This is scheduled to disappear from Yahoo soon — I wanted to capture it before it went away. Its a criticque of Supply Side economics by Charles Wheelan, former US columnist for the Economist, and at present an economics and public policy professor at the University of Chicago and visiting prof at Dartmouth College. Wheelan is the author of Naked Economics: Undressing the Dismal Science.
Debunking One of the Worst Ideas in Economics
Wednesday, May 3, 2006
"In this column, I’m focusing on bad economics. In fact, I’m going to write about what I consider to be the two worst economic ideas — or at least ideas that pass as economics, though both have been thoroughly repudiated by nearly all credible thinkers.
When I say worst, I don’t mean the most outlandish (e.g. stock prices are controlled by aliens) because those ideas usually collapse of their own weight. Rather, the most pernicious bad ideas in economics are those that have a ring of truth. They’re hard to debunk because they have a certain intuitive appeal. As a result, they stick around, providing bogus intellectual cover for bad policy, year after year, decade after decade.
For the sake of political balance, I’ll skewer a favorite of the right in this column, and then a favorite of the left in my next piece.
The Laffer Curve
Economist Arthur Laffer made a very interesting supposition: If tax
rates are high enough, then cutting taxes might actually generate more
revenue for the government, or at least pay for themselves. (In one of
life’s great coincidences, he first sketched a graph of this idea on
Dick Cheney’s cocktail napkin.) If the government cuts taxes, then
Uncle Sam gets a smaller cut of all economic activity — but reducing
taxes also generates new economic activity. Laffer reasoned that, under
some circumstances, a tax cut would stimulate so much new economic
activity that the government would end up with more in its coffers —
by taking a smaller slice of a much larger pie.
In fairness to Mr. Laffer, there’s nothing wrong with this theory.
It’s almost certainly true at very high rates of taxation. If you
consider the extreme, say a 99 percent marginal tax rate, then the
government will probably not be collecting a lot of revenue. To begin
with, citizens are going to hide as much income as possible. (The more
honest ones will turn to barter and avoid the tax system entirely.) And
no one is going to rush out and take a second job or build a factory if
they get to keep only $1 of every $100 that they earn.
So it’s entirely plausible that slashing tax rates from 99 percent
to 30 percent could increase government tax revenues. It would deflate
the black market and provide a huge new incentive to work and invest.
No Big Jolt for the U.S.
But here’s the problem when we take Laffer’s theory and try to apply
it in the U.S.: We don’t have a 99 percent marginal tax rate. Or 70
percent. Or even 50 percent. We start with low marginal tax rates
relative to the rest of the developed world. (Yes, I understand that it
may not feel that way after the check you wrote last month.)
So cutting the tax rate from 36 percent to 33 percent is not going
to give you the same kind of economic jolt as slashing a tax rate from
90 percent to 50 percent. There’s no huge black market to be shut down,
no big supply of skilled workers to be lured back into the labor
market, and so on.
Will it generate new economic activity? Probably. And that will
generate some incremental tax revenue for the government. But remember,
it also means that the government will be taking a smaller cut of all
the economic activity that we already have.
Think about a simple numerical example: Assume you’ve got a $10
trillion economy and an average tax rate of 30 percent. So the
government takes $3 trillion.
Let’s cut the average tax rate to 25 percent and, for the sake of
example, assume that it generates $1 trillion in new economic growth (a
Herculean assumption, by the way). So now, what does Uncle Sam get? One
quarter of $11 trillion is only $2.75 trillion. The economy grows,
government revenues shrink.
That’s basically what happened with the large Reagan and George W.
Bush tax cuts, both of which were followed by large budget deficits.
Yes, spending has a lot to do with that, but the bottom line is
unequivocal: In both cases, government revenue was lower than it would
have been without the tax cuts.
Can’t Lose Weight by Eating More
Neither the Reagan nor the George W. Bush tax cuts were
"self-financing," as the Laffer disciples like to argue. According to
The Economist — my former employer and no bastion of left-wing thought
— the current Bush Administration’s top economist, Gregory Mankiw,
estimated that decreasing taxes on labor would generate enough growth
to recoup only about 17 cents for each lost dollar; a tax cut on
capital is better, paying for more than half of itself. Still, the
bottom line from the Bush Administration itself is that tax cuts reduce
Uncle Sam’s take.
So why does Laffer’s sketch on Dick Cheney’s cocktail napkin rank
near the top of my list of bad economic ideas? Because, when applied to
the U.S., it’s intellectually dishonest. The Laffer Curve offers the
false promise that we can cut taxes without making any sacrifice on the
spending side, and that’s simply not true. It’s the economic equivalent
of arguing that you can lose weight by eating more.
Let me be perfectly clear: I’m not arguing that tax cuts are bad.
I’m simply pointing out that we can’t pretend that tax cuts won’t
require reductions on the spending side to balance the budget. In fact,
you can disregard every other argument in this column and think about
one thing: If Laffer were right, lower taxes would never require any
spending sacrifice. We could pay a mere one percent of our income in
taxes and still fund all of our government spending — and maybe more!
Do you think that’s really possible?
This column should give you a hint of why economics is called the
dismal science — it’s all about tradeoffs. We’re the ones telling you
that if you get more of something, you probably have to get less of
Whether it’s tax policy or dieting, you can’t have your cake and
lose weight, too, which is why America currently has huge deficits and
a lot of fat people.