Tuesday, April 8, 2008

Laffer curve redux

The Laffer curve has evidently returned as a topic du jour amongst the US chattering classes. Arthur B. Laffer (photo at left) himself, you see, has apparently just signed on to the McCain campaign and in late January Laffer penned a WSJ piece where he declared:

Mark my words: If the Democrats succeed in implementing their plan to tax the rich and cut taxes on the middle and lower income earners, this country will experience a fiscal crisis of serious proportions that will last for years and years...

Note Laffer's claim that it is tax cuts for the rich that generate more tax revenue for the government, not tax cuts generally. It wasn't always so. In their original Reagan-era incarnation the "supply siders" (aka "charlatans and cranks") advocated income tax cuts full stop. But as Robert Solow notes, ""The supply-side argument these days really applies to upper-income people."

Indeed, the extent to which a tax cut "pays for itself" is very dependent on the type of tax and on whom. Greg Mankiw, for instance, estimates that:

a broad-based income tax cut ... would recoup only about a quarter of the lost revenue through supply-side growth effects. For a cut in capital income taxes, the feedback is larger - about 50% - but still well under 100%...

Given that, at bottom, the Laffer curve is simply based on the undisputed premise that a revenue-maximizing tax rate lies somewhere between zero and 100%, Mankiw doesn't exactly deliver the knock-out blow here. Also, those laughing at the Laffer curve who are inclined to trot out Mankiw as one of their heavyweight champions should take note of this speech which suggests Mankiw would be a rather reluctant warrior to say the least.

I would also note that, in response to a comment in a previous post, Jack Mintz's citation of the Laffer curve is in the context of a cut in the corporate rate. The connection to more taxable income is more obvious in the coporate context where one can connect the fact more output means more investment in new equipment and hiring more workers with the fact that this is something generally done by corporations. However elastic the behaviour of individuals is to tax policy, it should be higher for the large multinational corporations with big tax bills given that they are relatively highly mobile in terms of where they can arrange their costs and profits for taxable jurisdiction purposes. Mankiw's observations apply only to what an increase in the size of the "pie" resulting from a smaller relative slice means for a government's absolute slice. With a corporate tax cut, we are also talking about poaching from slices of other governments (when Austria cuts its corporate rate to 25% from 34% and German firms started moving across the border, the German Finance Minister accused the Austrians of "fiscal dumping.").

In any case, the difficulty of modeling the revenue impact is great enough that this argument will have to be settled empirically. On that count Mintz notes that
Ireland’s corporate income taxes comprised a 3.4% share of GDP in 2005, which is similar to the corporate tax collected in Canada as a share of GDP (3.5%), even though Canada has a statutory corporate income tax rate that is almost three times higher than the Irish rate. The US, with one of the highest corporate income tax rates in the world at 38.5%, collects only 2.9% of GDP in corporate tax revenue, less than in Canada where corporate income tax rates are lower. ...

Mintz also runs a regression that shows an inverse relationship between METR rates and net foreign direct investment (FDI). A 2003 study by de Mooij and Enderveen has found that a 1% reduction in the effective tax rate on capital can increase the foreign direct capital stock by about 3.3%. KPMG's latest corporate-tax survey noted that while VATs have been going up around the world (a trend defied by our federal Tories), corporate rates have been going down: "In the past 14 years, the average corporate tax rate of countries surveyed by KPMG declined nearly 29%."

Will Barack Obama's chief economist Austan Goolsbee challenge the existence of a Laffer curve for corporate taxes? It appears that Goolsbee already has his hands full challenging it with respect to personal taxes:

The NTR [New Tax Responsiveness] literature has tried to estimate the impact with data on high income people and claims to find large effects. If true, this work means that the marginal deadweight cost of the income tax is quite high and it calls the progressivity of the tax code into serious question.

What does Goolsbee conclude? That the "...evidence from the 1980s—is atypical..." In other words, the work of Lawrence Lindsey and Martin Feldstein et al with respect to the Reagan income tax cuts proves the supply side point with respect to those particular cuts.

In any case, check out TIME blogger Justin Fox's interview with Laffer from December:

Fox: [Goolsbee] saw Obama as pretty moderate ...
Laffer: Not from what I read. I love Obama and I think he's a hell of a neat guy and a smart guy. But he'll destroy the economy...

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