This might very well be a long post (if not a series of posts turned into a quick book).

The target of this post is something called the “Laffer Curve”.   There’s a few different things this might refer to.  Let me lay out a basic level of understanding of this concept now, straight from the source…

If the existing tax rate is too high–in the “prohibitive range” shown above–then a tax-rate cut would result in increased tax revenues. The economic effect of the tax cut would outweigh the arithmetic effect of the tax cut.

…

Because tax cuts create an incentive to increase output, employment, and production, they also help balance the budget by reducing means-tested government expenditures. A faster-growing economy means lower unemployment and higher incomes, resulting in reduced unemployment benefits and other social welfare programs [hence lower spending -RPN].

[source…which will be referred to again]

If you would like, wikipedia is a good source of info on this as well as further reading.  The analysis you are about to read is not concerned so much with the theory, but the application and the results.

Over time, the idea of the Laffer Curve has evolved into a notion that “tax cuts pay for the themselves” and “raising taxes will only decrease revenue”.   There are a number of other popular myths and misconceptions dealing with taxes in the 21st Century United States, far too many to deal with today in this post.    One we will deal with in part two of this series is who is paying those taxes and how the application of the Laffer Curve has changed that dynamic.  However, that is beyond the scope of this initial piece.

Section I : The Perfect Lab

In the year 2000 (que Conan…)…the United States of America had a balanced budget.  I know, I know…this is hard to believe.   Hard to even conceive of at this point.  However, it was true.

Q: During the Clinton administration was the federal budget balanced? Was the federal deficit erased?

A: Yes to both questions, whether you count Social Security or not.

[source]

A couple terms to deal with real quick, “deficit” which is a yearly negative difference between revenue and spending, and “debt” which is  accumulated, usually counted on a per year basis as we’ll do below.  While it doesn’t seem particularly relevant as this point, such a thing as a “surplus” also exists.  A surplus is when revenue exceeds spending.  Surpluses are the only thing that can be used to pay down “debt”.

So in the United States, circa 2000, there existed the perfect “test case” for an economic theory dealing with the direct and raw stimulative power of tax cuts directed mainly at top earners.  We would be able to see, very clearly, whether or not “the economic effect of the tax cut would outweigh the arithmetic effect of the tax cut.”

IMPORTANT NOTE: For simplification purposes, the charts below DO NOT INCLUDE debt accumulated prior to 2000.  Back in the 20th Century (mostly the 80’s) the U.S. racked up $10,000,000,000,000 in debt.  We’re going to ignore that for the next little while (it became a custom in the 90’s, and for not horrible reasons).   In part 3 of this series we’ll tie the whole thing  together with unemployment [here’s a taste].

As math tends to do, the “arithmetic effect” on revenues was immediate.   Our next section will deal with the math that goes into the “arithmetic effect” (which BTW, is a euphemism for saying, “Duh, it’s obvious if you cut taxes you get less revenue.”)

So let’s start small and build from there.

Section II : The Little Equation

To be honest, there are many “equations” which figure into public accounting.  In this case the equations we’re talking about are the ones that governs the graphs below.  The first can be described simply as this…

A deficit (and it’s alter ego the “surplus”) is simply the difference (negative for deficits, positive for surplus) between the amount of revenue the government takes in and the amount of spending it puts out.

Part of the disconnect that is happening right now is we are seeing huge deficits, focusing solely on the “spending” side of the equation, and don’t seem to be largely aware how badly *revenues* have dropped off during the recession.

To simplify:  Revenues [R] – Spending [S]= Deficit(-)/Surplus(+) [I]

Those are the only numbers driving this first graph, spending, revenue and deficits.  In addition to the straight spending, revenue and deficit surplus numbers, we’ve also added to lines for change over time (in this case % per year), and one section for accumulated gross debt.

Here’s how the numbers came out.   In a moment we’ll looks a few choice events in the timeline, and the corresponding (general) effects in the graph.

What we see here is a *very* basic look at the economic situation in the United States in the 21st Century.   As indicated in the legend, we’ve set up Revenue as positive income, Spending as negative, and graphed the *cumulative* difference, in the this case “debt” in the black-fading-to-bright-red.

One thing which is on this chart you will not see quite so often on other charts are the wavy lines.   The blue wavy line is the Year 0ver Year (YoY) percent change in revenue.  That is…compared to the previous year, how much did it change?  Understanding the reason this line is so important brings us back to the definition of the Laffer Curve.  Recall:

If the existing tax rate is too high–in the “prohibitive range” shown above–then a tax-rate cut would result in increased tax revenues. The economic effect of the tax cut would outweigh the arithmetic effect of the tax cut.

The reason this stands as such a perfect lab example for testing this theory is that we had both a balanced budget (with a surplus, no less) in 2000, and then has massive tax cuts in both 2001 and and in 2003 (note: both these included specifically in their titles that they would create jobs and economic growth.  Their titles, however, have little to do with their effects).

What this graph indicates, and we’ll do a close-up below, is that tax cuts decimated revenue in 2001, 2002, and 2003.

As we’ll indicate in a moment, there is no larger contextual reason for this reduction outside of tax rate.  During each of these years, GDP went up.   The above chart indicates the “arithmetic effect” of tax cuts.  This is the basic idea that if you tax a smaller percentage of something, you get a smaller amount of that something (i.e. it’s “duh” math).

When many* point to as the “economic effect”  of tax cuts, they use the following cut out.

* who are trying to selectively use data to prove a point that doesn’t exist in the larger data set.

The problem with the above data is that it is *very* selective about what data it is representing.  We can’t even count the number of times we at RPN have seen opinion columns that claims “the Bush Cuts worked” and then selectively use the period 2003/4-2007.   When you pick the year with the *lowest revenue* and then start going from there, even if it’s a number of years *after* the tax cuts took revenue to that lowest point, there’s some honesty issues with those numbers.

