The Tax Debate and the Laffer Curve

[anvi]

In recent debt-ceiling/budget negotiations, the idea of cutting top marginal tax rates, with a view to growing the economy and thereby raising more revenue in the long term, gained a great deal of headway in Washington.  Obama and Boehner were close to a deal on a rate adjustment and the Gang of Six in the Senate proposed its own downward rate adjustment.  The debate about how to optimize revenue through tax policy will surely play a starring role in coming negotiations on the Joint Select Committee tasked with long-term budget outlays and in Congress as a whole thereafter.

As with all such issues these days, the debate about whether the Laffer Curve hypothesis gains revenue through lowering marginal rates seems to have only two sides.  One side (the supply-side, usually) cites evidence such as the 1920's downward tax adjustments, the 1980's Reagan tax cuts, and the downward marginal tax adjustments in Europe in the '80's and '90's.  Their estimates also point out that simply and mechanically raising marginal rates causes deadweight loss in the economy, and such loss not only reduces the net effect of raised revenues but eventually reduces them over time.  Opponents call the Laffer Curve a "myth" and conjecture that the marginal tax increases by FDR and Clinton demonstrated that such straightforward increases are better at both maximizing and optimizing government revenue.  They also argue that the effects of the Reagan tax cuts were distorted by increased government spending, and in any event that lowering marginal rates requires considerable amounts of time to recoup the lost revenues.

I have only read a few articles and papers about the Laffer Curve from different perspectives.  I am hardly an expert on taxes, but for those on the forum who have more knowledge than I do, I have a few questions.

--If the Laffer Curve is credible, then shouldn't we first determine on which side of the curve we are currently on with regard to optimized tax revenues before we make a downward rate adjustment, since if we are on the forward-sloping end of the curve, lowering rates would cost revenue?

--Given the ever-increasing costs of funding politically popular federal budget priorities, may not lowering marginal rates now incur some danger, given that there seems to be some agreement that lowering marginal rates requires some extended period of time for the economy to grow and thus for the government to recoup the lost revenue?  Wouldn't we be in danger of lowering our revenue at a time of increasing costs and thus only worsening our deficit woes?

--Would those who support rate adjustments according to the dictates of the Laffer Curve still support them if the Curve at current rates dictated the slight increase of marginal rates?  Or is the embrace of the Laffer Curve hypothesis merely a rationalization for lowering marginal rates regardless of the circumstances?

--Shouldn't we learn more about the credibility of the Laffer Curve hypothesis before staking so much on it in a time when the federal budget is facing a veritable crisis?

I realize that equally difficult questions can be raised of advocates of simply increasing the marginal rates, given that the change in economic behavior they would cause may have an adverse effect on economic growth and, in the long run, perhaps even government revenue collection itself.  But I'd like to be better informed of the actual likelihood of the Laffer effects of lowering marginal rates before myself fully buying the idea, or, even more importantly, before Congress signs off on it.

Any feedback is welcome.  Thanks.   

[anvi]

Thanks for the feedback, J.J.

I agree that the same economic measures obviously don't work in all situations.  Even if the Laffer Curve Hypothesis is correct, we need, as mentioned, to figure out where we currently are on the curve and do some fairly mathematically sophisticated estimates and projections in order to determine what sorts of rate adjustments are optimal.  If it is found that we are on the forward-sloping end of the curve an that an upward-adjustment would therefore be best, I think that would give the Hypothesis itself increased credibility.  If on the other hand it is agreed we're on the backward-sloping end of the curve, it may indeed make sense to adjust the rates downward.  But even in that case, we should also figure out how long it will take to recoup the initially lost revenues and then start generating more, because if, during whatever that time-lag is, our budget priorities coupled with rising costs force us to borrow more money, not only will our deficit woes worsen, but the effects of the Laffer Curve revenue projections may be distorted. 

In short, it seems to me we need people to do some very good math in a a very unbiased way to determine whether upward or downward tax rate adjustments are appropriate for our situation before we commit ourselves to a ten-year long binding budget plan.  The fact that I don't know the answer to this question of what exactly to do with the rates is not surprising.  My big worry is that Congress doesn't rightly know at the moment either, and since they are under the gun to make decisions by the end of the year, I hope some very credible evidence and projections can be made so they can make an informed decision.

That's hoping for way too much from D.C. and the studies they commission, isn't it? 

[anvi]

Thanks Torie, as always, for the clarification.  I do suspect that a combination of deduction and loophole elimination combined with downward-adjusted rates would likely increase economic efficiency and enhance revenues in the long term, depending on what rates the margins were adjusted to.  But all the major examples of Laffer Curve effects from downward adjustments always strike me as simplistic, since there are a lot of economic dynamics at work in any given situation that make it unique.  

The downward rate adjustments are also very politically difficult for both sides.  If you combine them with deduction and loophole elimination, the Norquist crowd makes noise because they smell a net increase in upper-bracket taxation.  And if you adjust the rates downward, the Democratic base (not necessarily Democrats in the Senate) go wild because they just want to see the upper brackets increased.  So, in addition to the whole matter being a very tricky economic one, it's also a tough needle to thread politically.

Laffer was a prof. of yours, eh?  Well, I'm impressed, even though you seem less so.  Fixed exchange rates, huh?  Yeah, that really isn't a good idea; wow!

.....

J.J, yes, I think the papers I've read do suggest that the curve kicks in at the higher rates.  The bell-curve would in any case be misleading because it suggests far to static of an economic situation.  Even David Stockton, Reagan's first-term budget director, seemed suspicious of how literally top administration officials were assuming the Laffer Curve worked, especially in the face of increased government spending which distorted the effects of the curve anyway, even when bringing top rates down from 70%.

[anvi]

The Laffer Curve doesn't dictate anything. If you believe that tax revenues should be maximised, then sure. But that is a highly questionable objective - it means you would support a tax hike that raised revenue by $1 even if it caused an additional $1,000,000 in deadweight losses. The tax maximising level is a very conservative measure of what the top tax rate should be - a point beyond which there should be little controversy over cutting taxes (assuming agreement of where it is, which is not likely to be the case in practice). Below it, you no longer have a "free lunch", but the lunch starts out cheap.

It's of course a good point that tax maximization shouldn't be mistaken for optimization, and the goal should be to optimize revenue.  But the Laffer Curve does figure in such discussions too.

[anvi]

I've even toyed with the idea of a Intangible Property Tax for cash/bank accounts over a certain amoun with credits offset by hiring employees or making capital investments.  Any thoughts?

Wouldn't companies with large holdings just move them around?  But I like the sentiment; just waiting around for new sources of demand to pop up while we trap ourselves in a diminished production and hiring stagnation seems dumb.  If the economy continues to worsen or if Europe pulls us down, it may be necessary to reverse course for a while and take more stimulative measures.