Saturday, May 14, 2011

The Laffer Curve Myth

From Capitol Hill to the chambers of state and local governments there has been and continues to be a massive debate over whether or not lowering taxes will lead to economic stimulation. Those who argue that lowering taxes leads to increased economic stimulation constantly cite the Laffer Curve. However, the argument that lowering taxes create more revenue is a myth.

To get a better understanding of where the pro-Laffer Curve group is coming from, we must first take an examination of the Laffer Curve itself. The Laffer Curve was created in December 1974. A meeting between Donald Rumsfeld, Dick Cheney, Jude Wanniski, and Arthur Laffer. The four were discussing then-President Gerald Ford's proposal for tax increases when Laffer took a napkin and on it sketched a curve of the trade-off between tax rates and tax revenues.[1]

The Laffer Curve has two effects, the arithmetic effect and the economic effect. The arithmetic effect is that "if tax rates are lowered, tax revenues (per dollar of tax base) will be lowered by the amount of the decrease in the rate. The reverse is true for an increase in tax rates." [2] The economic effect (which is what those who are pro-Laffer Curve focus on) "recognizes the positive impact that lower tax rates have on work, output, and employment--and thereby the tax base--by providing incentives to increase these activities. Raising tax rates has the opposite economic effect by penalizing participation in the taxed activities." [3]

This may seem to prove the pro-Laffer Curve group correct, yet Laffer himself stated that "The Laffer Curve itself does not say whether a tax cut will raise or lower revenues." [4] (emphasis added) The Laffer Curve was never meant to serve as proof that lowering taxes increases revenues, however this myth persisted and several Presidents, most notably Reagan and Bush Jr., attempted to apply the Laffer Curve in hopes of bettering the nation's economy.

In 1981, in an attempt to stimulate the economy, Regan cut taxes. However by the end of 1982 "unemployment stood at nearly 11% and 50% of the public was telling Gallup that it disapproved of how the president was handling his job." [5] In later years he was forced to raise taxes six times to try and cover the damage that was done, yet the US debt still tripled. [6]

Bush Jr also tried the same plan, yet in a 2005 New York Times economist Paul Krugman stated that "revenues plunged during the first three years of the Bush administration, not just because of tax cuts, but also because of the end of [the 1990s stock market bubble]." [7] While the stock bubble did have an effect on the decreases in revenue, the tax cuts also played a role.

Krugman goes on to say:

But wait – what about claims that the tax cuts have led to a surge in economic growth? If that were true, calculating taxes as a percentage of G.D.P. would be missing the point because the tax cuts have made G.D.P. larger. So have the tax cuts made the economy grow faster?

Well, no. We had a recession followed by slow growth in the early Bush years, then faster growth after that as the economy recovered. But even now real G.D.P. is considerably lower than most people thought it would be back when President Bush was selling his tax cuts.

Thus, President Bush's tax cuts actually went and lowered real GDP.

At the end of day, we must realize that "in the long run, taxes are equal to government spending. Every dollar the government spends is a tax dollar -- it has no other source of revenue." [8] Since the government's only source of income is taxes, if we are to cut taxes, then we are cutting our children's education spending, the nation's defense budget, Social Security and Medicare for the elderly, and thereby putting the nation at risk.



2: Ibid

3: Ibid

4: Ibid





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