The Laffer Curve Revisited (Part Deux)

In our previous post, we essentially debunked the right-wing talking points about the Laffer Curve.  We showed that, generally speaking, the peak of the curve for the top marginal tax rate is most likely 70% or perhaps even a bit higher.  That is, tax cuts (particularly at the top) can nearly always reasonably be expected to decrease revenue rather than increase it, and vice-versa. We also showed that there is another curve called the Kimel Curve, which illustrates that a top marginal rate of 60-70% maximizes economic growth based on empirical data.

But what about Hauser's Law?  For those who don't know, Hauser's Law (a supposed corollary to the Laffer Curve) postulates that federal tax revenue cannot exceed 19.5% of GDP for long regardless of what the marginal tax rates are.  Indeed, at first glance the empirical data from 1945 to the present do appear to agree, but it really doesn't stand up to closer scrutiny.  Part of it comes from lying with statistics to obscure significant swings in revenues, and part of it comes from omitting key facts about less obvious changes in the tax code over the years that confound the apparent (non)correlation.  Thus anyone who cites Hauser's Law (which it turns out is not really a law at all) is either ignorant or disingenuous at best.  Consider it debunked.

Another important question is whether the Laffer Curve differs depending on the type of income being taxed.  Conservatives frequently argue that the tax rate on long-term capital gains should be significantly lower than the rate on ordinary income, as is currently the case.  For example, they claim that the Laffer Curve peaks at a much lower rate due to the so-called "lock-in" effect (when investors hold onto their underperforming assets longer to avoid taxation) induced by higher tax rates, an effect that allegedly hurts the economy.  However, this appears to be primarily a short-term phenomenon that occurs when investors either anticipate the change in tax rate in advance and/or believe that the rate hike or cut will only be temporary.  Effects on economic growth do not appear to be large in the short or long term, and may even be perverse in the short term.  In fact, rather than encourage investment, one experimental study finds that taxing capital gains at too low a rate may, at least in some circumstances, encourage too much divestment (consumption) of capital at the expense of further investment.  This might be one reason why overall private investment was actually lower on average in the lower-tax 1980s than it was in the higher-tax 1970s.  Also, a lower rate on capital gains is a key part of many tax shelters, and adds unnecessary complexity to the tax code. Thus, taxing long-term capital gains at a lower rate does not appear to be justified.  And to avoid taxing illusory gains due to inflation, it would make more sense to simply allow taxpayers to index the basis for inflation (which is not currently the case) while taxing all forms of income at the same rate. 

In addition, one should also observe how nearly every single time the capital gains tax was cut, an asset bubble of some sort eventually followed.  These include the notorious 1920s stock market bubble (tax cut was in 1922-1925), the late 1970s commodities bubble (cut in 1978), the late 1990s NASDAQ/tech bubble (cut in 1997), and the 2000s housing bubble (cuts in 1997 and 2003).  The one exception was the 1982 tax cut, which occurred during a deliberately-induced (i.e. by the Feral Reserve) recession and was followed by an equally large hike in the capital gains tax five years later that restored the rate back to its 1981 value before another bubble had a chance to form.  (The relatively small stock market correction in 1987 represented only a minor bubble in the market.)  While correlation does not necessarily equal causation, it is uncannily suggestive to say the least.  Though a low tax rate may appear be investor-friendly on the surface, one should keep in mind all of those hapless investors that lost their shirts when the bubbles inevitably burst, and all the damage the fallout did to the general economy.

How about corporations?  It appears that the Laffer Curve for the corporate income tax peaks somewhere between 20-30%, which is significantly lower than is the case for individuals.  However, the current corporate income tax rate of 35% in the USA (supposedly one of the highest in the world) is largely a fraud--due to loopholes, most companies pay nowhere close to that, and two-thirds of them effectively paid zero (or even negative) rates in 2008-2010.  And most estimates of the Laffer Curve simply don't take that into account.  While cutting the rate to 20-25% may very well make America more competitive in the global economy, the loopholes absolutely must be closed, period.

