In this 2012 Making Sen$e report, former Reagan White House economic adviser Arthur Laffer drew his famous curve on a napkin — just the way he did for the Ford administration — and explained how it works.
Paul Solman: In the second of his recent economic policy speeches, President Obama laid out a repackaged “grand bargain” on Tuesday, offering to Republicans a cut in corporate tax rates in exchange for more spending on middle class job creation. The idea of cutting tax rates to spur business comes from the economist behind Ronald Reagan’s “Reaganomics” tax cuts, Arthur Laffer.
Laffer is one of those rare economists whose name has become a possessive. His “Laffer Curve” draws a quarter of a million results in a Google search, dwarfing Al Harberger triangles (4,680), the Samuelson-Stolper Theorem (10,700) and even “laws” like Arthur Okun’s (114,000) or Jean-Baptiste Say’s (94,000).
The Laffer Curve delivers a simple, seemingly obvious message: When the tax rate is zero percent, government will collect nothing from the earnings it taxes. When the tax rate is 100 percent, the curve also shows the government collecting zero revenue because there will presumably be no earnings: who would work if they kept absolutely none of what they earned? And thus it follows that the government will take in more as it increases the tax rate up until some unknown percentage point at which workers become frustrated with the tax rate and start working less, thus lowering their earnings and, as a result, the government’s total take.
The communist counter would be that even at a 100 percent tax rate, people might work, and work hard, perhaps, if they received sufficient benefits from the state. But the U.S. is not a communist society — not even Scandinavia is. For market economies, the Laffer Curve depicts a hard-to-reject reality. But how pervasive are the work-discouraging effects of taxes? And at what percentage point do the discouraging effects set in? Fifty percent, as the shape of the Laffer Curve implies? Or, as Nobel Laureate Peter Diamond argued on the NewsHour, when I interviewed both him and Laffer last year, at a much higher percentage, at least for earnings above a certain healthy threshold?
In February, I encountered a study by the Institute on Taxation and Economic Policy about the effects of state income taxes on state economic growth. It begins:
“Lawmakers in about a dozen states are giving serious consideration to either cutting or eliminating their state personal income taxes. In each case, these proposals are being touted as a way to boost economic growth.
“One claim often made during these debates is that the nine states without personal income taxes are outperforming the rest of the country, and that their growth can be easily replicated in any state that dares to abandon its income tax. Some have also claimed that the nine states with the highest top income tax rates are experiencing below-average growth. The governors of Indiana, Oklahoma and South Carolina, as well as high-ranking officials pushing for income tax repeal in Louisiana and North Carolina, are just some of the more influential lawmakers that have attempted to frame the debate in this way.
“But these talking points, which have been widely disseminated by the American Legislative Exchange Council (ALEC), Americans for Prosperity, and The Wall Street Journal’s editorial board, are based on an analysis by supply-side economist Arthur Laffer that is extremely flawed.”
It seemed a convincing piece of work. So I called Art Laffer to interview him about the study and about his work in general, including the inflection point of his curve. Here’s an edited version of that interview. Our next post will spotlight a response from the eminent tax economist at the University of Michigan Joel Slemrod.
Paul Solman: In the study I sent, you there was no discernible evidence that states lowering their tax rates, or raising their tax rates, had any effect on people’s behavior, your own move from California to Tennessee notwithstanding. Is that true?
Arthur Laffer: I went to Tennessee exclusively because of taxes. It took quite a big difference in taxes to dislodge me from California, but I paid for my house in Belle Meade, (Tenn.), with my first year’s tax saving. So as soon as my son Justin chose to go to Vanderbilt, that determined to which of the three no-income-tax states we were considering we would move.
What’s the Evidence for Zero-Income-Tax States?
Paul Solman: Yes, and Gérard Depardieu moved from France, supposedly to Russia, but how many people are you if you don’t show up in the data, as the paper suggests?
Arthur Laffer: That’s the issue. It’s not correct that there is no evidence to suggest anyone ever has moved for taxes. I gave you a counter-example. Now the question becomes: how big is this effect? Maybe very small, maybe very large, so how will you go about looking at it?
Paul Solman: And, by the way, isn’t it the same question one would ask about the eponymously named Laffer Curve? That is, it’s not that at some point there will be a reduction in revenue, given a high enough tax rate. That must be true — at a 100 percent tax rate, say. The question is: how high is that tax rate before you start taking in less money?
