I am regularly amazed at how many great ideas/novels/Harry Potter characters were invented in restaurants and then jotted down on serviettes. Mainly because all these people seem to be carrying pens. And if they’re not carrying pens, then they’re borrowing pens from waiters – although it’s apparently a step too far to ask for a piece of paper from their order pads. Even though attempting to write anything on a paper napkin is an exercise in frustration.
That aside, you should know that the Laffer Curve is also on this prestigious list of ideas that occur to great minds over a rib-eye.
And good news, he used a cloth napkin (easier to write on. Also: ruder – but what’s a bit of rudeness when you’re talking importantly?):
Anyway, the basic summary is:
- If you make the tax rate 100%, then no one will work. Because then they’ll be working for free. Therefore: you raise no tax revenue.
- If you make the tax rate 0%, then by definition, you raise no tax revenue.
- Thus, if you step up from 0%, each tax hike results in more tax revenue.
- Thus also, if you step down from 100%, each tax cut results in more tax revenue.
- So there is an argument for saying that tax cuts result in more tax revenue – it’s just a question of where you sit on the Laffer curve.
The Laffer Curve:
For the record, I did write about this some time ago – so for a slightly more favourable version of the Laffer Curve, have a read of Tax-oh-no-mics 106: Changing Tax Rates Make Me Laff.
So, as with any theory, there are some broad simplifications that need to be mentioned:
- The thought experiment assumes that everyone pays tax (in practice, the bulk of a population sit at 0% already, because they’re not eligible to pay tax in the first place).
- At a tax rate of 100%, people would still work. Firstly, because remuneration is not the only reason that people work. And secondly – communism, for all its failings, did continue to function for long periods of time (even though the lack of private income effectively functioned as a 100% tax rate).
- There is no talk here of tax evasion – there is an assumption of totalitarian enforcement of the tax code.
You might think that those are outlier observations – and that what’s important is what happens in the in-between tax rates.
But I’d give you this picture of Hauser’s Law:
Which is to say: regardless of tax brackets, the actual tax revenues collected as a percentage of GDP have remained largely the same – suggesting that people inevitably end up paying whatever they feel is reasonable.
Anyway – the reason I’m talking about this is a Planet Money episode that I listened to while I made coffee this morning: Episode 577: The Kansas Experiment.
What was the Kansas Experiment?
When Tea Party extremist Sam Brownback was elected Governor of Kansas, he did so on the “I’m going to cut taxes like a Laffer king” ticket. He got hold of Mr Laffer himself, and had him come and speak to the state legislature. And then proceeded to:
- Drop taxes on businesses down to zero.
- As well as some other fairly-substantial tax cuts.
- And then to raise the sales tax a little in order to compensate for the lost revenue.
Those tax cuts came into play on 1 January 2013, and they were meant to make Kansas grow faster than all the states around it.
Only, that hasn’t happened. In fact, the prevailing sense is that the whole thing has made Kansas lag behind the surrounding states. And not helped by this sort of graph:
Why It’s Failing
According to Mr Laffer (in an interview in that podcast episode), the change can’t come overnight. Which is sort of understandable – but also sort of not. Mainly because economic policy is about perception – so you’d almost expect to see a spike of initial activity as people/businesses react optimistically to the tax cuts (as in: “OMG – 0% tax? That’s crazy! Let’s do it TODAY!”). And when you don’t get that, then there is almost a sense of “What does everyone else know that I don’t?” doom and gloom.
To put it another way: would you move your business to Kansas for lower taxes if the general sentiment is that it isn’t working? That entails a whole host of risks that might not even be worth the pay-off.
A Better Reason For Why It’s Failing
So I’m going to refer back to that first problematic assumption about everyone paying tax…
As was well publicised by Mr Romney, 47% of Americans pay no personal income tax. That is: their tax rate is 0%. These Americans also happen to be the big consumers.
So reducing the personal income tax rate had no effect on these people. They were already paying no tax. Their consumption was already whatever it was.
Then there are the small businesses, which were the other supposedly big beneficiaries of the tax cuts.
Here’s the thing about small businesses: they probably don’t pay that much tax anyway. Most businesses aren’t hugely profitable. They’re livelihoods. They’re there to break-even after paying everyone’s salaries, and hopefully pay a little bonus to the owner-director, and then maybe close out with a tiny profit (if at all).
Offering them a 0% tax rate? It’s the equivalent of giving the owner a free weekend away to a timeshare chalet in some moderately-pretty mountains. It’s nice – but it’s not the kind of thing that gets you all hot-under-the-collar to expand your business and hire a bunch of people in return.
But Sam Brownback went ahead and gave the 0% taxpayers the option to pay less tax the next time they get a paycheck, and gave all those small business owners that free weekend away, and in exchange, he raised the sales tax.
Which is a tax on consumption – and as it turns out, that’s the only real tax that the 47% pay (because they’re the big consumers).
Also, because the State was now collecting less money from all the tax cuts, they had to cut back on spending programs. Which mostly benefited the 47%. And the small businesses that have been built around the fringes of those spending programs (like the little grocery and stationery stores that operate near state-funded schools, etc).
So in short:
- The consumers were paying higher taxes.
- Small businesses were suffering from the drop in consumption (and as anyone will tell you, paying less tax when your business is not doing well is not a good thing).
- But the wealthy savers got to save more.
Which is really my way of saying: you have to be careful about discussing economics over dinner. Because theories that work well on napkins usually involve wine. And a theory that pairs well with a decent Syrah probably isn’t that well thought out…
For more, I give you Paul Krugman. And this awesome blog post.
Rolling Alpha posts opinions on finance, economics, and the corporate life in general. Follow me on Twitter @RollingAlpha, and on Facebook at www.facebook.com/rollingalpha.