From: Zhang, Yangkun (Yangkun.Zhang@FMR.COM)
Date: Tue Oct 17 2000 - 08:19:12 PDT
Taxes, Revenues, and the "Laffer Curve"
JUDE WANNISKI
Associate Editor
The Wall Street Journal
JUNE, 1978
As Arthur Laffer has noted, "There are always two tax rates that yield
the same revenues." When an aide to President Gerald Ford asked him once
to elaborate, Laffer (who is Professor of Business Economics at the
University of Southern California) drew a simple curve, shown on the
next page, to illustrate his point. The point, too, is simple enough --
though, like so many simple points, it is also powerful in its
implications.
When the tax rate is 100 percent, all production ceases in the money
economy (as distinct from the barter economy, which exists largely to
escape taxation). People will not work in the money economy if all the
fruits of their labors are confiscated by the government. And because
production ceases, there is nothing for the 100-percent rate to
confiscate, so government revenues are zero.
On the other hand, if the tax rate is zero, people can keep 100 percent
of what they produce in the money economy. There is no governmental
"wedge" between earnings and after-tax income, and thus no governmental
barrier to production. Production is therefore maximized, and the output
of the money economy is limited only by the desire of workers for
leisure. But because the tax rate is zero, government revenues are again
zero, and there can be no government. So at a 0-percent tax rate the
economy is in a state of anarchy, and at a 100-percent tax rate the
economy is functioning entirely through barter.
In between lies the curve. If the government reduces its rate to
something less than 100 percent, say to point A, some segment of the
barter economy will be able to gain so many efficiencies by being in the
money economy that, even with near-confiscatory tax rates, after-tax
production would still exceed that of the barter economy. Production will
start up, and revenues will flow into the government treasury. By
lowering the tax rate, we find an increase in revenues.
On the bottom end of the curve, the same thing is happening. If people
feel that they need a minimal government and thus institute a low tax
rate, some segment of the economy, finding that the marginal loss of
income exceeds the efficiencies gained in the money economy, is shifted
into either barter or leisure. But with that tax rate, revenues do flow
into the government treasury. This is the situation at point B. Point A
represents a very high tax rate and very low production. Point B
represents a very low tax rate and very high production. Yet they both
yield the same revenue to the government.
The same is true of points C and D. The government finds that by a
further lowering of the tax rate, say from point A to point C, revenues
increase with the further expansion of output. And by raising the tax
rate, say from point B to point D, revenues also increase, by the same
amount.
Revenues and production are maximized at point E. If, at point E, the
government lowers the tax rate again, output will increase, but revenues
will fall. And if, at point E, the tax rate is raised, both output and
revenue will decline. The shaded area is the prohibitive range for
government, where rates are unnecessarily high and can be reduced with
gains in both output and revenue.
Tax rates and tax revenues
The next important thing to observe is that, except for the 0-percent and
100-percent rates, there are no numbers along the "Laffer curve." Point E
is not 50 percent, although it may be, but rather a variable number: it
is the point at which the electorate desires to be taxed. At points B and
D, the electorate desires more government goods and services and is
willing -- without reducing its productivity -- to pay the higher rates
consistent with the revenues at point E. And at points A and C, the
electorate desires more private goods and services in the money economy,
and wishes to pay the lower rates consistent with the revenues at point
E. It is the task of the statesman to determine the location of point E,
and follow its variations as closely as possible.
This is true whether the political leader heads a nation or a family. The
father who disciplines his son at point A, imposing harsh penalties for
violating both major and minor rules, only invites sullen rebellion,
stealth, and lying (tax evasion, on the national level). The permissive
father who disciplines casually at point B invites open, reckless
rebellion: His son's independence and relatively unfettered growth comes
at the expense of the rest of the family. The wise parent seeks point E,
which will probably vary from one child to another, from son to daughter.
For the political leader on the national level, point E can represent a
very low or a very high number. When the nation is at war, point E can
approach 100 percent. At the siege of Leningrad in World War II, for
example, the people of the city produced for 900 days at tax rates
approaching 100 percent. Russian soldiers and civilians worked to their
physical limits, receiving as "pay" only the barest of rations. Had the
citizens of Leningrad not wished to be taxed at that high rate, which was
required to hold off the Nazi army, the city would have fallen.
