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Reaganomics

From Wikipedia, the free encyclopedia

Reaganomics (/reɪɡəˈnɒmɪks/; a portmanteau of Reagan and economics attributed to Paul Harvey), or Reaganism, were the neoliberal economic policies promoted by U.S. President Ronald Reagan during the 1980s. These policies are characterized as supply-side economics, trickle-down economics, or "voodoo economics" by opponents, while Reagan and his advocates preferred to call it free-market economics.

The pillars of Reagan's economic policy included increasing defense spending, balancing the federal budget and slowing the growth of government spending, reducing the federal income tax and capital gains tax, reducing government regulation, and tightening the money supply in order to reduce inflation.

The results of Reaganomics are still debated. Supporters point to the end of stagflation, stronger GDP growth, and an entrepreneurial revolution in the decades that followed. Critics point to the widening income gap, what they described as an atmosphere of greed, reduced economic mobility, and the national debt tripling in eight years which ultimately reversed the post-World War II trend of a shrinking national debt as percentage of GDP.

Historical context

Prior to the Reagan administration, the United States economy experienced a decade of high unemployment and persistently high inflation (known as stagflation). Attacks on Keynesian economic orthodoxy as well as empirical economic models such as the Phillips Curve grew. Political pressure favored stimulus resulting in an expansion of the money supply. President Richard Nixon's wage and price controls were phased out. The federal oil reserves were created to ease any future short term shocks. President Jimmy Carter had begun phasing out price controls on petroleum while he created the Department of Energy. Much of the credit for the resolution of the stagflation is given to two causes: renewed focus on increasing productivity and a three-year contraction of the money supply by the Federal Reserve Board under Paul Volcker.

In stating that his intention was to lower taxes, Reagan's approach was a departure from his immediate predecessors. Reagan enacted lower marginal tax rates as well as simplified income tax codes and continued deregulation. During Reagan's eight year presidency, the annual deficits averaged 4.0% of GDP, compared to a 2.2% average during the preceding eight years. The real (inflation adjusted) average rate of growth in federal spending fell from 4% under Jimmy Carter to 2.5% under Ronald Reagan. GDP per employed person increased at an average 1.5% rate during the Reagan administration, compared to an average 0.6% during the preceding eight years. Private sector productivity growth, measured as real output per hour of all persons, increased at an average rate of 1.9% during Reagan's eight years, compared to an average 1.3% during the preceding eight years. Federal net outlays as a percent of GDP averaged 21.4% under Reagan, compared to 19.1% during the preceding eight years.

During the Nixon and Ford Administrations, before Reagan's election, a combined supply and demand side policy was considered unconventional by the moderate wing of the Republican Party. While running against Reagan for the Presidential nomination in 1980, George H. W. Bush had derided Reaganomics as "voodoo economics". Similarly, in 1976, Gerald Ford had severely criticized Reagan's proposal to turn back a large part of the Federal budget to the states.

Justifications

In his 1980 campaign speeches, Reagan presented his economic proposals as a return to the free enterprise principles, free market economy that had been in favor before the Great Depression and FDR's New Deal policies. At the same time he attracted a following from the supply-side economics movement, which formed in opposition to Keynesian demand-stimulus economics. This movement produced some of the strongest supporters for Reagan's policies during his term in office.

The contention of the proponents, that the tax rate cuts would more than cover any increases in federal debt, was influenced by a theoretical taxation model based on the elasticity of tax rates, known as the Laffer curve. Arthur Laffer's model predicts that excessive tax rates actually reduce potential tax revenues, by lowering the incentive to produce; the model also predicts that insufficient tax rates (rates below the optimum level for a given economy) lead directly to a reduction in tax revenues.

Ronald Reagan also cited the 14th-century Arab scholar Ibn Khaldun as an influence on his supply-side economic policies, in 1981. Reagan paraphrased Ibn Khaldun, who said that "In the beginning of the dynasty, great tax revenues were gained from small assessments," and that "at the end of the dynasty, small tax revenues were gained from large assessments." Reagan said his goal is "trying to get down to the small assessments and the great revenues."

Policies

Reagan lifted remaining domestic petroleum price and allocation controls on January 28, 1981, and lowered the oil windfall profits tax in August 1981. He ended the oil windfall profits tax in 1988. During the first year of Reagan's presidency, federal income tax rates were lowered significantly with the signing of the Economic Recovery Tax Act of 1981, which lowered the top marginal tax bracket from 70% to 50% and the lowest bracket from 14% to 11%. This act slashed estate taxes and trimmed taxes paid by business corporations by $150 billion over a five-year period. In 1982 Reagan agreed to a rollback of corporate tax cuts and a smaller rollback of individual income tax cuts. The 1982 tax increase undid a third of the initial tax cut. In 1983 Reagan instituted a payroll tax increase on Social Security and Medicare hospital insurance. In 1984 another bill was introduced that closed tax loopholes. According to tax historian Joseph Thorndike, the bills of 1982 and 1984 "constituted the biggest tax increase ever enacted during peacetime".

With the Tax Reform Act of 1986, Reagan and Congress sought to simplify the tax system by eliminating many deductions, reducing the highest marginal rates, and reducing the number of tax brackets. In 1983, Democrats Bill Bradley and Dick Gephardt had offered a proposal; in 1984 Reagan had the Treasury Department produce its own plan. The 1986 act aimed to be revenue-neutral: while it reduced the top marginal rate, it also cleaned up the tax base by removing certain tax write-offs, preferences, and exceptions, thus raising the effective tax on activities previously specially favored by the code.

Federal revenue share of GDP fell from 19.6% in fiscal 1981 to 17.3% in 1984, before rising back to 18.4% by fiscal year 1989. Personal income tax revenues fell during this period relative to GDP, while payroll tax revenues rose relative to GDP. Reagan's 1981 cut in the top regular tax rate on unearned income reduced the maximum capital gains rate to only 20% — its lowest level since the Hoover administration (1929 –1933). The 1986 act set tax rates on capital gains at the same level as the rates on ordinary income like salaries and wages, with both topping out at 28%.

Reagan significantly increased public expenditures, primarily the Department of Defense, which rose (in constant 2000 dollars) from $267.1 billion in 1980 (4.9% of GDP and 22.7% of public expenditure) to $393.1 billion in 1988 (5.8% of GDP and 27.3% of public expenditure); most of those years military spending was about 6% of GDP, exceeding this number in 4 different years. All these numbers had not been seen since the end of U.S. involvement in the Vietnam War in 1973. In 1981, Reagan significantly reduced the maximum tax rate, which affected the highest income earners, and lowered the top marginal tax rate from 70% to 50%; in 1986 he further reduced the rate to 28%. The federal deficit under Reagan peaked at 6% of GDP in 1983, falling to 3.2% of GDP in 1987 and to 3.1% of GDP in his final budget. The inflation-adjusted rate of growth in federal spending fell from 4% under Jimmy Carter to 2.5% under Ronald Reagan. This was the slowest rate of growth in inflation adjusted spending since Eisenhower. However, federal deficit as percent of GDP was up throughout the Reagan presidency from 2.7% at the end of (and throughout) the Carter administration. As a short-run strategy to reduce inflation and lower nominal interest rates, the U.S. borrowed both domestically and abroad to cover the Federal budget deficits, raising the national debt from $997 billion to $2.85 trillion. This led to the U.S. moving from the world's largest international creditor to the world's largest debtor nation. Reagan described the new debt as the "greatest disappointment" of his presidency.

According to William A. Niskanen, one of the architects of Reaganomics, "Reagan delivered on each of his four major policy objectives, although not to the extent that he and his supporters had hoped", and notes that the most substantial change was in the tax code, where the top marginal individual income tax rate fell from 70.1% to 28.4%, and there was a "major reversal in the tax treatment of business income", with effect of "reducing the tax bias among types of investment but increasing the average effective tax rate on new investment". Roger Porter, another architect of the program, acknowledges that the program was weakened by the many hands that changed the President's calculus, such as Congress.

Results

Overview

Spending during the years Reagan budgeted (FY 1982–89) averaged 21.6% GDP, roughly tied with President Obama for the highest among any recent President. Each faced a severe recession early in their administration. In addition, the public debt rose from 26% GDP in 1980 to 41% GDP by 1988. In dollar terms, the public debt rose from $712 billion in 1980 to $2.052 trillion in 1988, a roughly three-fold increase. The unemployment rate rose from 7% in 1980 to 11% in 1982, then declined to 5% in 1988. The inflation rate declined from 10% in 1980 to 4% in 1988.