Luckily we have another way to look at these numbers (as Ratios of GDP), and we get to measure the “arithmetic effect” of the tax cuts vs the “economic effect”.

 Section III : The Big Equation

Now that we have a base set of data, we are going to expand it back into the big equation.   In order to give it context, and not just freak everyone out with big numbers, we are going to show both revenue and spending as a % of GPD.   Here’s how that looks.

What this shows is a slow and somewhat steady growth in the overall U.S. economy over the last decade.  However, as the tax cuts are implemented, not even that level of steady economic growth is enough to slow the quick decline in revenue.

Those next years, from 2003/4 through 2007/8 are the ones cited by supporters of this method of spurring economic growth.  Indeed, we do see a return to revenue growth (purple line), and it begins to catch up to steady spending (orange line).

The problem with this is that even with the favorable economic growth, steady spending patterns, and the “favorable tax rates” revenue still never quite manages to catch up.  And we still see that quickly reddening debt line.

So for the third time we look at the question, the data, and reach the conclusion.

The question:   Does the economic effect of the tax cut would outweigh the arithmetic effect of the tax cut?

The data: See graphs that should both have opened in new windows. 

The conclusion: As alluded to in the title and the next subject heading.

Section IV: Smashing the Laffer Curve

So now we bring the whole thing together, and point out what our analysis just indicated.

The revenues never catch up after falling so far behind, even in our perfect laboratory, the Laffer Curve didn’t work.

Previous analysis has shown that taking into consideration *even more* favorable, longer term, economic conditions, the revenue will never catch up.

What we have here is a situation where the reality has match up to the basic math quite nicely.  Except for one thing…what happens when long term public policy is based on an economic fallacy?

Section V: The Second Great Economic Collapse.

We are going to try and wrap this up shortly.  Examining the reactions to, and the results of, the economic collapse that happened in September/October of 2008 are going to take another decade at least.   Hindsight, such as we’ve employed throughout this analysis, is incredibly accurate…one is simply looking at what happened and doing the math.

Foresight, on the other hand, and even shall we say “current sight” are much more fickle beasts.  One thing that can be very easily said, when looking at either graph, is that spending is less than half our problem.   Revenue, both in real terms and as a % of GPD, has hallen through the floor.

You’ll noticed that the only year, in all of those posted, where we had a real and actual reduction in spending was from 2009 to 2010, our current President’s first full fiscal year in office.  An office taken amidst a literal plethora of crises.  To claim this is indicative of anything beyond that simple fact is a tough argument to make.

We’ll see how that works out when more data is available.  There is more hindsight to consider at the moment.

Section VI: What the Laffer Curve Really Does

This part, for now, we’ll let Art Laffer answer himself.

From the original Heritage Foundation link.

The most controversial portion of Reagan’s tax revolution was reducing the highest marginal income tax rate from 70 percent (when he took office in 1981) to 28 percent in 1988. However, Internal Revenue Service data reveal that tax collections from the wealthy, as measured by personal income taxes paid by top percentile earners, increased between 1980 and 1988–despite significantly lower tax rates (See Table 8).

Table 8

Table 8 Which shows how the rich got richer by paying a higher percentage of total income taxes

Here’s the thing that has misguided nearly 30 years of public policy.  Table 8.   What Art Laffer neglects to mention in that description of this chart are the following words, “as a percentage of total income.”

That is, what the data indicates (and has for nearly 30 years of this policy) is that “tax collections from the wealthy, when measured as a ratio of all income taxes paid, by top percentile earners, increased between 1980 and 1988–despite significantly lower tax rates (See Table 8).”

So despite having lower tax rates, the highest income earners still took in a higher percentage of all income, hence paying a higher percentage of total taxes.  The above graph is doubly misleading, as it consistently recounts the same people, over and over again, to give the impression that more actual money is being paid, not a higher ratio.   Indeed, in many of these years, much like after the Bush tax cuts, overall revenue went down.

What went up was how much, as a ratio, was earned by the top X %.

Final note on Art Laffer’s Table 8….it doesn’t include, anywhere, the bottom 50% of AGI.  Each one of those columns recounts the top 1%, with the final column recounting every single one to the left of it.  Were I to grade the chart on intellectual honesty, it would fail.   It is not saying what he is saying it says.  [NOTE: Illustrating this graphically is going to be the focus of Part II]

Quick note on where the Laffer Curve came from…

As recounted by Wanniski (associate editor of The Wall Street Journal at the time), in December 1974, he had dinner with me [Arthur Laffer] (then professor at the University of Chicago), Donald Rumsfeld (Chief of Staff to President Gerald Ford), and Dick Cheney (Rumsfeld’s deputy and my former classmate at Yale) at the Two Continents Restaurant at the Washington Hotel in Washington, D.C. While discussing President Ford’s “WIN” (Whip Inflation Now) proposal for tax increases, I supposedly grabbed my napkin and a pen and sketched a curve on the napkin illustrating the trade-off between tax rates and tax revenues. Wanniski named the trade-off “The Laffer Curve.”

At the time this happened, RPN was one month old.  This concept, sketched on a napkin, has been driving public policy in my country MY ENTIRE LIFE.

We guarantee you, we swear on it, Excel is faaaaaaaaar better at graphing numbers and doing economic analysis than any bar napkin.   Especially in hindsight.

CONCLUSION:

TL:DR, Applying “the Laffer Curve” cannot increase revenue unless current tax rates are north of 70-80%.  Oh, and it’s why we’ve run up 13 of the 15 trillion $ we owe.

—-