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Debunking One of the Worst Ideas in Economics

Thursday, July 06, 2006 | 06:15 AM

This is scheduled to disappear from Yahoo soon -- I wanted to capture it before it went away. Its a criticque of Supply Side economics by Charles Wheelan, former US columnist for the Economist, and at present an economics and public policy professor at the University of Chicago and visiting prof at Dartmouth College. Wheelan is the author of Naked Economics: Undressing the Dismal Science.

Debunking One of the Worst Ideas in Economics
Wednesday, May 3, 2006
http://finance.yahoo.com/columnist/article/economist/4065

"In this column, I'm focusing on bad economics. In fact, I'm going to write about what I consider to be the two worst economic ideas -- or at least ideas that pass as economics, though both have been thoroughly repudiated by nearly all credible thinkers.

When I say worst, I don't mean the most outlandish (e.g. stock prices are controlled by aliens) because those ideas usually collapse of their own weight. Rather, the most pernicious bad ideas in economics are those that have a ring of truth. They're hard to debunk because they have a certain intuitive appeal. As a result, they stick around, providing bogus intellectual cover for bad policy, year after year, decade after decade.

For the sake of political balance, I'll skewer a favorite of the right in this column, and then a favorite of the left in my next piece.

The Laffer Curve

Economist Arthur Laffer made a very interesting supposition: If tax rates are high enough, then cutting taxes might actually generate more revenue for the government, or at least pay for themselves. (In one of life's great coincidences, he first sketched a graph of this idea on Dick Cheney's cocktail napkin.) If the government cuts taxes, then Uncle Sam gets a smaller cut of all economic activity -- but reducing taxes also generates new economic activity. Laffer reasoned that, under some circumstances, a tax cut would stimulate so much new economic activity that the government would end up with more in its coffers -- by taking a smaller slice of a much larger pie.

In fairness to Mr. Laffer, there's nothing wrong with this theory. It's almost certainly true at very high rates of taxation. If you consider the extreme, say a 99 percent marginal tax rate, then the government will probably not be collecting a lot of revenue. To begin with, citizens are going to hide as much income as possible. (The more honest ones will turn to barter and avoid the tax system entirely.) And no one is going to rush out and take a second job or build a factory if they get to keep only $1 of every $100 that they earn.

So it's entirely plausible that slashing tax rates from 99 percent to 30 percent could increase government tax revenues. It would deflate the black market and provide a huge new incentive to work and invest.

No Big Jolt for the U.S.

But here's the problem when we take Laffer's theory and try to apply it in the U.S.: We don't have a 99 percent marginal tax rate. Or 70 percent. Or even 50 percent. We start with low marginal tax rates relative to the rest of the developed world. (Yes, I understand that it may not feel that way after the check you wrote last month.)

So cutting the tax rate from 36 percent to 33 percent is not going to give you the same kind of economic jolt as slashing a tax rate from 90 percent to 50 percent. There's no huge black market to be shut down, no big supply of skilled workers to be lured back into the labor market, and so on.

Will it generate new economic activity? Probably. And that will generate some incremental tax revenue for the government. But remember, it also means that the government will be taking a smaller cut of all the economic activity that we already have.

Think about a simple numerical example: Assume you've got a $10 trillion economy and an average tax rate of 30 percent. So the government takes $3 trillion.

Let's cut the average tax rate to 25 percent and, for the sake of example, assume that it generates $1 trillion in new economic growth (a Herculean assumption, by the way). So now, what does Uncle Sam get? One quarter of $11 trillion is only $2.75 trillion. The economy grows, government revenues shrink.

That's basically what happened with the large Reagan and George W. Bush tax cuts, both of which were followed by large budget deficits. Yes, spending has a lot to do with that, but the bottom line is unequivocal: In both cases, government revenue was lower than it would have been without the tax cuts.

Can't Lose Weight by Eating More

Neither the Reagan nor the George W. Bush tax cuts were "self-financing," as the Laffer disciples like to argue. According to The Economist -- my former employer and no bastion of left-wing thought -- the current Bush Administration's top economist, Gregory Mankiw, estimated that decreasing taxes on labor would generate enough growth to recoup only about 17 cents for each lost dollar; a tax cut on capital is better, paying for more than half of itself. Still, the bottom line from the Bush Administration itself is that tax cuts reduce Uncle Sam's take.

