The Laffer Curve and U.S. Tax Policy

One late afternoon in 1974 at a Washington DC restaurant, a young economist named Arthur Laffer met with Jude Wanniski, a Wall Street Journal reporter, and Dick Cheney, then-deputy to Donald Rumsfeld, President Ford’s Chief of Staff.

He described how reducing income taxes could actually lead to an increase in federal revenue and provide greater economic growth to boot. To make his point, Laffer drew a diagram on a napkin, and that diagram has become known as the Laffer curve.

The curve Laffer drew had government revenue on one axis and the tax rate on the other. He described that when the tax rate is zero, the government gets no revenue. Additionally, when the tax rate is 100% the government also gets no revenue because no one would see the benefit of working if all their money is taken away.

As tax rates increase from the zero point, government revenue goes up, until it reaches a maximum. Then, as the tax rate continues to rise, government revenue decreases, since people don’t see sufficient benefit in working extra hours or in working at all. Laffer did not assign any tax rates or revenue figures to his chart, but provided a conceptual framework.

The significant point was that a particular level of government revenue can be achieved at two different tax rates, one to the left of the maximum point and one to the right. This idea, coupled with an unsupported assumption that current tax rates were to the right of the maximum point, led to the advocacy for “trickle-down economics” during the Reagan administration. The trickle-down theory was that if the rich were given more money in the form of tax breaks, then the benefits would trickle down to the middle class through increased hiring, wages, and overall economic growth.

The theory behind the Laffer Curve is extremely appealing because it describes a win-win. Taxes can go down and the government still gets more revenue. This idea of greater revenue with tax reductions (or at least no decrease in government revenue) has continued to crop up in the ensuring decades. The key question, of course, is whether there is any basis for this contention.

Historical Analysis

During the Reagan years, taxes were significantly reduced in 1981, with the top rate going down from 70% to 50%. Other changes followed, including tax increases, while the top rate continued to be reduced, down to 28%.

An entry in Wikipedia provides a useful summary:

The results of Reaganomics are still debated. Supporters point to the end of stagflation, stronger GDP growth, and an entrepreneur revolution in the decades that followed. Critics point to the widening income gap, an atmosphere of greed, and the national debt tripling in eight years which ultimately reversed the post-World War II trend of a shrinking national debt as percentage of GDP.

As to the debt levels, the deficit exploded into record territory, and the U.S. moved from being the world’s largest international creditor to the world’s largest debtor nation.

Arguments abound about whether the normal business cycle of emerging from a recession, the trickle-down theory, the actions of the Federal Reserve, or the significant federal spending were the most responsible for improved economic growth in the 1980s. Largely it becomes a matter of what spin you want to give. There are too many myriad factors in a modern economy to attribute economic performance solely to a single parameter.

Furthermore, even if you believe Dick Cheney’s surprising claim that “Reagan proved deficits don’t matter,” this is not nearly the same as claiming that reduced taxes provide greater government revenue. On the contrary, a working paper from the U.S. Treasury estimates that the 1981 tax cuts resulted in the revenue decline of approximately $111 billion per year from what the revenue would have been without the cuts.

So the Reagan years do not provide support that reduced taxes provide greater government revenue, despite continued claims by some.

Another data point occurred during the Clinton presidency when the top tax rate was increased to 39.6%. The changes helped produce rare budget surpluses (if you ignore withdrawals from the Social Security Trust Fund) and strong economic performance. This leads to a conclusion that the new top tax rate of 39.6% was not beyond the maximum revenue point of Laffer, i.e. higher taxes resulted in higher government revenue, and was coupled with strong economic performance.

However, the strong economy during the Clinton years can also be attributed to the dot-com boom. Again, hard conclusions about an optimal tax rate will depend on a variety of considerations applicable to the time period.

The general concept of Laffer is logical: if the top tax rates are extremely high, then workers approaching that top rate may be disinclined to work longer or harder. Reagan himself is said to have changed from liberal labor advocate to sharp conservative because his high salary as an actor meant that he could only make about two pictures each year (at up to $400,000 per picture) before reaching a top tax rate at that time of up to 94%.

That perspective was understandable but not universal. During the international threats of the 1940s, actress Ann Sheridan said: “I regret that I have only one salary to give for my country.” Actress Carole Lombard in 1937 paid over $300,000 in federal income taxes on $465,000 in income. She said “I was glad to do it. Income tax money all goes into improvement and protection of the country.”

