Laffer Laughter and Truth in Tax Policy

by: Stone Street Advisors

Arthur Laffer recently penned an op-ed in the WSJ hawking his view that decreasing the tax rates on wealthy (or high-income, as it were, herein “The Rich” ) Americans will actually increase tax receipts from them. First, this is of course not a new argument. Second, as a result of the first, I’m immediately skeptical that what follows is not Economics so much as Polinomics or what-have you.

He begins the piece with this impressive lede, which I read anxiously anticipating cold, hard data proving unequivocally that tax cuts for “the rich” are indeed beneficial for the Economy (…he said half sarcastically):

Tax reduction thus sets off a process that can bring gains for everyone, gains won by marshalling resources that would otherwise stand idle—workers without jobs and farm and factory capacity without markets. Yet many taxpayers seemed prepared to deny the nation the fruits of tax reduction because they question the financial soundness of reducing taxes when the federal budget is already in deficit. Let me make clear why, in today’s economy, fiscal prudence and responsibility call for tax reduction even if it temporarily enlarged the federal deficit—why reducing taxes is the best way open to us to increase revenues.

Alas, while he makes several good points throughout the article, I finished wanting more; more data, more facts, more proof. As-written, Laffer makes some impressive claims without providing what I’d consider sufficient support, so I’d be remiss to take his word at face-value, absent said supporting material.
We all know that there are lots of factors influencing tax revenues from the rich, but the number one factor has to be the statutory tax rates government tells the rich they have to pay.

Of course, the only real thing compelling The Rich to pay taxes is the existence of said taxes in the first place, i.e. they pay taxes because The Government tells them they have to (or else!). However, an from an alternate interpretation of this statement – which was my initial one – he doesn’t seem to share whatever data/analysis is informing his conclusions with the rest of us. I’m not doubting that such material exists – and I realize this is an op-ed in the WSJ and not a research paper in an Economics journal – but for someone of Laffer’s stature to make such a (as-written) non-sequitur just reeks of political/ideological bias. Many popular studies on the relationship between tax rates and tax receipts have came to completely opposite conclusions, even looking at similar data.

The “Laffer Curve” may be an elegant concept in theory, but there seems to be a dearth of proof that its underlying idea – that there are situations where tax receipts will increase after a decrease in tax rates – has much, if any real grounding in reality.

Having not looked at income tax policy much since college, I’m fairly certain the amount of money earned by those at the top of the income scale has increased at a far greater rate over the past 20-30 years than it has for those not, and this increasing income disparity has a similarly far greater effect on income tax receipts than semi-arbitrary and inconsistent shifts in tax policy (i.e. rates).

To test this guess/hypothesis, I ran some numbers from the IRS to see how tax rates and other factors affect the % of GDP “The Rich” pay in annual Federal income taxes. While I hardly doubt tax rates (more specifically, the changes therein) are a material factor, I’m damn skeptical that they’re THE primary one. Again, this is a rough analysis and I used relatively simple data sets which may very-well skew the results from what they might be were I to use more granular, detailed, and nuanced data.

That being said, from 1986 through 2007 (Laffer went back to 1978 but I didn’t have time to go that far back, although a quick look suggests another 8 years wouldn’t materially skew the results) here’s what I found:

(Click to enlarge)

As I suspected, changes in the contribution of “the rich” to Federal income tax receipts (as measured by receipts as % of GDP) has a 3x stronger correlation with the floor (the least “rich” of “the rich” so-to-speak) of the top 1% of earners bracket as it does with the Average Tax rate levied upon those within that bracket. As I said, if I used more detailed numbers, this result might change, but I highly doubt the outcome would reverse, that is, that the changes in the tax rate would be shown to have a greater effect on receipts than (an increasing) income disparity.

If I’m missing something here please let me know, because I’m having a hard time with this Laffer piece. If the guy could have presented his argument with solid evidence, why the heck didn’t he? If he can’t, then he’s making a spurious – at best – “Economic” argument based on nothing more than “statistics” in the Mark Twain sense of the word.

Disclosure: No positions