We recently came across a website called EquityScore, which claims that cutting the corporate income tax to zero would actually increase revenue to the point that all other income taxes could also be eliminated except for the capital gains tax.  That is, they claim that taxing corporate profits suppresses market values, and the massive gain in market values would yield enough capital gains tax revenue (when the stocks are sold) from individual shareholders to more than offset the foregone revenue from eliminating the corporate income tax.  While there may be some truth to that, their calculations ignore the fact that the majority of corporations already pay an effective rate of zero (or close to zero) due to loopholes, and that typical corporations used to pay much more in the not-too-distant past than they do now.  A better idea to maximize revenue (and growth) would be to cut the corporate tax rate to 20-25%, close all of the loopholes, tax only the amount of profit left after dividends are paid out, and tax dividends (and capital gains) as ordinary income for individuals.  Not only would that raise more revenue directly, it would also allow companies to pay bigger dividends and attract more investors, thus increasing market values and indirectly raise even more revenue.  It would also make the "double taxation" argument moot as well.

In summary, we have shown that the supply-siders' conception of the Laffer Curve is largely a canard.  And for those who continue to eschew the notion of shared prosperity and still insist on the richest Americans and mega-corporations paying historically low (if any) taxes, we shall leave the reader with the following inspirational quote from a very wealthy businessman of many decades past.  This was the man who founded the famous Filene's department store and also founded the U.S. Chamber of Commerce.

"Why shouldn't the American people take half my money from me? I took all of it from them."

---Edward Albert Filene (1869-1937)

The Laffer Curve Revisited

Most people (at least those who took Econ 101) have heard of the Laffer Curve.  This idea is often attributed to economist Arthur Laffer in 1974, but similar ideas were put forth much earlier by John Maynard Keynes and Ibn Khaldun.  In a nutshell, it states that both a 0% tax rate and a 100% tax rate would both yield zero revenue, for obvious reasons, and that the level that would produce the maximum amount of revenue thus lies somwhere in between.  To wit:

However, this is a rather crude representation and the curve need not be symmetric or even single-peaked.  So where exactly is the (highest) peak of this curve?  That is the million-dollar question that has been nagging numerous economists ever since Arthur Laffer himself initially proposed it.  Different sources have given very different answers, and the true answer may very well vary from year to year and country to country.  Probably one of the most reliable estimates of the peak is the midpoint of the results of various studies, which according to the New Palgrave Dictionary of Economics is about 70% as of 2008.  Thus, the real curve would probably look something like this:

Of course, one source of variation of estimates has to do with whether or not you are talking about average rates or top marginal rates (i.e. the rate on the last dollar earned by those in the highest tax bracket), as well as where the threshold of the top bracket lies.  Most studies (and politicians) are more concerned with the top marginal rate, and both those rates and the thresholds for the top bracket have varied a great deal throughout history and from place to place.  The most recent study on the matter puts the peak for the federal top marginal rate at a whopping 76%, assuming no loopholes and all else being equal.  Thus, with a top marginal rate of 35% as of 2012, we clearly have plenty of room to raise it (even double it), close the loopholes, and still significantly increase revenue.  Policymakers should take note next time the issue of budget deficits comes up.

Of course, this is downright heresy to wealthy Republicans and their Tea Party lackeys, so when they aren't trying to deny it directly (which they often do) they at least try to argue that a higher top marginal rate will hurt economic growth and thus hurt all of us in the long run, even if it does raise more revenue in the short run.  But history doesn't really bear this out.  Recall that the top marginal rate hovered around 90% in the 1950s and early 1960s, and hovered around 70% from 1964 to 1981.  Some of the greatest economic growth we have ever had occured during top marginal rates north of 70%.  Which leads us to another, less well-known curve--the Kimel Curve.  Discovered by economics blogger Mike Kimel, this curve plots historical real GDP growth versus the top marginal tax rate and controls for several potential confounders.  And the peak of that curve turns out to be somewhere between 60-70% depending on how the model is specified.  Thus, a top marginal rate of 60-70% actually appears to maximize economic growth rather than hurt it! 

While this may seem counterintuitive to those who took Econ 101, it is entirely plausible that hoarding of wealth by the ultra-rich as well as excessive executive compensation has an adverse effect on GDP growth.  Inequality beyond a certain point appears to harm the economy--just look at the levels of inequality (and tax rates) immediately before both the first Great Depression and the current one.  And a top marginal rate north of 50% most likely discourages such hoarding and excessive executive salaries and bonuses, and encourages businesses to reinvest their profits in more productive ways.  This is similar to the rationale nicely summarized by Kimel himself:

At 70% tax rates, there is more of an incentive to reinvest in the business, creating more growth in the business in subsequent years, and more economic growth thereafter. 70% tax rates are more likely to generate faster economic growth than 25% tax rates precisely because people are self-interested and the higher tax rates induce people to continue investing in things they do well.