A more recent example of whether the Laffer curve is generally applicable comes from Kansas. Governor Sam Brownback achieved significantly reduced state taxes in 2012 in what he called a “real life experiment” for the Laffer concept. The results were reported by the Brookings Institute:

The Brownback plan aimed to boost the Kansas economy, but instead led to sluggish growth, lower than expected revenues, and brutal cuts to government programs. The Brownback tax cuts, one of the cleanest experiments for measuring the effects of tax cuts on economic growth in the U.S., were eventually reversed by a Republican-controlled legislature as a failure.

Earlier in 2018, President Trump’s economic advisor Larry Kudlow made the claim that the 2017 tax cuts were essentially paying for themselves, citing the non-partisan Congressional Budget Office (CBO). This claim appears completely unsupported, however, as the CBO predicts an increased deficit of $1.8 trillion between 2018 and 2028.

What do these results mean? Does the Laffer curve have any effect or applicability in comparison to traditional economic analyses? This is highly questionable. To the extent that there is empirical evidence in support, it is based on selective data and ignores a wealth of countervailing information.

The Laffer curve has been applied as a political tool, not an economic one. It is used under the pretense that current tax rates are known to be beyond the revenue-maximizing point, when this is not known, and in fact is more likely to be below the revenue maximum.

So, for the top tax rates in effect over the past few decades, there is no support for a contention that reducing taxes results in greater government revenue in comparison to not making a change in the tax rate. Even the top rates of the 1950s may not have much effect on economic performance if they affect a very small segment of the population. A 2016 article on The Blaze website supports this point:

“Back in 1955, the top marginal tax rate was 91 percent, but it didn’t come in until a wage earner earned what amounted to $3,426,776 (in inflation-adjusted dollars) when filing jointly.”

Seeking the Best Tax Policy

Whereas consideration of the Laffer curve does not seem particularly applicable in today’s tax rates, evaluation of some related details can be useful. First, the “best tax policy” is not necessarily the same as providing the “highest government revenue.” Several experts have argued that the ideal tax policy is one that optimizes economic growth, and this implies a lower tax rate than Laffer’s revenue-maximizing point.

Also, while the top income tax rate has been 39.6% (now reduced to 37% by the 2017 tax overhaul), the true rate of tax payments by the richest Americans is affected significantly by tax deductions and legal tax avoidance strategies. A Pew Research article provides statistics for the average tax rate actually paid by different annual income levels. Using information from 2015:

Less than $30,000                          4.9%

$50,000 to $100,000                      9.2%

$2 million to $5 million                   29.3%

$5 million to $10 million                 28.8%

$10 million and above                    25.9%

Note that the rich pay a much higher percentage of their income in taxes than do the middle class, consistent with a progressive income tax structure. Yet, the very wealthy ($10 million and above) pay a smaller percentage of their income than do the “mere” wealthy.

Discussions about tax policy and Laffer can vary in what taxes they include. Sometimes the scope is limited to the top income tax rate, and at other times additional taxes are included such as state, local, property, and payroll (i.e., Social Security and Medicare).

Opinions about an optimal top tax rate will depend on these complicating factors, so viewpoints can vary widely beyond only political orientations. A 2010 blog post provides a robust discussion by experts about a top tax rate and makes for interesting reading if one is willing to devote the time.

Additionally, a three-part video series from 2008 by libertarian Dan Mitchell provides some helpful insight into the limits of the Laffer concept. Note: his criticism of the government’s use of static scoring in Part 3 is no longer relevant due to the current use of dynamic scoring beginning in 2015.

Belief in the Laffer concept has been likened to a zombie that will not go away. The theory is appealing, reasonably simple to understand, and consistent with Republican orthodoxy for lower taxes. The story about how a drawing on a napkin led to economic policies has become part of political folklore and has been memorialized with a Laffer napkin on display at the American Museum of American History. At the same time, the majority of economists want to endorse policies that actually work.

Overall, the Laffer Curve can be said to be reasonable as a general concept but that has been misused by politicians arguing for decreased taxes. Assumptions that current tax rates are on the “wrong” side of the curve do not have support. An appealing description and wishful thinking is insufficient to show applicability.

This does not mean that a lower tax rate, or even a higher level of tax, is inherently bad. It simply supports the idea that discussion about an appropriate tax structure should be based on an honest dialogue.

The applicability of Laffer in supporting lower taxes, and a related argument that “lower taxes are always the right thing,” should be strongly questioned.