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October 23, 2006


Laffer's Defense?

A fair amount of (gleeful?) keystroking was instigated last week by a Washington Post article that included this "confession":

Robert Carroll, deputy assistant Treasury secretary for tax analysis, said neither the president nor anyone else in the administration is claiming that tax cuts alone produced the unexpected surge in revenue. "As a matter of principle, we do not think tax cuts pay for themselves," Carroll said.

In fact, one of the reasons to have some confidence that the most recent round of tax cuts in the United States did not pay for themselves is that the hard work of incorporating those incentive effects upon which the Laffer curve hinges has been done.  Kash had the story, at The Street Light

The tax cuts may indeed have stimulated some economic growth. In 2003 the Republican Congress convened a panel of economists (under the authority of the Joint Committee on Taxation, or JCT) to estimate exactly how much of a positive impact on tax revenues this feedback effect would provide, using a technique called "dynamic scoring" to measure the overall cost of the tax cuts.

This JCT study concluded that there would indeed be positive revenue effects from the economic growth that the tax cuts would stimulate, to the tune of some $30 or $40bn per year. But it turns out that the negative revenue effects of the tax cuts are a bit larger than that.

The "bit larger" there is facetious.  And, I think, the presumption that tax cuts won't pay for themselves is a good general principle.  But it is does have its limits.  Alex Harrowell, for example, unearths this interesting tidbit at A Fistful of Euros:   

... the Socialist government of Ferenc Gyurcsyany came up with a simple plan to cut the deficit from 10.1 per cent of GDP to something more reasonable.

Essentially, he decided to tax the rich until the pips squeaked. More accurately, he decided to tax industry until the pips squeaked, introducing a new 4 per cent “solidarity tax” on company profits...

The first results don’t look good. In fact they look disastrous. Volkswagen-Audi has reacted to this by cancelling €1 billion worth of investment at its plant in Gyor, which produces 20,000 Audi TT sports cars a year. The Gyor plant is Hungary’s biggest exporter, all on its own. VW had been planning to double its output. It is fair to say that essentially all the extra cars would be exported.

This particular anecdote does not, of course, indicate that Hungarian revenues will fall as a result of this tax hike.  But in this specific case, it doesn't seem implausible. 

Invoking a different example, both Mark Thoma and The New Economist reference a recent IMF paper that studies the aftermath of reforms in various countries that have implemented "flat taxes."  The conclusion:

... there is no sign of Laffer-type behavioral responses generating revenue increases from the tax cut elements of these reforms..."

I take no issue with that conclusion, but this, from the paper, bears emphasis:

But this paper—like the practical developments it addresses—is not about the HR flat tax.

Particularly in the United States, the term “flat tax” is associated with Hall and Rabushka (1983 and 1985; HR)... In effect, the HR flat tax is a consumption-type, origin-based value-added tax (VAT) collected by the subtraction method, supplemented by a (nonrefundable) tax credit against labor income.

And that really, really matters.  Several years back, I was part of a team that simulated the effects of the HR flat tax, and similar forms of fundamental tax reform.  We found that in the most straightforward version of this type of tax reform, the shift from something like our present income-based tax system to an HR-like consumption-based system would require a tax rate on labor-income of 21.4 percent in order to keep revenues from falling.  Over time, as the growth effects of removing capital taxation took hold in our experiments, the tax rate required to maintain revenue neutrality fell by 2 percentage points.  (The payroll tax rate required to finance social security benefits fell slightly as well).  In these experiments, then, really fundamental reforms did indeed generate "Laffer-type" effects, at least in the long run.

What's the moral to the story?  I guess it's that, even though the conventional wisdom is usually right, we probably shouldn't take for granted that it is always so.  There's a good reason to keep playing the game.      

UPDATE: Kash notes that the flat tax experiments I describe are about the efficiency gains of revenue-neutral fundamental tax reform and not that general cuts in tax rates raise revenues.  And right he is.  We are both agreed that the answer to what happens to revenues after any particular tax change depends on the both the nature and context of the change.  And I'll agree that once that point is recognized, the Laffer curve is not an idea that conveys much additional insight.

October 23, 2006 in Taxes | Permalink

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