So why does Laffer's sketch on Dick Cheney's cocktail napkin rank near the top of my list of bad economic ideas? Because, when applied to the U.S., it's intellectually dishonest. The Laffer Curve offers the false promise that we can cut taxes without making any sacrifice on the spending side, and that's simply not true. It's the economic equivalent of arguing that you can lose weight by eating more.

Let me be perfectly clear: I'm not arguing that tax cuts are bad. I'm simply pointing out that we can't pretend that tax cuts won't require reductions on the spending side to balance the budget. In fact, you can disregard every other argument in this column and think about one thing: If Laffer were right, lower taxes would never require any spending sacrifice. We could pay a mere one percent of our income in taxes and still fund all of our government spending -- and maybe more! Do you think that's really possible?

This column should give you a hint of why economics is called the dismal science -- it's all about tradeoffs. We're the ones telling you that if you get more of something, you probably have to get less of something else.

Whether it's tax policy or dieting, you can't have your cake and lose weight, too, which is why America currently has huge deficits and a lot of fat people.

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Comments

Mr. Wheelan's point is well taken but it raises a question in my mind which remains ignored. What is the tax rate that will allow the most good to be done both private and public? Everyone agrees 99% is too high and 1% is too low. It may be impossible to know this answer. Since it is unlikely that anyone can know the perfect rate should we aim to error on the high side or on the low side?

Posted by: Barry Miller | Jul 6, 2006 7:12:52 AM

Ohhhh, so that's why America has so many fat people. (Read the article to the end for reference to fat people.)

I get it now ...

But hey, it worked for Reagan. Hell, Laffer brought down the Iron Curtain. To hell with the dollar and our kids' future solvency. Tear down that wall! Oh, its already down. Nevermind.

Posted by: Opihi Man | Jul 6, 2006 7:21:30 AM

It's a fairly good idea, and one that at the time was radical. Essentially, getting the most tax revenue may not come from raising rates, but instead by encouraging growth and investment.

That flies in the face of the Dem argument repeated ad nauseuem in the times that tax cuts only benefit "the rich". funny how they then go on to call for "fixing" the AMT.

Posted by: JoshK | Jul 6, 2006 9:12:01 AM

Debunking? .. hardly.
It depends on time frame. Lets ussume an economy that grows at 0% and is taxed at a 35% rate. If the tax is cut to 25% lets assume the econony grows at a 2% rate. (not unreasonable in my opinion).
Now after 30 years the economy will be 1.8 times the size of the original. 1.8 x 0.25 = .45 which is bigger than if the econmy stayed at 1.0 x 0.35 = .35.

If this guy is an economist then it is indeed a dismal science.

Posted by: mrmanny | Jul 6, 2006 9:18:11 AM

I always thought that inflation played a role in being able to sell supply side economics in the late 1970s ...It has made less sense ever since to me.

Posted by: David | Jul 6, 2006 9:23:37 AM

Unfortunately Charles Wheelan does not provide any analytical evidence to bolster his case. His arguments are mainly subjective. Why is it that several economies of Europe have sluggish growth with high taxes and Hong Kong (pre-China takeover) with very low taxes had way above economic growth and was a bastion of capitalism?

The above post by mrmanny makes a lot more sense than Wheelan's.

Posted by: Steve C | Jul 6, 2006 9:26:42 AM

Thought the points were incomplete because they ignored the difference between private and public decisions. Except for obviously public goods, private decisions are more efficient in the long run and a higher proportion of private decision making surely helps foster a more responsible and reliant civil society. Also, no mention of the effect of lower capital taxes which undoubtedly are stimulating investment and job growth. Hope they remain low and perhaps some economists could discuss the merits of even lower capital taxes ??

Posted by: cdd | Jul 6, 2006 9:44:11 AM

Also, does anyone else pick up the "tsk-tsk"'ing tone of the piece. Debunking the simple thoughts of the right wing simpletons? The tone of "here, let someone wiser explain this to you".

Posted by: JoshK | Jul 6, 2006 9:55:59 AM

If the Laffer Curve doesn't work then how come Federal Tax revenue increased in fiscal year 2005 by $275 billion, a 14.6 percent increase over 2004 and $207 billion of which was from higher income tax revenue? Because the economy was growing? Would the economy have been growing without the tax cuts? I think it's called the dismal science because the field is populated mostly with pessimists like Dr. Wheelan. Give me an optimist like Arthur Laffer any day of any week of any year.

