Tuesday, December 16, 2014

The Laffer Curve at 40 years


This is my version of the Laffer Curve. What it shows is how basic economics and incentives work. If tax rates are zero, the government obviously collects no tax revenues. And if tax rates are 100%, the government also collects no revenues, because no one has an incentive to work. There is a tax rate "C" which maximizes the economy's strength and tax revenues. Higher rates produce a disincentive to work and invest, and thus reduce revenues, while lower rates also result in reduced revenues. If tax rates are too high (which is what Laffer originally asserted), then reducing tax rates can result in increased investment and work, thus increasing revenues by increasing the tax base.

But to see the original version and hear the key players recount their memories of where and when it was first drawn (forty years ago this month), and how it went on to impact fiscal policy during the Reagan administration, I recommend you read this BloombergBusinessweek article, "The Napkin Doodle That Launched the Supply-Side Revolution," which also includes a video.

Key takeaway:

How would you classify the Laffer Curve today?Laffer: It’s the same as always. It works. It’s not Republican, it’s not Democratic, it’s not conservative, it’s not liberal, it’s not left-wing, it’s not right-wing. It’s economics. People respond to incentives, and if you make something more attractive, they will do more of it. If you make something less attractive, they will do less of it. If you tax rich people and give the money to poor people, you are going to get lots and lots of poor people and no rich people. The dream in our country has always been to make the poor rich, not to make the rich poor.

As the BloombergBusinessweek article notes, the Laffer Curve proved to be one of the most special and disruptive events of the past 85 years. I consider myself lucky to have been mentored by both Art Laffer and Jude Wanniski.

15 comments:

Roy said...

" If you tax rich people and give the money to poor people, you are going to get lots and lots of poor people and no rich people."

Theoretically this seems correct however in practice the entire system is corruptible and destructible: people who become too rich can become too dangerous for a democracy. It is the rich man's incentive to give money to the poor or the poor will rise on him at some point and change the system for the worse. The system is not perfect and needs to be protected.

William said...
This comment has been removed by the author.
Vespasianus said...

I've always found the inequality debate (inherently related to Laffer's paradigm vs. Pikkety's) flawed in the way it is usually presented.

IMHO, the most important issue is making the pie larger enough to get everybody better off, even with rising inequality in terms of wealth's ownership (as long as wealth's creators and recipients are the same people).

However, here in Europe we're so obssesed with the wrong definition of inequality that in the end we'll probably end up all equally impoverished.

A great post, as usual.

William said...

No doubt the US tax code is a nightmare - a product of 100s of Congressional laws, erroneous theories and competing political influences / contributions.

At the extremes the Laffer's Curve seems correct. But what is rate "C" and is "C" the same for individuals as for corporations.

steve said...

what makes the tax code 'unfair" are the insane amount of deductions, exclusions, credits etc that corps and wealthy can take advantage of by hiring expensive tax attorneys. eliminate virtually all deductions and lower the rate for everyone. that is the way to more "equality"

Vladimir Novoselov said...

Interesting that according to H.T. Odum maximum ecosystem production occurs when it works at 50% power capacity.

Joseph Constable said...

Just a short while ago on September 19 everyone was very happy with the new high in the S&P. Tuesday's close is only down 38 points from there. Less than 2% down.

Just giving some perspective.

Joseph Constable said...

Lack of redistribution did not cause inequality.

The IRC is an edifice to the greatest corruption humans have ever devised.

Matthew Grech said...

Scott: I consider The Way the World Works by Jude Wanniski to possibly be the greatest book ever written. Wondering if you care to elaborate on how it came to be that Laffer and Wanniski mentored you? MG

Scott Grannis said...

Matthew: one of the best things I did at Western Asset was to hire both Jude and Art as consultants in the early 1990s. That gave me 15 years or so of learning and interaction with them. One of the best things Jude did was an annual conference that will always rank as the very best the world has to offer. Art held annual conferences at his home in San Diego that were like graduate level econ classes for a small number of lucky attendees. In between conferences there were volumes of things to read and discuss.

Joseph Calhoun said...

Scott,

I also had the pleasure of meeting both Wanniski and Laffer in the 90s. Wanniski was interested in the history of the "Laffer" curve which actually goes back a lot further than the famous (or infamous) napkin sketch. I sent him a speech given by my ancestor, john C. Calhoun, on the floor of the US Senate during a debate about tariffs in the 1830s which was a perfect explanation of the concept. I always kidded Laffer that it should be properly called the Calhoun curve.

Wanniski sparked a life long interest in economics for me with TWTWW. Great guy and very insightful even though, or maybe because, he wasn't an economist. We have him to thank not for just the Laffer curve but also the prominence of Robert Mundell whose ideas he promoted in the WSJ. Jude is and will continue to be missed.

NormanB said...

My rememberance of the Laffer Curve was the mocking of it by economists even though the logic was irrefutable. But the question of its use is valid: At any given tax rate (be it Federal taxes or taxes on cigarettes) where are we on that curve? The downside or the upside? But even this is knowable by looking at changes in tax rates.

A prime example of the Laffer Curve was the Japanese real estate bubble that burst in 1990. Tax rates on real estate profits were 95%. No one sold so no taxes were generated. What was generated was sky (no atmospheric) prices because there were no sellers. Why sell when all of what you have made would go to the government? Unfortunately, to my knowledge, this great issue has never been analyzied and learned from. Sad.

Matthew Grech said...

Scott: Sounds fascinating. I was lucky enough to be invited by a friend to a meeting with Jude just as the Iraq war was about to commence. Jude could talk about nothing else at the time as he was completely opposed to what we were about to do. Right again, Jude!

I'm hoping that one day somebody could enlighten all of us as to why Jude was so ostracized by the political class in the last decade or so of his life. Somehow, this is something of another badge of honor, at least in my mind.

Benjamin Cole said...

Love the Laffer Curve---but versions of it were in my basic econ text, pre-Laffer. Laffer only popularized a basic tax principle.
BTW---Who says tax revenues should be maximized? I prefer they be minimized.

russ said...

In response to Williams:point C is about 33% total tax revenue,fed,state and local.Based on a urban population size of 600 people.