The Laffer Curve Wins Again: Snooki 1 – IRS 0
The Laffer Curve is the simple notion that higher tax rates don’t necessarily generate as much loot as politicians expect because taxpayers have less incentive to earn and/or report income.
And it works in both directions. Lower tax rates don’t lose as much revenue as politicians fear because better tax policy leads to more taxable income.
In a few cases, higher tax rates may even lose revenue and lower tax rates may generate additional receipts. The IRS collected a lot more tax from upper-income taxpayers, for instance, after Reagan slashed the top tax rate from 70 percent to 28 percent.
Over the past few years, I’ve shown lots of evidence from around the world (England, Spain, and France) and in various states (Illinois, Oregon, Florida, Maryland, and New York) to make the case that it is foolish to ignore the Laffer Curve. Not surprisingly, leftists never seem to learn.
More recently, I’ve explained why Obama’s class-warfare tax policy is especially misguided because of Laffer Curve effects.
But I sometimes wonder whether I make any progress with these arguments. Maybe I’m being too much of a wonk? Perhaps I need an example that strikes a chord with regular people.
I don’t know if that’s true, but let’s give it a try. I now have an example of the Laffer Curve for the MTV audience. Best of all, the story is from USA Today.
The IRS got red-faced trying to collect the new tanning tax, burning a hole in estimates on how much the levy would bring in to federal coffers, a new report said Thursday. …Tanning tax receipts for that nine-month period totaled $54.4 million, the report found. That was below projections by the Congressional Joint Committee on Taxation, which had estimated the tax would raise $50 million in the last three months of fiscal year 2010 and $200 million for the full 2011 fiscal year.
Supply-Side Snooki?
Let’s deconstruct the numbers from the article. The Joint Committee on Taxation estimated that this new “Snooki” tax (part of the awful Obamacare legislation) was going to raise about $50 million every three months.
Yet during the first nine months, the tax raised just $54.4 million, not $150 million.
To be fair, some of this huge revenue shortfall may be a result of short-run factors associated with levying a new tax, but does anyone think the actual revenues will match the JCT’s estimates at any point in the future? If you think that will happen, get in touch with me so we can make a friendly wager.
Why am I willing to put my money where my mouth is? Simple, the government’s revenue estimators have been consistently wrong for decades because they use models that assume tax policy has no impact on economic performance.
Just in case you think I’m exaggerating, watch this video.
This is why I said last year that reforming the biased methodology at JCT was an important test of whether the GOP was genuinely on the side of taxpayers.
Debunking the Left’s Tax Burden Deception
I testified yesterday before the Joint Economic Committee about budget process reform. As part of the Q&A session after the testimony, one of the Democratic members made a big deal about the fact that federal tax revenues today are “only” consuming about 15 percent of GDP. And since the long-run average is about 18 percent of GDP, we are all supposed to conclude that a substantial tax hike is needed as part of what President Obama calls a “balanced approach” to red ink.
But it’s not just statist politicians making this argument. After making fun of his assertion that Obama is a conservative, I was hoping to ignore Bruce Bartlett for a while, but I noticed that he has a piece on the New York Times website also implying that America’s fiscal problems are the result of federal tax revenues dropping far below the long-run average of 18 percent of GDP.
In a previous post, I noted that federal taxes as a share of gross domestic product were at their lowest level in generations. The Congressional Budget Office expects revenue to be just 14.8 percent of G.D.P. this year; the last year it was lower was 1950, when revenue amounted to 14.4 percent of G.D.P. But revenue has been below 15 percent of G.D.P. since 2009, and the last time we had three years in a row when revenue as a share of G.D.P. was that low was 1941 to 1943. Revenue has averaged 18 percent of G.D.P. since 1970 and a little more than that in the postwar era.
To be fair, both the politician at the JEC hearing and Bruce are correct in claiming that tax revenues this year are considerably below the historical average.
But they are both being a bit deceptive, either deliberately or accidentally, in that they fail to show the CBO forecast for the rest of the decade. But I understand why they cherry-picked data. The chart below shows, rather remarkably, that tax revenues (the fuschia line) are expected to be back at the long-run average (the blue line) in just three years. And that’s even if the Bush tax cuts are made permanent and the alternative minimum tax is frozen.
It’s also worth noting the black line, which shows how the tax burden will climb if the Bush tax cuts expire (and also if millions of new taxpayers are swept into the AMT). In that “current law” scenario, the tax burden jumps considerably above the long-run average in just two years. Keep in mind, though, that government forecasters assume that higher tax rates have no adverse impact on economic performance, so it’s quite likely that neither tax revenues nor GDP would match the forecast.
