David Cameron's Foolish (or Cynical) Naivete about the Laffer Curve

Even though he's allowing the budget to grow twice as fast as inflation, some people seem to think the new U.K. Prime Minster is a fiscal conservative. I'm skeptical. Not only is spending rising much too fast (there are promises of more restraint in the future, but I'll believe it when it happens), but Cameron and the Tory/Liberal coalition government are increasing the value-added tax and increasing the capital gains tax. Perhaps worst of all, they are leaving in place the new 50 percent tax rate that former Labor Prime Minister Gordon Brown imposed in hopes that class-warfare policy would help him get elected. But as this Daily Telegraph story suggests, it is quite likely that the higher tax rate will lose revenue as productive people escape to Switzerland and other jurisdictions not influenced by the politics of hate and envy.

One-in-four hedge fund employees has already left London to move to Switzerland, which is said to have a more stable tax regime, according to consultancy Kinetic partners. Calculations by the company claim the UK could have already forgone about £500m in tax revenues, based on the 1,000 or so hedge fund managers it says have already left the country. ...High-profile departures this year include Alan Howard, founder of Brevan Howard, and Mike Platt, founder of BlueCrest Capital.

This story shows both the power of the Laffer Curve and the importance of tax competition. The greedy politicians in England doubtlessly resent the "brain drain" to Switzerland. Like their U.S. counterparts, politicians view taxpayers as serfs who are supposed to blindly produce more income for the ruling class to expropriate and redistribute.

While I'm obviously not a big fan of British fiscal policy, America is worse in one important way. At least British taxpayers have the liberty to leave without being raped by the U.K. tax authority. Once they leave the United Kingdom and make their home in Switzerland, they are no longer British taxpayers. Americans who want to move, by contrast, are unable to escape the punitive internal revenue code. Indeed, the United States is one of the few nations in the world to have exit taxes, an odious approach generally associated with loathsome regimes such as the Soviet Union and Nazi Germany.

A Debate Between John F. Kennedy and Barack Obama

Here's a clever video produced by the Winston Group, comparing the tax policies of two Democratic Presidents. Having previously highlighted Kennedy's tax-cutting approach, it is painful for me to observe the class warfare approach of the Obama Administration.

What's especially fascinating is that JFK intuitively understood the Laffer Curve, particularly the insight that deficits usually are the result of slow growth, not the cause of slow growth.

Higher Tax Rates on the Rich Will Backfire

I know I've beaten this drum several times before, but the Wall Street Journal today has a very good explanation of why class-warfare tax policy will backfire. The Journal's editorial focuses on what happened after the 2003 tax rate reductions. And below the excerpt, you'll find a table I prepared showing what happened with tax revenues from the rich following the Reagan tax cuts. The simple message is that lower tax rates are the best way to soak the rich.

Congress's Joint Committee on Taxation recently dropped a study claiming that millionaires will pay $31 billion of the $36 billion in revenue that it expects will be raised next year if tax rates rise as scheduled on January 1. ...If you believe that, you probably also believed Joint Tax when it predicted that the rich would gain a huge tax windfall when tax rates were cut in 2003. Let's go to the videotape. According to the most recent IRS data on actual tax payments, total revenues collected over the period 2003-07 were about $350 billion higher than Joint Tax and the Congressional Budget Office predicted when the 2003 tax cuts were enacted. Moreover, the wealthiest taxpayers paid a larger share of all income taxes from the beginning to the end of this period. The IRS data show that in 2003 those with incomes above $200,000 paid $313 billion in income tax. By 2007 they paid $610 billion. ...Guess what income group paid the most in higher taxes after tax rates were cut? Millionaires. From 2003 to 2008, millionaires increased their tax payments to $249 billion from $132 billion. One reason for the big increase in payments: the number of returns declaring $1 million or more in income increased 76% to 319,000 from 181,000 as the economy expanded. The IRS data are a useful reminder of how dependent Uncle Sam is on the rich to pay the government's bills. ...We're not saying that tax cuts "pay for themselves." What we are saying is that the 2003 tax cuts proved again, as we should have learned in the 1960s and 1980s, that rich people are the most responsive to changes in tax rates. When tax rates are high, the wealthy invest less, hire accountants to protect more of their income from the IRS, and park more of their money in tax shelters, such as municipal bonds. ...That's why it's a fantasy to think that raising income and capital gains and dividend tax rates on the rich is going to pry $31 billion out of millionaire households. History teaches that the best way to soak the rich and reduce the deficit is to promote rapid economic growth. But that's less likely to happen in 2011 if the economy is rear-ended with the biggest tax increase in at least 16 years.

What's the Ideal Point on the Laffer Curve?

There's been a bit of chatter in the blogosphere about a recent post on Ezra Klein's blog featuring estimates from various economists about the revenue-maximizing tax rate. It won't come as a surprise that people on the right tended to give lower estimates and folks on the left had higher guesses. Donald Luskin of National Review estimated 19 percent, for instance, while Emmanuel Saez, Dean Baker, Bruce Bartlett, and Brad DeLong all gave answers around 70 percent.

There are two things that are worth noting.

First, every single answer is to the right of the Joint Committee on Taxation. The revenue-estimators on Capitol Hill assume that taxes have no impact on overall economic performance. As such, even confiscatory tax rates have very little impact on taxable income. The JCT operates in a totally non-transparent fashion, so it is difficult to know whether they would say the revenue-maximizing tax rate is 90 percent, 95 percent, or 100 percent, but it is remarkable that a mini-bureaucracy with so much power is so far out of the mainstream (it's even more remarkable that Republicans controlled Congress for 12 years, yet never fixed this problem, but that's a separate story).