Indeed, another study of the 1920s and 1930s found high top marginal rates (even pushing 80%) did not appear to hurt business investments one iota, but possibly even slightly increased the formation of new businesses.  This was a time period in which the income tax was levied pretty much only on the wealthy (with the top rate applying only to the top 0.1%), the top rate varied a lot from year to year, and the tax code was a lot simpler with fewer opportunities for cheating and tax-sheltering.

In addition, there is always the fact that, contrary to popular opinion, sometimes the government actually spends and invests money in better ways than the ultra-rich and mega-corporations would.  Just think of public infrastructure, which enables the private sector to generate most of its wealth in the first place.  And the money for that comes from--you guessed it--taxes.

Thus, advocates of a more progressive tax system (as well as the more intelligent deficit hawks) should feel vindicated and motivated by the results of these studies.  And we can just hear the greediest members of society whining right now.  But taxes are the price we pay for civilization, and the alternative to civilization is far worse.

230 Million Unnecessary Returns

This tax day, April 17, about 230 million American taxpayers will file a federal income tax return if last year's numbers are any indication.  The federal income tax has been with us for nearly a full century, having been started in 1913.  It started out simple enough.  In the first few years, it was fairly straightforward, and only the wealthy really had to pay a significant amount.  Since then, our nation's tax code has grown into a convoluted 60,000 page mess filled with numerous loopholes and deductions.  Up until 1980, Americans typically believed that the income tax was the fairest of all taxes, but since then, most people now rate it as the least fair tax of all.  Originally intended to be progressive, it remains as such up to a point, but then actually becomes regressive above that point especially when other taxes are taken into account.  Just ask Warren Buffett.  And for corporations, 2/3 of them get away with paying zero federal income taxes (and sometimes even negative rates!) because of all the ridiculous special-interest loopholes and subsidies in our tax code.

Several thinkers believe that our tax code is in need of a major overhaul and thus have tried to come up with alternatives.  Americans for Fair Taxation, for example, believes that all our federal taxes can be replaces with one national sales tax of 30%.  Michael Graetz, on the other hand, believes that we can and should replace all income taxes for households earning below $100,000 and single individuals earning below $50,000 (i.e. 90% of the population) with a 10-15% value-added tax (VAT) and a 25% flat income tax for those earning above $50,000 or $100,000 as well as all corporations.  Others believe in a purely flat tax, and still others (such as the TSAP) believe we can and should retain a steeply graduated income tax with a generous personal exemption and no loopholes.  For the record, the TSAP would also support a plan similar to Graetz's if an additional 50% bracket were added for incomes north of $1 million or so and the VAT did not exceeed 10%.

However, we have recently discovered an even better way forward for the 21st century.  Enter the Automated Payment Transaction (APT) Tax.  The APT is a novel idea proposed in 2005 by economist Dr. Edgar Feige.   Basically, it would replace all of our current federal and state taxes (and possibly even some local ones) with one tiny little tax (say, 0.3%) on all automated transactions. This would essentially be the lowest possible rate on the broadest possible base, with no loopholes or finagling. It would actually be quite progressive in practice since the rich make a disproportionally large volume of transactions, and it is literally impossible to evade it or game the system. It is based on simple math, not half-baked voodoo economic theories. And the benefits to replacing the current messy, 60,000 page tax code with something so simple and easy are painfully obvious.  Finally, something most liberals, conservatives, and libertarians can actually agree upon!

Unlike Dr. Feige, however, the TSAP supports retaining an income tax on all individual incomes in excess of $1 million. The first million would be tax-free, while the amount over $1 million would be taxed, preferably at a rate of 50% or higher. Thus, 99.9% of Americans would pay any income taxes at all.  The TSAP also supports various luxury and vice taxes as well.  And to pay down our ludicrously high national debt, we support what should be called the Donald Trump Tax--a one-time wealth tax of 15% on individuals and trusts with net worths above $10 million.