The number represented by point E will change abruptly if the nation is
at war one day and at peace the next. The electorate's demand for
military goods and services from the government will fall sharply; the
electorate will therefore desire to be taxed at a lower rate. If rates
are not lowered consistent with this new lower level of demand, output
will fall to some level consistent with a point along the prohibitive
side of the "Laffer curve." Following World War I, for example, the
wartime tax rates were left in place and greatly contributed to the
recession of 1919-20. Warren G. Harding ran for President in 1920 on a
slogan promising a "return to normalcy" regarding tax rates; he was
elected in a landslide. The subsequent rolling back of the rates ushered
in the economic expansion of the "Roaring Twenties." After World War II,
wartime tax rates were quickly reduced, and the American economy enjoyed
a smooth transition to peacetime. In Japan and West Germany, however,
there was no adjustment of the rates; as a result, postwar economic
recovery was delayed. Germany's recovery began in 1948, when personal
income-tax rates were reduced under Finance Minister Ludwig Erhard, and
much of the government regulation of commerce came to an end. Japan's
recovery did not begin until 1950, when wartime tax rates were finally
rolled back. In each case, reduced rates produced increased revenues for
the government. The political leader must fully appreciate the
distinction between tax rates and tax revenues to discern the desires of
the electorate.
The easiest way for a political leader to determine whether an increase
in rates will produce more rather than less revenues is to put the
proposition to the electorate. It is not enough for the politician to
propose an increase from, say, point B to point D on the curve. He must
also specify how the anticipated revenues will be spent. When voters
approve a bond issue for schools, highways, or bridges, they are
explicitly telling the politician that they are willing to pay the high
tax rates required to finance the bonds. In rejecting a bond issue,
however, the electorate is not
necessarily telling the politician that taxes are already high enough, or
that point E (or beyond) has been reached. The only message is that the
proposed tax rates are too high a price to pay for the specific goods and
services offered by the government.
Only a tiny fraction of all government expenditures are determined in
this fashion, to be sure. Most judgments regarding tax rates and
expenditures are made by individual politicians, Andrew Mellon became a
national hero for engineering the rate reductions of the 1920s, and was
called "the greatest Treasury Secretary since Alexander Hamilton." The
financial policies of Ludwig Erhard were responsible for what was hailed
as "an economic miracle" -- the postwar recovery of Germany. Throughout
history, however, it has been the exception rather than the rule that
politicians, by accident or design, have sought to increase revenues by
lowering rates.
Work vs. productivity
The idea behind the "Laffer curve" is no doubt as old as civilization,
but unfortunately politicians have always had trouble grasping it. In his
essay, Of Taxes, written in 1756, David Hume pondered the problem:
Exorbitant taxes, like extreme necessity, destroy industry by producing
despair; and even before they reach this pitch, they raise the wages of
the labourer and manufacturer, and heighten the price of all commodities.
An attentive disinterested legislature will observe the point when the
emolument ceases, and the prejudice begins. But as the contrary character
is much more common, 'tis to be feared that taxes all over Europe are
multiplying to such a degree as will entirely crush all art and industry;
tho' perhaps, their first increase, together with other circumstances,
might have contributed to the growth of these advantages.
The chief reason politicians and economists throughout history have
failed to grasp the idea behind the "Laffer curve" is their confusion of
work and productivity. Through both introspection and observation, the
politician understands that when tax rates are raised, there is a
tendency to work harder and longer to maintain after tax income. What is
not so apparent, because it requires analysis at the margin, is this: As
taxes are raised, individuals in the system may indeed work harder, but
their productivity declines. Hume himself had some trouble with this
point:
There is a prevailing maxim, among some reasoners, that every new tax
creates a new ability in the subject to bear it, and that each increase
of public burdens increases proportionably the industry of the people.
This maxim is of such a nature as is most likely to be abused; and is so
much the more dangerous as its truth cannot be altogether denied: But it
must be owned, when kept within certain bounds, to have some foundation
in reason and experience.
Twenty years later, in The Wealth of Nations, Adam Smith had no such
problem: In his hypothetical pin factory, what is important to a nation
is not the effort of individuals but the productivity of individuals
working together. When the tax rates are raised, the workers themselves
may work harder in an effort to maintain their income level. But if the
pin-making entrepreneur is a marginal manufacturer, the increased tax
rate will cause him to shift into the leisure sphere or into a lower
level of economic activity, and the system will lose all the production
of the pin factory. The politician who stands in the midst of this
situation may
correctly conclude that the increase in tax rates causes people to work
harder. But it is not so easy for him to realize that they are now less
efficient in their work and are producing less.