Some economists have stated that Reagan's policies were an important part of bringing about the third longest peacetime economic expansion in U.S. history. During the Reagan administration, real GDP growth averaged 3.5%, compared to 2.9% during the preceding eight years. The annual average unemployment rate declined by 1.7 percentage points, from 7.2% in 1980 to 5.5% in 1988, after it had increased by 1.6 percentage points over the preceding eight years. Nonfarm employment increased by 16.1 million during Reagan's presidency, compared to 15.4 million during the preceding eight years, while manufacturing employment declined by 582,000 after rising 363,000 during the preceding eight years. Reagan's administration is the only one not to have raised the minimum wage. The inflation rate, 13.5% in 1980, fell to 4.1% in 1988, in part because the Federal Reserve increased interest rates (prime rate peaking at 20.5% in August 1981). The latter contributed to a recession from July 1981 to November 1982 during which unemployment rose to 9.7% and GDP fell by 1.9%. Additionally, income growth slowed for middle- and lower-class (2.4% to 1.8%) and rose for the upper-class (2.2% to 4.83%).

The misery index, defined as the inflation rate added to the unemployment rate, shrank from 19.33 when he began his administration to 9.72 when he left, the greatest improvement record for a President since Harry S. Truman left office. In terms of American households, the percentage of total households making less than $10,000 a year (in real 2007 dollars) shrank from 8.8% in 1980 to 8.3% in 1988 while the percentage of households making over $75,000 went from 20.2% to 25.7% during that period, both signs of progress.

Employment

The job growth (measured for non-farm payrolls) under the Reagan administration averaged 168,000 per month, versus 216,000 for Carter, 55,000 for H.W. Bush, and 239,000 for Clinton. The annual job growth percentages (comparing the beginning and ending number of jobs during their time in office to determine an annual growth rate) show that jobs grew by 2.0% annually under Reagan, versus 3.1% under Carter, 0.6% under H.W. Bush, and 2.4% under Clinton.

The unemployment rate averaged 7.5% under Reagan, compared to an average 6.6% during the preceding eight years. Declining steadily after December 1982, the rate was 5.4% the month Reagan left office.

The labor force participation rate increased by 2.6 percentage points during Reagan's eight years, compared to 3.9 percentage points during the preceding eight years.

Some commentators have asserted that over one million jobs were created in a single month — September 1983. Although official data support that figure, it was caused by nearly 700,000 AT&T workers going on strike and being counted as job losses in August 1983, with a quick resolution of the strike leading workers to return in September, then being counted as job gains.

Growth rates

Following the 1981 recession, the unemployment rate had averaged slightly higher (6.75% vs. 6.35%), productivity growth lower (1.38% vs. 1.92%), and private investment as a percentage of GDP slightly less (16.08% vs. 16.86%). In the 1980s, industrial productivity growth in the United States matched that of its trading partners after trailing them in the 1970s. By 1990, manufacturing's share of GNP exceeded the post-World War II low hit in 1982 and matched "the level of output achieved in the 1960s when American factories hummed at a feverish clip".

GDP growth

Real GDP grew over one-third during Reagan's presidency, an over $2 trillion increase. The compound annual growth rate of GDP was 3.6% during Reagan's eight years, compared to 2.7% during the preceding eight years. Real GDP per capita grew 2.6% under Reagan, compared to 1.9% average growth during the preceding eight years.

Real wages

The average real hourly wage for production and nonsupervisory workers continued the decline that had begun in 1973, albeit at a slower rate, and remained below the pre-Reagan level in every Reagan year. While inflation remained elevated during his presidency and likely contributed to the decline in wages over this period, Reagan's critics often argue that his neoliberal policies were responsible for this and also led to a stagnation of wages in the next few decades.

Income and wealth

In nominal terms, median household income grew at a compound annual growth rate (CAGR) of 5.5% during the Reagan presidency, compared to 8.5% during the preceding five years (pre-1975 data are unavailable). Real median family income grew by $4,492 during the Reagan period, compared to a $1,270 increase during the preceding eight years. After declining from 1973 through 1980, real mean personal income rose $4,708 by 1988. Nominal household net worth increased by a CAGR of 8.4%, compared to 9.3% during the preceding eight years.

Poverty level

The percentage of the total population below the poverty level increased from 13.0% in 1980 to 15.2% in 1983, then declined back to 13.0% in 1988. During Reagan's first term, critics noted homelessness as a visible problem in U.S. urban centers. According to Don Mitchell, the increased cuts to spending on housing and social services under Reagan was a contributing factor to the homeless population nearly doubling in just three years, from 1984 to 1987. In the closing weeks of his presidency, Reagan told David Brinkley that the homeless "make it their own choice for staying out there," noting his belief that there "are shelters in virtually every city, and shelters here, and those people still prefer out there on the grates or the lawn to going into one of those shelters". He also stated that "a large proportion" of them are "mentally impaired", which he believed to be a result of lawsuits by the ACLU (and similar organizations) against mental institutions.

Federal income tax and payroll tax levels

During the Reagan administration, fiscal year federal receipts grew from $599 billion to $991 billion (an increase of 65%) while fiscal year federal outlays grew from $678 billion to $1144 billion (an increase of 69%). According to a 1996 report of the Joint Economic Committee of the United States Congress, during Reagan's two terms, and through 1993, the top 10% of taxpayers paid an increased share of income taxes (not including payroll taxes) to the Federal government, while the lowest 50% of taxpayers paid a reduced share of income tax revenue. Personal income tax revenues declined from 9.4% GDP in 1981 to 8.3% GDP in 1989, while payroll tax revenues increased from 6.0% GDP to 6.7% GDP during the same period.

Tax receipts

Both CBO and the Reagan Administration forecast that individual and business income tax revenues would be lower if the Reagan tax cut proposals were implemented, relative to a policy baseline without those cuts, by about $50 billion in 1982 and $210 billion by 1986. According to a 2003 Treasury study, the tax cuts in the Economic Recovery Tax Act of 1981 resulted in a significant decline in revenue relative to a baseline without the cuts, approximately $111 billion (in 1992 dollars) on average during the first four years after implementation or nearly 3% GDP annually. Other tax bills had neutral or, in the case of the Tax Equity and Fiscal Responsibility Act of 1982, a (~+1% of GDP) increase in revenue as a share of GDP. The study did not examine the longer-term impact of Reagan tax policy, including sunset clauses and "the long-run, fully-phased-in effect of the tax bills". The fact that tax receipts as a percentage of GDP fell following the Economic Recovery Tax Act of 1981 shows a decrease in tax burden as share of GDP and a commensurate increase in the deficit, as spending did not fall relative to GDP. Total federal tax receipts increased in every Reagan year except 1982, at an annual average rate of 6.2% compared to 10.8% during the preceding eight years.

The effect of Reagan's 1981 tax cuts (reduced revenue relative to a baseline without the cuts) were at least partially offset by phased in Social Security payroll tax increases that had been enacted by President Jimmy Carter and the 95th Congress in 1977, and further increases by Reagan in 1983 and following years, also to counter the uses of tax shelters. An accounting indicated nominal tax receipts increased from $599 billion in 1981 to $1.032 trillion in 1990, an increase of 72% in current dollars. In 2005 dollars, the tax receipts in 1990 were $1.5 trillion, an increase of 20% above inflation.

Debt and government expenditures

Reagan was inaugurated in January 1981, making the first fiscal year (FY) he budgeted 1982 and the final budget 1989.

During Reagan's presidency, the federal debt held by the public nearly tripled in nominal terms, from $738 billion to $2.1 trillion. This led to the U.S. moving from the world's largest international creditor to the world's largest debtor nation. Reagan described the new debt as the "greatest disappointment" of his presidency.
The federal deficit as percentage of GDP rose from 2.5% of GDP in fiscal year 1981 to a peak of 5.7% of GDP in 1983, then fell to 2.7% GDP in 1989.
Total federal outlays averaged of 21.8% of GDP from 1981–88, versus the 1974–1980 average of 20.1% of GDP. This was the highest of any President from Carter through Obama.
Total federal revenues averaged 17.7% of GDP from 1981–88, versus the 1974–80 average of 17.6% of GDP.
Federal individual income tax revenues fell from 8.7% of GDP in 1980 to a trough of 7.5% of GDP in 1984, then rose to 7.8% of GDP in 1988.

Business and market performance

Nominal after-tax corporate profits grew at a compound annual growth rate of 3.0% during Reagan's eight years, compared to 13.0% during the preceding eight years. The S&P 500 Index increased 113.3% during the 2024 trading days under Reagan, compared to 10.4% during the preceding 2024 trading days. The business sector share of GDP, measured as gross private domestic investment, declined by 0.7 percentage points under Reagan, after increasing 0.7 percentage points during the preceding eight years.

Size of federal government

The federal government's share of GDP increased 0.2 percentage points under Reagan, while it decreased 1.5 percentage points during the preceding eight years. The number of federal civilian employees increased 4.2% during Reagan's eight years, compared to 6.5% during the preceding eight years.

As a candidate, Reagan asserted he would shrink government by abolishing the Cabinet-level departments of energy and education. He abolished neither, but elevated veterans affairs from independent agency status to Cabinet-level department status.

