Tax Ideologues, Economic Narrative, and Debt

This sentence might break a few hearts, but fiscal incentives are intractable through the orchestration of public policy. In fact, for fiscal and tax policies, it is best to have empirical backing when predicting behavioral outcomes to a policy change. In the United States, this affidavit has become available to the Trump administration and to the Republicans in office who hope to pass a tax reform bill this year. In the state of Kansas, a story about taxes is soon becoming a precautionary tale against the supply-side economic policies propagated by Arthur Laffer.

President Trump’s plan, in its most comprehensive unveiling thus far, proposed deep cuts to the corporate tax rate, arguing that such cuts would pay for themselves in the medium to long run through higher job creation and growth. Laffer predictably threw his support behind the proposed tax plan, as he did for the Kansas tax cuts in 2012. Laffer’s influence over US tax policy is enormous, and without precedent. The policies the come under the umbrella of ‘supply side economics’ (the field of which Laffer is considered a founder) have been criticized on all sides of the political spectrum from the time they were first proposed in the 1970s. President George H.W. Bush famously called these theories ‘voodoo economics’. Even Alan Greenspan, the legendary Federal Reserve Chairman, distanced himself from the naïve supply siders within the Republican Party.

Reducing the tax rate reduces government revenue, and unless government spending is reduced as well, the deficit will increase. Earlier this year, it was implied that the President would increase defense spending by $54 billion. At no point has there been a clear indication of from where these funds would be derived. On one instance, President Trump even implied that no current government spending would have to be compensated to contribute toward defense expenditure, but that such funds would be made available due to a boost in economic growth. This is a nebulous proposition at best. With the promise of increased infrastructure spending, including the infamous border wall, there is no evidence that the Trump administration plans on cutting government spending or on reducing the fiscal deficit. At one point in his presidential campaign, Trump claimed that he would eliminate the country’s $20 trillion deficit within 8 years, such declarations are now seldom heard. A reduced tax rate with no decrease in government spending will increase the deficit, and is unlikely to produce proportional long term revenue through economic growth.

Arthur Laffer, Napkins, and non-linearity

Dr. Laffer’s theory, and with it the foundations of supply-side economics, states that reducing taxes can increase government revenues in the medium to long run. This is based on the assumption that economic factors such as investment, wages, employment depend mostly on the tax rate. So high tax rates reduce the money available for business investments and thus reduce growth, employment, wages, and the amount of business and personal revenues that are subject to taxation. Thus, this theory argues, if tax rates are drastically lowered, the economy will expand along with the total revenues earned by businesses and their employees, the taxing of which increases government revenues. Laffer delineated his theory into a simple inverse U-shaped curve. There are 2 points where the government generates 0 revenues — when the tax rates are 0 and 100 percent. In between these 2 points, as tax rates are increased, revenues increase up to a point, after which they start reducing. This is the equilibrium point of maximum revenue. Supply-siders argue, as do most contemporary Republicans, that the US tax rates are between equilibrium and 100 percent, and so lowering the tax rate will bring in more revenues.

This theory is fetching. Extremely so. Politically, it’s a silver bullet. It’s a story that can be easily understood, and is thus used by many-a-politician to garner votes. The average voter is more than happy to support a tax cut, as long as the roads are still smooth, public schools are well funded, and she can still afford healthcare. As Hal Varian, the Chief Economist at Google, once famously put it — “the popularity of the Laffer curve is due to the fact that you can explain it to a Congressman in six minutes and he can talk about it for six months”.

But it is impossible to accurately prognosticate the effective tax rate at which government revenues can be maximized. Said unequivocally, it is impossible to know where the equilibrium point lies. It is also impossible to know whether the curve is as smooth as Laffer suggests on his infamous napkin, indeed the actual ‘Laffer Curve’ might be multimodal, or a plateau, or even vacillating. Where you need to go depends on where you are, and the equilibrium is impossible to normalize.

It is difficult to underestimate the power that the supply side rhetoric has had on Republicans. It usually follows that tax rates should be cut to increase economic activity and thus government revenue, if this does not happen, apparently enough time has not passed, or taxes have not been cut far enough. This is convincing for voters. (If just for the benefits that lower corporate taxes might provide to businesses and in stimulating employment opportunities, such a policy would not need to be argued against, but this is not the only effect (given the deficit and low likelihood of business investment)). Empirically, however, it is only convincingly wrong.

N. Gregory Mankiw, a Harvard economist and the former chairman of Bush Jr.’s Council of Economic Affairs, said that only about a third of the costs incurred from the tax cuts is recouped through economic growth. There thus isn’t a one-to-one revenue gain for the losses incurred through tax cuts.