Also, no wonder we had a surplus under Slick Willy. He and Rubin increased the tax burden of the average American household by 20% over GHW Bush. Even Carter, the previous Dem President, had a lower average tax burden by 19%. It's also worth noting that the tax burden of the average American household is still at historically high levels even after GW Bush's tax cuts.
http://www.heritage.org/research/features/BudgetChartBook/charts_R/r3.cfm

Also note how revenue did not trough until 2003, ala a J-Curve.
http://www.heritage.org/research/features/budgetchartbook/charts_C/c1.cfm

The Laffer Curve works. 'Nough said.

Posted by: ArizonaChartist | Jul 6, 2006 10:06:21 AM

I agree with Wheelan that there are some ranges over which decreasing the tax rate will increase revenue collected, and there are other ranges over which it will decrease revenue collected (so would Laffer, I presume, since his curve implies it).

Where we sit is an open question. What are the assumptions Wheelan is using? Where did his $1 trillion figure come from? Is that the NPV of the difference between low-tax economic activity and high-tax activity? Assuming it is, over what time period? What were the assumptions about growth and discount rate that generated the figure? Why is $1 trillion "hurculean", if (to mrmanny's point), the change in growth rate is permanent? If annual real growth went from 2% to 4% due to a cut from 36% tax rate to 25% tax rate, it's not "hurculean", it's peanuts!

More fundamentally, however, I disagree with the implicit assertion that the proper function of government is to maximize total taxation.

Posted by: Morgan | Jul 6, 2006 10:19:58 AM

ArizonaChartist: you're using ONE year's data point to bolster an argument about a trend, while ignoring the previous 3 years of data, which showed... what? You think tax revenue increased in 2002? Look at the numbers for yourself to see whether the tax cut really did what was intended... or was it deficit spending to the tune of over $1 trillion in less than 3 years? How much is $1 trillion in a $10 trillion economy? Doesn't that closely track how well GDP has done over the same period? Did we remove taxes or just print money to improve the economy?

Think critically about everything you're told. Don't just parrot someone else's party line.

Posted by: Andy | Jul 6, 2006 10:24:56 AM

I suggest that anyone stupid enough to defend supply side economics be banned from this site.

Posted by: ken | Jul 6, 2006 10:39:18 AM

I don't need the politcal part of this discussion.
I think that's part of the dishonesty.

What I need to know is, how would this "theory" work in reality, say in my business.

If I borrow record sums of money (see expense side of ledger) but i don't produce enough to cover those expenses, is my economy growing?

How is it that perfectly intelligent people apply theories to government fiscal policy that they would never dream of in their private dealings?

Borrowing money to increase production is how it works, not the opposite.

We have record deficits, record trade deficits, rising interest rates and inflationary costs, and essentially zero growth in the face of static to falling real wages.

IOW, we are taking in less money, borrowing more, and still clinging to the idea we can cut revenues or not cut spending?

Are republicans all hanging with Rush and doing drugs?
Are you drinking Kudlow's kool Aide or what?

Try it this way.....it;s the exact same thing as ethanol.
You CANNOT get MORE from less. This is the law of thermodynamics AND economics. There is no such thing as perpetual motion, a free lunch or something for nothing.

Can we acheive better efficiencies? Yes.
Can it be done with voodoo? Nope.

We have two choices or a combination.
We have to either CUT spending (good luck) or take in more money (raise taxes).

you cannot CUT taxes and spend like a broken water main and say the economy is growing.

YOU HAVEN'T PAID ANY EXPENSES YET, HOW CAN YOU KNOW IF THERE IS GROWTH?

Does ONE day of increased wages take care of a months expenses? A good month a year?

All we have to do is apply this voodoo to our own lives to see how bankrupt it is.

I guarantee Laffer doesn't run his investments, business or household on his curve or a like percentage of deficit, otherwise we wouldn't know him by anything other than a listing in the public section in the local paper announcing his bankruptcy.

I think we better let go of ideology and grasp simple economics....quickly.

You cannot spend more than you produce, or that the spending will produce.....for long.

if you cite increased tax revenue from "cuts" in taxes, then you need to cite the opposite side of the ledger.