Second, very few of the respondents made the critically important observation that it should not be the goal of tax policy to maximize revenue. After all, the revenue-maximizing point is where the damage to the overall economy is so great that taxable income falls enough to offset the impact of the higher tax rates. Greg Mankiw of Harvard and Steve Moore of the Wall Street Journal indicated they understood this point since they both explained that the long-run revenue-maximizing rate was lower than the short-run revenue-maximizing rate. But Martin Feldstein of Harvard explicitly addressed this issue, writing that, "Why look for the rate that maximizes revenue? As the tax rate rises, the "deadweight loss" (real loss to the economy rises) so as the rate gets close to maximizing revenue the loss to the economy exceeds the gain in revenue.... I dislike budget deficits as much as anyone else. But would I really want to give up say $1 billion of GDP in order to reduce the deficit by $100 million? No. National income is a goal in itself. That is what drives consumption and our standard of living."

For more information, I think my three-part video series on the Laffer Curve is a good summary of the key issues. Part I addresses the theory, and explicitly notes that policy makers should target the growth-maximizing tax rate rather than the revenue-maximizing tax rate. Part II reviews some of the evidence, including analysis of the huge increase in taxable income and tax revenue from upper-income taxpayers following the Reagan tax-rate reductions. Part III looks at the Joint Committee on Taxation's dismal performance.

The Destructive Economics of Class-Warfare Taxation

Caroline Baum of Bloomberg has an excellent column explaining why soak-the-rich taxes don't work. Simply stated, wealthy people are not like you and me. They have tremendous control over the timing, composition, and level of their income. When the rich are hit with higher tax rates, they adjust their behavior and protect themselves by reducing the amount of taxable income they earn and/or report to the IRS. That usually causes collateral damage for the economy, but the class-warfare crowd is either oblivious or uncaring about real-world effects.

Why, after all this time and an extensive body of data, are we still questioning whether reductions in marginal and capital- gains tax rates increase economic activity enough to generate more revenue for the federal government? “Because they don’t like the answer,” Laffer says of the doubters. “It’s not tax cuts that pay for themselves. Tax cuts on the poor cost you lots of money. Tax cuts on the rich pay for themselves. Rich people can afford lawyers, accountants, and can defer income.” ...The rich have the luxury to respond to incentives, to opt for more work and less leisure when the return on work is greater. They are motivated to take risks, maybe start a business, invent something, and get even richer while giving others the opportunity, through hiring, to do the same. The opposite is true for low-income workers. When the government raises taxes, someone struggling to put food on the table for his family may have to go out and get a second job to maintain his level of take-home pay. For this socio-economic group, higher taxes translate to more work. To ignore evidence that the rich behave differently is silly. The government can’t get more blood from a stone, yet it keeps trying. Instead of demagoguing tax cuts for the rich, Democrats should try embracing them for a change. ...Academics are busy churning out articles claiming tax cuts for the rich deliver less bang for the buck because the rich save more of the money than the poor. That’s true. It also misses the point. The goal isn’t spending, or distributing other people’s money to create “aggregate demand.” That’s a wealth transfer, not a net stimulus. (Fiscal policy gets its punch from monetary policy, from the increase in the money supply to pay for the spending.) The goal should be to incentivize individuals to work hard, save and invest in the future. It’s about growing the pie. Sound familiar? We’re right back to square one. I, for one, would like to see the debate shift from class warfare over tax rates and targeted tax relief to tax reform. Either scrap the tax code and introduce a simple flat tax with no deductions, or scrap the IRS and move to a consumption tax. If you want to get money out of politics, there’s only one way to do it. Take the tax code out of Congress’s hands.

Baum's column touches on most of the key issues, but she doesn't address the political economy of class-warfare taxation. In this video on soak-the-rich tax policy, I provide five reasons why high tax rates are misguided - including the oft-overlooked point that politicians impose punitive taxes on the rich as a prelude to hitting the rest of us with higher taxes.

Mitchell's Law Strikes Again

David Ignatius has a thoroughly boring and utterly predictable establishment left-wing column in the Washington post, but it is a perfect illustration of my maxim that "Bad government policy begets bad government policy." In this case, Ignatius wants to expand gun control in response to the foolhardy drug war. Neither effort will succeed, at least if either society wants even a smidgen of individual liberty, but statists never seen to worry about such niceties. If one of their policies leads to a mess, that's just an excuse for more bad policy.

Mexico is reeling from a drug-cartel insurgency that is armed mainly with weapons acquired in the United States... Naming a new ATF chief to lead the fight against illegal weapons would be a small symbolic step. But it would signal to Mexicans and Arizonans alike that the administration is mobilizing to deal with these problems -- and is willing to take some political heat in the process. ..."The absence of a chief has hamstrung ATF's ability to aggressively target gun trafficking rings or corrupt firearms dealers and has demoralized its agents," Paul Helmke, president of the Brady Campaign to Prevent Gun Violence, wrote in a June 10 letter to Obama. ...The prevailing political wisdom in America, to which the Obama administration evidently subscribes, is that it's folly to challenge the gun lobby. When Mexico's President Felipe Calderón addressed a joint session of Congress in May, he all but pleaded with lawmakers to help stop the flow of assault weapons. His call to action produced little more than a shrug of the shoulders in Washington.

By the way, several of you have been ribbing me for calling this phenomenon Mitchell's Law when great economists like Mises have written about this pattern. But I'm not saying that I invented the concept. I'm just trying to popularize it, much as I gave the name "Rahn Curve" to the theory about a growth-maximizing level of government. In effect, I'm trying to mimic Art Laffer. Art will freely tell anyone he meets that the concept behind the Laffer Curve existed for centuries. But he turned in into a curve and brought it to the attention of the world.

Pontificating about Class Warfare Taxation in the New York Post

I have a column in today's New York Post about Obama's plan for higher taxes next year. My main point is that higher tax rates on the so-called rich have a very negative impact on the rest of us because even small reductions in economic growth have a big impact over time. This is a reason, I explain, why middle-income people in Europe have been losing ground compared to their counterparts in the United States. This is an argument I'm still trying to develop (this video is another example), so I'd welcome feedback.

