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Wednesday, January 04, 2006

He who laughs last

Posted by: Jambo / 1:05 PM

From today's Strib:

At a Washington, D.C., luncheon in 1974, economist Arthur Laffer told some friends about his theory that the government could cut tax rates and, by triggering a burst of economic activity, actually increase its overall tax collections. The "Laffer Curve" became a hit among conservative intellectuals, helped President Ronald Reagan pass a big tax cut in 1981, and won an enduring place in public opinion about government finance.

So enduring, in fact, that no amount of historical experience and debunking by academic economists can dislodge it from the public's mind. President Bush embraced it while pushing a big tax cut through Congress in 2003, and his budget director, Joshua Bolten, has invoked it at least once.

So it's good to see that the Congressional Budget Office (CBO), the government's top arbiter of fiscal matters, has put the idea under a microscope and exposed its fallacies. It's time that members of Congress stopped selling tax cuts on the idea that they can be repaid with free money.

The issue is not whether the theory, which one political wag (OK, it was Hammer) called the most destructive cocktail napkin of the 20th century, is sound. The issue is where on the curve do US tax rates fall. Here's one version of the curve in question:

The two end points make perfect sense. The left endpoint says that at a tax rate of zero you get zero tax revenue. The right endpoint says that if you set the tax rate at 100% you will also get zero tax revenue because no one will work if they keep none of the money. The top of the curve is the the tax rate (T) that yields the largest amount of tax revenue. The curve doesn't tell us where that point is but we can see how we would approach it. Starting at the left as we increase tax rates we get more revenue up until a point where tax rates get to the point where some people actually stop working, or at least work less, because the take home pay gets increasingly small. As take home pay gets lower and lower more and more people drop out of work--some people won't work for less than $10 an hour, others will work until the pay drops to, say, $3 an hour.

But that's where the question for policy makers comes in. Is our current tax rate to the right or the left of the top point of the curve? If it's to the right then dropping the rate a little bit should in fact bring in a little more tax revenue. But that doesn't seem to be where we are in the US, as the recent CBO study shows. Now when the top rate is in the 95% range, as it was in England years ago, there's a good chance that it is to the right of the top. But it looks like both in the '80s and today we are clearly to the left of the maximum revenue point and any talk of tax cuts "paying for themselves" is dishonest politics and bad economics.

Bottom line? In the vast scheme of things the US has pretty low tax rates and conservative should quit their whining.


Bueller... Bueller... Farris Bueller

By Anonymous Anonymous, at 11:18 PM  

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