The Useless Laffer Curve
Many folks believe in the Laffer Curve as a basis for supply-side economics. Listening to folks like Sean Hannity on the radio, they constantly harp on the idea that cutting taxes will increase revenues. The thought is that taxes create a disincentive to work, and that taxes are currently so high that people are choosing not to work at all. Further discussion of the Laffer Curve can be found at Wikipedia or Investopedia. The supply-siders will argue that we’re on the right-hand side of the curve, and lowering rates will increase revenues. The Left, on the other hand, says that we’re on the left-hand side of the curve, and lowering rates will decrease revenues.
The Left is correct. With current tax rates, lowering rates will immediately lower revenues. The problem is not that supply-side economics is false. The problem is that the Laffer Curve is a static analysis. Supply-side economics does not imply that if we lower tax rates, we will immediately increase tax revenues, unless tax rates are tremendously higher than they are now. One of the intelligent leftists I typically debate with has said that it’s nearly impossible to be on the right side of the Laffer Curve. After all, the necessity to work is fairly inelastic. I think the Laffer Curve can be applied more directly to tax avoidance and evasion, although it’s not typically done.
What supply siders do claim is that lower tax rates increase economic growth, which in turn will increase tax revenues down the road. A better curve would be below (tax rates from 0-100%, as my Excel skills are failing me today):
Of course, this is a simple analysis. Obviously economic growth depends highly on the protection, by government, of private property rights, and the mechanisms to provide that protection require taxation. Likewise, if tax rates are too high, and you have businesses and productive people fleeing for fairer shores, economic growth could be negative, so a right-hand value of 0% may not be correct. Of course, government regulation can affect economic growth the same way, and that’s not even factored in to this chart. Last, it takes a very simple view of “tax rates”, be they income, corporate income, etc., but the Laffer Curve takes that simple view as well.
But I think this is a much better idea than the Laffer Curve. I know “Warbiany Curve” doesn’t have much ring to it, so title it what you want 
What supply-side economics is based upon is the idea that a rising tide lifts all boats. So policies, including tax policies, should be designed to increase economic growth. While work can be largely inelastic, the same is not true for investment. Invested dollars are the growth engine of the economy, and high tax rates have two negative impacts on investment. First, high tax rates make the reward for investment much lower, when an individual still carries all the risk for a bad investment. If the government takes 40% capital gains taxes from any positive return I make in a stock, but does not reimburse me 40% for every dollar I lose, it makes me much less likely to invest in the sort of higher-risk investments like startup companies, etc, which fuel technological and economic growth. Second, high tax rates simply take the money away from individuals who may choose to invest it, reducing the available pool of money that could be invested.
Thus, lower tax rates will reduce immediate government revenues. But lower tax rates will increase economic growth. From the Rule of 72, the difference between a GNP growth rate of 5% and 3.2% is huge. At 5%, the size of the US economy will double every 14.4 years. At 3.2%, it will double every 22.5 years. Assuming a $10 trillion economy today, in 45 years that’s roughly a $80T economy if we grow at 5%, and a $40T economy if we grow at 3.2%. Small changes in growth now have huge effects in the future. And it doesn’t take a mathematician to realize that tax revenues will be much greater if we have an $80T economy than a $40T economy.
The difference between supply-siders and liberals is that supply-siders are forgoing immediate gratification of government revenue, in expectation of greater future government revenue and an increased standard of living for all. Liberals, on the other hand, are more than willing to forego future economic growth, if we can provide things like socialized medicine now. Modern conservatives are the worst of both worlds, cutting taxes but increasing spending, pulling in government revenue through debt, which steals money from productive investments and forces greater future taxation to pay the cost of debt plus interest.
It is for this reason that a supply-sider like myself supports the FairTax. Changing the method of taxation removes many of the current system’s restraints on investment and economic growth. It allows us to fund government at current levels, but at the same time increase the size of the overall pie, so that in the future, the government will increase their revenues as well. It puts us much farther to the left of the Warbiany Curve. While folks like myself would love to couple the FairTax with balanced budgeting in Congress to ensure that we don’t dig ourselves deeper in the hole while we wait for that growth, the FairTax is in itself a step in the right direction.
I want to support the FairTax plan but would first like explanations as to the inconsistencies in this book:
1) In the section where they ask myth or truth the author asks if the president and congress pay social security taxes. He states they do just like “every other American Citizen.” The president and congress do pay social security taxes but not “every other American Citizen” does. You can opt out of social security for religious reasons. This is most popular among priests. Many priests do this as their religion states they must be good Stewards of Gods Money. They feel that handing their money over to a government who cannot control their own budget is not good stewardship of Gods money and therefore are able to opt out of the system. This inconsistency has no real bearing on the Fairtax itself but if I can catch something like this it makes me wonder what else in the book is not true.
2) In the chapter about abolishing the IRS, the author gives stories about the IRS abuse of power such as in the story about the missing Dime on a tax return payment of a major corporation. They state over and over again that with the Fairtax these types of issues would not happen. That is plain
misleading! Even if the Fairtax were passed I highly doubt the IRS would be abolished and even if they were, some other government organization would need to take their place. The government is not just going to trust that all companies are fairly and accurately paying 100% of the Fairtax payments they
collected from their customers. Businesses would still need to file some sort of Federal Sales Tax Return and hense there would likely still be audits whether by the IRS or a newly mandated FairTax agency!
