In 1974, on what was to become one of the most famous napkins in economic history, a young professor from Chicago, Arthur Laffer, sketched a statistical curve for Dick Cheney, then Deputy White House Chief of Staff, hoping to convince President Gerald Ford not to increase income taxes by another 5%.
The Laffer Curve, as it is now known, argues that raising taxes does not necessarily increase tax revenues. There is a tipping point in tax rates beyond which tax revenues actually diminish. Setting taxes too high creates a disincentive to earning, since the government simply takes a bigger bite of the income. Laffer’s idea was hardly new; no less than John Maynard Keynes once expressed a similar view. Indeed, the concept dates back at least to the great 14th century Arab scholar Ibn Khaldun.
While President Ford didn’t embrace the Laffer curve, it found more sympathy with advocates of what came to be known as supply-side economics or Reaganomics, after the fortieth US president. It never really went away but it was revived with gusto by the forty-third president, George W. Bush. US supply-siders argued that cutting taxes would increase tax revenues as all that untaxed income “trickled down” through the economy, raising incomes and, thus, tax revenues. But this never really happened. While the overall US economy grew robustly in the late 1980s – and some of that growth can fairly be attributed to tax cuts – it was not revenues but rather the government’s deficits that increased, and to dizzying heights.
There are several reasons why lower taxes failed to boost tax revenues. For one, the marginal tax rate in the US was already below the tipping-point tax rate. Hence, lowering it only led to lower revenues. A more subtle reason was given by another young conservative Chicago economist, Robert Barro. In an important paper, also published in 1974, he argued that people don’t see much difference between taxation and government debt because they know intuitively that today’s deficits are tomorrow’s higher taxes. When tax cuts only increase the government’s deficit, households and companies will not change their behavior. So if you want tax cuts to really have an impact, you also have to cut government expenditures.
Most economists today dismiss the Laffer Curve, and Reaganomics, given the poor results of both. Nevertheless, these ideas still resonate with many politicians. Lately, the German government has sought to justify its bold, new tax cuts along those lines. While we wish them every possible success, we are deeply skeptical. It remains to be seen whether Germany’s marginal tax rate exceeds the tipping point. Moreover, given Germany’s popular distaste for big government deficits, Barro’s argument is even more likely to apply there than in the US.
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