Thursday, September 22, 2005

Economics 101: The Laffer Curve

As the focus begins on rebuilding the Gulf region after hurricane Katrina, the conversation has begun on how to best fund the Federal government's portion of the bill. Democrats, predictably, are calling for tax increases presumably in an effort to bring more dollars into the U.S. Treasury. Republicans, on the other hand, want to extend the Bush tax cuts to keep the economy strong. The issue provides a great opportunity to examine the relationship between changing tax rates and resultant dollars recovered by the U.S. Treasury.

When Ronald Reagan took office in 1981, the top marginal income tax rate was about 70% !! Gradually, despite resistance from congressional Democrats, President Reagan slashed marginal income tax rates across the board, lowering the top rate eventually to about 28%. To the untrained eye, one may naively conclude that during the Reagan Era, receipts into the U.S. Treasury must have retreated in response to such sweeping tax cuts. The truth, however, was exactly the opposite!!! In each of Ronald Reagan's eight years as President, the U.S. Treasury took in more dollars in tax receipts than in any other year in U.S. history!!! How could this happen you may ask? For an explanation, let's turn to the simple bell-curve popularized by the econcomist, Arthur Laffer, called ( quite appropriately ) The Laffer Curve .

The Laffer Curve shows that to maximize tax reciepts, the tax rate must not be too small or too large. When tax rates are too high, a reduction in rates actually will increase tax receipts by stimulating more business, which creates more jobs and consequently sends more income tax to Washington. An understanding of this principle, lead President Reagan to take tax-cutting action that lead to the longest period of sustained growth in American history. This growth greatly reduced unemployment and lead to unprecedented wealth creation at all income levels.

Fast forward to the very beginning of the Bush administration's first term. Bush entered office with the economy slowing. Although the Clinton Era was a prosperous time for America; taxes had reached a historic high, the dot-com boom was ready to bust and when 9/11 hit, the economy fell into recession. In addition to the appropriate lowering the prime rate by the chariman of the Federal Reserve; President Bush began a series of tax cuts that culminated in an eventual across the board decrease in marginal income tax rates of about 5%. The results, which in part are nicely summarized by Stephen Moore in a Wall Street Journal article, include the following economic points of success.

In the past two years, 4.2 million jobs have been created, thereby dropping the unemployment rate to 4.9%! Remember that the average unemployment rate in each of the last three decades was about 6.4%. There are now more employed Americans than at any point in American history. Growth rates for the last several quarters have been consistently in the 3.5% to 4% range! Now here is the kicker. In the past two years, the deficit, as a percentage of GDP, has dropped from 4.5% to 2.7%!! Tax receipts for the last year are the highest in American history!!!! All this while we are at war and with oil prices doubling! The above facts have convinced me that the President is right on target with regard to tax policy.

The real economic threats that could drastically increase the deficit are 1. out of control spending on unnecessary pet-projects wrapped up in omnibus spending bills and, 2. entitlement programs like social security and medicare that are in desperate need of reform to adapt to significant changes in population dynamics.

A final plea to tax-loving Democrats. If you want more dollars to spend in D.C., don't increase tax rates!!!!!