A few laughs with the Laffer Curve

posted at 10:05 pm on July 7, 2011 by Jazz Shaw

In one of the more interesting and entertaining debates to take place at Hot Air in some time, my buddy Ed Morrissey led my horse to water on the question I posed as to whether or not the United States federal government has a revenue problem. But can he make the horse drink? Let’s see…

In the first portion of his response, Ed posted this graph showing that “federal revenues have more than tripled since 1965.” (While federal spending in the same period has more than quintupled.) Both of these items are facts beyond dispute, and I wouldn’t attempt to argue them. The math speaks for itself.

But in addition to that, he also correctly notes that some of the major peaks and troughs on the chart align with periods of maximum economic activity (or “boom times”) and with recessions. Again, who could argue? Though I would submit the following graph which tracks the same data from a slightly different perspective. It examines federal revenue not in raw dollars adjusted to 2010 values, but in adjusted raw revenue as a percentage of the GDP.
Federal revenue as a % of the GDP

Why do we care about taxes, spending and revenue as a percentage of the GDP? Well, for one thing, it’s what many of the GOP proposals for future spending are based on, as well as reflecting activity on both the government and private sector sides in relation to each other. It’s also useful for another reason which we’ll get to in a moment.

But first, what has Ed Morrissey proven with these irrefutable facts? Well, in his first point he as proven beyond a shadow of a doubt that in the last nearly fifty years the country has grown, the population has swelled, more people are working, more people are paying taxes, more companies are doing business, and that results in more revenue.

As I said, kind of hard to argue with that.

In his second point, dealing more with the peaks and troughs of the graphs in question, Ed talks about the fact that we have a recession problem. In his presentation he has established another unassailable fact. Recessions are bad for the economy and result in negative impacts on both employment and revenue.

Just in case, you know… you were wondering.

So, for those of you keeping the scorecards at home, we have everyone saying we have a spending problem, yours truly positing that we have a revenue problem, J.E. Dyer saying we have an over-regulation problem, and Ed saying we have a recession problem.

Two major problems crop up immediately. First, none of these problems are mutually exclusive. The existence of any of them does not by definition preclude the existence of the rest. That’s akin to having your wife yelling at you to run to the store because you’re out of baby formula and you telling her, “Don’t worry, dear. We have plenty of vodka left.” You may be right about the vodka (and may need it very soon in that case) but you haven’t solved the original problem. We can, and in my never very humble opinion do, have all four of those.

Unfortunately, none of these complaints address the original problem I cited. All of the GOP plans currently being considered (even if you went Full Bore Ryan) result in us still running up additional debt mounting into the trillions for decades to come. This means that, first, you’re only running up debt more slowly than the Democrats. And if that’s good enough for you then you’re setting the bar pretty darn low. And second, we’re going to be right back at the same table having to raise the debt ceiling again next year or the year after, only this time having to do it after following a conservative, Republican fueled plan.

Happy yet?

The next question is tougher and brings us full circle back to my original column. Would adding some modest revenue positive changes to the deal actually hasten us toward stopping the debt increase more quickly? I probably should have anticipated it, except for being tired of the argument, but no sooner had I uttered the words than the commentariat jumped in with both feet with the usual complaint. You already know it by now, and it goes something like this:

But.. but.. but… what about the Laffer Curve?!?!?elventy!!??

For those few of you not familiar, the Laffer Curve is based on the graph below, originally said to have been sketched on a cocktail napkin during a lunch meeting between Arthur Laffer, Jude Wanniski of the Wall Street Journal, Dick Cheney, Donald Rumsfeld, and Grace-Marie Arnett.
Laffer Curve

Laffer himself originally described it as having been a thought experiment, but it does contain some interesting analysis. In short, the curve seeks to examine the effect of the tax rate on government revenue. At the very far left, we see the inarguable fact that if the tax rate is zero, government revenue will also be zero. (Duh.) But at the far right end, it points out the only slightly less obvious point that if the government tax rate is 100% the revenue will also be zero because no sane tax payer would continue working if Uncle Sam was taking all of his hard earned wages. Laffer theorized that there must be some point on this curve where government revenue would be maximized, and any higher rate of taxation would result in diminishing returns.

That much is certainly true, and it’s both informative and interesting in a meta sense, but how does it apply to our current situation? As many people have previously noted, the Laffer curve is instructive and provides a nice cautionary tale in general, but much like the shiny used car you checked out, it looks a lot better on the show room floor than when you actually take it out for a spin in the real world. (Which brings us back to the first set of charts from Ed and I.)