To see this in another way, imagine that there are three men who are
skilled at building houses. If they work together, one works on the
foundation, one on the frame, and the third on the roof. Together they
can build three houses in three months. If they work separately, each
building his own home, they need six months to build the three houses. If
the tax rate on homebuilding is 49 percent, they will work together,
since the government leaves them a small gain from their division of
labor. But if the tax rate goes to 51 percent, they suffer a net loss
because of their teamwork, and so they will work separately. When they
were pooling their efforts, since they could produce six houses in the
same time it would take them to build three houses working alone, the
government was collecting revenues almost equivalent to the value of
three completed homes. At the 51-percent tax rate, however, the
government loses all the revenue, and the economy loses the production of
the three extra homes that could have been built by their joint effort.
The worst mistakes in history are made by political leaders who, instead
of realizing that revenues could be gained by lowering tax rates, become
alarmed at the fall in revenues that results when citizens seek to escape
high tax rates through barter and do-it-yourself labor. Their impulse is
to impose taxes that cannot be escaped, the most onerous of which is a
poll tax or head tax, which must be paid annually for the mere privilege
of living. Hume had no difficulty in pointing out the fallacy of that
line of thinking:
Historians inform us that one of the chief causes of the destruction of
the Roman state was the alteration which Constantine introduced into the
finances, by substituting a universal poll tax in lieu of almost all the
tithes, customs, and excises which formerly composed the revenue of the
empire. The people, in all the provinces, were so grinded and oppressed
by the publicans [tax collectors] that they were glad to take refuge
under the conquering arms of the barbarians, whose dominion, as they had
fewer necessities and less art, was found preferable to the refined
tyranny of the Romans.
The trouble with a poll tax, as Hume noted, is that it can be escaped --
one method being not to defend your country against an aggressor who
promises to remove the tax as soon as he has gained power. Montesquieu
made a similar observation in Book XIII of The Spirit of the Laws:
Because a moderate government has been productive of admirable effects,
this moderation has been laid aside; because great taxes have been
raised, they wanted to carry them to excess; and ungrateful to the hand
of liberty, of whom they received this present, they addressed themselves
to slavery, who never grants the least favor.
Liberty produces excessive taxes; the effect of excessive taxes is
slavery; and slavery produces diminution of tribute. . . .
It was this excess of taxes that occasioned the prodigious facility with
which the Mahommedans carried on their conquests. Instead of a continual
series of extortions devised by the subtle avarices of the Greek
emperors, the people were subjected to a simple tribute which was paid
and collected with ease. Thus they were far happier in obeying a
barbarous nation than a corrupt government, in which they suffered every
inconvenience of lost liberty, with all the horror of present slavery.
Modern governments have at least abandoned the notion of using a poll tax
to generate revenues. Instead, they often go directly to the barter
economy in search of revenues. Activities previously not admitted to the
money economy and public marketplace because of public disapproval --
e.g., gambling and pornography -- are welcomed because of the promise of
revenues. But this process tends to lower the quality of the marketplace
itself, hastening the exodus or discouraging the entry of enterprises
that have earned public approbation.
"Cracking down"
Another timeless remedy of governments that find revenues failing in the
face of rising tax rates is to increase the numbers and powers of the tax
collectors. Invariably, this method further reduces the flow of revenues
to the treasury. Yet even with a thousand-year history of failure, the
policy of "cracking down" on tax evasion remains a favorite of modern
governments. Here is Adam Smith, in The Wealth of Nations, on why such
policies are doomed from the start:
Every tax ought to be so contrived as both to take out and to keep out of
the pockets of the people as little as possible, over and above what it
brings into the public treasury of the state. A tax may either take out
or keep out of the pockets of the people a great deal more than it brings
into the public treasury in the four following ways.
First, the levying of it may require a great number of officers, whose
salaries may eat up the greater part of the produce of the tax, and whose
perquisites may impose another additional tax upon the people.
Secondly, it may obstruct the industry of the people, and discourage them
from applying to certain branches of business which might give
maintenance and employment to great multitudes. While it obliges the
people to pay, it may thus diminish, or perhaps destroy, some of the
funds which might enable them to do so.