Income distribution

Continuing a trend that began in the 1970s, income inequality grew and accelerated in the 1980s. The Economist wrote in 2006: "After the 1973 oil shocks, productivity growth suddenly slowed. A few years later, at the start of the 1980s, the gap between rich and poor began to widen." According to the CBO:

The top 1% of income earners' share of income before transfers and taxes rose from 9.0% in 1979 to a peak of 13.8% in 1986, before falling to 12.3% in 1989.
The top 1% share of income earners' of income after transfers and taxes rose from 7.4% in 1979 to a peak of 12.8% in 1986, before falling to 11.0% in 1989.
The bottom 90% had a lower share of the income in 1989 vs. 1979.

Analysis

According to a 1996 study by the Cato Institute, a libertarian think tank, on 8 of the 10 key economic variables examined, the American economy performed better during the Reagan years than during the pre- and post-Reagan years. The study asserted that real median family income grew by $4,000 during the eight Reagan years and experienced a loss of almost $1,500 in the post-Reagan years. Interest rates, inflation, and unemployment fell faster under Reagan than they did immediately before or after his presidency. The only economic variable that was lower during period than in both the pre- and post-Reagan years was the savings rate, which fell rapidly in the 1980s. The productivity rate was higher in the pre-Reagan years but lower in the post-Reagan years. The Cato study was dismissive of any positive effects of tightening, and subsequent loosening, of Federal Reserve monetary policy under "inflation hawk" Paul Volcker, whom President Carter had appointed in 1979 to halt the persistent inflation of the 1970s.

Economic analyst Stephen Moore stated in the Cato analysis, "No act in the last quarter century had a more profound impact on the U.S. economy of the eighties and nineties than the Reagan tax cut of 1981." He argued that Reagan's tax cuts, combined with an emphasis on federal monetary policy, deregulation, and expansion of free trade created a sustained economic expansion, the greatest American sustained wave of prosperity ever. He also claims that the American economy grew by more than a third in size, producing a $15 trillion increase in American wealth. Consumer and investor confidence soared. Cutting federal income taxes, cutting the U.S. government spending budget, cutting programs, scaling down the government work force, maintaining low interest rates, and keeping a watchful inflation hedge on the monetary supply was Ronald Reagan's formula for a successful economic turnaround.

Milton Friedman stated, "Reaganomics had four simple principles: Lower marginal tax rates, less regulation, restrained government spending, noninflationary monetary policy. Though Reagan did not achieve all of his goals, he made good progress."

The Tax Reform Act of 1986 and its impact on the alternative minimum tax (AMT) reduced nominal rates on the wealthy and eliminated tax deductions, while raising tax rates on lower-income individuals. The across the board tax system reduced marginal rates and further reduced bracket creep from inflation. The highest income earners (with incomes exceeding $1,000,000) received a tax break, restoring a flatter tax system. In 2006, the IRS's National Taxpayer Advocate's report characterized the effective rise in the AMT for individuals as a problem with the tax code. Through 2007, the revised AMT had brought in more tax revenue than the former tax code, which has made it difficult for Congress to reform.

Economist Paul Krugman argued the economic expansion during the Reagan administration was primarily the result of the business cycle and the monetary policy by Paul Volcker. Krugman argues that there was nothing unusual about the economy under Reagan because unemployment was reducing from a high peak and that it is consistent with Keynesian economics for the economy to grow as employment increases if inflation remains low. Krugman has also criticized Reaganomics from the standpoint of wealth and income inequality. He argues that the Reagan era tax cuts ended the post-World War II "Great Compression" of wealth held by the rich.

The CBO Historical Tables indicate that federal spending during Reagan's two terms (FY 1981–88) averaged 22.4% GDP, well above the 20.6% GDP average from 1971 to 2009. In addition, the public debt rose from 26.1% GDP in 1980 to 41.0% GDP by 1988. In dollar terms, the public debt rose from $712 billion in 1980 to $2,052 billion in 1988, a three-fold increase. Krugman argued in June 2012 that Reagan's policies were consistent with Keynesian stimulus theories, pointing to the significant increase in per-capita spending under Reagan.

William Niskanen noted that during the Reagan years, privately held federal debt increased from 22% to 38% of GDP, despite a long peacetime expansion. Second, the savings and loan problem led to an additional debt of about $125 billion. Third, greater enforcement of U.S. trade laws increased the share of U.S. imports subjected to trade restrictions from 12% in 1980 to 23% in 1988.

Economists Raghuram Rajan and Luigi Zingales pointed out that many deregulation efforts had either taken place or had begun before Reagan (note the deregulation of airlines and trucking under Carter, and the beginning of deregulatory reform in railroads, telephones, natural gas, and banking). They stated, "The move toward markets preceded the leader [Reagan] who is seen as one of their saviors." Economists Paul Joskow and Roger Noll made a similar contention.

Economist William A. Niskanen, a member of Reagan's Council of Economic Advisers wrote that deregulation had the "lowest priority" of the items on the Reagan agenda given that Reagan "failed to sustain the momentum for deregulation initiated in the 1970s" and that he "added more trade barriers than any administration since Hoover." By contrast, economist Milton Friedman has pointed to the number of pages added to the Federal Register each year as evidence of Reagan's anti-regulation presidency (the Register records the rules and regulations that federal agencies issue per year). The number of pages added to the Register each year declined sharply at the start of the Ronald Reagan presidency breaking a steady and sharp increase since 1960. The increase in the number of pages added per year resumed an upward, though less steep, trend after Reagan left office. In contrast, the number of pages being added each year increased under Ford, Carter, George H. W. Bush, Clinton, George W. Bush, and Obama. The number of pages in Federal Register is however criticized as an extremely crude measure of regulatory activity, because it can be easily manipulated (e.g. font sizes have been changed to keep page count low). The apparent contradiction between Niskanen's statements and Friedman's data may be resolved by seeing Niskanen as referring to statutory deregulation (laws passed by Congress) and Friedman to administrative deregulation (rules and regulations implemented by federal agencies). A 2016 study by the Congressional Research Service found that Reagan's average annual number of final federal regulatory rules published in the Federal Register was higher than during the Clinton, George W. Bush or Obama's administrations, even though the Reagan economy was considerably smaller than during those later presidents. Another study by the QuantGov project of the libertarian Mercatus Center found that the Reagan administration added restrictive regulations — containing such terms as "shall," "prohibited" or "may not" — at a faster average annual rate than did Clinton, Bush or Obama.

Greg Mankiw, a conservative Republican economist who served as chairman of the Council of Economic Advisers under President George W. Bush, wrote in 2007:

I used the phrase "charlatans and cranks" in the first edition of my principles textbook to describe some of the economic advisers to Ronald Reagan, who told him that broad-based income tax cuts would have such large supply-side effects that the tax cuts would raise tax revenue. I did not find such a claim credible, based on the available evidence. I never have, and I still don't ... My other work has remained consistent with this view. In a paper on dynamic scoring, written while I was working at the White House, Matthew Weinzierl and I estimated that a broad-based income tax cut (applying to both capital and labor income) 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 percent — but still well under 100 percent. A chapter on dynamic scoring in the 2004 Economic Report of the President says about the same thing.

Glenn Hubbard, who preceded Mankiw as Bush's CEA chair, also disputed the assertion that tax cuts increase tax revenues, writing in his 2003 Economic Report of the President: "Although the economy grows in response to tax reductions (because of higher consumption in the short run and improved incentives in the long run), it is unlikely to grow so much that lost tax revenue is completely recovered by the higher level of economic activity."

In 1986, Martin Feldstein — a self-described "traditional supply sider" who served as Reagan's chairman of the Council of Economic Advisers from 1982 to 1984 — characterized the "new supply siders" who emerged circa 1980:

What distinguished the new supply siders from the traditional supply siders as the 1980s began was not the policies they advocated but the claims that they made for those policies ... The "new" supply siders were much more extravagant in their claims. They projected rapid growth, dramatic increases in tax revenue, a sharp rise in saving, and a relatively painless reduction in inflation. The height of supply side hyperbole was the "Laffer curve" proposition that the tax cut would actually increase tax revenue because it would unleash an enormously depressed supply of effort. Another remarkable proposition was the claim that even if the tax cuts did lead to an increased budget deficit, that would not reduce the funds available for investment in plant and equipment because tax changes would raise the saving rate by enough to finance the increased deficit ... Nevertheless, I have no doubt that the loose talk of the supply side extremists gave fundamentally good policies a bad name and led to quantitative mistakes that not only contributed to subsequent budget deficits but that also made it more difficult to modify policy when those deficits became apparent.