The sad reality is that the effect of taxation on revenue does not occur in a vacuum. Numerous other factors affect it and to a much larger degree. One quick look at the peaks and troughs on the aforementioned chart demonstrates that and leads to endless rabbit hole arguments.

See? Once the Bush tax cuts took effect revenue climbed steeply!

That’s because the economy was rebounding from a recession and the effects of 9/11.

But it was the tax cuts that spurred it!

You’ll notice that at the height of the Clinton years, revenues as a percentage of GDP were higher than they ever got under Bush and the taxes were higher.

But that was the result of the tech and housing bubbles! It was a recovery period!

And so was the period after 9/11!

And so on.

But what really happened to tax revenue vs. GDP through those periods, as opposed to all revenue? Let’s take a look.

Tax revenue only

Notice anything different?

The real problem with the Laffer Curve is that you never know exactly where you are on it at any given time, where the actual peak is, or what happens when you tweak any of the factors involved. It’s useful in a general sense, as I said, but it’s basically economic voodoo when you try to pin it to a certain date in time. Over the decades some analysts have placed the peak revenue sweet spot as high as 70% taxation. Other more conservative voices swear, depending which country you’re talking about, it can’t be above 20.

So where are we on the curve and what happens if we just try to raise revenue by juicing the economy through lower taxes as so many of you suggest? A 2005 study by the CBO examined what would happen if you took a base 25% tax rate and reduced it by ten percent to 22.5%. Contrary to what seems obvious in conservative doctrine, they found that of the revenue you would “lose” by sending every company a 10% lower bill, you would only recoup 28% of the lost revenue over the next decade from increased economic activity.

A lot of this really is voodoo, and I don’t claim to have all the answers. I just know that some folks repeating Eric Cantor’s talking points this week don’t really know either. But it seems like we have to try something to get back to at least a deficit neutral position, and simply cutting spending (which we still have to do in massive amounts) and refusing any other new direct revenue through plugging some holes in the tax code isn’t going to do it. We do have a revenue problem until you can show a viable path to cutting spending to the point where we take in as much as we pay out.

This post was promoted from GreenRoom to HotAir.com.
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Um, help me understand something…other than paying off debt, why are we trying to give the government *more* revenue?

Personally, I’d be happy to 90% of the government wither up and die. Give us a military, have a treasury that prints money (return to the gold standard) and have Congress meet for 2 months a year. Make ALL of the bureaucrats find jobs in the private sector because God knows that they suck at anything but being faceless, unaccountable, pencil pushers…

So again I ask, why in the hell are we trying to maximize the revenue (taxes) that the government receives?!? We should be looking for ways to starve them to death because there is no way they’ll ever ween themselves off of the taxpayers’ teet.

Geministorm on July 8, 2011 at 12:13 PM

simply cutting spending (which we still have to do in massive amounts) and refusing any other new direct revenue through plugging some holes in the tax code isn’t going to do it

So you want a mix of tax hikes and spending cuts together?

http://minx.cc/?post=318548

take a look at the picture; we did this in 1990. 150 billion ion tax hikes to be offset with 250 billion in spending cuts.

Of course what we got was 150 billion in tax hikes, and about 10 billion in spending hikes… because spending cuts weren’t the major driving force.

But we’ should totally trust that congress will hold that football still so this time we’ll get to kick it? No really?

Yeah, you believe this time will be different if you want… don’t come crying to me when the football is pulled away at the last second and you fall on your ass.

I’d laugh that you think it’ll turn out differently this time, if the economic situation weren’t so serious.

gekkobear on July 8, 2011 at 12:15 PM

Finally, someone (other than me) talking sense on economics at Hot Air! Thanks, Jazz!

The only viable method of getting to a balanced budget is to cut social security, medicare, and medicaid. Those three programs, plus interest on the debt, consume all of the tax revenues, and that does not include the unfunded liabilities of those programs. There is no way to tax enough to maintain those programs.

Hiya Ciska on July 8, 2011 at 9:33 AM

Your conclusion is correct, even though the “fact” you based it on is not quite accurate. (Everyone interested in a plan to balance the budget should click here and look at the two pie charts at the top of the page.) What is accurate, is to say that interest on the debt plus total mandatory spending (Soc Sec, Medicare/aid, plus also food stamps, veterans’ benefits, etc.) is the size of total revenue.

