. If tax rates are raised, revenues will decrease.
I have had vivid debates with people on the left about this economic concept. They instinctively think the idea is counterintuitive. As is often the case, these folks have ideas of how government works in theory, but when reality is different they choose to ignore reality. I encourage them to look at the four major periods where rates were cut during the Kennedy, Reagan, Bush, and Trump administrations.
Review the records of federal government revenues after the tax rates are adjusted down, and anyone can see that revenues escalate significantly during all four periods. The political left wants to spend oodles on government programs that largely waste money. If reduced tax rates produced more revenue, they should get behind the idea. Empirical evidence does count for something.
If a policy produces more tax revenue, can someone characterize it as a “tax cut”? It is a rate adjustment, not a tax cut.
A recent study from the Congressional Joint Committee on Taxation, authored by Rachel Moore, Brandon Pecoraro, and David Splinter, examined previous studies of the Laffer curve. It found that Laffer’s theory was even better than was previously suggested by those studies. Many previous studies used tax bases either too broad or too narrow, and the new study draws attention to those flaws.
“Prior studies, however, largely overlook the Laffer curve’s shape, rely on simplified tax functions, and often omit shifting across business types and tax interactions,” the authors write. “We show that modeling distinct tax bases more accurately and incorporating these interactions lowers the revenue-maximizing top tax rate and the associated revenue gains, yielding ‘flat’ Laffer curves.”
When I asked Laffer about the new paper, he stated, “This paper is a huge step in the right direction, and the research is very impressive. But, in the long-term context of settling the academic debate, there is much further to go.”
“It’s long been true that the U.S. government could collect all of the revenue it currently collects with two flat rate taxes of approximately 12% each: one on unadjusted gross personal income and the other on value added at the corporate level—no deductions, no credits,” he continued. “Any tax rates beyond this level are, based on research, in the prohibitive range of the so-called Laffer curve.”
“When looking at the world, incentive rates should always be used when deriving behavioral issues, not tax rates per se. The question always to ask is: Where is the tradeoff between giving money to people who don’t work and cutting tax rates on people who do work?”
Simply put, the prior studies of the Laffer curve used imprecise tax assumptions. Using more accurate current tax information produces even surer results that benefits decrease when income tax rates are raised. Increased tax rates are less beneficial for creation of tax revenues than previously thought.
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