Wednesday, January 30, 2008

Lower taxes and Laffer Curve

I don't know how much more blatant things could be than this:

Do Repubs stand for lower taxes because they hate poor people and love rich people? Hay-yull no! I mean: maybe Repubs do hate poor people and love rich people - but that personal preference has nothing to do with tax policy!

"The Laffer Curve: Past, Present, and Future", by Dr. Arthur B. Laffer:
June 1, 2004

The story of how the Laffer Curve got its name begins with a 1978 article by Jude Wanniski in The Public Interest entitled, "Taxes, Revenues, and the `Laffer Curve.'"1 As recounted by Wanniski (associate editor of The Wall Street Journal at the time), in December 1974, he had dinner with me (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."

I personally do not remember the details of that evening, but Wanniski's version could well be true. I used the so-called Laffer Curve all the time in my classes and with anyone else who would listen to me to illustrate the trade-off between tax rates and tax revenues. My only question about Wanniski's version of the story is that the restaurant used cloth napkins and my mother had raised me not to desecrate nice things.

The Historical Origins of the Laffer Curve
The Laffer Curve, by the way, was not invented by me. For example, Ibn Khaldun, a 14th century Muslim philosopher, wrote in his work The Muqaddimah: "It should be known that at the beginning of the dynasty, taxation yields a large revenue from small assessments. At the end of the dynasty, taxation yields a small revenue from large assessments."

A more recent version (of incredible clarity) was written by John Maynard Keynes:

[...] I show ... to create wealth will increase the national income and that a large proportion of any increase in the national income will accrue to an Exchequer
Nor should the argument seem strange that taxation may be so high as to defeat its object, and that, given sufficient time to gather the fruits, a reduction of taxation will run a better chance than an increase of balancing the budget. For to take the opposite view today is to resemble a manufacturer who, running at a loss, decides to raise his price, and when his declining sales increase the loss, wrapping himself in the rectitude of plain arithmetic, decides that prudence requires him to raise the price still more--and who, when at last his account is balanced with nought on both sides, is still found righteously declaring that it would have been the act of a gambler to reduce the price when you were already making a loss.

Theory Basics
The basic idea behind the relationship between tax rates and tax revenues is that changes in tax rates have two effects on revenues: the arithmetic effect and the economic effect. The arithmetic effect is simply that if tax rates are lowered, tax revenues (per dollar of tax base) will be lowered by the amount of the decrease in the rate. The reverse is true for an increase in tax rates. The economic effect, however, recognizes the positive impact that lower tax rates have on work, output, and employment--and thereby the tax base--by providing incentives to increase these activities. Raising tax rates has the opposite economic effect by penalizing participation in the taxed activities. The arithmetic effect always works in the opposite direction from the economic effect. Therefore, when the economic and the arithmetic effects of tax-rate changes are combined, the consequences of the change in tax rates on total tax revenues are no longer quite so obvious.
Definition of Economics: the science of using scarce resources.

The tax rate question:
If, at any moment, we citizens can keep more of our income for ourselves and our families: is it then worth it, to enough of us, to produce a little more income?

At this moment, at this tax rate, our national answer is yes. It is worth it - to enough Americans - to create a national moment in which a lower tax rate will 1) overcome the arithmetic effect, and thus 2) increase government revenue.

Democrats (and media) understand the arithmetic of taxation, but do not understand the economics of taxation. They do not understand the science of using the scarce resource of time, as in: should I spend a bit more time working, or a bit more time recreating? Also: should I use my time at work a bit more productively, or a bit less productively? Dems do not understand that the decision about time and productivity - multiplied over hundreds of millions of Americans, and turbocharged by the power of the American economy - makes a very large difference in government revenue.

I sometimes joke about the difference between conservatives and liberals: conservatives took a basic economics class in school; liberals took a women's studies course instead. I sometimes joke about that - except, there's so much truth as to make it more tragedy than comedy.

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