However, if the APT does not come to fruition, the TSAP still supports a graduated, progressive income tax with no loopholes.  The TSAP would consider the following graduated scheme of marginal tax rates (loosely adapted from Robert Reich) to be fair:

Under $20,000: no income tax
$20,000 to $50,000: 5%
$50,000 to $90,000: 10%
$90,000 to $150,000: 20%
$150,000 to $250,000, 30%
$250,000 to $1,000,000, 40%
$1,000,000 to $10 million, 50%
over $10 million, 70%

Unlike the current Byzantine tax code, there would be no loopholes or any deductions other than for state and/or local income taxes paid, and a limited amount (up to 10% of income) for charitable donations. Also, all forms of income (wages, interest, dividends, and capital gains) would be taxed equally, unlike the status quo.   And a top marginal rate of 50% or even 70% is actually pretty tame compared to what it was in the 1950s and early 1960s, which hovered around 90%.   For those worried about the Laffer Curve, rest assured that the most recent study on the matter found that revenue peaks at a top rate of about 76%. 

For corporations, a 20% income tax with no loopholes would be infinitely better than the one we have now, with 2/3 or large corporations (including ExxonMobil, GE, B of A, and BP) currently paying zero income taxes while numerous unfortunate small businesses get hit with up to a 35% tax. Even better would be if the first $1,000,000 per year was tax-free, and only the amount of profit left over after dividends are paid out would be taxable if the company is publicly traded.

And as long as we have a FICA tax for Social Security and Medicare, the wage cap needs to be eliminated completely or set at a very high level such as $10 million or so.

At the very least, though, we definitely need something like the Buffett Rule for as long as we retain our 60,000 page mess of a tax code.  Of course, that doesn't go far enough, but at least it makes the tax code non-regressive at the very top.  50% for every dollar above $1 million with no exceptions would clearly be better, but the proposed 30% is a step in the right direction.

Those who oppose this idea can call us pinkos all they want, but they might just want to listen to Adam Smith, the man who is often considered to be the father of capitalism:

The necessaries of life occasion the great expense of the poor. They find it difficult to get food, and the greater part of their little revenue is spent in getting it. The luxuries and vanities of life occasion the principal expense of the rich, and a magnificent house embellishes and sets off to the best advantage all the other luxuries and vanities which they possess. A tax upon house-rents, therefore, would in general fall heaviest upon the rich; and in this sort of inequality there would not, perhaps, be anything very unreasonable. It is not very unreasonable that the rich should contribute to the public expense, not only in proportion to their revenue, but something more than in that proportion.  (Emphasis added)

And there you have it.  Even the father of capitalism himself essentially agrees with us, which really says something.

Does Atlas Really Shrug?

One favorite claim by the wealthiest 1% (and their lackeys) is that higher marginal tax rates at the state/local level will cause rich folks to vote with their feet, and take several jobs with them in the process.  During these times of recession and budget crises at all levels of government, when there is clearly a need to raise taxes, the rich love to scare people about this.  But is it true?

At least two recent, carefully controlled studies say no.  There apparently is little to fear about the alleged adverse effects of "soaking" the rich at the state level, or any level for that matter.  The vast majority of millionaires and billionaires will essentially stay put in the face of a tax hike, and for the very few that do leave, good riddance.  Just ask Donald Trump--despite his repeated threats to leave NYC, he never seems to get around to it.  But why do so many people still believe that there will be a mass exodus of the rich?  Part of it is due to the power of anecdotes, even though the plural of "anecdote" is not "data".  Also, superficial observational data that does not control for other variables can indeed produce spurious relationships.

In addition, the corollary idea that the states that have lower or no income taxes do better economically than states with progressive taxes is also a canard.  In fact, a recent study found that the nine states considered to be "high" in terms of income taxes actually had more economic growth per capita than the states with no income tax at all, despite (or perhaps even because of) the fact that the latter group has more income inequality than the former.  Unemployment rates, on average, were roughly equivalent between the two groups of states as well.  So much for Atlas shrugging.

We feel it is very important to debunk this idea now.  The question is, will our elected representatives listen to the truth?

New Platform

The TSAP has recently updated our platform from its 2009 version, as our dynamic party continues to evolve.  Please take a look at it under our list of pages bar at the top of the page.