Laffer’s theory was first adopted by Ronald Raegan in 1981. Raegan’s plan cut top rate taxes for the wealthiest Americans from 70 percent to 28 percent, slashing corporate and capital gains taxes as well. The Laffer curve was one of the key pieces of evidence (the word evidence has been used with extreme liberty here, given that it was not empirical in any way) that helped pass the bill. Predictably, the government had to rely on deficit spending due to a massive drop in tax revenue. From 1981 to 1993, US Government debt as a percentage of GDP rose from 30 to around 65 percent. When George Bush (the Second) became President, his administration passed two tax cuts with a similar philosophical motivation, both of which increased debt and reduced tax revenues. Both Raegan and Bush Jr. are on hallowed ground, being responsible for the 2 largest percentage hikes in public debt (as compared to their predecessors) among all US presidents since 1945.

While tax rates do not have a high correlation with growth rates, Bill Clinton’s policies — which increased the effective tax rate — show that tax increases do not interfere with the economic growth rate.

Of course there are economic factors other than the tax rate that influence debt and revenues, but Laffer and the supply-siders claim that the tax rate is the most important one of these, if not the only one that matters. So going by their own criterion, the claim that tax cuts are self-financing has not been proven. The point here is not that Laffer and the supply-siders are entirely wrong, for of course the marginal tax rate and economic incentives matter. But the supply-side ideology has pushed the importance of the tax rate well beyond what is warranted. As the Nobel Prize winning economist Robert Shiller puts it in a recent paper titled ‘Narrative Economics’ (which I think is one of the most important papers written in the recent past), the genius of supply-side is not in data collection, but in narratives.

Shiller writes: “To most quantitatively-inclined people unfamiliar with economics, this explanation of economic inefficiency was a striking concept, contagious enough to go viral, even though economists protested that we are not actually on the inefficient declining side of the Laffer curve”.

A policy that Reduces taxes on top earners is motivated by the assumption that they will invest and consume more with the additional disposable income. This behavior has not been empirically observed thus far. The reduced top rate shifts the burden of taxation on the middle class. The non-partisan Tax Policy Center found that 80 percent of the benefits of the proposed tax cuts would do to the top 1 percent of the population, and 25 percent of the households in the middle fifth of the population distribution would face an increase in their tax rate.

So why does a policy that widens inequality and increases national debt, while failing to meet its self-stylized objective of being self-financing continue to dominate the taxation philosophy of the Republican Party?

It could be ideology, or stubborn belief, or anything else for that matter. But if words have thus far spoken louder than evidence, let’s hand the mike over to the latter. The most recent supply-side experiment was conducted in Kansas, orchestrated by Governor Sam Brownback.

That’s how we got to Kansas

Governor Brownback passed his tax cuts in May 2012, reducing the income tax rate and eliminating taxes on the profits of LLCs and sole proprietorships. The results were predictable as the state government suffered a massive budget shortfall, 8 percent since 2012. While the taxes were aimed at changing the individual and corporate incentives to promote economic expansion, the incentive that was instead adopted was that of tax avoidance. Employees were quick to reclassify their income from wages to profits for sole-proprietorship companies. By changing their status from employees to contactors, Kansas residents paid a 0 percent effective income tax. Researchers believe that 1.7 percent of the 8 percent drop was due to such tax avoidance.

While the states poor economic performance can easily be blamed on Kansas being a largely agrarian economy, these criticisms are unfounded. Kansas lags behind its neighbors, which have similar economies, in all major relevant categories including GDP, unemployment, and tax collection. This gap has been expanding ever since 2012. Kansas has faced the one of the highest rates of outbound migration in the US. The state’s recent conditions are quite different from what they were before Brownback took office. Businesses did not expand or employ more labor. The tax cut was not an effective method in motivating business expansion, investment, or labor inflows.

People (and, for that matter companies as well) do not change their financial behavior just because of a moderate tax rate change. Such policies certainly have a negative impact on revenues from taxation, and perhaps act as a good benchmark for reducing government spending, if that is the goal. In Kansas it wasn’t, and spending had to be compromised to finance the revenue shortfalls. Road maintenance projects have been stalled and funding for social services has been gutted. The extent of the cuts made to educational funding have in fact been deemed unconstitutional by the US Supreme Court.

The Kansas experiment had no economic growth effects. It got to a point where the state stopped releasing economic data, and Moody’s massively downgraded their credit rating.

Trump-onomics 1.0

The Trump administration is planning a tax cut, the depth of which, in the Presidents own words, hasn’t been seen since Raegan. Details of this policy have not been articulated in much detail thus far, but the narrative surrounding the cuts has heavily involved the concept of self-financing. The Tax Policy Center estimates that the proposed rate cut would cost $770 billion over ten years — 30 percent of the tax plan’s net cost, and $129 billion in revenue lost due to tax avoidance by high earners.

This policy is clearly influenced by Laffer and the supply siders. The result could most certainly be an increase in public debt, unless government spending is reduced drastically — which is unlikely to say the least. Against all available evidence, the Republican Party is baking Trumps Laffer-inspired tax plan. Do we really expect the Party of Climate Change Deniers to do any different?

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