We’re On The Left Side Of The Laffer Curve…

…but on the right side of the supply-side argument growth curve.

I’ve posted about this several times, but I think the Laffer Curve is presented in such a way that it becomes highly misunderstood. Today that was made perfectly clear by Ezra Klein, who asked economists, political leftists and political rightists what tax rates would maximize revenue on the Laffer Curve.

The “neutral” economists all pointed to tax raters higher than we have today. Unsurprisingly, the political leftists agreed. Surprisingly, though, a number of the political rightists suggested a tax rate higher than we have today, but brought up an argument completely unrelated to the Laffer Curve in their response.

Here is one response that nails my criticism of “Laffer Curve Analysis” to a T:

Stephen Moore, senior economic writer and editorial board member, Wall Street Journal:

“The revenue maximizing rate is probably around 40 or 50 percent. But the growth maximizing rate, even given the current deficits, is probaby about 20 percent. So the goal is to get the rate down to 20 to 25 percent. For cap gains the revenue maximizing rate is between 15 and 20 percent.”

Interesting. The problem is the second sentence, describing maximizing the growth rate, has nothing to do with the Laffer Curve. The Laffer Curve ONLY describes the revenue-raising rate. It has nothing to do with long-term economic growth. In fact, any presentation of the Laffer Curve plots as related to economic growth are entirely the wrong shape, as economic growth doesn’t fall to zero at 0% taxation!

I think the below is a lot more representative:

laffer

Now, we can quibble over specifics (i.e. growth probably falls below 0% at high tax levels). But I think the shape is more representative of what you would expect from economic growth plotted vs. tax rates.

Economic growth and short-term revenue maximization are a trade-off, and that trade-off is NEVER represented in the Laffer Curve. Many suggest that revenue maximization is a lot closer to European tax levels than our own, but I’d state that the anemic economic growth seen in Europe suggests that they’re sacrificing economic growth for today’s tax receipts. America doesn’t really follow this, which is why our economic growth (and over time, now, our per capita GDP) are much higher than Europe.

But I think it’s clear that we’re below the maximizing revenue rate, but that we have a VERY GOOD REASON for remaining below that rate — we want to make a better world for our children and grandchildren through the possibilities that high GDP growth will open up to them.

  • Chris

    I strongly disagree that we need to increase corporate rates, they should remain essentially as is. We should; however, discontinue corporate welfare programs (especially those aimed at oil companies that have zero domestic production and no future green energy programs in the United States) and ensure tax compliance similar to the recent multinational loop hole fixes.

  • Tim

    Unfortunate that we would ever even consider the govt ‘maximizing it’s revenues.’

    How about we raise the minimal amount if revenue required to do the job?

  • http://thelibertypapers.org/ Brad Warbiany

    Chris,

    I don’t recall ever advocating raising taxes in the post (especially corporate rates). While I stated we’re on the left side of the curve, I thought I was pretty clear that I don’t think we should move right because the negative impact to growth is not worth the deficit reduction today.

    Tim,

    I completely agree with you… The problem, if you ask a politician, is that the revenue required to do the job always seems to outstrip tax intake — this year to the tune of $1.5T. I would tell a politician that they need to do a smaller job (or at least a more efficient one) rather than taking more of our money, but sadly that option doesn’t appear to be on the table.

  • Brent

    I read the Ezra Klein piece yesterday and I thought Mankiw’s response was very good also.

    However, I believe the point of the piece was to tackle the “tax cuts will pay for themselves” argument. If we’re on the left side of the curve tax cuts will reduce revenue and will not “pay for themselves”. Whether or not we should increase taxes to increase revenue to fund all of the government’s projects is, to me, a different question.

  • http://thelibertypapers.org/ Brad Warbiany

    Brent,

    You’re right, Mankiw nailed it.

    And I agree that Klein was trying to tackle the “pay for themselves” argument.

    The problem is that the argument is actually true:

    Tax cuts will pay for themselves — over time.

    The Laffer Curve doesn’t support lowering taxes to increase revenues, because it’s not intended to be a dynamic analysis of economic growth rates. It’s purely a way to show incentives towards tax avoidance. It’s a VERY WEAK tool, yet people focus entirely too much attention on it.

    Supply-side arguments, though, do support lowering tax rates to improve economic growth. And these supply-side arguments are actually common on the “Right”, but too many dolts themselves advancing these arguments refer to the Laffer Curve when doing so. As you point out, Mankiw is not one of those dolts.

    Most people in mainstream politics completely gloss over this because they’re woefully underqualified to shine my shoes, much less decide policies of national governance.

    Assume GDP of $13T today. Move 50 years in the future at consistent growth rates below:

    2% AGR: ~$34T
    3% AGR: ~$57T
    4% AGR: ~$92T
    5% AGR: ~$150T

    Real GDP growth 1950->2009 was 3.22% AGR. If higher taxes today drop it to 3% and lower taxes today raise it to 3.5%, that’s a pretty enormous difference 50 years out and beyond.

    Given the way exponential curves work, I’m far more concerned about that figure falling [and interested in ways to make it rise] than anything over the short term.

  • Brent

    Brad, you’re right that we shouldn’t trade short term revenue for GDP growth, and that lowering taxes to increase growth would likely pay for itself over a long enough period. I don’t agree that our elected officials have a long enough time frame in mind to consider that argument. I really do think those making the claim believe we’re on the wrong side of the Laffer Curve and that by cutting taxes we’ll immediately see higher revenue.

  • Brent

    I also forgot to mention that in our current state tax cuts could also be used as a short term keynesian stimulus (if you believe in that sort of thing). Though I doubt it would be large enough, that could potentially lead to some significant short term growth too. It might even “prove” the Laffer guys right, for entirely the wrong reason.