The deficit, then, is the size of military spending plus all non-military discretionary spending–i.e. the “core” functions of government. When people talk about cutting “waste, fraud, and abuse” they are talking about tiny pieces of the discretionary pie. Meanwhile, we could close down the government and the military and fire every soldier, civilian, and contractor, and we would still have an annual deficit thanks to the entitlement programs. Cuts to shrimp running on treadmills is mere window-dressing, and does absolutely nothing to fix the short-term deficit or the long-term debt (what’s $100k in a $4T budget? About a millionth of a percent.)

Once the recession and the wars are over the annual deficit won’t look as bad–it’ll be closer to $1T than to $2T–but the debt will be much higher, as will interest rates. Only huge tax increases (i.e. doubling tax rates on the working poor), or major cuts to Social Security and Medicare (think–every senior gets half the check they were promised) can address the structural imbalances.

hicsuget on July 8, 2011 at 12:20 PM

Cuts to shrimp running on treadmills is mere window-dressing, and does absolutely nothing to fix the short-term deficit or the long-term debt.

hicsuget on July 8, 2011 at 12:20 PM

Yes and no. While it won’t fix the short-term deficit or long-term debt directly, it is a practice in fiscal responsibility… which IS what got us into the short-term deficit and long-term debt. If Congressmen can’t even cut the easy no-brainer things, how in the world do you expect them to go after the big items?

People learn to crawl, walk and run in that order. You can’t expect toddlers to complete a marathon. They need to mature to adults, and then practice for the event by running shorter stretches, lengthening the runs out until they are ready for the big race. Our Congressmen are toddlers when it comes to fiscal discipline (which is why you see so many tantrums!)… and they need to practice on the small, easy stuff first.

dominigan on July 8, 2011 at 12:34 PM

You submitted the wrong graph, Jazz. That’s all levels of government revenues, not just the fed level.

Worse, you assume that government somehow “deserves” to spend more than the bit-under-17.8% of GDP it averaged in revenue between 1951 and 1995. Sorry, but that’s not happening. Indeed, every time revenues climb much above that, the economy rebels to send the average back down.

If there’s a “revenue” problem, it’s because we’re letting a significant portion of the population net money from the government, not that we’re taxing the “rich” too little.

Steve Eggleston on July 8, 2011 at 12:42 PM

The question the Republican Party needs to ask itself is this: if we cut spending as much as we can accomplish given the politics involved, and we are still running a deficit, what do we do? That is the revenue problem Jazz speaks of, and it is a real one.

RW Wacko on July 8, 2011 at 12:00 PM

I agree, but the problem, again, is in the specifics of any “deal”.

It appears that the deal being forged will be alleged spending cuts over a 12 year period – mostly to Medicare. Note, “spending cuts”, not any kind of structural reform of the program to make it more efficient, cheaper, etc.

In exchange for these “cuts”, the GOP is to agree to tax increases.

The problem with this approach is that it won’t work. The cuts will never materialize (remember, the current congress cannot restrain any future congress, so each successive congress would have to voluntarily honor the “deal” – which is highly unlikely). So, it is more likely that we will end up with the same result for the same basic deal Poppa Bush made in 1990 – that is the “cuts” never materialize, spending actually increases and taxes increase.

So while Jazz may be correct in describing the problem, he seems to be implying that some sort of deal a la what is being implied is acceptable. It is not acceptable.

If we enacted serious reform to entitlement programs such that lower costs were a given going forward (i.e., real cuts), then it would be acceptable to agree to some tax increases to go toward paying down the debt.

Until we get that deal, any tax increases will simply increase the size of the gov’t.

Monkeytoe on July 8, 2011 at 12:43 PM

You see, the very simple fatal flaw in your argument is that you assume, apparently, that government is currently at some kind of optimum size.

There is not one person visiting this website that considers themselves remotely conservative who believes that is the case, especially considering the $800 billion stimulus was indeed NOT a one time expense as all that spending has been inherently rolled into every agency through baseline budgeting.

There can be no doubt that the size of government can be shrunk to match our current revenues. With this as the starting point for these discussions, the need for “increased revenues” ceases to exist except in your mind and mind of fellow liberals.

deadrody on July 8, 2011 at 1:04 PM

I admire Jazz’s post in that he knew everyone would slam him….