Arthur Laffer: Exactly. The curve does exist. The question is, where do these effects come in and what are the implications?
The same thing is true for states. So what I’ve tried to do is look at some of the evidence. In my book, “Eureka! How to Fix California,” I’ve done a lot of work on this.
The first thing I did was to get the extremes. Let’s take the nine states that have no income tax and compare them with the nine states with the highest income tax rates in the nation. If you look at the economic metrics over the last decade for both groups, the zero-income-tax-rate states outperform the highest-income-tax-rate states by a fairly sizable amount.
Paul Solman: When you say “outperform,” what do you mean?
Arthur Laffer: States that outperform in population, in migration, in labor force growth, in gross state product growth, and it’s about 50/50 on tax revenue growth. It’s really sort of interesting: The zero-income-tax-rate states have far faster growth in tax revenues than did the states with highest income tax rate over this period.
In two zero-income-tax-rate states, oil is significant: Alaska and Wyoming. But even taking oil out of the picture, the story is still true — by a smaller amount, but it’s still true. There are lots of other things that affect state growth besides state taxes. However, the reason I look at taxes is because these are policy variables that can be changed by state governments in order to get better results than they otherwise had.
If you look at the performance of the zero-income-tax-rate states and the highest-income-tax-rate states, I believe a large amount of their difference is due to taxes. Not only is it true of the last decade, but I took these numbers back 50 years. And, you know, there’s not one year in the last 50 where the zero-income-tax-rate states have not outperformed the highest-income-tax-rate states.
Paul Solman: Now, let me ask you two questions. One, you are selecting a sub-sample of the 50 states, and by doing so, you’re taking a smaller sample. And, as we all know, smaller samples are more subject to variation than larger ones are.
Arthur Laffer: Your question is correct: I took the highest and the lowest so I could get the most extreme versions of tax rate differences.
But that’s not all I did. There are 11 states in the United States that in the last 50 years instituted an income tax. So I looked at each of those 11 states over the last 50 years, and I took their current economic metrics and their metrics for the five years before they put in the progressive income tax, although these states all did it in different time periods — states like Maine, Connecticut, New Jersey, West Virginia, Pennsylvania, Ohio, Illinois, Michigan and Nebraska.
Every single state that introduced a progressive income tax has declined as an overall share of the U.S. economy.
There are several states that move from Karl Marx-like policies to Adam Smith-like policies and back again in a weekend. So for the states with huge volatility in their income tax policies over time, the differences in growth rates in those periods are really amazingly consistent with tax rates really mattering.
Then I took another measure. Dartmouth economist Colin Campbell did a study in the ’70s comparing New Hampshire and Vermont. Vermont had high taxes, lots of regulation — just the way they are today. New Hampshire back then was just like New Hampshire today.
Paul Solman: Just to remind people, the license plate of New Hampshire is “Live free or die.” On the New Hampshire–Massachusetts border, right in front of a “Welcome to New Hampshire” sign, I once asked a CEO I was interviewing if he thought there was a difference between people on either side of the state line, and he said, “Absolutely.”
Arthur Laffer: You’ve got it. And there’s the Minnesota–South Dakota border and many other examples. The IRS publishes tax data on people moving from one state to another. In the last six years, the number of people filing tax returns who have gone from zero-income-tax-rate states to the highest-income-tax-rate states was 909,000 returns.
The number of returns that moved from the highest-income-tax-rate states to the lowest-income tax-rate states was 1,350,000 returns. Not only were there 50 percent more returns moving from the highest-income-tax-rate states to the zero-income-tax-rate states, but the average size of the return was about 30 percent larger as well.
Paul Solman: And so when you put all this together, that’s why you called your book “Eureka!” — because you discovered the answer to how a state gets rich: lower or no income taxes.
Arthur Laffer: I don’t do it just for income taxes. I look at state taxes; I look at corporate taxes; I look at right-to-work laws; I look at unionization of labor force; I look at welfare generosity; I look at the overall tax burden, which is different than the tax rate.
What’s the Matter with California?
Paul Solman: Let me ask you a question that will be in many people’s minds: Which way does the causation run? To some degree, New Hampshire grew and its citizens began to press for expenditures that the state didn’t have to make earlier on.
