Sunday, April 30, 2017

Back to Laffer

Quartz magazine succinctly describes what's wrong with the Laffer curve:
The problem is, this tidy arc of cause and consequence doesn’t exist in the real world. Sure, extremely high tax rates douse economic activity. But there’s no reason to assume the relationship between tax revenue and tax rates is perfectly U-shaped. And the equilibrium point at which a government collects the most revenue possible without dragging down the economy is impossible to know—and varies by country. There was no reason in 1974—or, for that matter, now—to think the US was on the curve’s “prohibitive” half (many economists put the inflection point for the highest marginal tax rate at around 70%). In fact, without detailed data, you can’t tell where on Laffer’s curve (or non-curve) you are at all.

Laffer’s general idea of supply-side stimulus can sometimes work. Cutting tax rates that primarily benefit rich people shifts wealth from the middle classes to the rich. That might sound unfair, but in developing countries where there’s not enough money to fund the investment needed to spur growth, a Laffer-style policy could (temporarily) help stimulate economic expansion by channelling wealth to potential investors.

But this scenario is not applicable to the US. Private investment tends to ebb and flow with the business cycle; when demand is feeble, so is investment. Cutting taxes on America’s rich isn’t going to encourage them to invest more—they already have plenty to spend and aren’t spending it. Worse, by shifting wealth from middle class families to the moneyed few—a group that is able to consume far less than the working masses—this sort of policy suffocates demand even more. Slowing demand drags on growth, causing debt and unemployment to rise.

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