RW Wacko on July 8, 2011 at 12:00 PM

You have a pretty low threshold of admiration.

slickwillie2001 on July 8, 2011 at 1:51 PM

A 2005 study by the CBO examined what would happen if you took a base 25% tax rate and reduced it by ten percent to 22.5%. Contrary to what seems obvious in conservative doctrine, they found that of the revenue you would “lose” by sending every company a 10% lower bill, you would only recoup 28% of the lost revenue over the next decade from increased economic activity.

The Laffer curve is a theoretical idea, whereby TOO MUCH taxation reduces economic activity so much that there is not enough income to tax, and a very low tax rate doesn’t bring in enough revenue even with a larger tax base. No one really knows the “optimum tax rate” which maximizes government revenue.

But the CBO study probably doesn’t mean much, because what is meant by a 25% “base tax rate”? If we’re talking about corporate taxes, which are now at 35%, does anyone really know what would happen at a 25% rate if it hasn’t been tried?

If we’re talking about individual income taxes, to whom does this “base tax rate” apply? Almost half of the population pays NO income taxes, due to income below the threshold, or lots of itemized deductions. Changing the “base tax rate” would have NO effect on tax revenue from them!

Then, what about the vast “middle class” who might be in a 15% or 25% MARGINAL bracket, but who pay only 5-10% of their total income in taxes, due to no taxes below the minimum threshold plus standard deduction plus dependent deductions? If the marginal rate was reduced from 25% to 22.5%, their tax bill might be decreased by 1% of their income, but if the drop in the corporate tax rate stimulated the economy enough, they might get a raise that compensates the lower percentage.

As for those liberals that claim that a 70% tax rate would maximize government revenues, they should remember that voters who elect them want to maximize their OWN revenues, not those of the Government! Any member of Congress who proposed a 70% FLAT tax would soon be seeking 30% of another salary!

Steve Z on July 8, 2011 at 3:06 PM

Another interesting point – if the Laffer Curve is correct as drawn above, the gov’t would theoretically get the same revenue from say a 17% tax rate and an 87% tax rate (making the numbers up – assuming those 2 numbers are equidistant from the optimal rate).

Thus, shouldn’t everyone, liberal and conservative alike, want to err on the side of a low rate rather than the confiscatory high rate that leaves individuals with less?

Of course, we have no idea what the actual curve looks like. It could be incredibly steep on one side and a very gradual decline on the other or vice versa.

Conservatives aren’t against high taxes just because of the Laffer Curve idea – that is an argument used in support, but the idea is that the gov’t should not be as large as it is, should not take as much from citizens as it does, and we should fight every attempt to make the gov’t larger – including attempts to increase taxes, which only ever lead to larger gov’t and never are used to actuall pay down debt.

Indeed, conservatives should get away from relying too much on the Laffer Curve and instead stick with teh principal of smaller, less confiscatory gov’t.

As pointed out in the post and in comments – the Laffer Curve can never be completely proven one way or another – there are way too many variables, and we will never find the exact sweet spot. So this argument will just go around in circles anyway.

Monkeytoe on July 8, 2011 at 4:56 PM

Building on my previous point,

even if we knew the optimal tax rate according to the Laffer Curve was 50%, would we be for it? No.

The idea isn’t to get the gov’t the most money it can possibly take in. Instead, the idea is to make gov’t only do those things its supposed to do and do them as efficiently as possible and not do all of this other stuff. Gov’t should not be trying to “make” as much money as it can – it should be trying to take as little money as absolutely necessary to perform legitimate purposes of the federal gov’t.

We are in this predicament b/c gov’t is doing things way beyond its scope. So increasing revenue to cover that foolishness is not the answer. Reducing the scope is the answer.

Monkeytoe on July 8, 2011 at 5:01 PM

Your very own mondegreen.

slickwillie2001 on July 8, 2011 at 2:09 AM

Very nice word slick, well done. I had to look it up and it looks like it’s a new phrase which surprises me considering how common they are. You just enhanced my vocabulary.

Funny thing about these mondegreens is that they are so hard to let go once corrected. :(

“Bangled” started to take on a mind of its own since I assumed it meant striped (stars and stripes) and started to refer to the Bengal tiger as the Bangled tiger. So my folks drilled the words spangled and bengal into my mind, but apparently bangled never truly died.

Daemonocracy on July 8, 2011 at 5:11 PM

Daemonocracy on July 8, 2011 at 5:11 PM

Mine, from Xmas, was “later on, we’ll perspire, as we dream, by the fire…”

Still think it makes more sense than conspire.

slickwillie2001 on July 8, 2011 at 5:37 PM

As pointed out in the post and in comments – the Laffer Curve can never be completely proven one way or another – there are way too many variables, and we will never find the exact sweet spot. So this argument will just go around in circles anyway.