The “Tax Expenditure” Con Job
For both political and policy reasons, the left is desperately trying to maneuver Republicans into going along with a tax increase. And they are smart to make this their top goal. After all, it will be very difficult – if not impossible – to increase the burden of government spending without more revenue coming to Washington.
But how to make this happen? President Obama is mostly arguing in favor of class-warfare tax increases, but that’s a non-serious gambit driven by 2012 political considerations. Moreover, there’s presumably zero chance that Republicans would surrender to higher tax rates on work, saving, and investment.
The real threat is back-door hikes resulting from the elimination and/or reduction of so-called tax breaks. The big spenders on the left are being very clever about this effort, appealing to anti-spending and pro-tax reform sentiments by arguing that it is important to get rid of “tax expenditures” and “spending in the tax code.”
I recently warned, however, that GOPers shouldn’t fall for this sophistry, noting that “If legislation is enacted that results in more money coming into Washington, that is a tax increase.” I also explained that tax breaks are not spending, stating that “When politicians tax (or borrow) money from one person and give it to another, that’s government spending. But if politicians allow a person keep more of their own money, that’s a tax cut.”
To be sure, the tax code is riddled with inefficient and corrupt loopholes. But those provisions should be eliminated as part of fundamental tax reform, such as a flat tax. More specifically, every penny of revenue generated by shutting down tax preferences should be used to lower tax rates. This is a win-win situation that would make America more prosperous and competitive.
It’s also important to understand what’s a loophole and what isn’t. Ideally, you determine special tax breaks by first deciding on the right benchmark and then measuring how the current tax system deviates from that ideal. That presumably means all income should be taxed, but only one time.
So what can we say about the internal revenue code using this neutral benchmark? Well, there are lots of genuine loopholes. The government completely exempts compensation in the form of employer-provided health insurance, for instance, and everyone agrees that’s a special tax break. There’s also the standard deduction and personal exemptions, but most people think it’s appropriate to protect poor people from the income tax (though perhaps we’ve gone too far in that direction since only 49 percent of households now pay income tax).
Overhauling CBO and JCT Is a Real Test of GOP Resolve, not the ‘Pledge to America’
While I’m glad Republicans are finally talking about smaller government, I’ve expressed some disappointment with the GOP Pledge to America. Why “reform” Fannie and Freddie, I asked, when the right approach is to get the government completely out of the housing sector. Jacob Sullum of Reason is similarly underwhelmed. He writes:
In the “Pledge to America” they unveiled last week, House Republicans promise they will “launch a sustained effort to stem the relentless growth in government that has occurred over the past decade.” Who better for the job than the folks who ran the government for most of that time? …Republicans, you may recall, had a spending spree of their own during George W. Bush’s recently concluded administration, when both discretionary and total spending doubled — nearly 10 times the growth seen during Bill Clinton’s two terms. In fact, says Veronique de Rugy, a senior research fellow at George Mason University’s Mercatus Center, “President Bush increased government spending more than any of the six presidents preceding him, including LBJ.” Republicans controlled the House of Representatives for six of Bush’s eight years.
Redemption is a good thing, however, so maybe the GOP actually intends to do the right thing this time around. One key test is whether Republicans do a top-to-bottom housecleaning at both the Congressional Budget Office and the Joint Committee on Taxation.
These Capitol Hill bureaucracies are not well known, but they have enormous authority and influence. As the official scorekeepers of spending (CBO) and tax (JCT) bills, these two bureaucracies can mortally wound legislation or grease the skids for quick passage.
Unfortunately, that clout gets used to dramatically tilt the playing field in favor of bigger government. It was CBO that claimed that Obama’s stimulus created jobs, even though the head of CBO was forced to admit that the jobs-created number was the result of a Keynesian model that was rigged to show exactly that result . You would think that would shame the bureaucrats into producing honest numbers, but CBO continues to produce absurd job creation estimates regardless of the actual rate of unemployment.
CBO favors deficits and debt when it is asked to analyze proposals for more spending, but it rather conveniently changes its tune when the discussion shifts to tax increases. Since we’re on the topic of twisted economic analysis, CBO actually relies on a model which, for all intents and purposes, predicts that economic performance is maximized with 100 percent tax rates.