The most important indirect costs are lost economic growth and reduced competitiveness. You don't have to be a radical supply-sider to recognize that higher tax rates -- particularly steeper penalties on investors and entrepreneurs -- are likely to slow economic growth. Even if growth only slows a bit, perhaps from 2.7 percent to 2.5 percent, the long-term impact can be big. After 25 years, a worker making $50,000 will make about $5,000 more a year if economic growth is at the slightly higher rate. So if this worker gets hit next year with a $1,000 tax hike, he or she understandably will be upset. In the long run, however, that worker may be hurt even more by weaker growth. ...The Obama administration's approach is to look at tax policy mainly through the prism of class warfare. This means that some of the 2001 and 2003 tax cuts can be extended, but only if there is no direct benefit to anybody making more than $200,000 or $250,000 per year. That's bad news for the so-called rich, but what about the rest of us? This is why the analysis about direct and indirect costs is so important. The folks at the White House presumably hope that we'll be happy to have dodged a tax bullet because only upper-income taxpayers will face higher direct costs. But it's the rest of us who are most likely to suffer indirect costs when higher tax rates on work, saving, investment and entrepreneurship slow economic growth. When the economy slows, that's bad news for the middle class -- and it can create genuine hardship for the working class and poor. Indeed, punitive taxation of the "rich" is one reason why middle-class people in high-tax European welfare states have lost ground in recent decades compared to Americans.

The Joint Committee on Taxation's Voodoo Economics

The Wall Street Journal has an excellent editorial this morning on the obscure - but critically important - issue of measuring what happens to tax revenue in response to changes in tax policy. This is sometimes known as the dynamic scoring vs static scoring debate and sometimes referred to as the Laffer Curve controversy. The key thing to understand is that the Joint Committee on Taxation (which produces revenue estimates) assumes that even big changes in tax policy have zero macroeconomic impact. Adopt a flat tax? The JCT assumes no effect on the economic performance. Double tax rates? The JCT assumes no impact on growth. The JCT does include a few microeconomic effects into its revenue-estimating models (an increase in gas taxes, for instance, would reduce gasoline consumption), but it is quite likely that they underestimate the impact of high tax rates on incentives to work, save, and invest. We don't know for sure, though, because the JCT refuses to make its methodology public. This raises a rather obvious question: Why is the JCT so afraid of transparency? Here's some of what the WSJ had to say about the issue, including some comparisons of what the JCT predicted and what happened in the real world.

...it's worth reviewing whether Joint Tax estimates are accurate. This is especially important now, because President Obama and Democrats in Congress want to allow the 2003 tax cuts to expire on January 1 for individuals earning more than $200,000. The JCT calculates that increasing the tax rates on capital gains, dividends and personal income will raise nearly $100 billion a year. ...we are not saying that every tax cut "pays for itself." Some tax cuts—such as temporary rebates—have little impact on growth and thus they may lose revenue more or less as Joint Tax predicts. Cuts in marginal rates, on the other hand, have substantial revenue effects, as economic studies have shown. In a 2005 paper "Dynamic Scoring: A Back-of-the-Envelope Guide," Harvard economists Greg Mankiw and Matthew Weinzierl looked at the revenue feedback effects of tax cuts. They concluded that in all of the models they considered "the dynamic response of the economy to tax changes is too large to be ignored. In almost all cases, tax cuts are partly self-financing. This is especially true for cuts in capital income taxes." We could cite other evidence that squares with what happened after tax cuts in the 1960s, 1980s and in 2003. So how well did Joint Tax do when it predicted a giant revenue decline from the 2003 investment tax cuts? Not too well. We compared the combined Congressional Budget Office and Joint Tax estimate of revenues after the 2003 tax cuts were enacted with the actual revenues collected from 2003-2007. In each year total federal revenues came in substantially higher than Joint Tax predicted—$434 billion higher than forecast over the five years. ...As for capital gains tax receipts, they nearly tripled from 2003 to 2007, even though the capital gains tax rate fell to 15% from 20%. Yet the behavioral models that Mr. Barthold celebrates predicted that the capital gains cuts would cost the government just under $10 billion from 2003-07 when the actual capital gains revenues over five years were $221 billion higher than JCT and CBO predicted. ...Estimating future federal tax revenues is an inexact science to be sure. Our complaint is that Joint Tax typically overestimates the revenue gains from raising tax rates, while overestimating the revenue losses from tax rate cuts. This leads to a policy bias in favor of higher tax rates, which is precisely what liberal Democrats wanted when they created the Joint Tax Committee.

All of the revenue-estimating issues are explained in greater detail in my three-part video series on the Laffer Curve. Part I looks at the theory. Part II looks at the evidence. Part III analyzes the role of the Joint Committee on Taxation and speculates on why the JCT refuses to be transparent.

Top House Democrat Calls for Middle-Class Tax Hikes

I've frequently argued that the main purpose of "taxing the rich" is not to collect more revenue. Smart leftists, after all, understand that there are very strong Laffer Curve effects at the top of the income scale since investors and entrepreneurs have considerable ability to control the timing, level, and composition of their income. So if higher tax rates on upper-income taxpayers don't collect much revenue, why is the left so insistent on class-warfare taxation? The answer, I think, is that soak-the-rich taxes are a "loss-leader" that politicians impose in order to pave the way for higher taxes on the middle class. Indeed, I made this point in my video on class warfare taxation, and noted that are not enough rich people to finance big government. As such, politicians that want to tax the middle class hope to soften opposition among ordinary people by first punishing society's most productive people. We already know that tax rates on the so-called rich will jump next January thanks to higher income tax rates, higher capital gains tax rates, more double taxation of dividends, and higher death taxes. Now the politicians are preparing to drop the other shoe. Excerpted below is a blurb from the Washington Post about a member of the House Democratic leadership urging middle-class tax hikes, and let's not forgot all the politicians salivating for a value-added tax.