Optimal tax

From Wikipedia, the free encyclopedia
https://en.wikipedia.org/wiki/Optimal_tax

Optimal tax theory or the theory of optimal taxation is the study of designing and implementing a tax that maximises a social welfare function subject to economic constraints. The social welfare function used is typically a function of individuals' utilities, most commonly some form of utilitarian function, so the tax system is chosen to maximise the aggregate of individual utilities. Tax revenue is required to fund the provision of public goods and other government services, as well as for redistribution from rich to poor individuals. However, most taxes distort individual behavior, because the activity that is taxed becomes relatively less desirable; for instance, taxes on labour income reduce the incentive to work. The optimization problem involves minimizing the distortions caused by taxation, while achieving desired levels of redistribution and revenue. Some taxes are thought to be less distorting, such as lump-sum taxes (where individuals cannot change their behaviour to reduce their tax burden) and Pigouvian taxes, where the market consumption of a good is inefficient, and a tax brings consumption closer to the efficient level.

In the Wealth of Nations, Adam Smith observed that

“Good taxes meet four major criteria. They are (1) proportionate to incomes or abilities to pay (2) certain rather than arbitrary (3) payable at times and in ways convenient to the taxpayers and (4) cheap to administer and collect.”

Tax revenue

Generating a sufficient amount of revenue to finance government is arguably the most important purpose of the tax system. Optimal taxation theory attempts to derive the system of taxation that will achieve the desired revenue and income distribution with the least inefficiency—that is, that interferes least with market participants making Pareto optimal exchanges—economic transactions that make both parties better off.

Free Market economies use prices to allocate resources to produce the products society wants most. If demand exceeds supply, the price will rise as those who want the product most compete to buy it. The high price induces producers to make more, until supply is adequate to meet demand and the price comes down. If supply exceeds demand, the price falls as producers try to induce more people to buy the product. The low prices then induce producers to make something else, that consumers want more.

If the government imposes a tax however, the price the consumer pays is different from the price the producer receives because the government takes its cut. If demand is inelastic—if consumers will pay what they must to get the product at any price, consumers will pay the tax and government will appropriate some of their benefit from the transaction (and hopefully provide useful services like public education in exchange). If supply is inelastic—producers will sell the same amount regardless of price—producers will pay the tax and government will take some of their benefit from the transaction. Note that it does not matter which side actually writes the government's check, the market price will adjust to compensate.

However, if both supply and demand are elastic—producers will make less at a lower price and consumers will buy less at a higher price—then the equilibrium quantity will decrease. There may be a consumer willing to buy at a price for which a producer is willing to sell, but this Pareto optimal transaction does not occur because neither is willing to pay the government's cut. The consumer then buys something less desirable and the producer makes something less profitable (or simply produces less and enjoys more leisure), so that the economy is no longer producing the optimal mix of products. Moreover, the sale does not occur, so the government never collects the revenue that was the whole reason for the distortion. This is the deadweight loss—the government has not merely taken a cut of the benefits from the exchange, it has destroyed those benefits for all three. These are the results optimal tax theorists seek to avoid.

Horizontal and vertical equity

Another criterion for an optimal tax is that it should be equitable. Equity in the context of taxation demands that the tax burden should be proportional to the taxpayer's ability to pay. This criterion can be further broken down into horizontal equity (imposing the same tax on two taxpayers with equal ability to pay) and vertical equity (imposing greater tax burdens on those with greater ability to pay). Of course, reasonable minds may differ as to whether two taxpayers, in fact, have equal ability to pay, and on how quickly the tax burden should rise with ability to pay (that is, how progressive the tax code should be).

Of the hundreds of provisions in the US tax code, for example, only a handful actually impose a tax (26 USC Sections 1, 11, 55, 881, 882, 3301, and 3311 are the primary examples). Instead, most of those provisions help to define how much income a taxpayer has—that is, their ability to pay. Even after the code has answered all the technical questions and determined a taxpayer's taxable income, normative questions remain as to whether they have the same ability to pay. For example, the US tax code (26 U.S.C. Section 1(a)-(d)) imposes less tax on couples filing joint returns and on heads of households than it does on taxpayers that are single, and provides a credit reducing the tax bills of those supporting children (26 U.S.C. Section 24). This can be seen as an attempt at horizontal equity, reflecting a judgement that taxpayers supporting families have less ability to pay than taxpayers with the same income but no dependents.

Vertical equity raises an additional normative question: once we have agreed which taxpayers have the same ability to pay and which taxpayers have more, how much more should those with greater ability to pay be made to contribute? While that question has no definitive answer, tax policy must balance competing goals such as revenue raising, redistribution, and efficiency.

However, as with any tax, implementing higher taxes will negatively affect incentives and alter an individual's behavior. In his article "Effects of Taxes on Economic Behavior," Martin Feldstein discusses how economic behavior determined by taxes is important for estimating revenue, calculating efficiency and understanding the negative externalities in the short run. In his article, like much of his research on this topic, he chooses to focus primarily on how households are affected. Feldstein recognizes that high taxes deter people from actively engaging in the market, causing a lower production rate as well as a deadweight loss. Yet, because it is difficult to see tangible results of deadweight loss, policy makers largely ignore it. Feldstein expresses his frustration that policy makers have yet to grasp these concepts and therefore do not make policy that correct this wrong.

The thrust of thinking among some economists is that taxes on consumption are always more efficient than taxes on income, arguing that the latter have a greater disincentive effect. One problem with this analysis is defining what constitutes consumption and what constitutes investment. Another problem is that the impact will vary from country to country, depending on the design of the tax system and the relative levels of different tax rates. A more nuanced empirical analysis is required to evaluate this issue. For lower-income working people, who spend most of their income, taxes on consumption also have a significant disincentive effect; while higher-income people may be motivated more by prestige and professional achievement than by after-tax income. Any gain in economic efficiency from shifting taxes to consumption may be quite small, while the adverse effects on income distribution may be large.

Lump-sum taxes

One type of tax that does not create a large excess burden is the lump-sum tax. A lump-sum tax is a fixed tax that must be paid by everyone and the amount a person is taxed remains constant regardless of income or owned assets. It does not create excess burden because these taxes do not alter economic decisions. Because the tax remains constant, an individual's incentives and a firm's incentives will not fluctuate, as opposed to a graduated income tax that taxes people more for earning more.

Lump-sum taxes can be either progressive or regressive, depending on what the lump sum is being applied to. A tax placed on car tags would be regressive because it would be the same for everyone regardless of the type of car the owner purchased and, at least in the United States, even the poor own cars. People earning lower incomes would then pay more as a percentage of their income than higher-income earners. A tax on the unimproved aspects of land tends to be a progressive tax, since the wealthier one is, the more land one tends to own and the poor typically do not own any land at all.

Lump-sum taxes are not politically expedient because they sometimes require a complete overhaul of the tax system. Lump-sum taxes are also unpopular when they are assessed per capita because they are regressive and make no allowance for a citizen's ability to pay.

A one-off, unexpected lump-sum levy which is proportional to wealth or income is also non-distorting. In this case, although wealth or income is penalised, the unexpected nature of the tax means that there is no disincentive to asset accumulation- as by definition those accumulating such assets are unaware that a portion of those assets will be taxed in the future.

Commodity taxes

Frank P. Ramsey (1927) developed a theory for optimal commodity sales taxes in his article "A Contribution to the Theory of Taxation". The problem is closely linked to the problem of socially optimal monopolistic pricing when profits are constrained to be positive, known as the Ramsey problem. He was the first to make a significant contribution to the theory of optimal taxation from an economic standpoint, and much of the literature that has followed reflects Ramsey's initial observations.

He wanted to confront the problem of how to adjust consumption tax rates, under specified constraints, so that the reduction of utility is at a minimum. In an attempt to reduce excess burden of consumption taxes, Ramsey proposed a theoretical solution that consumption tax on each good should be "proportional to the sum of the reciprocals of its supply and demand elasticities". However, practically, it is problematic to constrain social planners to one form of taxation. It is better to enable them to consider all possible tax structures.

Using Ramsey's rule as a basis for their papers, Peter Diamond and James Mirrlees propose an alternative to Ramsey's proposition by allowing the planner to consider numerous tax systems, and their model has prevailed in taxation theories. In their first paper, "Optimal Taxation and Public Production I: Production Efficiency" Diamond and Mirrlees consider the problem of imperfect information exchanged between taxpayers and the social planner. According to their argument, an individual's ability to earn income differs. Though the planner can observe income, they cannot directly observe the individual's ability or effort to earn income, so that if the planner attempts to increase taxes on those with high ability to earn an income, the individual's incentives to earn a high-income decrease. They confront the government tradeoff between equality and efficiency that when higher taxes are imposed on those with the potential to earn higher wages, they are not incentivized to expend the extra effort to earn a greater income. They rely on what has been labeled the revelation principle where planners must implement a tax system that provides proper incentives for people to reveal their true wage-earning abilities.

