Deinonychus antirrhopus

Give Back that PhD!

Charles Wheelan (PhD and all), has written article debunking one of the most outlandish ideas in economics. No, he hasn't gone after somebody like Karl Marx and the labor theory of value. No, he hasn't gone after the idea of anarcho-communism. Instead he has decided to go after the Laffer curve. Boy what a laffer...I hate that joke.

What I find absolutely amazing is all that is wrong with Wheelan's article. Right off the bat Wheelan is wrong,

Economist Arthur Laffer made a very interesting supposition: If tax rates are high enough, then cutting taxes might actually generate more revenue for the government, or at least pay for themselves.

In a word, no. The reason that the Laffer curve is called the Laffer curve is that Arthur Laffer, according the the "legend" expressed the idea at a lunch (or dinner) on a napkin. Those present, I believe Jude Wanniski was one of people in attendance, were struck by the description and started calling it the "Laffer" curve. The name stuck.

However, the idea of the Laffer curve is far older than Laffer. I recall in an economics course somewhere one of my professors mentioning that John Maynard Keynes was aware of the concept. President John F. Kennedy basically described the concept when he proposed his tax cuts.

In short, it is a paradoxical truth that tax rates are too high today and tax revenues are too low and the soundest way to raise the revenues in the long run is to cut the rates now. The experience of a number of European countries and Japan have borne this out. This country's own experience with tax reduction in 1954 has borne this out. And the reason is that only full employment can balance the budget, and tax reduction can pave the way to that employment. The purpose of cutting taxes now is not to incur a budget deficit, but to achieve the more prosperous, expanding economy which can bring a budget surplus.

According to Wikipedia, the Laffer curve was discussed in some form by,

1. John Maynard Keynes,
2. Frédéric Bastiat,
3. Ibn Khaldun,
4. Alexander Hamilton,
5. The 19th century constitution of the Confederate States of America

The basic idea is quite sound. Here is a pictue of an idealized Laffer curve. When the tax rate is 0%, it is axiomatic that the tax revenues will also be 0. Further, when the tax rate is 100% it can easily be derived from the axioms of neo-classical economics that tax revenue will also be 0. We also know that tax rates are bounded between 0 and 100% (or 1). Hence it follows that tax revenues will reach at least on peak inside the range of 0 and 1.

The idea is that chances are we are not going to be at the peak. Further, if we are to the "right" of the peak, then we can raise tax revenues by decreasing taxes. In fact, if we are to the right of the peak, then there exists another tax rate t* that is less than the current tax rate that will raise exactly the same amount of revenue.

Now, there are issues with the Laffer curve when formulating policy. The big problem is that we don't know the shape of the curve, nor do we know what the maximum is. Hence it really isn't much help in setting some sort of "optimal" tax rate in the sense of maximizing tax revenues. Further, if it happens that we are in fact to the "left" of the maximum then lowering the tax rate will only lower tax revenues.

And from here things just get worse for Dr. Wheelan,

But here's the problem when we take Laffer's theory and try to apply it in the U.S.: We don't have a 99 percent marginal tax rate. Or 70 percent. Or even 50 percent. We start with low marginal tax rates relative to the rest of the developed world. (Yes, I understand that it may not feel that way after the check you wrote last month.)

Actually there have been periods when the marginal tax rate has been very high (link--pdf). Dr. Wheelan notes that cutting the top marginal tax rate from 36% to 33% isn't a big deal. While he is likely correct, this isn't a flaw with the idea of the Laffer curve. In fact, the good Dr. has already conceded that the theory is correct. Frankly, at that point how he can go on and try to make the case that this idea is hair-brained is indicative that perhaps the one who actually hair-brained is Dr. Wheelan.

Here is the nut of Dr. Wheelan's argument,

So why does Laffer's sketch on Dick Cheney's cocktail napkin rank near the top of my list of bad economic ideas? Because, when applied to the U.S., it's intellectually dishonest. The Laffer Curve offers the false promise that we can cut taxes without making any sacrifice on the spending side, and that's simply not true. It's the economic equivalent of arguing that you can lose weight by eating more.

No Dr. Wheelan, the idea isn't dishonest just like the idea that demand falls as prices increase isn't dishonest. What is dishonest is how the idea is used or more accurately misused by some. To Dr. Wheelan the idea itself is bad, how it is used is irrelevant. I find this view to be anti-intellectual and something I'd expect from a primitive savage, not somebody with a PhD.

Posted by Steve at May 8, 2006 10:17 PM