So far no one has done that. They simply spout-off on the side of the ledger that supports their ideology....at the expense of the facts, our wallets, and our children and grandchildren.

Not only is that bankrupt of logic, it is immoral and un-American.

Posted by: Craig | Jul 6, 2006 10:41:11 AM

Europe and Japan have sluggish growth because they have aging populations that are in a long term savings mode and still trying to shove their exports (savings) down the throat of a customer that has been to the buffet too many times, period, end of sentence.

Posted by: alan | Jul 6, 2006 10:51:22 AM

Craig:

If real growth increases from 2% to 4% due to a cut from 36% to 25% in total tax burden (and I'm just throwing numbers out there - I have no basis for the exact numbers), taxes collected in a given year will be higher under the low-tax scenario after about 20 years. Total cumulative taxes collected (in raw, real dollars) will be higher after 36 years. Discount future flows at an additional 3% and the cumulative tax breakeven pushes out another 2-3 years.

So there: I've shown that it is at least theoretically possible that total tax revenue (citing both sides of the ledger, you'll note, by using cumulative figures) over the next 40 years will increase given a decrease in tax rate. With our shared concern about our children and grandchildren, we should both be pleased with the possibility that their government will take less of their paycheck while collecting more total revenue when they are in their prime taxpaying years.

The problem is this - the Laffer curve is clearly correct in positing that there is some range over which revenues will increase and some range over which it will decrease, but exactly where those ranges lie is unknown. We don't know what change in growth rate would result from a change from x to y in tax burden.

Posted by: Morgan | Jul 6, 2006 11:09:47 AM

I should also note that the idea that there will be some permanent increase in growth rate from x to y is also just hypothetical.

Posted by: Morgan | Jul 6, 2006 11:17:46 AM

There are a couple ideas getting mixed up here. This is typical for supply side economics.
1) The Laffer Curve only implies that there are conditions where a tax cut will result in increased revenues. The Curve also implies that there are conditions where a tax increase will result in additional revenues. For whatever reason, the former is almost always assumed despite our historically lower marginal rates in the upper brackets.
2) Say's Law is assumed to be true, e.g. supply creates its own demand. Keynes pretty much demolished it, but here are the assumptions involved:
a) Business investment is solely determined by an ability to produce.
b) If more money is available, more goods will be produced.
c) Therefore, if you cut taxes, production will be increased resulting in an increase in taxable events and hence more revenue.

Posted by: M.Z. Forrest | Jul 6, 2006 11:25:59 AM

To me, the important point that Whelan makes is not whether the Laffer curve works in the U.S. or not, but rather any policy that looks solely at the revenue side without addressing the spending side is doomed to failure.

Given the right's affinity for the "tax cut=revenue increase" argument and the left's mantra "tax cut=favored rich", I would bet the truth is somewhere in the middle. The reason the argument gets so much attention is because it helps the politicians to keep our minds off of the real problem and their larger failure: too much spending!

Posted by: J | Jul 6, 2006 11:32:36 AM

Andy,

Look at the second chart. No, tax revenue did not increase in 2002. The tax cuts had a J-Curve effect as per my statement. You know, J-Curve = things get worse before they get better. The trend in Federal Tax Revenue since 2003 is up. I simply used 2005 as one data point to help put some numbers to a very generalized graph.

Ken,

You are what's wrong with the liberal elite. Anybody who doesn't agree with the lefties must be stupid, huh? Well that approach hasn't worked for the last 6 years. Just ask Al Gore and John Kerry. This is an economic discussion, not a political one, so you should check your 'tude.

Posted by: ArizonaChartist | Jul 6, 2006 11:34:34 AM

"I suggest that anyone stupid enough to defend supply side economics be banned from this site. "

Awesome. That is the motto of today's left. "We are smarter because we say so".

Posted by: JoshK | Jul 6, 2006 11:41:22 AM

So he's saying small cuts don't work? :) Let's assume the rate's at 30% now... how about we cut it to 15%. If we turn 3% growth into 6% growth, we're +$EV over the long term.

Laffer Curve or not.... I'm all for anyone putting money in my pocket... because in the end, it's my family I care about more than anyone elses.

Posted by: Chad K | Jul 6, 2006 11:41:48 AM

Mankiw has already solved this debate. No hypotheticals and no matter how much you want Laffer to be right, he isn't and never will be.

