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Laffer Economics: The Long Spiral into Debt

Wed ,28/08/2013

The Laffer Curve: Laffer economics, or supply side economics, is based on the idea that cutting taxes will provide more money for investments and job creation. That in turn should increase economic growth, resulting in an increase in tax revenue. That has not worked well in practice.

The idea was not new to Arthur  Laffer, but he used it to greatly shape the United  States’ economic policies during the Reagan Administration and to this day.  Laffer used the curve  below to argue his case:

LafferIt is based on the idea that at a zero tax rates, the government collects no taxes – and at a 100% tax rate,  the economy would collapse, resulting in zero tax collected.  If taxes are too high, then cutting them will cause a move to the left on the curve, toward higher tax revenue. The top tax rate when Reagan came into office was 60%.  Laffer used his curve to convince the Reagan Administration that lowering the tax rate would move the country to the left on the curve, stimulating the economy, and increasing tax revenue.  Did it work?

Empirical data: Laffer, and those favoring  supply-side economics, often point to the 3.5%  growth in GDP during the Reagan years as validating their theories. However, the GDP growth was less under Reagan and George W. Bush, when tax rates were low, than under administrations where the tax rates were higher.  The table below compares economic indicators among administrations:

President Top Tax Rate  GDP Growth  Job Growth    Public Debt
D. Eisenhower 90% 4% 7.20%      +14.9% GDP
Ronald Regan 28% 3.50% 16.40%        +7.1% GDP
Bill Clinton 39.60% 3.90% 19.60%       -13.6% GDP
George W. Bush 35% 2.50% 1.40%        +5.6% GDP
Source Historical CBO Records Bureau of Labor        CBO

Laffer was certainly wrong about tax cuts leading to GDP growth and increasing tax revenue. Certainly, the public debt grew substantially when taxes were lower. Public debt was high during Eisenhower’s administration because of war debts and because he built the interstate highway system that accelerated economic growth under following administrations.

What went wrong?   Basing economic decisions on Laffer’s theory involves accepting the assumption that tax rates are the main factor driving economic growth, an assumption not borne out by the empirical evidence. Also, Laffer did not present evidence showing that the maximum in his curve was at 50% . Some economists argue that the curve should  actually look like this :


If that is the case,  cutting the tax rate from 60%  would not necessarily stimulate the economy, but certainly would decrease tax revenue, as happened.  Taxes need not be as high as the optimum rate,  but they should be high enough to pay the country’s debts .

Recent tax cuts: Despite its failures, Congress is still trying to justify tax cuts using Laffer’s Theory. A recent survey of 40 economists found that not one agreed with Mr. Laffer that reducing the top tax rate would lead to economic growth over the next five years. A University of Chicago poll  taken in 2012 found that of 40 leading economists, not one agreed with the statement: ”  A cut in federal income tax rates in the US right now would raise taxable income enough so that the annual total tax revenue would be higher within five years than without the tax cut. ”  The results of the survey is listed below:

Laffer survey

  Still, Paul Ryan has proposed  a budget that would reduce the top tax rate to 25%. The nonpartisan Tax Policy Center estimated Ryan’s budget would add $5.7 trillion to the deficit over the next decade and would increase the after-tax income of the top 1% of citizens by 18%.  His budget is a case of ideology trumping practical economics.

 State tax cuts: Arthur Laffer now sits on the Board of Directors of the American Legislative Exchange Council (ALEC).  One of  ALEC’s  goals  is to pass laws at the state level which allow wealthy citizens and corporations to avoid regulation and taxes.  Laffer’s research has been used by members of ALEC to try to justify state tax cuts by claiming  that the nine states that have no income tax had the highest rates of job creation, as shown in his chart below:



 It looks impressive, but most of the growth was in Texas and in a carefully chosen time period when job growth was strong because of oil revenues and population growth.  Besides carefully picking his data, Laffer also ignored other economic indicators – and didn’t do a comparison with high tax states. If Laffer were correct, the nine States  with the highest income taxes should have failing economies. However, that is not the case, as shown below:


Laffer hgh

  The nine states with high income taxes had higher economic growth , a much smaller decline in household income, and almost exactly the same unemployment rate. Laffer’s research was biased and would never stand up to peer review, yet many states have used it as a justification for income tax cuts for the wealthy.

 Summary: Laffer’s theories are highly popular with the wealthy who want to lower  their income taxes, and with those who want to reduce the size of the Federal government.  While Arthur Laffer may be charismatic, his theories are not borne out by empirical evidence and we should not make economic decisions based upon his theories or his articles. While money may trickle down, it flows upward and pools at the top.  Cutting top tax rates has led to a more regressive tax structure, shifting more of the tax burden to sales taxes, property taxes and a myriad of government fees. Following Laffer’s economics has led to a great disparity in wealth in United States and a crushing national debt.  Arthur Laffer’s legacy is not economic growth, but a long spiral downward into debt and austerity and a tremendous increase in the number of poor Americans. Forbes put it best a couple of years ago – “Economist Arthur Laffer has had a long, distinguished career. Unfortunately one of the things that has distinguished it is that he has often been extremely wrong.”