The Joint Committee on Taxation, meanwhile, is infamous for its assumption that taxes have no impact – at all – on economic output. In other words, instead of showing a Laffer Curve, JCT would show a straight line, with tax revenues continuing to rapidly climb even as tax rates approach 100 percent. This creates a huge bias against good tax policy, yet JCT is impervious to evidence that its approach is wildly flawed.
And don’t forget that CBO and JCT both bear responsibility for Obamacare since they cranked out preposterous estimates that a giant new entitlement would lead to lower budget deficits.
Not that we need additional evidence, but the head of the CBO just repeated his higher-taxes-equal-more-growth nonsense in testimony to the Senate Budget Committee. With this type of mindset, is it any surprise that fiscal policy is such a mess?
Douglas Elmendorf said extending breaks due to expire at year’s end would increase demand in the next few years by putting more money in consumers’ pockets. Over the long term, he said, the tax cuts would hurt the economy because the government would have to borrow so much money to finance them that it would begin competing with private companies seeking loans. That, in turn, would drive up interest rates, Elmendorf said.
I’ve already written once about how the GOP sabotaged itself when it didn’t fix the problems with these scorekeeping bureaucracies after 1994. If Republicans take power and don’t raze CBO and JCT, they will deserve to become a permanent minority party.
What’s the Ideal Point on the Laffer Curve?
There’s been a bit of chatter in the blogosphere about a recent post on Ezra Klein’s blog, featuring estimates from various economists about the revenue-maximizing tax rate. It won’t come as a surprise that people on the right tended to give lower estimates and folks on the left had higher guesses. Donald Luskin of National Review estimated 19 percent, for instance, while Emmanuel Saez, Dean Baker, Bruce Bartlett, and Brad DeLong all gave answers around 70 percent.
There are two things that are worth noting.
First, every single answer is to the right of the Joint Committee on Taxation. The revenue-estimators on Capitol Hill assume that taxes have no impact on overall economic performance. As such, even confiscatory tax rates have very little impact on taxable income. The JCT operates in a totally non-transparent fashion, so it is difficult to know whether they would say the revenue-maximizing tax rate is 90 percent, 95 percent, or 100 percent, but it is remarkable that a mini-bureaucracy with so much power is so far out of the mainstream (it’s even more remarkable that Republicans controlled Congress for 12 years, yet never fixed this problem, but that’s a separate story).
Second, very few of the respondents made the critically important observation that it should not be the goal of tax policy to maximize revenue. After all, the revenue-maximizing point is where the damage to the overall economy is so great that taxable income falls enough to offset the impact of the higher tax rates. Greg Mankiw of Harvard and Steve Moore of the Wall Street Journal indicated they understood this point since they both explained that the long-run revenue-maximizing rate was lower than the short-run revenue-maximizing rate. But Martin Feldstein of Harvard explicitly addressed this issue and hit the nail on the head.
Why look for the rate that maximizes revenue? As the tax rate rises, the “deadweight loss” (real loss to the economy) rises. So as the rate gets close to maximizing revenue the loss to the economy exceeds the gain in revenue…. I dislike budget deficits as much as anyone else. But would I really want to give up say $1 billion of GDP in order to reduce the deficit by $100 million? No. National income is a goal in itself. That is what drives consumption and our standard of living.
For more information, I think my three-part video series on the Laffer Curve is a good summary of the key issues. I posted them in May 2009, but Cato-at-Liberty has been growing rapidly and many people have not seen them. Part I addresses the theory, and explicitly notes that policy makers should target the growth-maximizing tax rate rather than the revenue-maximizing tax rate. Part II reviews some of the evidence, including analysis of the huge increase in taxable income and tax revenue from upper-income taxpayers following the Reagan tax-rate reductions. Part III looks at the Joint Committee on Taxation’s dismal performance.
With Tax Increases Looming, CBO Does About-Face and Frets about Deficits and Debt
Like the swallows returning to Capistrano, the Congressional Budget Office follows a predictable pattern of endorsing policies that result in bigger government. During the debate about the so-called stimulus, for instance, CBO said more spending and higher deficits would be good for the economy. It then followed up that analysis by claiming that the faux stimulus worked even though millions of jobs were lost. Then, during the Obamacare debate, CBO actually claimed that a giant new entitlement program would reduce deficits.
Now that tax increases are the main topic (because of the looming expiration of the 2001 and 2003 tax bills), CBO has done a 180-degree turn and has published a document discussing the negative consequences of too much deficits and debt. A snippet:
[P]ersistent deficits and continually mounting debt would have several negative economic consequences for the United States. Some of those consequences would arise gradually: A growing portion of people’s savings would go to purchase government debt rather than toward investments in productive capital goods such as factories and computers; that “crowding out” of investment would lead to lower output and incomes than would otherwise occur.