Tax cuts that benefit the middle class should not be "totally sacrosanct" as policymakers try to plug the nation's yawning budget gap, House Majority Leader Steny Hoyer (D-Md.) said Monday, acknowledging that it would be difficult to reduce long-term deficits without breaking President Obama's pledge to protect families earning less than $250,000 a year. Hoyer, the second-ranking House Democrat, said in an interview that he expects Congress to extend middle-class tax cuts enacted during the Bush administration that are set to expire at the end of this year. But he said the extension should not be permanent. Hoyer said he plans to call for a "serious discussion" about the affordability of the tax breaks. ...The overarching point in Hoyer's remarks is the need for a bipartisan plan that includes spending cuts and tax increases, in the tradition of deficit-reduction deals cut under former presidents George H.W. Bush and Bill Clinton. Drafting such a plan would require a reexamination of tax cuts enacted in 2001 and 2003, Hoyer says -- cuts that benefited most taxpayers.

Will Higher Tax Rates in 2011 Cause an Economic Collapse?

Art Laffer has a compelling column in yesterday's Wall Street Journal, where he makes the case that future tax rate increases will cause considerable economic damage because people have an incentive to maximize income this year to take advantage of current tax rates - resulting in an artificial drop in economic activity next year. In effect, this will be a reverse version of the experiment in the early 1980s, when entrepreneurs and investors had an incentive to postpone economic activity since Reagan's tax rate reductions were phased in over several years. I am reluctant to endorse Art's prediction that the "economy will collapse," since even good economists are lousy forecasters. But we certainly will see a large degree of tax planning, which will lead to less revenue than expected next year. And the higher tax rates will inhibit growth, though it is impossible to predict whether this means 2.1 percent growth instead of 2.3 percent growth, for instance, or 0.5 percent growth instead of 0.6 percent growth.

On or about Jan. 1, 2011, federal, state and local tax rates are scheduled to rise quite sharply. ...the highest federal personal income tax rate will go 39.6% from 35%, the highest federal dividend tax rate pops up to 39.6% from 15%, the capital gains tax rate to 20% from 15%, and the estate tax rate to 55% from zero. ...Tax rates have been and will be raised on income earned from off-shore investments. Payroll taxes are already scheduled to rise in 2013 and the Alternative Minimum Tax (AMT) will be digging deeper and deeper into middle-income taxpayers. And there's always the celebrated tax increase on Cadillac health care plans. State and local tax rates are also going up in 2011 as they did in 2010. Tax rate increases next year are everywhere. ...if people know tax rates will be higher next year than they are this year, what will those people do this year? They will shift production and income out of next year into this year to the extent possible. As a result, income this year has already been inflated above where it otherwise should be and next year, 2011, income will be lower than it otherwise should be. ...In 1981, Ronald Reagan—with bipartisan support—began the first phase in a series of tax cuts passed under the Economic Recovery Tax Act (ERTA), whereby the bulk of the tax cuts didn't take effect until Jan. 1, 1983. Reagan's delayed tax cuts were the mirror image of President Barack Obama's delayed tax rate increases. For 1981 and 1982 people deferred so much economic activity that real GDP was basically flat (i.e., no growth), and the unemployment rate rose to well over 10%. But at the tax boundary of Jan. 1, 1983 the economy took off like a rocket, with average real growth reaching 7.5% in 1983 and 5.5% in 1984. It has always amazed me how tax cuts don't work until they take effect. Mr. Obama's experience with deferred tax rate increases will be the reverse. The economy will collapse in 2011. ...The result will be a crash in tax receipts once the surge is past. If you thought deficits and unemployment have been bad lately, you ain't seen nothing yet.

Greetings from Hungary

A conference in Hungary was the most recent event on the Free Market Road Show. I tried to do something different at this event, focusing mostly on the Laffer Curve as I explained how European governments will fail if they try to fix the over-spending problem by raising taxes.

But regular readers of this blog have been exposed to plenty of Laffer Curve analysis, so allow me instead speculate on the meaning of the recent Hungarian elections, which resulted in a landslide victory for the supposedly right-wing party. With more than two-thirds of seats in Parliament, there is no obstacle to economic reform, and the party campaigned on smaller government and lower tax rates.

But here's the issues. Is the Fidesz Party a bunch of Bush clones, politicians who talk a good game but then make government bigger once they get in power? Or will the new Prime Minister (who also ruled from 1998-2002) be a principled advocate of freedom who uses his overwhelming mandate to implement a flat tax and reduce the horrific burden of government spending in his country (more than 50 percent of GDP)? I'm not overflowing with optimism, but I hope I'm wrong.

Greetings from Austria

I spoke yesterday in Vienna on the third stop on the FMRS tour. My speech focused on solutions to the fiscal crisis. I pointed out the need to substantially reduce the burden of government spending and also warned against higher tax rates - in part because higher tax rates discourage much-needed economic growth.

This puts me in direct conflict with many European politicians, many of whom think extracting more money from taxpayers is the answer to the over-spending problem. Some of these politicians try to sound more rational by saying they don't necessarily want to boost tax rates and instead would be happy to collect more money by more onerous enforcement of existing tax laws.