Thirdly, by the forfeitures and other penalties which these unfortunate
individuals incur who attempt unsuccessfully to evade the tax, it may
frequently ruin them, and thereby put an end to the benefit which the
community might have received from the employment of their capitals. An
injudicious tax offers a great temptation to smuggling. But the penalties
of smuggling must rise in proportion to the temptation. The law, contrary
to all the ordinary principles of justice, first creates the temptation,
and then punishes those who yield to it; and it commonly enhances the
punishment too in proportion to the very circumstances which ought
certainly to alleviate it, the temptation to commit the crime.
Fourthly, by subjecting the people to the frequent visits and odious
examination of the tax-gatherers, it may expose them to much unnecessary
trouble, vexation, and oppression; and though vexation is not, strictly
speaking, expense, it is certainly equivalent to the expense at which
every man would be willing to redeem himself from it.
Adam Smith's point about smuggling may now seem obscure. After all,
smuggling was something that went on in the 18th century, wasn't it?
Consider the following excerpts from a recent editorial in The Wall
Street Journal, which urged New York State and New York City to reduce
their combined cigarette tax from 26c to 10c a pack:
Through our browsings in the United States Tobacco journal we have
learned of estimates that half the cigarettes smoked in New York City are
smuggled in from North Carolina, where the tax is 2c a pack. State
Senator Roy M. Goodman, a Manhattan Republican, says the state and city
are losing $93 million a year in this fashion. The smugglers load 40-foot
trailers with 60,000 cartons purchased legally at $2.40 each and peddle
them in the city via the organized crime network for $3.75, which is
$1.25 or more below legitimate retail.
Mr. Goodman recommends a one-year suspension of the city's 8c-a-pack tax
in order to break up the smuggling, plus an increase in the state
enforcement field staff to 250 from the current 50, plus five years in
jail for anyone caught smuggling 20,000 cartons or more. Last year only
nine smugglers were jailed, each for a few months, with the common
penalty $10 or $15.
If Mr. Goodman's solution were adopted, at the end of the year the
smugglers would be back, and the state would have a bigger bureaucracy.
More smugglers would be caught, more judges and bailiffs and clerks would
have to be hired, more jails would have to be built and more jailers
hired. The wives and children of the jailed smugglers would go on
welfare.
Cutting the tax to 10c avoids all that. It immediately becomes uneconomic
to smuggle. The enforcement staff of 50 can be assigned to more useful
work, the state saving $1 million on that count alone. The courts would
be less clogged with agents and smugglers, and the taxpayers would save
court costs, as well as the costs of confining convicted smugglers and
caring for their families.
The state and city would appear to face a loss of $50 million or $60
million in revenues, but of course smokers would now buy their cigarettes
through legitimate channels and the 10c a pack would yield about as much
in revenues as 26c a pack yields now. But that's not all. Legitimate
dealers would double their cigarette sales, earning higher business
profits and personal income that the city and state then taxes.
And don't forget the impact on the millions of cigarette smokers who
would save 16c a pack. At a pack a day, that's $58.40 per year. At
average marginal tax rates, a smoker has to earn more than $80 before
Federal, state, and city taxes are deducted to get that amount. He can
thus maintain his or her standard of living on $80 less in gross wage
demands per year, which means it becomes economic for the marginal
employer to do business in New York, increasing the number of jobs of all
varieties and reducing cost and tax pressure on social services.
Among other benefits, the industrious smugglers would have to find
legitimate employment. It might be argued that they would he thrown on
the welfare rolls. But it we know New York City, they are already on the
welfare rolls, and would be forced to get off once they have visible
jobs.
The Finance Office of New York City, unwilling to take the advice of
either Adam Smith or The Wall Street Journal, simply rejected the idea
that lowering rates would produce expanded revenues. But Adam Smith's
advice was not even taken in England at the time he tendered it. The
theory was not tested until 1827, and then only by accident, by an Act of
Parliament. Oddly enough, the incident in question involved tobacco
smuggling. Stephen Dowell gives the following account in A History of
Taxation and Taxes in England:
The consumption of tobacco had failed to increase in proportion to the
increase in the population. A curious circumstance had happened as
regards the duty on tobacco. In effecting the statutory rearrangement of
the duties in the previous year, the draughtsman of the Bill, in error,
allowed one fourth of the duty to lapse in July. Unconsciously he had
accomplished a master stroke, for his reduction in the duty was followed
by a decrease in smuggling so considerable as to induce [Chancellor of
the Exchequer] Robinson to allow his [budget] surplus, estimated at about
?700,000, to go to continue the reduction thus unconsciously effected.
