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.
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.
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 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.
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.
To see the comments on the original post, look here.