I don't think it is reasonable to expect big reductions in the underground (or shadow) economy. In a previous post, I quoted an IMF paper authored by Friedrich Schneider, which noted (with particular reference to Austria):

Macroeconomic and microeconomic modeling studies based on data for several countries suggest that the major driving forces behind the size and growth of the shadow economy are an increasing burden of tax and social security payments… The bigger the difference between the total cost of labor in the official economy and the after-tax earnings from work, the greater the incentive for employers and employees to avoid this difference and participate in the shadow economy. …Several studies have found strong evidence that the tax regime influences the shadow economy. …In Austria, the burden of direct taxes (including social security payments) has been the biggest influence on the growth of the shadow economy… Other studies show similar results for the Scandinavian countries, Germany, and the United States. In the United States, analysis shows that as the marginal federal personal income tax rate increases by one percentage point, other things being equal, the shadow economy grows by 1.4 percentage points. …A study of Quebec City in Canada shows that people are highly mobile between the official and the shadow economy, and that as net wages in the official economy go up, they work less in the shadow economy. This study also emphasizes that where people perceive the tax rate as too high, an increase in the (marginal) tax rate will lead to a decrease in tax revenue.

Interestingly, I just came across a new study from the Bank of Italy that looks at the issue from the perspective of "taxpayer morale." The study finds that tax compliance also is sensitive to public perceptions about whether taxpayer money is being wasted. This excerpt touches on many of the key issues, and all I could think of when reading the study was bailouts, handouts, and other forms of corrupt and inefficient spending on both sides of the Atlantic:

...our measure of public spending inefficiency enters with the expected negative sign, and it is significant at the 1 percent level. Taxpayers interacting with a more efficient public sector are likely to show a higher level of tax morale. Our result can be interpreted by looking at the interaction between citizens and the government as a contractual relationship, implying duties and rights for each contract partner. If the taxpayer observes that the tax burden is not spent efficiently, he will feel cheated and his willingness to cooperate will fall. ...Torgler and Werner (2005) state that greater fiscal autonomy allows regions to spend the tax revenues according to local preferences and this, in turn, might have a positive impact on tax morale. ...As expected, the coefficient on the level of public spending per capita enters with a positive sign, and it is significantly different from zero. On the other side, we find a weak positive relationship between fiscal autonomy and tax morale, thus partially confirming the results by Torgler and Werner (2005). At the same time, the coefficient of public spending inefficiency remains negative and highly significant. ...We find that tax morale is higher when the taxpayer perceives and observes that the government is efficient; that is, it provides a fair output with respect to the revenues. This evidence can be interpreted in terms of a psychological contract between taxpayer and fiscal authorities in which the former punishes the local government when he observes that resources are not spent well. Therefore, encouraging more efficient spending of public resources has wider consequences and contributes to increasing the citizens’ propensity to pay taxes.

Will "Hauser's Law" Protect Us from Revenue-Hungry Politicians?

David Ranson had a good column earlier this week in the Wall Street Journal explaining that federal tax revenues historically have hovered around 19 percent of gross domestic product, regardless whether tax rates are high or low. One reason for this relationship, as he explains, is that the Laffer Curve is a real-world constraint on class warfare tax policy. When politicians boost tax rates, that motivates taxpayers to earn and/or report less income to the IRS:

The feds assume a relationship between the economy and tax revenue that is divorced from reality. Six decades of history have established one far-reaching fact that needs to be built into fiscal calculations: Increases in federal tax rates, particularly if targeted at the higher brackets, produce no additional revenue. For politicians this is truly an inconvenient truth. ...tax revenue has grown over the past eight decades along with the size of the economy. It illustrates the empirical relationship first introduced on this page 20 years ago by the Hoover Institution's W. Kurt Hauser—a close proportionality between revenue and GDP since World War II, despite big changes in marginal tax rates in both directions. "Hauser's Law," as I call this formula, reveals a kind of capacity ceiling for federal tax receipts at about 19% of GDP. ...he tax base is not something that the government can kick around at will. It represents a living economic system that makes its own collective choices. In a tax code of 70,000 pages there are innumerable ways for high-income earners to seek out and use ambiguities and loopholes. The more they are incentivized to make an effort to game the system, the less the federal government will get to collect.

Several people have asked my opinion about the piece. I like the column, of course, but I'm not nearly so optimistic that 19 percent of GDP represents some sort of limit on the federal government's taxing power. There are many nations in Europe with tax burdens closer to 50 percent, for instance, so governments obviously have figured how to extract much higher shares of national output. Part of the difference is because America has a federal system, and state and local governments collect taxes of about 10 percent of GDP. That still leaves a significant gap in total tax collections, though, so the real question is why American politicians are not as proficient as their European cousins at confiscating money from the private sector?

One reason is that European countries have value-added taxes, which are a disturbingly efficient way of generating more revenue. So does this mean that "Hauser's Law" will protect us if politicians are too scared to impose a nationwide sales tax? That's certainly a necessary condition for restraining government, but probably not a sufficient condition. If you look at the table, which is excerpted from the OECD's annual Revenue Statistics publication, you can see that nations such as New Zealand and Denmark have figured out how to extract huge amounts of money using the personal and corporate income tax.

In some cases, tax rates are higher in other nations, but the main factor seems to be that the top tax rates in other nations are imposed at much lower levels of income. Americans don't get hit with the maximum tax rate until our incomes are nine times the national average. In other nations, by contrast, the top tax rates take effect much faster, in some cases when taxpayers have just average incomes. In other words, European nations collect a lot more money because they impose much higher tax rates on ordinary people. Here's a chart I put together a few years ago for a paper I wrote for Heritage (you can find updated numbers in Table 1.7 of this OECD website, but the chart will still look the same).

Europeans also sometimes impose high tax rates on rich people, but this is not the reason that tax receipts consume nearly 50 percent of GDP in some nations. Rich people in Europe, like their counterparts in America, have much greater ability to control the amount of taxable income that is earned and/or reported. These "Laffer Curve" responses limit the degree to which politicians can finance big government on the backs of a small minority.

But high tax rates on the rich do serve a very important political goal. Politicians understand that ordinary people will be less likely to resist oppressive tax rates if they think that those with larger incomes are being treated even worse. Simply stated, higher tax rates on the rich are a necessary precondition for higher tax rates on average taxpayers.

