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Tim Cavanaugh | July 17, 2006

Véronique de Rugy finds a lot less than meets the eye in President Bush's deficit-reduction claims.

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OregonCoast|7.17.06 @ 7:59PM|#

The Laffer Curve is a total joke. The increased revenues have nothing to do with it. Most of the increase in tax revenues is from...wait for it...increased Government spending. The more they spend the more taxable income in the system.

|7.17.06 @ 8:41PM|#

The more they spend the more taxable income in the system.

By that logic, we could eliminate the deficit if only the government would spend more.

|7.17.06 @ 8:55PM|#

We're all Keynesians now.

|7.17.06 @ 9:28PM|#

By that logic, we could eliminate the deficit if only the government would spend more.

True. I'm curious to know if OregonCoast qualifies for the "Most Ridiculous Argument Ever" award here on Hit and Run.

|7.17.06 @ 9:32PM|#

I am wondering if there is an alternate explanation; that it is an effect of inflation.

Until the mid-70's, tax brackets were not adjusted for inflation, and as people's dollars became worth less, the increasing numbers of dollars traded in the form of wages and purchases of assets resulted in people being pushed into higher and higher brackets of taxation despite a relatively constant (in terms of goods and services) income.

This was supposed to be obviated by tying tax brackets to the CPI. However, the CPI is heavily massaged by econometricians. In my opinion the effect of these myriad adjustments result in it understating the true effects of monetary inflation by ignoring goods and services that are being bid up more rapidly.

So I am curious if this is not a case of the old bracket creep rearing its ugly head.

|7.17.06 @ 9:44PM|#

Tax rec'ts are up at least in part due to "creep" in the AMT.

Every time I hear somebody braying about how the Bush Tax Cuts have stimulated the economy, I ask myself "And what about the gargantuan Keynesian spending binge? What effect did that have?"

ps- I am one hundred per cent in favor of tax cuts, particularly for taxes on income. I would like to see a little better prioritisation on the spending side. Ho ho ho.

|7.17.06 @ 9:50PM|#

And- by the way, I automatically assume that White House numbers relating to the economy are totally bogus.

|7.17.06 @ 9:56PM|#

Oregon Coast reminds me of a musician friend who plays the Nevada Casino circuit. According to her, "If you're not winning, you haven't gambled enough."

OregonCoast|7.17.06 @ 10:34PM|#

JF

How is it ridiculous?
The the Gov. spends 500 billion more, 10-20% of that will come back into the tax coffers.

If The Govmint gives "company A" a 20 million dollar subsidy, it will add to their profit, thus they send more back to the Govmint via taxes.
And the "company A's" and their subsidies increase every day.

What is ridiculous is "lowering taxes (Which I agree with) equals more revenue", it defies logic.

Don't fall for the Neocon bullshit and try to get something for nothing.
Lowering taxes (via consumption tax) and Lowering spending is the only way to get this country back on the right track.
The Laffer Curve is just a sideshow to get your eye off the ball.

|7.17.06 @ 11:22PM|#

OregonCoast - I can assure you that, whatever bullshit we neocons put out, it has little to do with taxes.

OregonCoast|7.18.06 @ 2:17AM|#

What an echo chamber, no one wants to debate anything.

And Mike, your bullshit isn't taxes, you are correct. The bullshit is spending. But it gets you folks elected so I give you props for framing the debate.

|7.18.06 @ 3:50AM|#

I'm amazed when anyone defends Bush's record on fiscal responsibility. It seems to me that the only thing worse than taxing and spending is not taxing and spending even more. Taxing is only half of the equation. Bush and his loyalists simply pretend the other half doesn't exist. I mean, isn't 50% a failing grade?

|7.18.06 @ 4:29AM|#

Actually, lowering direct tax rates does increase tax revenues, whether public spending is simultanley lower or not. It worked in the UK in the 1980s under Maggie Thatcher, it worked in Austria in the 1950s (under Raab-Kamitz)and it worked in Western Germany when tried by Ludwig Erhard.

