Questions on the Laffer Curve Jude Wanniski March 15, 2002

Supply Side University Spring Semester Lesson #7

Memo To: SSU Students
From: Jude Wanniski
Re: Questions on the Laffer Curve

I asked the TalkShop participants for questions on the last three lessons devoted to the Laffer Curve and received some great ones. A number came in that were more or less covered by those I have chosen. This is a good way to deepen our class work, I have discovered, and I will continue the practice in the future – asking in the SSU TalkShop for questions. If this lesson were read by the folks in Washington, they would have a much better idea of what they should be doing!

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Q. Terje Petersen: The Laffer Curve is a model showing government revenue for different rates of taxation. However a tax can be levied in a multitude of different ways. Capital-gains taxes, income taxes, VAT, retail taxes, import tariffs, fringe-benefit taxes, etc., etc. At what point does the structure of the tax system become a bigger determinant on revenue than the rate of tax? For instance, should US policy currently focus more on the overall tax rate or the overall tax structure?

A. The Laffer Curve is not really a model showing government revenue for different rates of taxation. There are no “rates” described on the Curve, which is meant as a pedagogical device useful for thinking about the kind of question you have raised here. It is just as useful for a corporation, trying to decide how to price a new product, for it if were to decide on a price too low it would forego revenues, and if it should decide on a price too high it would lose sales volume and profits. Andrew Mellon, the Treasury Secretary in the 1920s responsible for cutting the income-tax rates from wartime levels to the peacetime levels that produced the Roaring Twenties, had a metaphor for both public and private pricing methods. Ford Motor Co., he said, had the option of pricing its Model T at $500 each and selling 1 million or pricing them at $1 million each and selling only 500. The reason they sell for $500 is because Ford has competitors who are also struggling to find the optimum price. The market for GM cars, Chryslers and Fords drives them all to a similar pricing structure, where volumes vary according to the features of each. Mellon noted that there is only one United States government, so there is no internal competition to force it to an optimum “price” for public goods and services. The political process is the determinant, he said, as some political forces prefer more public goods and will accept higher tax rates while other forces prefer fewer public goods and argue against higher tax rates. Mellon actually verbalized the Laffer Curve by arguing the wartime income-tax rates were so high that their reduction would produce the best of both conditions, high revenues to support the preferred level of spending.

Terje’s question goes beyond those simple variations in important ways. There is an old French saying that the goose may be plucked most easily when the right feathers are chosen. Textbook economics addresses this idea with the concept of “elasticity.” If you should levy taxes on apples, people would buy oranges. The demand for both is elastic. If you were to levy taxes on cigarets, the tax would go much higher without shifting demand, as it is relatively inelastic. At the margin, people will quit smoking, smoke less, or buy paper and tobacco and “roll their own,” or buy smuggled cigarets. You can see that a national tax on cigarets is more efficient than a state or local tax, as smokers can cross borders to buy or smugglers can load trucks in states with no cigaret tax and unload them in states with high cigaret taxes. Also note that cigaret manufacturers cannot charge more than their competitors as they would quickly lose sales. Government monopoly means errors can be made in overcharging for public goods if the political system is inefficient. When Ronald Reagan ran for President in 1980, he promised a one-third reduction in the marginal tax rates, which then ranged as high as 70%, and he easily defeated incumbent Jimmy Carter, using Laffer Curve arguments to do so. When the 1984 Democratic nominee Walter Mondale tried again to run against Reagan tax cuts, he lost 49 of the 50 states, winning only his home state of Minnesota. In 1988, George Bush pledged not to raise taxes, and also to cut the capital- gains tax to 15% from 28%. The Democratic candidate, Michael Dukakis, argued against a cut in the capital-gains tax. He also was buried in a Bush landslide. In 1992, having broken his no-tax pledge and given up on cutting the capital-gains tax, Bush was defeated by Democrat Bill Clinton, who promised a “middle-class tax cut,” but then did not deliver.

In Terje’s question, he mentioned the capital gains tax, which is the most “elastic” of all taxes, in that it is the most easily avoided. How? By not putting capital at risk. In order to get a capital gain that the government can tax, an individual first must pay taxes on ordinary income from wages or salary. What remains can be consumed or saved or invested. If the capital-gains tax were high, the individual would tend to consume or save income after it had been taxed, not put it at risk for a gain that will be taxed away by the government. For this reason, the capital-gains tax should be zero, at least for those supply-siders who believe all growth is the result of risk-taking.

The last part of the question was about where the focus should be now, the overall tax rate or the tax structure. The “overall” tax rate should never be the focus of policy, although it deserves peripheral attention. That is, what slice of total national output goes through the hands of the government? The issue is a static one, as I would much rather live in a country with a high standard of living even though half of all GDP goes through the government’s hands -- Germany, for example, with 50% -- than in a country with a low standard of living, although only 10% goes through the government’s hands (Bangladesh, for example). Germany’s tax structure invites prosperity while Bangladesh’s tax structure invites poverty. This is something demand-side economics has not figured out, which is why the Keynesians and Monetarists who run the International Monetary Fund and the World Bank produce poverty wherever they go instead of prosperity. Good question, Terje.

Q. Thomas Schmidt: For me, the most interesting taxation note you've provided has been how liberal the elected representatives of Massachusetts are, yet how conservatively the populace as a whole votes on taxation initiatives, repealing rent control to boot. Does this state's example provide a counterpoint to the notion that national initiatives, a la Switzerland, provide a better grasp on where the electorate wishes to be taxed?