For "Hauser's Law" to be effective, this means proponents of limited government need to fight two battles. First, they need to stop a VAT. Second, they need to block higher tax rates on the so-called rich in order to prevent higher tax rates on the middle class.

Excellent Defense of Supply-Side Economics

I recently posted favorable comments about a National Review article that made two important points about fiscal policy and supply-side economics. First, the article reminded "supply siders" that the burden of government spending is very important (and very worrisome). Second, the article correctly explained that not all tax cuts are created equal, and Republicans should be careful not to make silly claims about all tax cuts "paying for themselves" (particularly tax credits that have no positive effect on growth).

My Cato colleague Alan Reynolds has responded to the article, largely to remind everyone that the core premise of supply-side tax policy is 100 percent correct. Someone emailed me to ask what I thought about what they perceived to be a "big disagreement" on the right, but I don't think that Alan's points are inconsistent with the core premises of Williamson's article. Maybe I'm in a "can't-we-all-get-along" mood, so judge for yourself. Here's the key excerpt from Alan's article:

The trouble with what Williamson calls “the bottom-line question of balancing the budget” is the implication that it makes no difference whether the budget is balanced by curbing spending or increasing taxes. A 2002 study by Alberto Alesina of Harvard and three colleagues found that the surest way to make economies boom is through deep cuts in government spending. Higher tax rates had the opposite effect. Although “growth isn’t going to make the debt irrelevant,” as Williamson says, the ratio of debt to GDP can become much larger and more troublesome if GDP stagnates. ...The burden of government depends on spending, but the “excess burden” or “deadweight loss” of tax distortions depends on marginal tax rates. The size of this excess burden grows with the square of the tax rate, making a 40 percent tax rate 16 times more damaging than a 10 percent rate. Recent estimates find at least a dollar of damage to the private economy for each additional dollar raised through today’s progressive taxes. Supply-side tax policy is about raising tax revenues in ways that do the least damage to the private economy. Spending cuts are entirely consistent with supply-side theory because (1) transfer payments that phase out with rising income are a disincentive to work and (2) government purchases divert real resources into unproductive uses. ...Supply-side economists criticized the Bush tax cuts as wasteful, and the phasing-in of lower tax rates as positively harmful. University of Michigan economists Christopher House and Matthew Shapiro, in the American Economic Review of December 2006, “attribute the slow recovery from the 2001 recession, in part, to declines in labor supply stemming from the phased-in nature of the tax cuts. Additionally, the rebound in economic activity in mid-2003 coincides with the removal of the phase-ins enacted in the 2003 tax bill. A comparison of the simulated and actual time series over this time period shows that about half of the rebound in GDP in mid-2003 can be attributed to the elimination of the phase-in of the tax cuts.” Revenue from top-bracket taxpayers, dividends, and capital gains all soared after those tax rates came down in mid-2003. Offsetting the supply-side revenue gains, however, were big losses from reducing the lowest rate to 10 percent and adding various tax credits. ...Williamson says, “When the Reagan tax cuts were being designed, the original supply-side crew thought that subsequent growth might offset 30 percent of the revenue losses. That’s on the high side of the current consensus.” On the contrary, the current consensus is that the typical effect of lower marginal tax rates on revenues will offset at least 40 percent of the losses, and perhaps more than 100 percent at very high incomes.

The Laffer Curve Strikes...Again

Here's a blurb from a Wall Street Journal Editorial this morning. It seems a high tax rate is leading to less revenue. When will the politicians finally learn?

What do you do about a tax that costs jobs and raises little money? Florida lawmakers have been pondering that question in relation to the 6% registration tax for owning a boat in the Sunshine State. If you buy a $1 million boat and register it in Florida, you currently pay $60,000 in sales taxes. If you buy the same boat and register it in another coastal state like North Carolina, you pay a maximum of $1,500, in South Carolina $500, and in Rhode Island $600. Even more common is to register the boat in a nearby foreign nation like the Cayman Islands, where you pay close to zero tax. So to refloat the boat business, the Florida House voted last Wednesday to cap the boat sales tax at $18,000. This is roughly the amount of legal costs to register a yacht in the Caymans. Opponents call the repeal a tax cut for the leisure class, and the state's official revenue estimators predict it will cost $1.4 million a year in lost revenue. This ignores some basic math: Collecting $18,000 per yacht beats getting nothing. ...An estimated eight in 10 expensive boats in Florida are registered somewhere else, mostly abroad, and a boating industry study estimates this costs the state $120 million in lost revenue. ...This tale is reminiscent of the 10% luxury tax on yachts costing more than $100,000 that Congress passed in 1990. That tax, also passed in the name of social justice, nearly ruined the boat-building industry in states like Florida and Maine, because the rich went to the Bahamas and elsewhere to buy their boats until Congress repealed the yacht tax in 1993.

What's the Future for Supply-Side Economics?

Kevin Williamson has a long-overdue piece in National Review making two essential points about supply-side economics and the Laffer Curve. First, he explains that tax cuts are not the fiscal equivalent of a perpetual motion machine. Simply stated, too many Republicans have fallen into very sloppy habits. They oftentimes fail to understand the difference between "supply-side" tax rate reductions that actually improve incentives to engage in productive behavior and social-engineering tax cuts that simply allow people to keep more money, regardless of whether they create more wealth. This does not necessarily mean the latter form of tax cuts are bad, but they definitely do not boost economic performance and generate revenue feedback. Moreover, even when GOPers are talking about supply-side tax cuts, they frequently exaggerate the positive effects by claiming that lower tax rates "pay for themselves." I certainly think that can happen, and I give real-world examples in this video on the Laffer Curve (including Reagan's lower tax rates on those evil rich people), but self-financing tax cuts are not common.

