Why Laffer Lingers: Tax Cut Snake Oil Is Still for Sale

The New York Times’s new “Upshot” section provides useful evidence-based reporting about current political and economic issues. A column last week by Josh Barro reported that the State of Kansas is facing a huge shortfall in its expected tax revenues. The reason that the decrease in tax collections in the Jayhawk State was interesting, however, is that it provided another resounding rejection of a surprisingly resilient claim: that reductions in tax rates can surprise us by resulting in more tax revenues, rather than less.

Barro’s column was designed to be provocative, carrying the headline: “Yes, if You Cut Taxes, You Get Less Tax Revenue.” He specifically meant to convey the idea that our intuition turns out to be right, that tax cuts really do reduce tax revenues, and that Kansas’s experience should hardly be surprising. Yet somehow it does surprise many people when the promised miracles of “supply side” tax cuts fail to emerge.

Following on the heels of Barro’s news analysis, the economist Paul Krugman devoted his Monday op-ed column to trying to explain why, despite repeated disproof of the idea that “tax cuts pay for themselves,” surprisingly large numbers of people continue to fall for such long-discredited claims.

Under the title “Charlatans, Cranks and Kansas,” Krugman offered two interrelated explanations. First, being able to sell the snake oil of self-financing tax cuts serves a political purpose for those Republicans who wish to claim that they care about deficits and debt, even as they furiously pursue their agenda to cut taxes for wealthy people. Second, well-funded groups continue to sell the snake oil, because they are fronts for people and corporations who will gain from the tax cuts, even though they really know that the tax cuts will drain money from states and the federal government.

Krugman’s analysis is surely right, as far as it goes. However, I think that his cynical explanations need to be leavened with a third, more forgiving explanation.

It is true that one political party refuses to give up the ghost on this issue, and it is true that big money is helping them to feed disinformation to the public. It is also true, however, that there is something peculiarly appealing about the logic of self-financing tax cuts. As I will describe below, it could be true that tax cuts would pay for themselves (as a matter of logic, but not reality), and it is even a fun game to try to describe how it could happen.

This is, I believe, why a surprisingly large number of apparently smart people continue to believe that it actually does happen. Indeed, the counterintuitive quality of the logic itself could explain why so many well-meaning people continue to be taken in by it.

First Things First: The Basic Counterintuitive Logic of “Laffer Curve” Tax Analysis

Before explaining how we know that this claim is completely wrong, we need to understand what it is that we are discussing. Although the ideas behind the analysis were hardly his inventions, the economist Arthur Laffer now has his name permanently attached to the notion that it is possible to decrease tax rates yet to see the government subsequently increase its tax collections. How could this happen?

We know three basic things about the relationship between tax rates and tax revenues. (The logic is the same for any kind of tax, although it is useful to focus here on income taxes). First, if the tax rate is zero percent, then we will necessarily collect no taxes. Second, if the tax rate is one hundred percent, then we will collect almost no revenues. (I say “almost” because some people might continue to earn income, even if it is all taxed away, simply because they like what they do. But we can treat that as a vanishingly small category of people.) Third, we know that if the tax rate is anywhere between zero and one hundred percent, then we will almost certainly collect some positive amounts of revenue.

It is tempting to put these facts together in a misleading way, as Laffer did, saying that there is a smooth curve that shows that tax revenues will rise with tax rates until a turning point is reached, at which point there will be declining revenue. That, however, turns out to be extremely simplistic. All we really know is that cutting a tax rate from 100% would increase revenue, and increasing a tax rate from 0% would increase revenue. Everything else is a matter for empirical inquiry, to which I will turn later in this column.

So, how do we get from these bare facts to the idea that we can cut tax rates in the real world (where they are not 100%) and confidently believe that tax revenues will rise? The claim is that tax cuts will so encourage people to increase their economic activity that they will earn more money; and even though they will be paying fewer cents in taxes per dollar earned, they will earn so many more dollars that the net effect on revenues will be positive.

It is easy to see why this is so appealing, because it seems to belie the “no free lunch” idea that economists glumly embrace (to the point that our field is known as the Dismal Science). Under Laffer-like logic, we can give people what they want (tax cuts) and still be “fiscally responsible.” Who would not want that to be true?

The problem is that it is not true.

Pouring Water on a Fun Idea: Tax Cuts Do Not Pay for Themselves, at Least in Any World That We Have Ever Known

Before turning to the empirical evidence, it is important to explore two related points. First, people will often flip back and forth between saying that tax cuts pay for themselves and the more limited claim that tax cuts increase economic activity. If, however, the argument is merely that tax cuts can have positive effects on the economy, then that is nowhere near enough to back up the broader Laffer-esque claim. We might well be happy if a tax cut expanded the economy, but we would still need to face the reality that we reaped that benefit at the cost of reducing tax revenues.

As it happens, of course, even that more modest claim—admitting that tax cuts do not pay for themselves, but claiming that they are “worth it” in the sense that they increase economic growth—has turned out not to withstand economic scrutiny. As I pointed out in an earlier column here on Justia’s Verdict, the empirical evidence simply fails to back up the claim that tax cuts encourage economic expansion (or that tax increases harm the economy).

