THE LAFFER CURVE, TOP MARGINAL TAX RATES AND WHAT’S BEST FOR THE PEOPLE AS A WHOLE …
Today’s economics lesson for AOC, Bernie Sanders and other Democrats pushing socialist ideas, like a 70% to 90% top marginal tax rate, will be taught by economist Arthur Laffer, political economist Jude Wanniski and president Calvin Coolidge.
Art Laffer, our first instructor, has provided economic advice to U.S. government leaders since the 1970s. He famously developed the Laffer Curve to explain how government can maximize production and tax revenue.
Laffer made the following observations:
- There are always two tax rates that yield the same revenues, for example: 0% = 100%, A = B and C = D.
- At points B and D, the electorate desires more government goods and services and wishes to pay the higher tax rates producing the revenue consistent with E.
- At points A and C, the electorate desires more private goods and services in the economy, and wishes to pay the lower rates consistent with revenues at E.
- It is the task of the political leader to determine point E, where the electorate desires to be taxed.
- The shaded area is the prohibitive range for government, where rates are unnecessarily high and can be reduced with gains in both output and revenue.
A look at United States income tax history shows that we have tried the full breadth of possible top marginal rates.
Yet income tax revenue (red line in graph below) as a percentage of GDP has remained essentially flat since the end of WWII, which underscores why government should avoid tax rates in the shaded area of the Laffer Curve.
Jude Wanniski, our second instructor of the day, made a keen observation in his book, The Way The World Works:
The chief reason politicians and economists throughout history have failed to grasp the idea behind the Laffer Curve is their confusion of work and productivity. As taxes are raised, individuals in the system may indeed work harder to maintain their after-tax income, but their productivity will decline.
In point of fact, Wanniski provided the example of Soviet taxation on collective farms during the Khrushchev era (1953 – 1964):
The Soviet Union had 250 million people, with 34.3 million engaged in producing the nation’s food, of which there was never enough. The United States, with 220 million, employed only 4.3 million in food production, which supplied enough for the U.S. as well as a surplus for export equivalent to a quarter of all Soviet production. The source of that problem was high marginal tax rates on the state’s collective farms. The communist government exacted a 90% tax rate on the state land provided to the farmers and a 0% tax rate on private plots (0.5 to 1.5 acres) that the farmers were allowed to keep. The result: 27% of Soviet farm output came from private plots amounting to < 1% of the nation’s agricultural lands (~26 million acres). Farming on private plots was 40 times more efficient than farming on the state’s collective land.
Our last lesson of the day comes from Calvin Coolidge, who succeeded Warren Harding as U.S. president from August 2, 1923 – March 4, 1929.
After WWI, Republican presidents Harding and Coolidge won elections based largely on their promise for a return to normalcy from high war-time tax rates. They signed into law multiple reductions in the top marginal income tax rate, from 77% to 25%, resulting in the ‘Roaring Twenties’ economy:
- GDP grew 47%, from $69.9B to 103.1B.
- Consumer prices fell 4.3%, from 53.6 to 51.3, which meant that GDP grew even faster in real terms.
- Worker productivity grew 66.5%, from 44.6 to 74.3, and industrial productivity leaped 92%, from 12 to 23.
- National debt was cut 28%, from $24.3B to $16.9B.
The foundations of this economic boom were laid down in a speech by Calvin Coolidge, delivered on February 12, 1924 before the National Republican Club in New York. It is probably the best articulation by a politician of how marginal tax rates affect multiple aspects of the economy and all levels of taxpayers … and why lower top marginal rates are best for the good of the people as a whole. It is worth quoting at length:
In time of war, finances, like all else, must yield to national defense and preservation. In time of peace, finances, like all else, should minister to the general welfare. Immediately upon taking office it was determined after conference with Secretary Mellon that the Treasury Department should study the possibility of tax reduction for the purpose of securing relief to all taxpayers of the country and emancipating business from unreasonable and hampering exactions.
The proposed bill maintains the fixed policy of rates graduated in proportion to ability to pay. The policy has received almost universal sanction. It is sustained by sound arguments based on economic, social and moral grounds. But in taxation, like everything else, it is necessary to test a theory by practical results. The first object of taxation is to secure revenue. When the taxation of large incomes is approached with that in view, the problem is to find a rate which will produce the largest returns. Experience does not show that the higher rate produces the larger revenue. Experience is all in the other way. When the surtax on incomes of $300,000 and over was but 10%, the revenue was about the same as when it was at 65%. There is no escaping the fact that when the taxation of large incomes is excessive, they tend to disappear. In 1916, there were 206 incomes of $1,000,000 or more. Then the high rate went into effect. The next year there were only 141, and in 1918, but 67. In 1919, the number declined to 65. In 1920 it fell to 33, and in 1921 it was further reduced to 21. I am not making argument with those who believe that 55% ought to be taken away from the person with $1,000,000 income, or 68% from a $5,000,000 income; but when it is considered that in the effort to get these amounts we are rapidly approaching the point of getting nothing at all, it is necessary to look for a more practical method. That can be done only by a reduction of the high surtaxes when viewed solely as a revenue proposition.
I agree perfectly with those who wish to relieve the small taxpayer by getting the largest possible contribution from the people with large incomes. But if the rates on large incomes are so high that they disappear, the small taxpayer will be left to bear the entire burden. If, on the other hand, the rates are placed where they will get the most revenues from large incomes, then the small taxpayer will be relieved.
A very important social and economic question is also involved in high rates. That is the result taxation has upon national development. Our progress in that direction depends upon two factors — personal ability and surplus income. An expanding prosperity requires that the largest possible amount of surplus income should be invested in productive enterprise under the direction of the best personal ability. This will not be done if the rewards of such action are very largely taken away by taxation. If we had a tax whereby on the first working day the Government took 5% of your wages, on the second day 10%, on the third day 20%, on the fourth day 30%, on the fifth day 50%, and on the sixth day 60%, how many of you would continue to work on the last two days of the week? It is the same with capital. Surplus income will go into tax-exempt securities. It will refuse to take the risk incidental to embarking in business. This will raise the rate which established business will have to pay for new capital, and result in a marked increase in the cost of living. If new capital will not flow into competing enterprise the present concerns tend toward monopoly, increasing again the prices which the people must pay.
It is essential, therefore, for the good of the people as a whole, that we pay not so much attention to the tax paid directly by a certain number of taxpayers, but we must devote our efforts to relieving the tax paid indirectly by the whole people.
Unnecessarily high tax rates (in Laffer Curve’s prohibitive range) on personal and corporate income inevitably leads to economic contraction, resulting in some form of state relief requiring additional taxation, which adversely impacts the whole of the American people.
Here endeth the lesson.