Williamson's second point is that the true fiscal burden is best measured by looking at how much government is spending. I might quibble with his description of deficits as a form of deferred taxation since technically debt can be rolled over in perpetuity, but his main point is right on the mark. There is no doubt that most forms of government spending - regardless of the means of financing - harm growth by diverting money from the productive sector of the economy (technically, the economic damage occurs because capital and labor are misallocated and incentives are diminished, but let's not get too wonky). Here are some excerpts from Williamson's article:

Properly understood, there were no Reagan tax cuts. In 1980 federal spending was $590 billion and in 1989 it was $1.14 trillion; you don’t get Reagan tax cuts without Tip O’Neill spending cuts. Looked at from the proper perspective, we haven’t really had any tax cuts to speak of — we’ve had tax deferrals. ...even during periods of strong economic growth, there has been nothing to indicate that our economy is going to grow so fast that it will surmount our deficits and debt without serious spending restraint. This should be a shrieking klaxon of alarm for conservatives still falling for happy talk about pro-growth tax cuts and strategic Laffer Curve optimizing. ...The exaggeration of supply-side effects — the belief that tax-rate cuts pay for themselves or more than pay for themselves over some measurable period — is more an article of faith than an economic fact. But it’s a widespread faith: George W. Bush argued that tax cuts would serve to increase tax revenues. So did John McCain. Rush Limbaugh talks this way. Even Steve Forbes has stepped into this rhetorical stinker from time to time. ...t is true that tax cuts can promote growth, and that the growth they promote can help generate tax revenue that offsets some of the losses from the cuts. When the Reagan tax cuts were being designed, the original supply-side crew thought that subsequent growth might offset 30 percent of the revenue losses. That’s on the high side of the current consensus, but it’s not preposterous. ...The problem with magical supply-siderism is that it gives Republicans a rhetorical and intellectual framework in which to ignore spending — just keep cutting taxes, the argument goes, and somebody else will eventually have to cut spending. The results speak for themselves: Tom DeLay and Dennis Hastert and Trent Lott and Bill Frist all know how to count, but, under their leadership, Republicans spent all the money the country had and then some. ...It’s really hard to create political incentives that will keep legislators from overspending. Conservatives should know this, because we’ve tried it before. The Gramm-Rudman-Hollings Act of 1985, which enacted automatic federal spending cuts if the deficit exceeded predefined targets, went through hell, high water, and the federal courts before its provisions were allowed to kick in. But when they did kick in, they worked. They worked with a hard and furious vengeance: The deficit was reduced from $221 billion in 1986 to $153 billion in 1989, from 5.2 percent of GDP to 2.8 percent of GDP. In fact, Gramm-Rudman worked so well that Congress, facing real spending constraints for the first time, killed the act, replacing it with the toothless Budget Enforcement Act of 1990.

Now that we've chastised Republicans, it's time to turn our attention to the Democrats. We know they are bad on spending (I often joke that Republicans expand government out of stupidity, while Democrats do it for reasons of malice), so let's focus on their approach to Laffer Curve issues. If the GOP is guilty of being too exuberant, the Democrats and their allies at the Joint Committee on Taxation (the bureaucracy on Capitol Hill that estimates the revenue impact of tax policy changes) are guilty of deliberate blindness. The current methodology used by the JCT (with the full support of the Democrats) is to assume that changes in tax policy - regardless of magnitude - have zero impact on economic performance. If you double tax rates, the JCT assumes the economy is unaffected and people earn just as much taxable income. If you replace the IRS with a flat tax, the JCT assumes there is no effect on macroeconomic performance. Sounds unbelievable, but this video has the gory details, including when my former boss, Senator Bob Packwood was told by JCT that revenues would rise year after year even if the government imposed a 100 percent tax rate.

Interestingly, the European Central Bank just released a new study showing that there are substantial Laffer Curve affects and that lower tax rates generate large amounts of revenue feedback. In a few cases (Sweden and Denmark), the researchers even conclude that some lower tax rates would be in that rare category of self-financing tax cuts. But the key point from this ultra-establishment institution is that changes in tax rates do lead to changes in taxable income. This means it is an empirical question to determine the revenue impact. Here's a key excerpt from the study's conclusion:

We show that there exist robust steady state Laffer curves for labor taxes as well as capital taxes. ...EU-14 countries are much closer to the slippery slopes than the US. More precisely, we find that the US can increase tax revenues by 30% by raising labor taxes but only 6% by raising capital income taxes, while the same numbers for EU-14 are 8% and 1% respectively. ...We find that for the US model 32% of a labor tax cut and 51% of a capital tax cut are self-financing in the steady state. In the EU-14 economy 54% of a labor tax cut and 79% of a capital tax cut are self-financing. We therefore conclude that there rarely is a free lunch due to tax cuts. However, a substantial fraction of the lunch will be paid for by the efficiency gains in the economy due to tax cuts.

Contrary to over-enthusiastic Republicans and deliberately-dour Democrats, the Laffer Curve/supply-side economics debate is not a binary choice between self-financing tax cuts and zero-impact tax cuts. Yes, there are examples of each, but the real debate should focus on which types of tax reforms generate the most bang for the buck. In the 1980s, the GOP seems to have the right grasp of this issue, focusing on lowering tax rates and reducing the discriminatory tax bias against saving and investment. This approach generated meaningful results. As Nobel laureate Robert Lucas wrote, “The supply side economists, if that is the right term for those whose research we have been discussing, have delivered the largest genuinely free lunch that I have seen in 25 years of this business, and I believe we would be a better society if we followed their advice.”

But identifying and advocating pro-growth tax reforms, as Williamson notes, is just part of the battle. The real test of fiscal responsibility if controlling the size of government. Republicans miserably failed at this essential task during the Bush year. If they want to do the right thing for the nation, and if they want to avert a Greek-style fiscal collapse, they should devote most of their energies to reducing the burden of government spending.