Occasionally, deficit spending works too. But the law of diminishing marginal utility applies to throwing money around rather fast (and of course faster than to giving incentives like tax-rate cuts.

|7.18.06 @ 7:52AM|#

OregonCoast: "What is ridiculous is 'lowering taxes... equals more revenue', it defies logic."

Aikon: Actually, lowering direct tax rates does increase tax revenues"

You're both half-wrong.

Does lowering tax rates really result in increased tax revenue? The correct answer... "It depends."

There is no universally correct answer. If the tax rate is either 95% or 5%, the answer is pretty clear.

In the first case, the lower rate effect will be small compared to the higher income effect, and revenues would rise. In the latter, the reverse would be true and revenues would fall.

But for moderate tax rates, (e.g. 30%) it's almost impossible to determine the net effect on revenues ex ante. Even ex post it can be difficult as you try to strip away exogenous factors.

Anyone who tells you they know the answer with certainty is either an idiot or a liar.

The next issue is... why the hell do we want to increase tax revenues anyway? I'm perfectly happy with lower taxe rates AND lower tax revenues.

|7.18.06 @ 8:34AM|#

Spending has increased by 45 percent since 2001

Every time I read that, my soul dies a little bit. 45%??

|7.18.06 @ 8:48AM|#

Bush and his loyalists simply pretend the other half doesn't exist. I mean, isn't 50% a failing grade?

Les, there is no failing grade, remember, "no president will be left behind"

|7.18.06 @ 8:53AM|#

Oregon Coast reminds me of a musician friend who plays the Nevada Casino circuit. According to her, "If you're not winning, you haven't gambled enough."

That can be sort of true. My typical approach to slot-machine-type destinations was always:

1, put 1 quarter in slot machine.
2, spin wheel.
3, go out and get drunk as cheaply as possible.

And never won anything for my quarter.

I've since been told by someone who works in the actual slot machine industry that the odds (and percentage of win returned) improve dramatically when you put in as many coins as you can (i.e. 3, 5, 10--whatever the one-arm bandit lets you play.)

It's something like $.85 of every dollar spent, when spent one coin at a time, is returned to the bettor, vs. $.97 of every dollar spent when bettor spends as many coins as possible per spin of wheel.

Just had to share that.

(Of course, after your first bet, repeat step three.)

|7.18.06 @ 8:54AM|#

OregonCoast is right that some of what the government spends comes back in tax revenues. But certainly the revenue falls far short of the original spending.

Still, that sort of effect could be a nice way to produce misleading stats: "Look, tax revenues went up!" Um, yeah, but it fell far short of spending.

As to the Laffer curve: The basic idea is sound. Very high marginal rates do tend to encourage tax evasion and discourage investment and job growth. The Economist has reported on the high prevalence of tax evasion in developing countries with tax codes that make ours look almost sane. (Their favorite example was a country where, if one took the tax code literally, corporate profits would be taxed at rates above 100%.)

The question is, where is the "magic number"? I have no clue whether American tax rates are above or below the magic number that maximizes revenue. I think it's complicated by the fact that the American tax code has numerous loopholes, exemptions, deductions, and credits. Taking marginal rates at face value doesn't tell the full story of how much people are actually paying.

None of this should be taken as a defense of our tax code. I'm simply suggesting that (1) the concept of the Laffer curve is perfectly reasonable but (2) it's hard to say what the "optimal" rate is, in part because (3) our tax code is so complicated that the marginal rates on page 1 of the booklet are only part of the story. You have to look at the other 400,000 pages (or whatever) to get the full story of what percentage people are actually paying.

|7.18.06 @ 9:01AM|#

As Russ R pointed out, with intermediate rates the question is harder to address. Also, as I said before, our tax code has lots of loopholes and exemptions. At high tax rates, it may be worth your time to structure your activities so that you qualify for some of those exemptions. At lower rates, it may not be worth your time to structure your activities for tax purposes.