They continued this idea in the second installment of their paper "Optimal Taxation and Public Production II: Tax Rules", where they discuss marginal tax rate schedules for labor income. If the policy maker implemented a tax increase in the marginal tax rate at a lower income, it discourages the individuals at that income from working hard. However, this same increase for high-income individuals does not distort their incentives because though it raises their average tax rate, their marginal tax rate remains the same. For example, giving $100 is worth more to a low-income earner than to a high-income earner. Diamond and Mirrlees came to the conclusion that the marginal tax rate for the top earner should be equal to zero and the optimal rate must be between zero and one. This provides the correct incentives for individuals to work at their optimal level.

Developments in tax theory

William J. Baumol and David F. Bradford in their article "Optimal Departures from Marginal Cost Pricing" also discuss the price distortion taxes cause. They examine the proposition that in order to reach the optimal point of allocating resources, prices that deviate from marginal cost are required. They recognize that with every tax, there is some sort of price distortion, so they state that any solution can only be the second-best option and any solution proposed is under that added constraint. However, their theory differs from other literature in this topic. First, it deals with quasi-optimal pricing, looking at four options for Pareto optimality with adjusted commodity prices. Second, they express their theory in more simplified terms which incurs a loss of realistic application. Third, it combines the three discussions: the welfare theory, the contributions of the regulations and public finance. They conclude that under constraints, the best possible theory to get close to optimality, which is not “best” at all, is the systematic division between prices and marginal costs.

In his article entitled "Optimal Taxation in Theory", Gregory Mankiw reviews that current literature in theories on optimal taxation and analyzes the change in the tax theory over the past few decades. Like Diamond and Mirrlees, Mankiw recognizes the flaw in Ramsey's model that planners can raise revenue through taxes only on commodities but also points out the weakness of Mirrlees's proposition. Mankiw argues that Diamond's and Mirrlees's theory is extremely complex because of how difficult it is to keep track of individuals producing at their maximum levels.

Mankiw provides a summary of eight lessons that represent the current thought in optimal taxation literature. They include, first, the idea considering horizontal and vertical equity, that social planners should base optimal tax schedules on income rates for labour, which marks the equality and efficiency trade-off. Second, the more income an individual makes, their marginal tax schedule could actually decrease because they are discouraged from working at their optimal production level. The solution is to, after individuals reach a certain income level, ensure that the marginal tax remains steady. Third, reaching an optimal tax level could mean flat taxes. Fourth, the increase in wage inequality is directly proportionate to the extent of income redistribution as revenue is distributed to low-income earners. Fifth, taxes should not only depend on income amounts, but also on personal characteristics such as a person's wage-earning capabilities. Sixth, goods produced should only be taxed as a final good and should be taxed uniformly, which leads to their seventh point that capital should also not be taxed because it is considered an input of production. Finally, policymakers should consider individuals’ income histories, which require reliance on different types of taxation to derive optimal taxation. Mankiw identifies that the tax policy has largely followed the theories laid out in tax literature because social planners believe that the flatter the tax, the better, there are declining top marginal rates in OECD countries and taxes on commodities are now uniform and usually only final goods are taxed.

Joel Slemrod in his paper "Optimal Taxation and Optimal Tax System", argues that optimal tax theory, as it stood when Slemrod wrote this paper, was an insufficient guide to determine tax policies because policymakers had yet to find a way to implement a tax system that enticed individuals to work at their optimal level. As a solution, Slemrod proposes the theory of optimal tax systems a phrase he uses to refer to the normative theory of taxation. Slemrod advocates this theory because not only does it take into account the preferences of individuals, but also the technology involved in tax collecting. A practical application of this, for example, is implementing value-added taxes, a tax on the purchase price of a good or service, to correct tax evasion. He argues that any future tax literature in normative theory needs to focus less on consumer preferences and more on tax-collecting technology and the areas of the economy that affect tax collection.

Globalisation has also taken an important role in the development of taxes and tax systems. As referred previously, taxes have the purpose of fixing economic disparities among individuals, and that assortment of living standards and income generates competitiveness, especially among countries. The globalisation process has created new rules for companies and citizens to move across borders and, therefore, the tax systems they shall oblige to. Consequently, countries compete with each other on the taxation programme offered to both singular individuals and corporations, with the aim of becoming attractive to foreign agents, and simultaneously breed tax revenues to fund the government’s budget. Regarding the government’s budget and its strategy, it can also be a factor of attractiveness. Generally, countries with higher tax levels have also a tax structure tax differs from other countries, which can be related to the share of the government's expenditure that is invested in the population. For example, Sweden has one of the highest tax revenues (% of GDP), but invests almost 16% of the government expenditure in education. According to an OECD report, multiple countries have been changing their tax policies, being the normal procedure to cut the tax rate and broaden the tax base, which improves efficiency. From the same report, some situations were pointed out regarding the importance of the choice of tax policies, such as the imposition of taxes on products and services and the way these are perceived when exported, and the progressiveness of the taxes that can affect the inflow of economic agents (especially high-income ones). Initially, the last point was almost always directed to firms, but nowadays more high skilled workers are concerned with the subject; as opposed to low-skilled workers that are less affected by globalisation since the tax bases are not so flexible. Some studies show that there is a positive correlation between globalisation and capital taxes but, at the same time, that governments decrease the corporate taxes because of the globalisation phenomenon. It may sound somewhat paradoxical, but the change in the tax rates makes individuals more aware of the tariffs that are practised in other countries, contributing then for the globalisation.

Income taxes

Another aspect of optimal taxation is determining income taxes, which can be regressive, flat, or progressive.

Labor income tax

The theory of optimal income tax on individual labor aims to find the optimal trade-off between the following three effects of increasing taxation:

The mechanical effect - an increase in tax-rate increases the government revenue, if no individuals changed their behaviour in response.
The behavioural effect - an increase in tax-rate discourages labour supply, and this leads to lower tax revenue as a result.
The welfare effect - an increase in tax-rate reduces the individual utility, and thus reduces social welfare.

Corporate income tax

Arnold Harberger researched optimal taxation for corporations. Corporation income taxes are based on corporate profits. In the Journal of Political Economy, Harberger wrote an article called "The Incidence of the Corporation Income Tax" where he provided a theoretical framework to understand the effects of corporate income taxes and to determine the impact of such taxes in the United States. He proposed a general-equilibrium model, in which he analyzed a two-sector economy (one corporate and the other not). In this model, Harberger concluded that the market will move toward a long-run equilibrium in which the after tax rate of return of all corporations would equalize, compensating for any impact of corporate income taxes. Thus, taxing profits would lower the overall rate of return and therefore the level of investment and output in the economy. Furthermore, he claimed that this model could apply to a broader range of conditions.

Martin Feldstein disputed Harberger's assumptions. Feldstein argues that one of Harberger's shortcomings is that policy makers typically focused on the effects on personal income tax. Feldstein argued that policy makers should analyze corporate and personal taxation separately. He presented a method on how to reflect the net effect of the changes ro corporate tax rates on individual tax returns by focusing on the difference between real and nominal capital income. Feldstein noted the shortcomings of his model because of the lack of data to properly compare the two.

William Fox and LeAnn Luna proposed another theory in a joint article called "State Corporate Tax Revenue Trends: Causes and Possible Solutions", in which they take on the role of this taxation. They purport to determine the effects on revenue and propose some ways to reverse the trend. They claim that because the effective corporate income tax rate fell by one-third over two decades, the effective tax rate decline was the result of a tax base that is eroding in relation to income and profits. This was because legislation narrowed the tax base.

One option to reduce the negative investment effect of corporate taxes on the level of private investment (and hence increase investment) is the provision of an investment tax credit or accelerated depreciation. In these cases, the effective rate becomes a negative function of the reinvestment rate.

In recent years, the concept of a corporate tax system incorporating deductions for "normal" profits (where normal is defined in relation to the long-term interest rate and the risk premium) has gained attention as a tax system that could minimise these distortions without reducing total tax revenue. Such a taxation system would in effect levy a higher rate of tax on firms earning "superprofits" which will likely be unaffected even when taxed at a higher rate, as the post-tax return on capital is significantly higher than the threshold or "normal" level. Conversely, the effective tax rate on marginal projects (with returns closer to the "normal" level) will be reduced. One example of such a tax system is Australia's Minerals Resource Rent Tax.

When an investment tax credit or equity-based deduction is applied, the optimal effective rate of taxation is generally increased as the distortionary effect of a given level of taxation is diminished. If the unadjusted tax rate was optimal, the assumption is that the net marginal benefit of increased taxation is zero near the optimum rate (the marginal costs and benefits sum to zero). If the distortionary costs of capital taxation are then lowered by deductions or credits, then the net benefit of rate increases will become positive, implying the tax rate should be raised.

Sales tax

A third consideration for optimal taxation is sales tax, which is the additional price added to the base price of a paid by the consumer at the point when they purchase a good or service. Poterba in a second article called "Retail Price Reactions To Changes in State and Local Sales Taxes" tests the premise that sales taxes on the state and local level are fully shifted to the consumers. He examines clothing prices before and after World War II. He recognizes that monetary policy is important to determine the response of nominal prices under a national sales tax and points to possible differences in taxes applied at the local level as to taxes applied at a national level. Poterba finds evidence reinforcing the idea that sales taxes are fully forward shifted, which raises the consumer prices to match the tax increase. His study coincides with the original hypothesis that retail sales taxes are fully shifted to retail prices.