Class Warfare, Tax Rates, and the Laffer Curve

Obama imposed higher tax rates on the so-called rich as part of his government-run healthcare scheme, and he wants to punish success with additional tax rate increases at the end of this year. This excerpt from a New York Post column comments on how many people are getting a free ride from the tax system, but then goes on to explain why a spiteful policy based on class warfare will backfire:

Nearly half of American tax filers didn't have to pay any federal income tax last year. But Americans -- especially New Yorkers -- shouldn't enjoy the free ride. Soon enough, everybody will pay for the higher spending that Washington's "generosity" encourages. And thanks to Washington, we'll be paying for higher state and local spending at the same time, too. Just a decade ago, two-thirds of American tax filers still paid into the tax system. ...everyone should have to pay something -- and anyone who earns enough to have cable TV can pay something toward their own national defense, too. A big majority of people, in fact, should pay enough to be annoyed on April 15 rather than excited. Otherwise, the politicians will figure they can just keep spending without angering a critical mass of voters. ...seems certain to let the Bush tax cuts for upper-income Americans expire -- so in January the top rate will jump back to 39.6 from 35 percent. Two years later, a new 3.8 percent tax kicks in on investment income earned by families who make $250,000 and up (part of the health-care bill). Thing is, the rich already do pay. And when it comes time to pay for all of the spending we're doing now, the rich may not be able or willing to pay even more. Taxpayers earning over $200,000 paid more than 54 percent of federal income taxes in 2007, way more than the 32 percent of the nation's income they earned. ...there's a limit to how much the government can get. Last year, New York hiked income taxes on people who earn more than $200,000. But, as E.J. McMahon of the Empire Center for New York State Policy noted last month, the expected take from that tax hike seems likely to come in half a billion below estimates. There's good reason to think Obama's tax hikes on the rich will fall short, too. No, federal taxpayers can't leave the country as easily as a handful of Bloomberg's Upper East Side neighbors can leave New York -- but they can park more money in tax-free investments or simply decline to earn it in the first place. Such tax-avoidance is perfectly legal -- but it means less economic growth, and thus less income earned by everyone else.

The Flat Tax: Good for America, Bad for Washington

America's biggest fiscal challenge is excessive government spending. The public sector is far too large today and it is projected to get much bigger in coming decades. But the corrupt and punitive internal revenue code is second on the list of fiscal problems. This new video, narrated by yours truly and produced by the Center for Freedom and Prosperity, explains how a flat tax would work and why it would promote growth and fairness.

Lies, Damned Lies, and CBO Estimates

Washington is buzzing with news that the Congressional Budget Office has a new cost estimate for the President's proposal to further expand the federal government's control over the healthcare system. The White House is doubtlessly pleased because the takeaway message, as blindly regurgitated by the Associated Press, is that a giant new entitlement program is going to "drive down red ink":

The Congressional Budget Office estimated the legislation would reduce the federal deficit by $138 billion over its first 10 years, and continue to drive down the red ink thereafter. Democratic leaders said the deficit would be cut $1.2 trillion in the second decade - and Obama called it the biggest reduction since the 1990s, when President Bill Clinton put the federal budget on a path to surplus.

My Cato Institute colleague Michael Cannon already has explained that the cost estimate is fraudulent because of what it leaves out, so let me explain why it is fraudulent because of what it includes. The CBO has a very dismal track record of getting the numbers wrong (see first video below), in part because there is no attempt to measure how a bigger burden of government has negative macroeconomic effects, but also because the number crunchers do a poor job of measuring the degree to which people (recipients, healthcare providers, state and local politicians, etc) will modify their behavior to become eligible for other people's money. The problem is compounded by similar mistakes for revenue estimates from the Joint Committee on Taxation, which (like CBO) makes no attempt to capture macroeconomic effects and has a less-than-stellar history of predicting behavioral responses (see second video below).

If the legislation passes, we will get more spending, more taxes, and more debt. Equally troubling, we will get more dependency. That's good for Washington and bad for the country.

Maryland Politicians Crash on the Laffer Curve

An insightful editorial from the Wall Street Journal examines how soak-the-rich taxes in Maryland backfired, leading to less revenue for the government. The politicians would like us to think this is just the effect of the recession, but the article points out that one out of every eight millionaires who filed a tax return in 2007 did not file one in 2008. A few may have died, but the big reason for this shocking reduction is migration. As one study discovered, Maryland's tax base fell by $1 billion because successful taxpayers escaped to other states:

Illinois Governor Pat Quinn is the latest Democrat to demand a tax increase, this week proposing to raise the state's top marginal individual income tax rate to 4% from 3%. He'd better hope this works out better than it has for Maryland. ...The politicians in Annapolis had said they'd collect $106 million by raising its income tax rate on millionaire households to 6.25% from 4.75%. In cities like Baltimore and Bethesda, which apply add-on income taxes, the top tax rate with the surcharge now reaches as high as 9.3%—fifth highest in the nation. Liberals said this was based on incomplete data and that rich Marylanders hadn't fled the state. Well, the state comptroller's office now has the final tax return data for 2008, the first year that the higher tax rates applied. The number of millionaire tax returns fell sharply to 5,529 from 7,898 in 2007, a 30% tumble. The taxes paid by rich filers fell by 22%, and instead of their payments increasing by $106 million, they fell by some $257 million. Yes, a big part of that decline results from the recession that eroded incomes, especially from capital gains. But there is also little doubt that some rich people moved out or filed their taxes in other states with lower burdens. One-in-eight millionaires who filed a Maryland tax return in 2007 filed no return in 2008. Some died, but the others presumably changed their state of residence. (Hint to the class warfare crowd: A lot of rich people have two homes.) A Bank of America Merrill Lynch analysis of federal tax return data on people who migrated from one state to another found that Maryland lost $1 billion of its net tax base in 2008 by residents moving to other states. ...Thanks in part to its soak-the-rich theology, Maryland still has a $2 billion deficit... The state's best hope is that politicians in other states are as self-destructive as those in Annapolis.