Posted by: Brendon | Jul 6, 2006 12:00:02 PM

Morgan,
I agree that we can make this case by plugging in some numbers, but I want to plug in actual numbers, not the numbers government 'economists' pull from their posteriors.

The problem is we aren't running off an honest ledger or on a known return for a known expense....we are flying blind, or worse, on faulty political BS instead of actuals.

If we use the standard view on this list, which is tending toward slowing growth, increasing expenses (inflation) and tapped-out bank accounts and assets, (recession/stagflation) then we are looking at the same picture in our overall personal financial lives that mirrors itself in our government.

Afterall, it is of, by and for the people! If the people are running negative savings, record personal deficits, and looking at falling incomes, real assets and currency value, how can we expect the governmental reflection of those same people will be markedly different?

If we are all citing trouble in personal finance, as is the case here as a result of our collective denial, then we must apply the same principle to our government, or we are simply not being honest with ourselves.

I wonder, how many folks with ARMs, tapped-out equity and no real wage gain are telling themselves the truth about their future? The same is true for our government.

Replace ARMs with budget deficits, trade deficits and future expenses, and falling revenues RELATIVE to these long term expenses, (static to falling wages compared to inflation) and we have a correlation between our individual (mis)management and our collective (mis)management. Micro/macro, the difference is scale, not theory.

In theory "relative" efficiencies can be obtained, but the relative figures are the issue. Using todays budget and trade deficits, spending, future rising obligations, accompanying expenses and the cost of the debt, it is certainly more difficult to make that case with the revenues claimed.

If we use the relativity POV and factor in the trade deficit (we are buying more than we sell) and the budget deficit, (we are spending more than we make) and we are taking in additional short-term income (taxes), but in deflated dollars and in the face of massively rising **future** expenses, (remember, we have borrowed against the "trust funds" thereby hiding increased indebtedness) then how do we see net gain enough to proclaim growth, especially over any meaningful period of time? IE: the payback period for the debt, or how long it takes us to pay it off.

Does anyone here really say they are projecting net gain from the current tax cuts that will overcome our overall future indebtedness? If NOT, (and we know this isn't possbile without dimentia) then how can "growth" be proclaimed by these short-term claimed gains? Come on now.....

Can anyone proclaim growth in the face of soft expense numbers for Iraq, hard numbers for medicare/SS and trade deficits, and soft income numbers? I know in my business this would freak me out. If I get hot numbers for a month (no doubt like your tax cuts I'm grateful) but I know I have rising expenses that are soft figures for years to come and I know will be monumental, can I tell the bank
I'm "growing income"?

They would laugh me out of the place.

You will note I'm not simply accepting the BS that we have actually increased revenues, that is as unsubstantiated as the "surpluses" under the previous managers. Also, you can see I'm not trusting of either political ideology....all politicians are warmed over attorneys. Make of that what you will but
I trust em' as far as I can throw em. See above article regarding weight.

Posted by: Craig | Jul 6, 2006 12:03:23 PM

According to conservatives arithmatic is liberal.

Please, leave your politics outside this discussion.

Supply side economics is as phoney as saying that you can spend more money by taking a pay cut at work and borrow whatever you want to make up the difference. Yes, you can do it but it is not sound fiscal policy for a nation or for a household.

Posted by: ken | Jul 6, 2006 12:15:03 PM

There is a fundamental difference between the way business and government operate.
Business is interested primarily in growth in revenue and profit. Business spends more to earn more.
Government is interested in spending. The more it gets the more it spends.
My mother was a government employee. Every year at the end of the budget year everyone in her department was encouraged to spend, lest they lose thier allocated funds next year. There are lot's of good people in government, they just have a warped incentive scheme.
I agree that cutting taxes results in increased deficit. But to expect the government to reduce spending first and cut taxes second is a fantasy. It's like continuing to supply drugs to a junkie and expecting him to stop. It just ain't gonna happen.
The only way politicians and bureaucrats will stop spending is if you take away the money. Yes, that results in deficits, the same way that taking away the drugs results in violent withdrawl symptoms. But at the risk of being simplistic, pain is the only way to get better.
For business minded people, this sounds completely counterintuitive. But big government is a different species and needs to be approached as such.

Posted by: Paul Y | Jul 6, 2006 12:23:35 PM