Donald Bruce, William Fox, and M. H. Tuttle also discuss tax revenues through sales tax in their article "Tax Base Elasticities: A Multi-State Analysis of Long-Run and Short-Run Dynamics". In this article, they look at how personal state revenues and sales tax bases elasticities change for the short and long term in an attempt to determine the difference between them. With this information, the authors believe that states can both enhance and customize their tax structures, which can be used for careful resource planning. They found that for state personal income tax bases as compared to sales taxes, the average long-term income elasticity is more than doubled and the short-term display disproportionate results higher than the long-term elasticities. The authors contend with the conventional literature by declaring that neither the personal income tax nor the sales tax is, at least, universally, the more volatile tax. Though, the authors concede that in certain situations, the sales tax is more volatile, and in the long term, personal income taxes are more elastic.

Furthermore, in understanding this argument, it must also be considered, as Alan Auerbach, Jagadeesh Gokhale, and Laurence Kotlikoff do in "Generational Accounting: A Meaningful Way to Evaluate Fiscal Policy", what the implications to optimal taxation are for future generations. They propose that generational accounting represents a new method for fiscal planning in the long-run, and that unlike the budget deficit, this generational accounting is not arbitrary. Instead, it is a remedy for how to approach the generation burden and effects of fiscal policy on a macroeconomic level. Ethically, it is a problem to have low taxes now, and therefore low revenue now, because it inevitably puts the burden of responsibility to pay for those expenditures on future generations. So through generational accounting, it is possible to analyze this and provide the necessary information for policy makers to change the policies needed to alter this trend. However, according to Auerbach, politicians are currently only relying on accounting and are not seeing the potential consequences that will ensue in future generations.

The incidence of sales taxes on commodities also results in distortion if say food prepared in restaurants is taxed but supermarket-bought food prepared at home is not taxed at purchase. If a taxpayer needs to buy food at fast food restaurants because he/she is not wealthy enough to purchase extra leisure time (by working less) he/she pays the tax although a more prosperous person who enjoys playing at being a home chef is taxed more lightly. This differential taxation of commodities may cause inefficiency (by discouraging work in the market in favor of work in the household).

Capital income tax

The theory of optimal capital income tax considers the capital income as future consumption. Thus, the taxation of capital income corresponds to a differentiated consumption tax on present and future consumption, and results in the distortion of individuals' saving and consumption behavior as individuals substitute the more heavily taxed future consumption with current consumption. Due to these distortions, zero taxation of capital income might be optimal, a result postulated by the Atkinson–Stiglitz theorem (1976) and the Chamley–Judd zero capital income tax result (1985/1986). In contrast, subsequent work on optimal capital income taxation has elucidated the assumptions underlying the theoretical optimality of a zero capital income tax and advanced diverse arguments for a positive (or negative) optimal capital tax.

Capital taxes

Taxation of wealth or capital (i.e. stocks, assets) should not be confused with taxation of capital income or income from wealth (i.e. transfers, flows). Taxation of capital in any form: above all financial instruments, assets then property was proposed as most optimal by Thomas Piketty. His proposition consist of progressive taxation of capital up to 5% yearly. Gregory Papanikos showed that even proportional taxation of capital may be considered as optimal.

Land value taxation

One of the early propositions on taxing capital (according to the broader neoclassical definition of "capital") was to capture the full rental value of land. Political economist and social reformer Henry George most notably championed the idea of a land value tax in Progress and Poverty, as a levy on the value of unimproved or natural aspects of the land, primarily location; it disregards the improvements such as buildings and irrigation. Land value taxation has no deadweight loss because the input of production being taxed (land) is fixed in supply; it cannot hide, shrink in value, or flee to other jurisdictions when taxed.

Economic theory suggests that a pure land value tax which succeeds in avoiding taxation of improvements could actually have a negative deadweight loss (positive externality), due to productivity gains arising from efficient land use. The taxation of locational values encourages socially optimal development on land in highly valued areas, like cities, since it reduces the incentive to speculate in land prices by leaving potentially productive locations vacant or underused.

Despite its theoretical benefits, implementing land value taxes is difficult politically. However, land value tax is considered progressive, because the ownership of land values is more concentrated than other sources of revenue, such as personal income or spending. George argued that because land is the fruit of nature (not labor) and the value of location is created by the community, the revenue from land should belong to the community.

Laffer curve

From Wikipedia, the free encyclopedia
https://en.wikipedia.org/wiki/Laffer_curve

In economics, the Laffer curve illustrates a theoretical relationship between rates of taxation and the resulting levels of the government's tax revenue. The Laffer curve assumes that no tax revenue is raised at the extreme tax rates of 0% and 100%, meaning that there is a tax rate between 0% and 100% that maximizes government tax revenue.

The shape of the curve is a function of taxable income elasticity—i.e., taxable income changes in response to changes in the rate of taxation. As popularized by supply-side economist Arthur Laffer, the curve is typically represented as a graph that starts at 0% tax with zero revenue, rises to a maximum rate of revenue at an intermediate rate of taxation, and then falls again to zero revenue at a 100% tax rate. However, the shape of the curve is uncertain and disputed among economists.

One implication of the Laffer curve is that increasing tax rates beyond a certain point is counter-productive for raising further tax revenue. Particularly in the United States, conservatives have used the Laffer curve to argue that lower taxes may increase tax revenue. However, the hypothetical maximum revenue point of the Laffer curve for any given market cannot be observed directly and can only be estimated—such estimates are often controversial. According to The New Palgrave Dictionary of Economics, estimates of revenue-maximizing income tax rates have varied widely, with a mid-range of around 70%.

The Laffer curve was popularized in the United States with policymakers following an afternoon meeting with Ford Administration officials Dick Cheney and Donald Rumsfeld in 1974, in which Arthur Laffer reportedly sketched the curve on a napkin to illustrate his argument. The term "Laffer curve" was coined by Jude Wanniski, who was also present at the meeting. The basic concept was not new; Laffer himself notes antecedents in the writings of the 14th-century social philosopher Ibn Khaldun and others.

History

Ibn Khaldun, a 14th-century philosopher, wrote in his work The Muqaddimah: "It should be known that at the beginning of the dynasty, taxation yields a large revenue from small assessments. At the end of the dynasty, taxation yields a small revenue from large assessments."

—Arthur Laffer, The Laffer Curve: Past, Present, and Future

Origin

Laffer states that he did not invent the concept, citing numerous antecedents, including the Muqaddimah by 14th-century Islamic scholar Ibn Khaldun, John Maynard Keynes and Adam Smith. Andrew Mellon, Secretary of the Treasury from 1921 to 1932, articulated a similar policy idea in 1924.

Laffer's name began to be associated with the idea after an article was published in National Affairs in 1978 that linked him to the idea. In the National Affairs article, Jude Wanniski recalled a 1974 dinner meeting at the Two Continents Restaurant in the Washington Hotel with Arthur Laffer, Wanniski, Dick Cheney, Donald Rumsfeld, and his deputy press secretary Grace-Marie Arnett In this meeting, Laffer, arguing against President Gerald Ford's tax increase, reportedly sketched the curve on a napkin to illustrate the concept. Cheney did not accept the idea immediately, but it caught the imaginations of those present. Laffer professes no recollection of this napkin, but writes: "I used the so-called Laffer Curve all the time in my classes and with anyone else who would listen to me".

Economist John Quiggin distinguishes between the Laffer curve and Laffer's analysis of tax rates. According to Quiggin, the Laffer curve was "correct but unoriginal", but Laffer's analysis that the United States was to the right of the peak of the Laffer curve "was original but incorrect."

Precedents

There are historical precedents other than those cited by Laffer. Ferdinando Galiani wrote in Della Moneta (1751) that "It is an enormous error ... to believe that an impost always yields more revenue as it becomes heavier". He gave the example of a toll on late-night entry to a town which would be less remunerative if set unreasonably high. David Hume expressed similar arguments in his essay Of Taxes in 1756, as did fellow Scottish economist Adam Smith twenty years later.

At the time of the Irish famine of the mid 1840s, Edward Twisleton suggested that lower local taxes in Ireland would increase the amount of taxes successfully collected towards relief. An analysis of actual collection rates has indicated that areas with higher rates did collect a lesser proportion of the tax due.

The Democratic party embraced this argument in the 1880s when high revenue from import tariffs raised during the Civil War (1861–1865) led to federal budget surpluses. The Republican party, which was then based in the protectionist industrial Northeast, argued that cutting rates would lower revenues.