In other countries, where bribery is much more widespread (or at least much more widely discussed), at a high tax rate it may be worth your while to offer a small "donation" to the local tax collector. And if that tax collector's official income is also subject to a high tax rate, he may be very eager to accept that "donation."

The important thing here is that the Laffer curve doesn't only depend on the relationship between taxes and investment. It also depends on the ease with which one can get around the tax code. And that makes it all the more complicated.

|7.18.06 @ 9:21AM|#

Sorry, OregonCoast, for never getting back to you, but I see thoreau answered you with an excellent argument. Your original argument suggest that the government has invented some sort of economic perpetual motion device, and the output will be greater than the input.

|7.18.06 @ 10:15AM|#

I personally liked the quick trigger on the "echo chamber" accusation. It's like this guy read this one thread where two people called his argument stupid and concluded that Hit and Run was populated with people who do nothing but agree with one another.

Tremendous stuff.

VM|7.18.06 @ 10:43AM|#

The thing is that there is a "Laffer Curve".

However, (and apologies if this has been said - am on first cup of coffee), "supply side" economics is not taken seriously these days. I'd like to send the final paragraph to the head of econ depts across the country for an assessment. I don't see any of them thinking that's correct.

Plus, since the laffer curve is derived basically from the standard labor market model, you don't need the laffer curve to find the growth maximizing point - you actually can't. (And we have different ideas here of what that point would be. (Tobin, Sidrowski).)

The Laffer Curve is the relationship between tax revenue, T, and the (income) tax rate, t.

In the steady state: T = ty = t f(k); since y = f(k)

k(t) = f'(k) = (n+p+d)/(1-t).

In practice, however, the resulting laffer curve is not an upside down bowl shape. It drops off rather steeply. (Test this with cobb douglas).

For the supplly siders, the mere presence of the Laffer Curve suggests that tax cuts stimulate and cause growth. However, in the US, the (averag highest marginal) tax rate would be >70%. Also, the supply siders imply t(max) --> t(optimal), and that's not necessarily true. But our tax burdon isn't close to that point. It was once, however. That is important to remember.

I disagree that we could talk "Laffer Curve" here. Picking up David Romer's "Advanced Macroeconomics" (2nd ed.)ISBN: 0072318554. 2001 McGraw-Hill/Irwin. Gary Burke is publisher.

"Laffer Curve" is not a big topic. I couldn't find it in the index. We briefly touched upon it on March 3rd, 2005. (and when calculating seinorage, the monetary laffer curve is used). Does anybody have an advanced Macro textbook that devotes modern-time study to it?

There are other models used that have held up better empirically. The RBC people are challenging these, and it'll be cool to see what they come up with! Maybe the neoclassical will get thrown out. :)

Also, it's a misunderstood dichotomy to suggest that rejection of Supply Side economics means that one embraces "Keynesianism". Furthermore, Keynesianism, as practiced these days - New Keynesian Economics - would be basically unrecognizable to those who claim dichotomy.

Professor Mankiw, the Prez's first economic advisor is a Keynesian. As is Ben Bernanke. MIT, Harvard, Northwestern, and others are called "Salt Water" schools - they're in the new Keynesian camp, broadly speaking.

The "Fresh Water Schools" (U of C, for example) have moved in a different direction. "New Classical" is what it's sometimes labeled.

New Growth Economics is another direction of econ.

These distinctions have been around since the late 80s or so.

Sticking with neoclassical economics (I'll let the non-formalized Austrians provide their own explanation, as I don't want to misrepresent those views)...

This big tent "neoclassical" economists have basic, broad brush agreement here:

Short run:

Shifts in aggregate demand affect output. Higher consumer confidence, a larger budget deficit, and faster growth of money are all likely to increase output and decrease unemployment

Medium run:

Output returns to the natural level. This natural level depends on the natural rate of unemployment, on the capital stock, and the state of technology (NRU and size of the labor force determine unemployment)

Long run: there are two main factors that determine how the level of output evolves � capital accumulation and the rate of technological progress.

