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Laffer Curves Not Seductive

November 14th, 2008 · No Comments

When you’re name is attached to an idea, it’s hard to change track. In fact, the incentives are such (especially if you have no other interesting idea anymore) to get as much milage out of it as possible. This is what Arthur Laffer does, yes, the one from that curve on a napkin that was supposed to show that if you lower taxes, especially those on top incomes, tax revenues go up. It is nonsense, of course.

He’s still at it though, 28 years or so after he draw that famous curve on a napkin (or so the story goes).

A couple of simple empirical observations:

  1. Contrary to Laffer’s prediction, Reagan’s tax cuts didn’t reduce the budget deficit, quite the contrary. The Bush Jr. tax cuts fared no better (to put it mildly)
  2. Contrary to the alarmist book title (“The End of Prosperity –How Higher Taxes Will Doom The Economy — If We Let It Happen”) countries with much higher taxes are alive and kicking, and quite a few of them are as innovative as the US. Perhaps Mr. Laffer thinks Europe is a country, but he could have a look in European countries such as Finland, Sweden, Denmark, and Ireland (although the latter is now suffering from a deflation of a property bubble). Those three Scandinavian countries especially have much higher taxes than the US. Have these doomed the economy? Hardly. In fact, one could argue that in many ways, these countries often more pleasant to live in for the majority of people, and they score very well in terms of innovation (not to speak of healthcare, education, crime, etc.)
  3. There is a tendency for the state to grow bigger (and hence taxes to go up) because of the type of services it provides. Contrary to much of industry, where the relentless march foreward of technology and organization makes the average worker ever more productive (by a couple of percentage points a year at least), it is difficult to improve productivity in stuff like healthcare, education, defense, police, justice, foreign affairs, administration, etc..  That means that if wages rise at roughly the same pace as in industry, workers in the public sector become relatively more expensive, a phenomenon known as Baumol’s disease.
  4. This movement is compounded by the fact that as countries get more prosperous, demand for collective services is likely to rise disproportionally. We’ll place a premium on things like environment, health, education, a safe environment, all demands for which the state is often quite deeply involved because of the more or less collective nature of these. Goods and services also generally become more complex, often needing more regulation to avoid the kind of problems we’ve seen in the financial sector (one party knowing much more of the good or service transacted than the buyer, which can predispose him/her to opportunistically exploit that information advantage), and generally leading to lower quality equilibrium outcomes (as there can be trust issues with high price/high quality claimes).

So, unless you’re ideologically predisposed to a growing public sector, there is not a whole lot wrong with it. It’s a natural process, and there are numerous countries out there to show the doomsayers, like mr. Laffer himself, are plain wrong.

He argues that “the whole point of the curve is to figure out where you should be on your taxes depending on which income group you’re taxing. Nothing more.” (see article below). As Scandinavian countries show, that point lies a whole lot higher than were taxes are now.

That doesn’t mean that one should let the state grow without opposing these tendencies (we’re no socialists), and there are points at which the state becomes so large and unwielding as to become a serious drag on wealth creation.

But this is better done through critically looking at the political process (special interest politics especially is liable to create a dynamic leading to ever more state involvement, witness the rather perverse tax incentives and subsidies for agriculture and big energy in the US, for instance).

Also, a critical look should be given to the methods of collective service provision, there are often large efficiency and effectiveness gains to be made through programs like ‘Reinventing the Government’ and/or community involvement.

In short, Laffer has been shown both wrong empirically, and even in concept. Here he is again:

Laffer: Obama Picked a Losing Team

  • Gregg Greenberg
  • President-Elect Obama has lined up what appears to be a formidable team, including Berkshire Hathaway’s (BRK.A Quote – Cramer on BRK.A – Stock Picks)Warren Buffett and former Federal Reserve chairman Paul Volcker, to advise him on the economy.
  • Economist Arthur Laffer is not impressed.
  • “I know Paul Volcker very, very well. He was the best Fed chairman ever. Just wonderful,” says Laffer in a conversation with TheStreet.com. “Without him, the Reagan revolution never would have occurred. But on fiscal policy, he’s not so good.”
  • As for Buffett, and the rest of Obama’s economic gurus, Laffer is equally skeptical, especially when it comes to their plans to raise taxes.
  • “You can’t raise taxes on the rich. These people know how to get around taxes,” says Laffer. “Warren Buffett pays no taxes because all of his wealth is in unrealized capital gains. There’s no tax on unrealized capital gains, so how do you get it? You have to tax poor people.”
  • Laffer makes his case against Obama’s tax plan in his new book The End of Prosperity –How Higher Taxes Will Doom The Economy — If We Let It Happen. And while he is forever linked to Ronald Reagan through the curve which bears his name, Laffer says his book isn’t political. In fact, he voted for Bill Clinton twice.
  • “There is a chance that Obama could very much do a Clinton and flip and become one of the best presidents ever,” says Laffer. “He’s got all the resources, all the abilities to do something like that. I don’t think it’s going to happen. But wow, you would see a great economy.”
  • Laffer lauds Clinton as a great supply-side President. On the other hand, George W. Bush, despite his party affiliation, has ushered in the end of supply-side economics, says Laffer. Lower taxes have indeed raised revenues, says Laffer, but the Bush administration’s inability to cut spending has threatened the economy with huge deficits that Obama will have a hard time erasing.
  • “Obama’s going to probably raise taxes on the upper income groups. He’s going to probably be forced to raise other taxes as well. He’s going to increase spending which is already a real problem. He said he’s going to go much more towards protectionism,” says Laffer, adding that all of that will be bad for the economy.
  • And as for the Laffer curve that vaulted him into the limelight, Laffer says the press continues to get it wrong.
  • “It’s about people’s incentives to work. At a 110% tax rate, if you came into the office every day and got a bill instead of a paycheck then you wouldn’t work very long,” says Laffer. “The government wouldn’t collect any money. And obviously if there are no taxes, the government will also collect no revenue. So the whole point of the curve is to figure out where you should be on your taxes depending on which income group you’re taxing. Nothing more.”

There is one thing we do agree with though:

Protectionism is indeed almost always bad (but providing big industries, like oil and agriculture, with subsidies and tax brakes amount to the same thing). It’s probably the single biggest policy mistake in the 1930s, a period of time that has come back into fashion again, for obvious reasons.

However:

Fiscal deficits really should not be the first, nor main worry at the moment, nobody has said that better than Paul Krugman today in the NYT, in an article about Depression Economics. We await the appearance of a new edition of this book by the end of the year. Compelling reading.

Tags: Opinion