The second point is that even the Laffer-like logic cuts in both directions. That is, the most that we can say is that it is possible that tax rate cuts could increase revenues or decrease revenues. This means that invoking Laffer merely opens up a possibility, rather than closing the case.

And why would we even expect that the free-lunch reality would await us, were we to cut tax rates in the real world? Suppose, although this estimate is a bit high, that the overall tax rate in the U.S. is thirty percent. With U.S. GDP currently above seventeen trillion dollars, that means that all levels of government combined collect a total of about five trillion dollars in tax revenue per year.

Now suppose that you want to cut the tax rate to twenty percent. How much bigger would GDP have to be, to prevent tax revenue from falling? It would have to rise to twenty-five trillion dollars. Even if the growth rate of GDP more than doubled, to levels that we have never sustained for more than one or two boom years at a time, it would take a decade of extra-fast growth for our current GDP to reach $25 trillion. In the meantime, we would be collecting lower revenues every year because of the tax rate cut.

In short, in anything resembling the economic circumstances of the United States, the facts on the ground make it simply unimaginable that we would see tax cuts that pay for themselves. And, to repeat, we do not even see reliable evidence that tax cuts increase GDP growth at all, much less that they are so growth-inducing as to offset lost revenues.

The Empirical Realities: No Surprise, the Laffer Logic Does Not Pan Out in Real Life

Some ideas are new, and thus have never been subject to serious scrutiny. For example, no one had ever imagined before 2011 that U.S. politicians would consider playing political games with the debt ceiling, risking a first-ever default on the obligations of the country. When House Republicans suddenly made that nightmare a reality, it was necessary for people to analyze a truly unique (and terrible) idea, essentially from scratch. When my fellow Verdict columnist Michael Dorf and I wrote about the subject, therefore, we were essentially creating a new area of scholarship. There had been no reason to analyze that insane idea before that time.

The idea under consideration here, by contrast, has been studied at length. When I was a graduate student in 1984, I developed an undergraduate seminar studying supply-side economics, because acolytes of Laffer were plentiful in the Reagan Administration. What was surprising was that all of the ideas that fell under the rubric of supply-side economics were already quite old, and they had been studied in detail, for many years. Even back then, it was obvious that there was, at best, only cherry-picked and anecdotal evidence to back up the idea that tax cuts could pay for themselves.

Interestingly, even Republican politicians have often actually taken no for an answer. Laffer-like claims fell out of favor for a number of years in the 80’s and 90’s, before being revived in 1996 by the Dole/Kemp Republican ticket. Even then, however, their re-embrace of the most naïve kind of supply-side claims were considered an indication of their desperation during a losing campaign.

If ever there were a president who would have revived the faith, it was George W. Bush. His signature domestic policy initiative was the huge 2001 tax cuts (followed by another huge tax cut bill in 2003), and he talked a good supply-side game. His Treasury officials, however, admitted reality in 2006, when they issued a “dynamic analysis” showing that tax rate cuts do not even come close to fulfilling the dreams of supply-siders. Still, as one commentator wrote: “The Treasury report probably won’t change the minds of supply-siders, coming as it does on top of 25 years of similar findings by economists.”

Without real evidence on which to rely, it is always possible for believers to mischaracterize isolated incidents. For example, suppose that the government announced in advance that a tax rate was going to be reduced a year from now. People who are able to rearrange their lives so that they can book their income after rates fall will do so, meaning that tax revenues and income will go down in the current year, with a bounce in the following year as incomes and tax revenues magically appear.

That is essentially what has happened with some “tax holidays” and capital gains tax cuts, where people artificially increase tax revenues briefly after a rate cut. That, however, is merely a matter of timing, not overall increases in growth or tax revenues.

In short, although there are still people who are ideologically committed to the idea that tax cuts pay for themselves, and other people who are being paid to say that they believe that down is up, this is a topic on which an often-fractured economics profession has spoken with a surprisingly unified voice.

The title of Paul Krugman’s column, which I noted earlier in this column, refers to “charlatans and cranks,” which is the dismissive label that uber-conservative economist Greg Mankiw (a former advisor to George W. Bush, Mitt Romney, and most other prominent Republicans) once bestowed on those who believe in self-financing tax cuts.

As I noted above, however, the failure of Laffer-like claims to die is incompletely explained in Krugman’s column. The idea that cutting tax rates can surprise us is a welcome thought, and wishful thinking is a powerful force. Moreover, many people are especially drawn to the thought that they can see something that others do not see. It is fun to be able to say, “Well, you would think that it works in the conventional way, but I know otherwise!”

That appeal, however, does not change the reality. No matter the reasons that it will not die, the claim that tax cuts are self-financing is only barely plausible as a matter of logic, and it has been disproven over and over again, by economists who align with both parties. People who want to justify tax cuts need to find a different excuse.