Arthur Laffer: Yeah, I went from (looking at) tax rates to revenues, and then to expenditures. Let me give you an example on expenditures: Education. California is the highest-tax state in the nation and has been for a long time. It has the highest paid teachers in the nation, by far — $400 a month more than New Jersey — and yet California is the third lowest state on test scores for fourth and eighth grade English and math in the nation, and has been at the low level for a long, long time.
Paul Solman: But isn’t California’s poor test score performance widely recognized as being because of the enormous in-migration from Mexico, Central and South America?
Arthur Laffer: Well, the in-migration has probably been part of that, but we’ve also looked at in-migration in the five super-states: Florida, Texas, California, Illinois and New York. The states that have large in-migrations of Hispanics are Florida, Texas and California. And Florida and Texas are way above average in educational achievement, while California’s the lowest, just about. So, I don’t think that explains it. When you look at the percentage of the population who is Hispanic, or non-English speaking, it just doesn’t match with that explanation, and I also find that explanation quite insensitive, to be honest with you. But I’m willing to look at it very carefully.
Paul Solman: California students do worse on test scores than Texas students do?
Arthur Laffer: Much worse. And the cost per student is about half in Texas what it is in California. And if you look at prison expenditures or police and their salaries, California is providing (fewer) public services in spite of the highest tax rates. The linkage between tax rates and public services is, if not non-existent, negative.
Paul Solman: And you say that’s because California is paying their employees so much more than other states pay their employees?
Arthur Laffer: That’s right. The cost per prisoner per day in California is about $129. The cost per prisoner per day in Texas is $59. If you look at prison guards’ salaries in California versus in Texas, it’s hugely different. If you look at the prevailing wages in building highways, it’s enormously different. Even look at the permitting cost of a house in Orange County, California: it’s like $50,000 a door. California is being taxed highest and providing very low public services.
Paul Solman: And that money is going to public employees?
Arthur Laffer: That’s all part of the fees and revenues of state government, yes.
Paul Solman: But, essentially, so that readers understand, your contention is that the money is going to much higher-than-average, and by implication, higher-than-necessary, remuneration to state or public employees?
Arthur Laffer: In some cases, that’s it. Maybe in some cases it’s regulatory fees that don’t go directly to people. I don’t know where all the money’s going, every dollar. Salaries are much higher in California than they are in other states, yes. And performance is much lower in California than in other states.
Paul Solman: So that’s the nub of your response to the study I emailed you?
Arthur Laffer: Yes.
Where Does the Laffer Curve Really Bend?
The Laffer Curve shows a hypothetical relationship between tax rates and government revenue. Image courtesy of Wikimedia Commons.
Paul Solman: One last question. The way you draw the Laffer Curve is as a parabola that peaks halfway. Now, I understand that it’s just for the purposes of illustration, but it looks like past a 50 percent tax rate, total revenues will diminish.
Arthur Laffer: Yeah.
Paul Solman: So it was pointed out to me that if, for example, economists Peter Diamond and Emmanuel Saez are correct, and in fact the federal government doesn’t start getting less total revenue until the tax rate is up around 70 percent, the curve would look rather different. It would look kind of lopsided. That isn’t ridiculous, right?
Arthur Laffer: No, no, no, far from ridiculous. What you’ve got is three things going on here that determine the shape independently. Number one is the length of time you’re willing to wait with the tax rate. The short-term tax rate is far more like Saez and Diamond see it, but a long-term one would be almost the exact opposite shape.
Paul Solman: In other words, where it’s peaking below 50 percent?
Arthur Laffer: Right. Then, number two, the size of the tax base is also important. The broader the base, the more it will look like Saez/Diamond. The narrower the base, the more it will look like the converse of Saez/Diamond. (This is because people with higher income will respond more to a higher tax rate than those with a lower income.)
Then the third factor is that the higher tax rates are, the more likely it is that an increase in tax rates will lower revenues because people work for after-tax income, not pre-tax income. So the time period affects the shape; the size of the tax base affects the shape; and the height of existing taxes affects the shape.
What I’m saying is, sometimes, tax rate increases create the very problems that the spending is intended to cure. In other words, the tax rate increases reduce economic growth; they shrink the pie; they cause more poverty, more despair, more unemployment, which are all things government is trying to alleviate with spending.
This entry is cross-posted on the Making Sen$e page, where correspondent Paul Solman answers your economic and business questions