3) It is stated that the Fairtax would be an inclusionary tax. In other words the taxes would not be added at the cash register. They would be forced by law to be included in the final price of the goods. It is stated over and over again that with the Fairtax you will know exactly what you are paying in taxes rather then only knowing what you are taking home after withholding. Mandating an inclusionary tax is just as sneaky a tactic to disguising government imposed taxes as withholding is. In addition it would give the government an easier time at raising the percentage of the FairTax (if it were instituted) because people wouldnt notice it as much as if there were a seperate line on your reciept (as is done with state sales tax) saying Fairtax 23%. Making this an inclusionary tax is just trading one evil (withholding) with another (an embedded tax). You are gaining no ground in creating a progressive tax system.
4) A major and perhaps the number 1 selling point to the FairTax plan is that you would take home 100% of your paycheck. If you were making $100,000 and taking $70,000 after taxes you would now get a virtual raise and be taking home $100,000 as stated by the author. This does make sense to me and is also my number 1 selling point if I were to support the FairTax legislature. The only problem is that you may not be taking home that $100,000, 100% paycheck after all. In Money Magazine’s “Just how fair is the ‘FairTax’?” article published 9/7/2005, Pat Regnier states
“What The FairTax Book fails to mention is that prices can only fall this sharply if companies cut wages. Say your salary is $100,000 a year today, but you take home $80,000 after taxes. Your company is still paying that extra $20,000. In a FairTax world, it will save that money, and be able to lower its prices accordingly, only if it can reduce your salary to $80,000. In other words, your take-home pay is the same as before. Sure, you’d get to “keep 100 percent of your paycheck,” as Boortz and Linder repeatedly write, but it would be a smaller paycheck. That’s kind of a big thing to leave out. I pressed the point with Boortz and Linder. Boortz denies that the book intentionally overpromises. The introduction, he notes, emphasizes that “this book isn’t about saving a penny in taxes.” But he concedes that the book is confusing about this, and vows to correct it in later printings. Fair enough. Meanwhile, these guys want to replace the entire tax code, they’ve ignited a populist movement to get it done, and tens of thousands of copies of the uncorrected book make the FairTax sound like magic.”
So according to this Money Magazine article the Authors agreed that wages would need to be cut to accomplish all that is stated in the book. If it is true that wages would need to be cut it puts the nail in the coffin in my support of the FairTax. I went as far as to write an email to the Authors at their website FairTax.org asking for an explanation about inconsistencies between their statements in the book and their statements to Money Magazine but have yet to recieve a response.
1) That’s truly nit-picking. An exception that applies to a very small percentage of ministers, already a very small percentage of the population, seems irrelevant for them to bring up in the book. If there were a number of other exempted groups that comprise a large portion of the population, it might be worth mentioning. But to mention something so small would be a waste of ink in the context of that discussion.
2) An investigation/enforcement body would need to exist, with sharp enough teeth to enforce the tax code, this is true. However, there are several things that should make it easier and less fraught with abuse than the current system. First, it will no longer be tasked with coming after individuals. As far as public support is concerned, this is absolutely huge. Never again will you, as an individual, have to face an audit. Regarding enforcement of businesses, it is true that they will be faced with an enforcement scheme. However, with the simplification of the tax code, the goal is that this will be less onerous than the current system. It is at the very least, hard to imagine it being worse than the current system.
3) The main basis for making it inclusionary is to avoid “sticker shock”, and to understand the tax rate in the same way that our current income tax is understood. I.e. if you spend $100, $23 of that is tax. While I agree that it may be easier to hide rate increases than if it were completely exclusionary, I do disagree that it’s just trading one problem for another. The current tax code is so complex that it can’t be understood by humans, and so much of the real cost of taxation is hidden by all the loopholes, deductions, and yes, the evil of withholding.. But I think knowing that any increase creates an detectable increase to the real cost of goods will help to keep politicians from trying it. At least, I think there will be enough of a backlash if they try to raise the rate that it will only happen once.
4) Boortz clarifies this here, and I had previously posted on it as well. Simple answer, you’re right. Long answer at the those links.
My own experience leads me to object to the assertion – which I have encountered entirely too many times in my life – that “a rising tide lifts all boats.” I lived through the Reagan Boom and, well, ended up worse off than when it started. As a lifetime low earner, my income didn’t exactly boom (I had one raise during the ’80s) but rents went through the roof! In fact, I faced five rent increases in five years, and had to move three times when I could not afford the higher rent.
This reminds me of something P.J. O’Rourke once wrote, to the effect that if you have more money, that doesn’t mean I have less money. But for renters, this is exactly what it means. My rent went up five times in five years precisely because other people had more money (and the 1986 tax reform might have contributed as well), which meant that after paying my rent, I definitely had less money.
Does a rising tide lift the hamburger flipper’s boat? Probably not.