Monetary policy:

this affects output in the short run, but is neutral in the medium and long run (doesn�t have an effect). Increased (�a higher�) rate of money growth will at some point translate into a one for one higher rate of inflation.

Fiscal policy:

This has short, medium, and long run implications. Output is affected in each run. It is expected that a budget deficit is likely to increase output in the short run. The deficit won�t have an effect on output in the medium, and is expected to decrease capital accumulation (see above) and therefore output is expected to decrease in the long run (deficits do matter).

There is no agreement in time horizons or "how long is the SR?"
---
As for the arguments about Thatcher and Kohl and teh UK/FRG experiences in the 80s, we would have to look at a myriad of factors to see what was happening. Understanding that there are disagreements in the time horizons (SR, MR, LR), we could see different explanations. That claim needs to be supported better if it is to be used as "proof" of the laffer curve's effect. It may be the case, or it could be a SR stimulus effect.

Invoking the laffer curve seems to bring up strong feelings (like gold standard or the strong reaction against what people imagine is "Keynesian"), but as Heijdra and von der Ploog ("The Foundations of Modern Economics") note, "Although Laffer's advice itself is logically correct and appeals to wishful thinkers, it was empirically irrelevant..." (page 25).

The supply side appeal (Mundell and Art Laffer) is that S.S. rejects gov't intervention in markets and "emphasize the distorting effects of taxation" (ibid).

It has a simple appeal, it's easy to describe, and there appears to be superficial empirical evidence of its effect. However, I disagree that it is relevant economics to mention.

|7.18.06 @ 10:51AM|#

VM-

Sorry, I guess I put my foot in my mouth there. As I understand it, there is a germ of a reasonable idea there: At very high high marginal rates, a tax increase will increase revenues, and at very low marginal rates a tax increase will increase revenues. As a general observation, that seems rather sound. I didn't mean to imply that the general observation has translated into a good working theory, and I tried to emphasize (as others did) that applying that observation anywhere in the middle ground will probably be a hopeless business.

I'll shut up before I embarass myself any further.

|7.18.06 @ 10:54AM|#

I should, however, correct a typo to avoid some embarassment, and then shut up before I embarass myself any further:

"At very high high marginal rates, a tax increase will decrease revenues..."

Now I really will shut up before I embarass myself any further.

VM|7.18.06 @ 11:03AM|#

Hi Thoreau!

no worries - you hit the intuition behind the Supply Siders: distortionary effects of taxation. A more complicated tax code distorts more! There is a lot of work on types of taxation used to minimize distortions, too!

And empirical studies imply that the tax cut effect would take place in the US when the highest avg marg tax rate >70%, and IIRC, we were there once. (http://www.truthandpolitics.org/top-rates.php says 1970 was the last time >70%)

Again, you're right - in theory it makes sense. And you can derive the laffer curve. It's just that empirically it hasn't held up...

There were a few other comments that were misunderstood applications that prompted the comment :)

cheers!
VM

|7.18.06 @ 11:10AM|#

So, in a nutshell, they're right on the qualitative effect, but wrong on the numbers regarding when it actually happens. And since numbers are what matter most in science...

Got it.

|7.18.06 @ 11:32AM|#

Any or All?

If I take a dollar bill to 7/11 at five in the morning and buy a paper the government agencies get $.06. If someone spends other money there at 5:30 and gets the dollar I spent in change and then goes to Walmart and spends it government agencies another $.06 from the same dollar. Say this goes on 4 more times that day, =$.36. So, if I am thinking right and this is a continuous trend for a dollar bill, then in three days one dollar could be worth itself to the gov????

So, if true, why wouldn't the government want all spending and none saving??? Or was I way to sober before I thought of this?

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