…[A] growing level of federal debt would also increase the probability of a sudden fiscal crisis, during which investors would lose confidence in the government’s ability to manage its budget, and the government would thereby lose its ability to borrow at affordable rates. …If the United States encountered a fiscal crisis, the abrupt rise in interest rates would reflect investors’ fears that the government would renege on the terms of its existing debt or that it would increase the supply of money to finance its activities or pay creditors and thereby boost inflation.
At some point, even Republicans should be smart enough to figure out that this game is rigged. Then again, the GOP controlled Congress for a dozen years and failed to reform either CBO or its counterpart on the revenue side, the Joint Committee on Taxation (which is infamous for its assumption that tax policy has no impact on overall economic performance).
The Joint Committee on Taxation’s Voodoo Economics
The Wall Street Journal has an excellent editorial this morning on the obscure — but critically important — issue of measuring what happens to tax revenue in response to changes in tax policy. This is sometimes known as the dynamic scoring versus static scoring debate and sometimes referred to as the Laffer Curve controversy.
The key thing to understand is that the Joint Committee on Taxation (which produces revenue estimates) assumes that even big changes in tax policy have zero macroeconomic impact. Adopt a flat tax? The JCT assumes no effect on the economic performance. Double tax rates? The JCT assumes no impact on growth.
The JCT does include a few microeconomic effects into its revenue-estimating models (an increase in gas taxes, for instance, would reduce gasoline consumption), but it is quite likely that they underestimate the impact of high tax rates on incentives to work, save, and invest. We don’t know for sure, though, because the JCT refuses to make its methodology public. This raises a rather obvious question: Why is the JCT so afraid of transparency? Here’s some of what the WSJ had to say about the issue, including some comparisons of what the JCT predicted and what happened in the real world.
…it’s worth reviewing whether Joint Tax estimates are accurate. This is especially important now, because President Obama and Democrats in Congress want to allow the 2003 tax cuts to expire on January 1 for individuals earning more than $200,000. The JCT calculates that increasing the tax rates on capital gains, dividends and personal income will raise nearly $100 billion a year. …we are not saying that every tax cut “pays for itself.” Some tax cuts—such as temporary rebates—have little impact on growth and thus they may lose revenue more or less as Joint Tax predicts. Cuts in marginal rates, on the other hand, have substantial revenue effects, as economic studies have shown. …So how well did Joint Tax do when it predicted a giant revenue decline from the 2003 investment tax cuts? Not too well. We compared the combined Congressional Budget Office and Joint Tax estimate of revenues after the 2003 tax cuts were enacted with the actual revenues collected from 2003-2007. In each year total federal revenues came in substantially higher than Joint Tax predicted—$434 billion higher than forecast over the five years. …As for capital gains tax receipts, they nearly tripled from 2003 to 2007, even though the capital gains tax rate fell to 15% from 20%. Yet the behavioral models that Mr. Barthold celebrates predicted that the capital gains cuts would cost the government just under $10 billion from 2003-07 when the actual capital gains revenues over five years were $221 billion higher than JCT and CBO predicted. …Estimating future federal tax revenues is an inexact science to be sure. Our complaint is that Joint Tax typically overestimates the revenue gains from raising tax rates, while overestimating the revenue losses from tax rate cuts. This leads to a policy bias in favor of higher tax rates, which is precisely what liberal Democrats wanted when they created the Joint Tax Committee.
All of the revenue-estimating issues are explained in greater detail in my three-part video series on the Laffer Curve. Part I looks at the theory. Part II looks at the evidence. Part III, which can be watched below, analyzes the role of the Joint Committee on Taxation and speculates on why the JCT refuses to be transparent.
Obamacare Will Be a Budget Buster
Does anyone think that a huge new entitlement program will lead to lower budget deficits? Sounds implausible, yet proponents of government-run healthcare claim this is the case according to the official estimates from the Congressional Budget Office and Joint Committee on Taxation.
To use a technical phrase, this is hogwash. This new 6-1/2 minute video, narrated by yours truly, gives 12 reasons why Obamacare will lead to higher deficits – including real-world evidence showing how Medicare and Medicaid are much more costly than originally projected.
By the way, this video doesn’t even touch on the mandate issue, which Michael Cannon explains is not being counted in order to make the cost of government-run healthcare less shocking.
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