Monkeytoe on July 8, 2011 at 4:56 PM

It isn’t taken seriously. It’s never been published as a serious theory.

lexhamfox on July 8, 2011 at 8:04 PM

Hey, if Jazz wants to die on the hill of raising taxes in a depression, so be it.

Taxpayers are rightly suspicious of “revenue enhancement” schemes because that’s all we ever get. They claim they’ll reduce spending, but it’s always about picking our pockets instead.

That’s not an unlimited resource, and it’s only renewable to the extent that government takes it’s grubby hands off and lets the private sector grow. It’s always worked that way, it always will, and some people will be in denial about it forever.

If you let them have more taxes, they will spend it all and demand more, because that’s all they ever do. So you can’t let them have more taxes, they MUST solve the spending problem first, or we will go bankrupt. PERIOD.

Federal spending has gone up obscenely since 2006. Unsustainably. Ruinously. And we will be ruined if that isn’t reversed.

And slamming the economic brakes (high taxation) on won’t fix the problem, it will just make it worse.

Everybody but politicians, pundits, and tax sponges knows this. And yet we keep arguing about it, dancing around the subject while the problem gets worse.

Merovign on July 9, 2011 at 4:17 PM

You know, lexhamfox, someone who had googled “laffer curve study” wouldn’t say that.

It’s also obvious that the far ends of the curve behave largely as was predicted, because we’ve tested that all over the world (as well as the fact that it’s completely obvious).

There are lags and hitches all over the curve that make it hard to analyze, but the core assumption of the policy implication – that extremely high marginal tax rates encourage avoidance – is not only so obvious as to be a cliche, but well documented.

Of course, everyone who wants government to be a 40,000-ton gorilla does not WANT it to be true.

Seriously, even if you could force people to work for nearly nothing (relative to their production), wouldn’t you essentially be running a slave state at that point? How could you call such a society free?

Merovign on July 9, 2011 at 4:23 PM

The Laugher curve is a concept mostly relevant to the highest earners, who not only face the highest marginal tax rates, but also probably have the smallest “turning point” tax rate.
Lower income individuals have turning points that are much higher, as there goal is more to do the minimum work necessary to meet a particular level of take home pay. For them, if you increase the taxes they pay (by whatever means) you will find that they work longer hours or take more jobs in order to achieve the same take home pay.
The marginal tax rate at which tax revenues from the highest earners is maximized is around 20%, lower than current rates. The total tax rate at which the tax revenues from the lowest earners is maximized is significantly higher, probably above 50%, much, much higher than what they currently pay.

Count to 10 on July 10, 2011 at 7:31 AM

It isn’t taken seriously. It’s never been published as a serious theory.

lexhamfox on July 8, 2011 at 8:04 PM

Yes, it is taken seriously. Also, are you claiming that it is not true? That if govt taxed at 100% it would increase revenue to the Gov’t? That there is no high rate at which gov’t revenue decreases?

Please. The Laffer Curve is actually just obvious. The problem is with finding the exact spot, that is where the serious disagreement is. Not on whether or not Laffer’s theory is true.

Monkeytoe on July 12, 2011 at 8:51 AM

The marginal tax rate at which tax revenues from the highest earners is maximized is around 20%, lower than current rates. The total tax rate at which the tax revenues from the lowest earners is maximized is significantly higher, probably above 50%, much, much higher than what they currently pay.

Count to 10 on July 10, 2011 at 7:31 AM

The first sentance is only “true” (I’m not sure about 20%, but I would guess it is a low number) b/c of the convaluted tax code, which allows top earners to protect most of their income from taxes. If you just had a rate with no deductions, credits, etc., it is not clear what the optimal rate would be for the high earners.

I’m not sure about the second sentance. I suppose you can argue that the lower earners really have no choice but to keep working and trying to survive and can’t afford to hide money in deductions, credits, etc, so they would continue to work and the gov’t would collect the 50%. So, yes, it may be true from that standpoint, but it would probably also hurt the economy b/c these individuals who do most of the spending (i.e., its the broadest part of consumers) would not have money left to spend and would likely have trouble surviving – so the economy would likely take a hit.

I think the Laffer Curve takes into account not just the personal incentive for people to earn based on tax rates, but also how the tax rates effect the overall economy and growth.

Monkeytoe on July 12, 2011 at 8:57 AM

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