TaxProf Blog

Editor: Paul L. Caron, Dean
Pepperdine University School of Law

Saturday, March 18, 2017

Republicans Keep Repeating The Same Tax Mistake

Laffer Curve (2017)Bloomberg View:   Republicans Keep Repeating the Same Tax Mistake, by Megan McArdle:

It looks as if Governor Sam Brownback may be leaving Kansas to take up a job at the United Nations. Brownback’s critics, of which there are many, charge that having led his state into a fiscal crisis, he’s bailing out on the wagon train while the rest of his party staggers onward over the cliff. “Brownback would be fleeing a political and economic crisis,” writes Alan Pyke of ThinkProgress, “leaving about 3 million Kansans behind in a budgetary inferno of his own devising.”

You can certainly see why Brownback would want to get out. After Republicans pushed through aggressive tax cuts in 2012 and 2013, the state keeps coming up with deep budget holes that have to be patched in an annual scramble. This year’s drama is still being played out after the governor vetoed a plan to raise taxes, and the state Senate responded by crushing Brownback’s proposed alternative.

For budget wonks, the saga of the Kansas budget will be reminiscent of the Reagan years, when supply-side tax cuts resulted in big deficits. The administration had hoped that the tax cuts could be paid for by a combination of faster economic growth unleashed by lower marginal rates, and the infamous “magic asterisk” (in which unidentified spending cuts were promised, details to come later).

Such rosy hopes are never sustained for long; the cruel arithmetic of inflow and outflow cannot long be dammed, or hidden. Reagan was forced to do another tax reform a few years later, hiding the fact that he was increasing taxes by cutting marginal rates but doing away with the generous exemptions that had dramatically lessened what people actually paid. Nonetheless, it took two more tax hikes — under Bush the First, and Clinton — to get the budget into some semblance of structural balance.

History does not repeat itself, but it often stutters. Which raises an interesting question: Why has this happened more than once? Was the example set under Reagan not clear enough?

The answer is, I think, that a lot of Republicans have a view of how taxes affect labor markets that is simple, intuitive, and wrong. (Not necessarily any less wrong than what Democrats think, mind you. But differently wrong, and in a way that matters here).

The basic intuition driving a lot of Republican conversation on taxes is simple: Taxes discourage work. After all, if your taxes go up from 30 percent of your income to 40 percent, you’ve essentially taken a 15 percent pay cut. In general, if the reward for doing something goes down, you will do less of it. Ergo, the higher the taxes, the lower the work effort. 

We can take this further with a simple observation: If the tax rate on your efforts is 100 percent -- that is to say, if you are allowed to keep none of the fruits of your own labor, not so much as a pen filched from the office supplies -- then you will not work, because what’s the point? Then the government will get no revenue from its 100 percent rate. If the tax rate is zero percent, you will also not generate any revenue for the government. Somewhere in between those points, there is a rate at which the maximum amount of tax revenue will be raised; any tax rate higher than that will cause revenue to start declining again.

Many of you will recognize that I am describing the famous Laffer curve. And the Laffer curve is absolutely right — for some effective tax rates. It has not, however, turned out to be correct for the tax rates actually prevailing in the United States during the later postwar era. Relatively modest decreases from modest tax levels do not increase economic growth enough to offset the losses from the lower tax rate, at least not in the short or medium term. In fact, they may not increase economic growth at all.

How can I say that? How can I call myself a libertarian? Don’t I understand Econ 101?

Well, yes. But here’s another concept from Econ 101 that is crucial to understanding why tax cuts have not worked out as some Republicans hoped: elasticity. ...

These are empirical questions, mind you: Whether the substitution effects of lower taxes outweigh the income effects depends on many factors, including how high the existing tax rate is, what sort of value your culture places on work and leisure, how much flexibility you have to decide how many hours you work, and how enjoyable the work available is. But it’s safe to say that in America, in the late 20th and early 21st century, they didn’t outweigh the income effects, and the other various factors keeping work rates relatively constant, enough to pay for themselves, or even come close. Nor did they dramatically goose the growth rate. As long as tax rates are kept within a reasonable range, most of what happens in the economy will end up being determined by other factors, such as regulation, technological change, demographics, and the individual decisions made by millions of people about what they want to do with their lives.

And yet, this simple view of how taxes affect labor supply remains common currency among Republican voters, and Republican politicians. What happened in Kansas is a reminder of the costs of betting too hard on what we know that ain’t so.

New York Times editorial, Kansas’ Trickle-Down Flood of Red Ink:

It was five years ago that Gov. Sam Brownback proudly engineered the biggest tax cuts in the history of Kansas. He put all his political chips on the trickle-down fantasy that personal and corporate tax cuts for rich business owners would produce higher state revenues.

In the process, he made his state an experimental showcase for the driving philosophy of supply-side theorists like Paul Ryan, the House speaker, who served as a staff acolyte when Mr. Brownback was in the Senate. “See, we’ve got a different way and it works,” Mr. Brownback promised.

Er, not really. The multibillion-dollar cuts have not moved employers to invest and hire more; the state budget is now flooded with red ink. Kansans have become alarmed at years of deep deficits, shrinking state support for education, two downgrades in the state’s credit rating and enough regret among legislators to prompt an extraordinary uprising last week by Statehouse Republicans. ...

The fiction remains alluring as a campaign con, and it will undoubtedly be invoked as the Republican Congress and the Trump administration embroider the next federal budget with grand tax-cut schemes. But if they dare to look, there slumps Kansas, a supply-side casualty, bleeding red ink.

(Hat Tip:  Glenn Reynolds.)

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