In 1924, Secretary of Treasury Andrew Mellon wrote: "It seems difficult for some to understand that high rates of taxation do not necessarily mean large revenue to the government, and that more revenue may often be obtained by lower rates". Exercising his understanding that "73% of nothing is nothing", he pushed for the reduction of the top income tax bracket from 73% to an eventual 24% (as well as tax breaks for lower brackets). Mellon was one of the wealthiest people in the United States, the third-highest income-tax payer in the mid-1920s, behind John D. Rockefeller and Henry Ford. While he served as Secretary of the U.S. Treasury Department his wealth peaked at around US$300–400 million. Personal income tax receipts rose from US$719 million in 1921 to over US$1 billion in 1929, an average increase of 4.2% per year over an 8-year period, which supporters attribute to the rate cut.

In 2012, economists surveyed by the University of Chicago rejected the viewpoint that the Laffer Curve's postulation of increased tax revenue through a rate cut applies to federal US income taxes of the time in the medium term. When asked whether 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", none of the economists surveyed agreed and 71% disagreed. According to Harvard University economist Jeffrey Frankel, a substantial majority of economists reject the proposition that income taxes are so high in the United States that tax cuts will pay for themselves.

Empirical analysis

One of the conceptual uses of the Laffer curve is to determine the rate of taxation that will raise the maximum revenue (in other words, "optimizing" revenue collection). The revenue maximizing tax rate should not be confused with the optimal tax rate, which economists use to describe tax rates in a tax system that raises a given amount of revenue with the fewest distortions to the economy.

In 2017, Jacob Lundberg of the Uppsala University estimated Laffer curves for 27 OECD countries, with top income-tax rates maximising tax revenue ranging from 60 to 61% (Austria, Luxembourg, Netherlands, Poland, Sweden) to 74–76% (Germany, Switzerland, UK, US). Most countries appear to have set their highest tax rates below the peak rate, while five countries are exceeding it (Austria, Belgium, Denmark, Finland, Sweden).

Writing in 2010, John Quiggin said, "To the extent that there was an economic response to the Reagan tax cuts, and to those of George W. Bush twenty years later, it seems largely to have been a Keynesian demand-side response, to be expected when governments provide households with additional net income in the context of a depressed economy." A 1999 study by University of Chicago economist Austan Goolsbee, which examined major changes in high income tax rates in the United States from the 1920s onwards found no evidence that the United States was to the right of the peak of the Laffer curve.

Income tax rate at which revenue is maximized

An asymmetric Laffer curve with a maximum revenue point at around a 70% tax rate, as estimated by Trabandt and Uhlig (2011)

In the early 1980s, Edgar L. Feige and Robert T. McGee developed a macroeconomic model from which they derived a Laffer curve. According to the model, the shape and position of the Laffer Curve depend upon the strength of supply side effects, the progressivity of the tax system and the size of the unobserved economy. Economist Paul Pecorino presented a model in 1995 that predicted the peak of the Laffer curve occurred at tax rates around 65%. A draft paper by Y. Hsing looking at the United States economy between 1959 and 1991 placed the revenue-maximizing average federal tax rate between 32.67% and 35.21%. A 1981 article published in the Journal of Political Economy presented a model integrating empirical data that indicated that the point of maximum tax revenue in Sweden in the 1970s would have been 70%. A 2011 study by Trabandt and Uhlig published in the Journal of Monetary Economics estimated a 70% revenue maximizing rate, and estimated that the US and most European economies were on the left of the Laffer curve (in other words, that raising taxes would raise further revenue). A 2005 study concluded that with the exception of Sweden, no major OECD country could increase revenue by reducing the marginal tax rate.

The New Palgrave Dictionary of Economics reports that a comparison of academic studies yields a range of revenue maximizing rates that centers around 70%.

Taxation of goods and services

The Laffer curve has also been extended to taxation of goods and services. In their 2018 Econometrica paper, Miravete, Seim, and Thurk, show that in non-competitive markets, the strategic pricing response of firms is important to consider when estimating the Laffer curve. The authors show that firms increase their prices in response to a decrease in the ad valorem tax, leading to less of a quantity increase than would otherwise be expected. The net effect is to flatten the Laffer curve and move the revenue maximum point to the right.

Congressional Budget Office analysis

In 2005, the United States Congressional Budget Office (CBO) released a paper called "Analyzing the Economic and Budgetary Effects of a 10 Percent Cut in Income Tax Rates." This paper considered the impact of a stylized reduction of 10% in the then existing marginal rate of federal income tax in the US (for example, if those facing a 25% marginal federal income tax rate had it lowered to 22.5%). Unlike earlier research, the CBO paper estimates the budgetary impact of possible macroeconomic effects of tax policies, that is, it attempts to account for how reductions in individual income tax rates might affect the overall future growth of the economy, and therefore influence future government tax revenues; and ultimately, impact deficits or surpluses. In the paper's most generous estimated growth scenario, only 28% of the projected lost revenue from the lower tax rate would be recouped over a 10-year period after a 10% across-the-board reduction in all individual income tax rates. In other words, deficits would increase by nearly the same amount as the tax cut in the first five years, with limited feedback revenue thereafter. Through increased budget deficits, the tax cuts primarily benefiting the wealthy will be paid for—plus interest—by taxes borne relatively evenly by all taxpayers. The paper points out that these projected shortfalls in revenue would have to be made up by federal borrowing: the paper estimates that the federal government would pay an extra US$200 billion in interest over the decade covered by the paper's analysis. In 2019, economists at the Joint Committee on Taxation revisited the macroeconomic and budgetary response to the stylized 10% reduction in statutory ordinary income tax rates, but from the levels set by P.L. 115-97. While incorporating additional tax detail within the modeling framework relative to previous analyses, the paper similarly estimates that this policy change would result in increased budget deficits - both in the short- and long-run - after accounting for revenue feedback from macroeconomic changes.

United Kingdom

Following the reduction of the top rate of income tax in the UK from 50% to 45% in 2013, HMRC estimated the cost of the tax reduction to be about £100 million (out of an income for this group of around £90 billion), but with large uncertainty on both sides. Robert Chote, the chairman of the UK Office for Budget Responsibility commented that Britain was "strolling across the summit of the Laffer curve", implying that UK tax rates had been close to the optimum rate.

Other

Laffer has presented the examples of Russia and the Baltic states, which instituted a flat tax with rates lower than 35% around the same time that their economies started growing. He has similarly referred to the economic outcome of the Kemp-Roth tax cuts, the Kennedy tax cuts, the 1920s tax cuts, and the changes in US capital gains tax structure in 1997. Some have also cited Hauser's Law, which postulates that US federal revenues, as a percentage of GDP, have remained stable at approximately 19.5% over the period 1950 to 2007 despite changes in marginal tax rates over the same period. Others however, have called Hauser's Law "misleading" and contend that tax changes have had large effects on tax revenues.

More recently, based on Laffer curve arguments, Kansas Governor Sam Brownback greatly reduced state tax rates in 2012 in what has been called the Kansas experiment. Laffer was paid $75,000 to advise in the creation of Brownback's tax cut plan, and gave Brownback his full endorsement, stating that what Brownback was doing was "truly revolutionary." The state, which had previously had a budget surplus, experienced a budget deficit of about $200 million in 2012. Drastic cuts to state funding for education and infrastructure followed before the tax cut was repealed in 2017 by a bipartisan super majority in the Kansas legislature.

In US political discourse

Supply-side economics rose in popularity among Republican Party politicians from 1977 onwards. Prior to 1977, Republicans were more split on tax reduction, with some worrying that tax cuts would fuel inflation and exacerbate deficits.

Use in supply-side economics

Supply-side economics is a school of macroeconomic thought that argues that overall economic well-being is maximized by lowering the barriers to producing goods and services (the "Supply Side" of the economy). By lowering such barriers, consumers are thought to benefit from a greater supply of goods and services at lower prices. Typical supply-side policy would advocate generally lower income tax and capital gains tax rates (to increase the supply of labor and capital), smaller government and a lower regulatory burden on enterprises (to lower costs). Although tax policy is often mentioned in relation to supply-side economics, supply-side economists are concerned with all impediments to the supply of goods and services and not just taxation.

In their economics textbook Principles of Economics (7th edition), economists Karl E. Case of Wellesley College and Ray Fair of Yale University state "The Laffer curve shows the relationship between tax rates and tax revenues. Supply-side economists use it to argue that it is possible to generate higher revenues by cutting tax rates, but evidence does not appear to support this."

Reaganomics

The Laffer curve and supply-side economics inspired Reaganomics and the Kemp-Roth Tax Cut of 1981. Supply-side advocates of tax cuts claimed that lower tax rates would generate more tax revenue because the United States government's marginal income tax rates prior to the legislation were on the right-hand side of the curve. This assertion was derided by George H. W. Bush as "voodoo economics" while running against Reagan for the Presidential nomination in 1980. During the Reagan presidency, the top marginal rate of tax in the United States fell from 70% to 28%.