The Politburo of the Soviet Union has the same problem as the Finance
Office of New York City: It also rejects the idea behind the "Laffer
curve." The greatest burden to Soviet economic development is Soviet
agriculture. Roughly 34.3 million Soviet citizens, out of a total
population of 250 million, are engaged in producing food for the nation
-- and there is never enough. The United States, by contrast, employs
only 4.3 million workers in food production, out of a total population of
200 million, generating an annual surplus for export equivalent to
one-fourth the entire Soviet output. The drain on the Soviet economy is
not only the low productivity of the farm sector. Because there are
always shortages, and the state puts farm goods on the market at
regulated prices rather than using the market system to allocate what is
available, Soviet citizens spend billions of hours annually waiting on
lines. If food were produced in plentiful quantities, it could still be
allocated through regulated prices in conformance with Soviet ideology,
but most of the lines would disappear, and the talents and energies of
the urban work force would not be wasted in long lines.
The real source of this problem is the high marginal tax rates exacted on
the state's collective farms. The state provides land, capital, housing,
and other necessities on its collectives. It also permits the workers to
keep 10 percent of the value of their production. The marginal tax rate
is thus 90 percent. In agriculture, a small expenditure of effort might
yield, say, 100 units of production; but twice the effort might be
required for 150 units, and four times the effort for 200 units. The
worker on the collective thus faces a progressive tax schedule so
withering that any incentive to expend anything beyond a minimal effort
is lost. With minimum work, he gets land, capital, housing, and other
necessities, as well as 10 units of output. By quadrupling his effort
(not necessarily physical effort, but perhaps increased attentiveness to
details), he gets the same services and only 10 more units of output.
Meanwhile, however, the peasants on the collective farms are also
permitted to tend private plots, the entire output of which is theirs to
keep. The tax rate on these private plots is zero. Here is the result, as
detailed by Hedrick Smith in The Russians:
Twenty-seven percent of the total value of Soviet farm output -- about
$32.5 billion worth a year -- comes from private plots that occupy less
than 1 percent of the nation's agricultural lands (about 26 million
acres). At that rate, private plots are roughly 40 times as efficient as
the land worked collectively. . . .Peasants farm their own plots much
more intensively than they do collective land.
Ultimately, the Communist ideal is to have this last embarrassing but
necessary vestige of private enterprise wither away as industrialized
state farming grows in scale and output. Nikita Khrushchev, in spite of
rural roots, pursued that end vigorously and earned the enmity of the
peasantry. He cut the size of private plots to a maximum of half an acre
and made life difficult for the farm market trade. I was told by Russian
friends that Ukrainian peasants became so irate that they stopped selling
eggs as food and made paint out of them.
Under Brezhnev things have improved. The maximum plot went back up to an
acre and measures were taken to improve farm market operations. Soviet
figures show the private farm output grew nearly 15 percent from 1966 to
1973.
In terms of the "Laffer curve," what Khrushchev did by reducing the size
of the private plots from one acre to one-half acre was to increase the
marginal tax rate of the system from point C to point A. This was
undoubtedly a major cause of his political downfall. On the other hand,
Brezhnev moved the marginal tax rate of the system back to point C,
increasing output and revenues to the previous levels. This was an
"economic miracle" of minor dimensions, but it has undoubtedly
contributed heavily to Brezhnev's durability as a political leader.
The politics of the "Laffer curve"
The "Laffer curve" is a simple but exceedingly powerful analytical tool.
In one way or another, all
transactions, even the simplest, take place along it. The homely adage,
"You can catch more flies with molasses than with vinegar," expresses the
essence of the curve. But empires are built on the bottom of this simple
curve and crushed against the top of it. The Caesars understood this, and
so did Napoleon (up to a point) and the greatest of the Chinese emperors.
The Founding Fathers of the United States knew it well; the arguments for
union (in The Federalist Papers) made by Hamilton, Madison, and Jay
reveal an understanding of the notion. Until World War I -- when
progressive, taxation was sharply increased to help finance it -- the
United States successfully remained out of the "prohibitive range."