A. More democracy is better than less democracy in helping the political class determine the optimum point on the Laffer Curve. In California in 1978, Proposition 13 was put on the state ballot by citizens who proposed a one-third reduction in taxes. Both political parties opposed Prop.13 and so did all the newspapers and 99% of the economists. They argued it would wreck the finances of the state. The people paid no attention and passed Prop.13 by a 2-to-1 margin and the state flourished. Former California Governor Ronald Reagan was one of the few political figures to support it. It was an intellectual stepping stone to his election as President in 1980. The same California citizen group came back later with another proposition to cut taxes and were defeated at the polls, no doubt because the proposition proposed taxation below the optimum rate. In 2000, Texas Governor George W. Bush called upon a conservative Keynesian, Lawrence Lindsey, to design a tax plank for his presidential race. Lindsey rejected supply-side advice to cut the capital-gains tax and instead offered a watered-down package to “put money into people’s pockets.” Bush won the presidency, but just barely, as the Democratic nominee’s planks were much worse. A national initiative and referendum system on taxation, which Switzerland does have, would be a great addition to our democratic mechanisms.

Q. Ed Mauro: My state voted for an income-tax rate cut this year. But then the economy went sour and tax revenues fell. Was the electorate accurately assessing the amount of services they were expecting for the amount of taxes they were paying? Is it still a good time to cut taxes?

A. The U.S. economy is in the grip of a monetary deflation, which cannot be fixed with tax cuts. Indeed, while lower tax rates are surely desirable where they are higher than they need to be to produce a given level of revenue, such action now intensifies the deflation problem. This is because the Federal Reserve is flying blind and has no tool to increase “money” when there is an increased demand for it in the banking system. This is why the dollar/gold price fluctuates so much. Your state cut tax rates because it had more reserves than it needed at the time, but the deflation is overwhelming the expansion effects of the lower tax rates. If your state had not cut tax rates, it is probable that its revenues would be even lower. I would still support a lower capital gains rate in the United States, even though it would intensify the deflation, simply on the hope that the Fed would figure this out and join correct monetary policy to correct fiscal policy.

Q. Bill More: Can the Laffer Curve be optimized with a low flat-tax regime -- and the economy thus benefit -- if the US gold price goes up and down by significant amounts over time?

A. Hong Kong and Singapore have had low flat-tax regimes, with top rates of 15% and no capital gains tax, with currencies tied to the U.S. dollar as it fluctuated against gold. If you inflate and cannot increase the tax above 15% because it is capped there, you are better off than if you inflate in a country with a top tax rate of 70% and a capital-gains tax that hits inflated rather than real gains. These are two separate economic issues. You can also be on a gold standard and wreck your economy with high tax rates and tariffs, as we did in 1929-34.

Q. Jason the Mason: What happens when a unified Federal tax system goes up against myriad local and regional Laffer Curves? Nobody's really taxed at the optimum level. Do some states suffer and others benefit? Does everyone suffer in different ways? Does federalism solve this effectively?

A. It may take some time, but the politicians eventually get the message in one way or another. When Reagan and the supply-siders identified the problem in 1980, the highest state income-tax was in Delaware, where it approached 20%, as I recall. The combined NY/NYC income tax was in the teens. Delaware then elected Republican Pete du Pont as governor and he slashed away at the rates until they became bearable. New York elected Democratic governors who got the message, Hugh Carey and then Mario Cuomo, at times with pressure from GOP legislatures. The Reagan tax cuts had the effect of exposing high state and local rates and they were trimmed everywhere. If they had not, labor and capital would have exited for more hospitable jurisdictions until equilibrium were reached.

Q. John Brownfield: If it was possible to determine the exact tax rate at which government revenues were maximized, should that rate be taken as the one the electorate wishes to be taxed at, because it yields the maximum level of government services (a positive view)? Or should it be seen as the maximum level of confiscation the economy will tolerate before it begins to shrink (a negative view)? In other words, if the ideal rate at which government revenues are maximized could be determined, should that rate be considered a ceiling or a floor?

A. It’s up to you. If you have a preference for more government then it will be a floor. If less, then a ceiling. At the moment, we have Republicans who insist they are for low taxes and smaller government who are supporting new wars and higher defense spending at the expense of budget surpluses and lower tax rates. The political process will work this out as you decide these issues with your fellow citizens, at the polls this November.

Q. Charles Elkins: Do you believe point "E" has risen since 9/11? If the electorate is more tolerant of taxation, (point “E” rising), does that have an expansionary, contractionary or neutral effect on the demand for money?

A. Clearly point “E” has risen since 9/11. The demand for money has also clearly fallen since 9/11, as the price of gold has risen by more than $20. This represents a decline in the demand for liquidity that has not been drained by the Fed. Tax cuts would increase the demand for liquidity, but political pressure for tax cuts has dwindled since 9/11 as the electorate gives the Congress a green light on funds for the Pentagon and “homeland security.”

Q. Terje Petersen: In so far as every economy is different is there anything that can be said about the typical shape of the Laffer Curve for a poor country versus a rich country. That is can a poor country optimize revenue at a higher rate of tax than a rich country or is the opposite true?

A. Poor countries are poor because they put too many barriers between their citizens and their individual desires to produce and exchange. Suddenly Russia is growing lickety-split after a decade of miserable growth rates. Why? The Putin government tore down the high tax walls between the people and put up a modest 13% fence. The demand for ruble liquidity made it easy for the central bank to manage the ruble and keep it steady, so the risks to contractual exchanges have been reduced as well. It would not be quite as easy to fix, say, Zimbabwe, because Russia had a highly educated work force that was being smothered and Zimbabwe does not have a population educated at that level. But Zimbabwe would function much better if President Robert Mugabe were to have a talk with Russia's President Vladimir Putin about tax policy and the Laffer Curve.