David Stockman, Ronald Reagan's budget director during his first administration and one of the early proponents of supply-side economics, was concerned that the administration did not pay enough attention to cutting government spending. He maintained that the Laffer curve was not to be taken literally—at least not in the economic environment of the 1980s United States. In The Triumph of Politics, he writes: "[T]he whole California gang had taken [the Laffer curve] literally (and primitively). The way they talked, they seemed to expect that once the supply-side tax cut was in effect, additional revenue would start to fall, manna-like, from the heavens. Since January, I had been explaining that there is no literal Laffer curve." Stockman also said that "Laffer wasn't wrong, he just didn't go far enough" (in paying attention to government spending).

Some have criticized elements of Reaganomics on the basis of equity. For example, economist John Kenneth Galbraith believed that the Reagan administration actively used the Laffer curve "to lower taxes on the affluent". Some critics point out that tax revenues almost always rise every year, and during Reagan's two terms increases in tax revenue were more shallow than increases during presidencies where top marginal tax rates were higher. Critics also point out that since the Reagan tax cuts, income has not significantly increased for the rest of the population. This assertion is supported by studies that show the income of the top 1% nearly doubling during the Reagan years, while income for other income levels increased only marginally; income actually decreased for the bottom quintile. However, a 2018 study by the Congressional Budget Office showed average household income rising 68.8% for the bottom quintile after government transfers (in the form of various income support and in-kind programmes, subsidies, and taxes) from 1979 to 2014. This same study showed the middle quintile's income rising 41.5% after government transfers and taxes.

Bush tax cuts

The Congressional Budget Office has estimated that extending the Bush tax cuts of 2001–2003 beyond their 2010 expiration would increase deficits by $1.8 trillion over the following decade. Economist Paul Krugman contended that supply-side adherents did not fully believe that the United States income tax rate was on the "backwards-sloping" side of the curve and yet they still advocated lowering taxes to encourage investment of personal savings.

Theoretical issues

Justifications

Supply-side economics indicates that the simple descriptions of the Laffer curve are usually intended for pedagogical purposes only and do not represent the complex economic responses to tax policy which may be observed from such viewpoints as provided by supply-side economics. Although the simplified Laffer curve is usually illustrated as a straightforward symmetrical and continuous bell-shaped curve, in reality the bell-shaped curve may be skewed or lop-sided to either side of the 'maximum'. Within the reality of complex and sudden changes to tax policy over time, the response of tax revenue to tax rates may vary dramatically and is not necessarily even continuous over time, when for example new legislation is enacted which abruptly changes tax revenue expectations.

Laffer curve: t* represents the rate of taxation at which maximal revenue is generated. The grey curve is as drawn by Laffer; however, the curve might not have only a single peak, nor must it peak symmetrically at whatever value maximizes tax revenue, n%.

The simplified static Laffer curve

In calculus, Rolle's theorem says that if a real-valued function $f$ is continuous on a closed interval $[a, b]$ , differentiable on the open interval $(a, b)$ , and $f (a) = f (b)$ , then there exists a $c$ in the open interval $(a, b)$ such that $f (c)$ is a maximum or a minimum and the gradient at $x = c$ is zero, meaning $f' (c) = 0$ .

Laffer explains the model in terms of two interacting effects of taxation: an "arithmetic effect" and an "economic effect". The "arithmetic effect" assumes that tax revenue raised is the tax rate multiplied by the revenue available for taxation (or tax base). Thus revenue $R$ is equal to $t \times B$ where $t$ is the tax rate and $B$ is the taxable base ( $R = t \times B$ ). At a 0% tax rate, the model states that no tax revenue is raised. The "economic effect" assumes that the tax rate will affect the tax base itself. At the extreme of a 100% tax rate, the government collects zero revenue because taxpayers change their behavior in response to the tax rate: either they lose their incentive to work, or they find a way to avoid paying taxes. Thus, the "economic effect" of a 100% tax rate is to decrease the tax base to zero. If this is the case, then somewhere between 0% and 100% lies a tax rate that will maximize revenue.

Graphical representations of the curve sometimes appear to put the rate at around 50%, if the tax base reacts to the tax rate linearly, but the revenue-maximizing rate could theoretically be any percentage greater than 0% and less than 100%. Similarly, the curve is often presented as a parabolic shape, but there is no reason that this is necessarily the case. The effect of changes in tax can be cased in terms of elasticities, where the revenue-maximizing elasticity of the tax base with respect to the tax is equal to 1. This is done by differentiating $R$ with respect to $t$ and grouping terms to reveal that the rate of change of $R$ with respect to $t$ is equal to the sum of elasticity of the tax base plus one all multiplied by the tax base. Thus as elasticity surpasses one absolute value, revenues begin to fall. The problem is similar to that of the monopolist who must never increase prices beyond the point at which the elasticity of demand exceeds one in absolute value.

Wanniski noted that all economic activity would be unlikely to cease at 100% taxation, but it would switch from the exchange of money to barter. He also noted that there can be special circumstances in which economic activity can continue for a period at a near 100% taxation rate (for example, in war economy).

Various efforts have been made to quantify the relationship between tax revenue and tax rates (for example, in the United States by the Congressional Budget Office). While the interaction between tax rates and tax revenue is generally accepted, the precise nature of this interaction is debated. In practice, the shape of a hypothetical Laffer curve for a given economy can only be estimated. The relationship between tax rate and tax revenue is likely to vary from one economy to another and depends on the elasticity of supply for labor, as well as various other factors. Even in the same economy, the characteristics of the curve could vary over time. Complexities such as progressive taxes and possible differences in the incentive to work for different income groups complicate the task of estimation. The structure of the curve may also be changed by policy decisions. For example, if tax loopholes and tax shelters are made more readily available by legislation, the point at which revenue begins to decrease with increased taxation is likely to become lower.

Laffer presented the curve as a pedagogical device to show that in some circumstances, a reduction in tax rates will actually increase government revenue and not need to be offset by decreased government spending or increased borrowing. For a reduction in tax rates to increase revenue, the current tax rate would need to be higher than the revenue maximizing rate. In 2007, Laffer said that the curve should not be the sole basis for raising or lowering taxes.

The supply-side dynamic Laffer curve

Supply-siders argue that in a high tax rate environment, lowering tax rates would result in either increased revenues or smaller revenue losses than one would expect relying on only static estimates of the previous tax base.

This led supply-siders to advocate large reductions in marginal income and capital gains tax rates to encourage greater investment, which would produce more supply. Jude Wanniski and many others advocate a zero capital gains rate. The increased aggregate supply would result in increased aggregate demand, hence the term "supply-side economics".

Criticisms

Laffer assumes that the government's revenue is a continuous function of the tax rate. However, in some theoretical models, the Laffer curve can be discontinuous, leading to an inability to devise a revenue-maximizing tax rate solution. Additionally, the Laffer curve depends on the assumption that tax revenue is used to provide a public good that is separable in utility and separate from labor supply, which may not be true in practice.

The Laffer curve as presented is simplistic in that it assumes a single tax rate and a single labor supply. Actual systems of public finance are more complex, and there is serious doubt about the relevance of considering a single marginal tax rate. In addition, revenue may well be a multivalued function of tax rate; for instance, an increase in tax rate to a certain percentage may not result in the same revenue as a decrease in tax rate to the same percentage (a kind of hysteresis). Furthermore, the Laffer curve does not take explicitly into account the nature of the tax avoidance taking place. It is possible that if all producers are endowed with two survival factors in the market (ability to produce efficiently and ability to avoid tax), then the revenues raised under tax avoidance can be greater than without avoidance, and thus the Laffer curve maximum is found to be farther right than thought. The reason for this result is that if producers with low productive abilities (high production costs) tend to have strong avoidance abilities as well, a uniform tax on producers actually becomes a tax that discriminates on the ability to pay. However, if avoidance abilities and productive abilities are unrelated, then this result disappears.

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Tuesday, April 23, 2024

Reaganomics

Historical context

Justifications

Policies

Results

Overview

Employment

Growth rates

GDP growth

Real wages

Income and wealth

Poverty level

Federal income tax and payroll tax levels

Tax receipts

Debt and government expenditures

Business and market performance

Size of federal government

Income distribution

Analysis

Optimal tax

Tax revenue

Horizontal and vertical equity

Lump-sum taxes

Commodity taxes

Developments in tax theory

Income taxes

Labor income tax

Corporate income tax

Sales tax

Capital income tax

Capital taxes

Land value taxation

Laffer curve

History

Origin

Precedents

Empirical analysis

Income tax rate at which revenue is maximized

Taxation of goods and services

Congressional Budget Office analysis

United Kingdom

Other

In US political discourse

Use in supply-side economics

Reaganomics

Bush tax cuts

Theoretical issues

Justifications

The simplified static Laffer curve

The supply-side dynamic Laffer curve

Criticisms

Operator (computer programming)