In the 20th century, especially since World War I, there has been a
constant struggle by all the nations of the world to get down the curve.
The United States managed to do so in the 1920s, because Andrew Mellon
understood the lessons of the "Laffer curve" for the domestic economy.
Mellon argued that there are always two prices in the private market that
will produce the same revenues. Henry Ford, for example, could get the
same revenue by selling a few cars for $100,000 each, or a great number
for $1,000 each. (Of course, Ford was forced by the threat of competition
to sell at the low price.) The tax rate, said Mellon, is the "price of
government." But the nature of government is monopolistic; government
itself must find the lowest rate that yields the desired revenue.
Because Mellon was successful in persuading Republican Presidents --
first Warren G. Harding and then Calvin Coolidge -- of the truth of his
ideas the high wartime tax rates were steadily cut back. The
excess-profits tax on industry was repealed, and the 77-percent rate on
the highest bracket of personal income was rolled back in stages, so that
by 1925 it stood at 25 percent. As a result, the period 1921-29 was one
of phenomenal economic expansion: G.N.P. grew from $69.6 billion to
$103.1 billion. And because prices fell during this period, G.N.P. grew
even faster in real terms, by 54 percent. At the lower rates, revenues
grew sufficiently to enable Mellon to reduce the national debt from $24.3
billion to $16.9 billion.
The stock market crash of 1929 and the subsequent global depression
occurred because Herbert Hoover unwittingly contracted the world economy
with his high-tariff policies, which pushed the West, as an economic
unit, up the "Laffer curve." Hoover compounded the problem in 1932 by
raising personal tax rates almost up to the levels of 1920.
The most important economic event following World War II was also the
work of a finance minister who implicitly understood the importance of
the "Laffer curve." Germany had been pinned to the uppermost ranges of
the curve since World War I. It took a financial panic in the spring of
1948 to shake Germany loose. At that point, German citizens were still
paying a 50-percent marginal tax rate on incomes of $600 and a 95-percent
rate on incomes above $15,000. On June 22, 1948, Finance Minister Ludwig
Erhard announced cuts that raised the 50-percent bracket to $2,200 and
the 95-percent bracket to $63,000. The financial panic ended, and
economic expansion began. It was Erhard, not the Marshall Plan, who saved
Europe from Communist encroachment. In the decade that followed, Erhard
again and again slashed the tax rates, bringing the German economy
farther down the curve and into a higher level of prosperity. In 1951 the
50-percent bracket was pushed up to $5,000 and in 1953 to $9,000, while
at the same time the rate for the top bracket was reduced to 82 percent.
In 1954, the rate from the top bracket was reduced again, to 80 percent,
and in 1955 it was pulled down sharply, to 63 percent on incomes above
$250,000; the 50-percent bracket was pushed up to $42,000. Yet another
tax reform took place in 1958: The government exempted the first $400 of
income and brought the rate for the top bracket down to 53 percent. It
was this systematic lowering for unnecessarily high tax rates that
produced the German "economic miracle." As national income rose in
Germany throughout the 1950s, so did revenues, enabling the government to
construct its "welfare state" as well as its powerful national defense
system.
The British empire was built on the lower end of the "Laffer curve" and
dismantled on the upper end. The high wartime rates imposed to finance
the Napoleonic wars were cut back sharply in 1816, despite warnings from
"fiscal experts" that the high rates were needed to reduce the enormous
public debt of ?900 million. For the following 60 years, the British
economy grew at an unprecedented pace, as a series of finance ministers
used ever-expanding revenues to lower steadily the tax rates and tariffs.
In Britain, though, unlike the United States, there was no Mellon to risk
lowering the extremely high tax rates imposed to finance World War I. As
a result, the British economy struggled through the 1920s and 1930s.
After World War II, the British government again made the mistake of not
sufficiently lowering tax rates to spur individual initiative. Instead,
the postwar Labour government concentrated on using tax policy for
Keynesian objectives -- i.e., increasing consumer demand to expand
output. On October 23, 1945, tax rates were cut on lower-income brackets
and surtaxes were added to the already high rates on the upper-income
brackets. Taxes on higher incomes were increased, according to Chancellor
of the Exchequer Hugh Dalton, in order to "continue that steady advance
toward economic and social equality which we have made during the war and
which the Government firmly intends to continue in peace."
