Homo Economicus vs Homo Sapiens: Changing Behavior

Here is a sentence I never thought I’d write: Art Laffer is right.

I refer specifically to tax incentives. Laffer was recently asked about the mess that is Kansas, and he responded by saying Governor Sam Brownback had the right idea in cutting taxes. He just failed to cut taxes massively enough.

When it comes to supply-side economics, go bigly or go home.

This is actually a nuanced change in position for Laffer, the creator of the Laffer curve and the father of supply-side economics. It used to be you couldn’t get him to say a negative word about any tax cut. The obvious logical conclusion to his argument that the tax cuts in Kansas were not large enough is that small tax cuts don’t really make much of a financial difference to enough people to matter economically. Indeed, modest tax cuts fail to create sufficient economic incentives for people to change their behavior enough to make up for lost tax revenues. The supply-side magic that Laffer has long advocated is, by his own admission, unsupported.

Consider the recent tax history of Kansas: In 2010, Brownback, then a U.S. senator, ran for governor on a platform of slashing taxes for business owners and lowering personal income tax rates. He was advised on his tax plan by Laffer and the American Legislative Exchange Council, a conservative group that specializes in promoting draft legislation.

Brownback promised tens of thousands of new jobs and an economic renaissance in Kansas. He was elected, pushed his legislative agenda through the Statehouse, and signed his bill in May 2012. It initially lowered the top personal income tax rate to 4.9 percent (now 4.6 percent) from 6.45 percent, and eliminated income tax on profits for owners of limited liability companies, subchapter S corporations and sole proprietorships.

The results have been disastrous for Kansans. Massive budget shortfalls, huge cuts to basic services such as road maintenance, and slashing of education budgets became annual events. You can’t blame broader conditions for the state’s weak agricultural- and energy-based economy; as my Bloomberg View colleague Justin Fox pointed out, Kansas lags its economically similar neighbors in nearly every major category: job creation, unemployment, gross domestic product, taxes collected. Pretty much across the board, the gap between Kansas and nearby states has widened, and it has been getting even wider lately.

So when Laffer made the claim that the Kansas tax cuts were not big enough, he was correct — but not for the reasons he claims. Theoretically, incremental changes in tax policy can change the behavior of homo economicus. The problem is modest incentives fail to rise to the level needed to change the behavior of homo sapiens.

Why is this? A tax cut of only a few percent is not worth the attempt to change people’s inertia or habits. It is doubtful that it is going to nudge people to make big new investments or hire new workers, or attract new residents to your state.

Demand does those things; incremental tax policy does not.

Consider the tax rates that might generate the maximum amount of revenue for state coffers. A 100 percent tax rate removes any incentive to work; a tax rate of 0 collects no tax. Somewhere in between is an optimal tax rate that maximizes state tax revenues.

What Laffer originally got right is that when nations tax citizens at confiscatory levels — think 90 percent — behavior changes dramatically: People won’t work, or they’ll seek tax shelters, or, as the Rolling Stones did, they’ll simply move to a friendlier venue (preferably with better weather).

Over the years, supply-siders seem to have extrapolated Laffer’s original thought to infinity. This is why the tax cuts of Ronald Reagan and George Bush were advocated as generators of more revenue than they cost. As the revenue portions of our deficits show, they don’t. Not every tax cut pays for itself — indeed, most do not.

A fair argument for incremental tax cuts is about the proper level of taxation. Claims they pay for themselves are intellectually dishonest nonsense.



1. I refer to not just income tax but also total tax burden. States that have no state income tax (Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington and Wyoming) have other ways of taxing residents.

2. Bands including the Rolling Stones and the Beatles, smarting from the top standard rate of 83 percent with a 15 percent super-tax on high earners and a rate of more than 90 percent on unearned income, chose to become tax exiles, moving to such places as Switzerland, Brazil, Monte Carlo, the Netherlands, Luxembourg and the British Virgin Islands.



Originally: How Much Can You Cut Taxes? Don’t Ask Kansas


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