From that day in 1945, there has been no concerted political voice in
Britain arguing for a reduction of the high tax rates. Conservatives have
supported and won tax reductions for business, especially investment-tax
income credits. But while arguing for a reduction of the 83-percent rate
on incomes above ?20,000 (roughly $35,000 at current exchange rates) of
earned income and the 98-percent rate on "unearned income" from
investments, they have insisted that government first lower its spending,
in order to permit the rate reductions. Somehow, the spending levels
never can be cut. Only in the last several months of 1977 has Margaret
Thatcher, the leader of the opposition Conservative Party, spoken of
reducing the high tax rates as a way of expanding revenues.
In the United States, in September 1977, the Republican National
Committee unanimously endorsed the plan of Representative Jack Kemp of
New York for cutting tax rates as a
way of expanding revenues through increased business activity. This was
the first time since 1953 that the GOP had embraced the concept of tax
cuts! In contrast, the Democrats under President Kennedy sharply cut tax
rates in 1962-64 (though making their case in Keynesian terms). The
reductions successfully moved the United States economy down the "Laffer
curve," expanding the economy and revenues.
It is crucial to Western economic expansion, peace, and prosperity that
"conservative" parties move in this direction. They are, after all,
traditionally in favor of income growth, with "liberals" providing the
necessary political push for income redistribution. A welfare state is
perfectly consistent with the "Laffer curve," and can function
successfully along its lower range. But there must be income before there
can be income redistribution. Most of the economic failures of this
century can rightly be charged to the failure of conservatives to press
for tax rates along the lower range of the "Laffer curve." Presidents
Eisenhower, Nixon and Ford were timid in this crucial area of public
policy. The Goldwater Republicans of 1963-64, in fact, emphatically
opposed the Kennedy tax-rate cuts!
If, during the remainder of this decade, the United States and Great
Britain demonstrate the power of the "Laffer curve" as an analytical
tool, its use will spread, in the developing countries as well as the
developed world. Politicians who understand the curve will find that they
can defeat politicians who do not, other things being equal. Electorates
all over the world always know when they are unnecessarily perched along
the upper edge of the "Laffer curve," and will support political leaders
who can bring them back down.
* * * * *
Jude Wanniski later wrote:
If I were to write this essay today from scratch, I would write it a bit
differently, stressing the difference between taxing labor and taxing
capital. I've learned new things about the way the world works since 1978
and the subtle differences between taxing labor and capital is one of
them. It led me, for example, to see the proper tax rate on capital gains
is zero, where I had originally thought it might be closer to 10% or 15%.
A zero tax would seem to be inconsistent with the Laffer Curve, but
capital gains have to be seen as something which should not be subject to
taxation at all, and that any tax on capgains causes overall government
revenues to decline. We will take this up in a subsequent lesson. In next
week's Part II of the 1978 article, the emphasis is on how the principle
of the Laffer Curve has worked through history. Again, take your time on
this lesson and ask questions.
Here is a wonderfully shameless endorsement of the Laffer Curve concept
from New York City Mayor Rudy Giuliani, in a February 17, 1999 Crossfire
exchange with Robert Novak.
GIULIANI: ...I'm in favor of eliminating -- or at least cutting, but
preferably eliminating -- the capital gains tax. I think it would be
tremendous for the development of business right in New York if we did
that.
NOVAK: What do you respond to demagogic remarks from people like my
friend Bill Press... (LAUGHTER)... who say that that would just help the
rich, and it wouldn't help the poor?
GIULIANI: Well, I've seen the benefit of tax-cutting in New York. I cut
the hotel occupancy tax by 30 percent. I convinced the state legislature
to do that the first year that I was mayor, and we're now collecting $90
million more from the much-reduced hotel occupancy tax than from the
higher one. And we've got, you know, 20 percent more employment in the
restaurant and hotel business. And we're at the highest level of
private-sector job creation than we've been at since the 1940s.
So not only do I believe in the theory of tax cutting, I've actually done
it; I've done it more than any other mayor of the city of New York, and I
can show you the positive results of it. Just come to New York City, see
what it's like now, compared to five years ago. And tax cutting had
something to do with that, not everything, but something to do with it.
* * * * *
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