Tax cuts on rich pay for themselves

Thirty-six years after an academic economist named Arthur Laffer drew a curved line on a cocktail napkin, the debate over supply-side tax cuts paying for themselves is still going strong. • Why, after all this time and an extensive body of data, are we still questioning whether reductions in marginal and capital-gains tax rates increase economic activity enough to generate more revenue for the federal government? "Because they don't like the answer," Laffer says of the doubters.

"It's not tax cuts that pay for themselves. Tax cuts on the poor cost you lots of money. Tax cuts on the rich pay for themselves. Rich people can afford lawyers, accountants, and can defer income."

That's one answer. Another may be that, unlike the hard sciences, there is no conclusive test. In a dynamic economy, it's impossible to hold everything else constant except tax rates. Monetary policy, government regulation, trade policy and the stage of the business cycle all affect economic growth. Absent a controlled experiment — giving one group a placebo and the other a (tax-cut) drug — a conclusive answer is out of reach.

What we do know, empirically, is this: Over time, federal revenue as a share of gross domestic product has stayed fairly constant at 17.9 percent. That's true if the top marginal tax rate is 91 percent (1950s), 50 percent (early 1980s) or 35 percent (2000s). Recessions are the one exception.

So, if the government's tax take varies little, why create uncertainty over how much of our income we'll have to fork over to Uncle Sam three, five, 10 years down the road? Why not flatten the rate, fix it and forget about it? Fairness, for one. The government wants to take money from the rich and give it to the poor.

"They are wrong," Laffer says. "It doesn't work that way. The rich can change the volume, timing, composition and location of their income. Poor people can't."

Congress is the second. The tax code is the means through which lawmakers dole out tax breaks, credits and exemptions in return for campaign contributions. Which is why tax simplification in 1986 was such a short-lived phenomenon, says Jim Glassman, senior economist at JPMorgan Chase.

While scientific proof for the supply-side credo remains elusive, we have lots of statistics from the Internal Revenue Service that demonstrate the effect tax changes have on the rich, or top 1 percent of income earners. Laffer described them in an Aug. 2 Wall Street Journal op-ed. Since 1978, a series of reductions in the top marginal tax rate served to increase the share of taxes paid by the rich.

This should come as no surprise. The rich have the luxury to respond to incentives, to opt for more work and less leisure when the return on work is greater. They are motivated to take risks, maybe start a business, invent something, and get even richer while giving others the opportunity, through hiring, to do the same.

The opposite is true for low-income workers. When the government raises taxes, someone struggling to put food on the table for his family may have to go out and get a second job to maintain his level of take-home pay. For this socioeconomic group, higher taxes translate to more work.

To ignore evidence that the rich behave differently is silly. The government can't get more blood from a stone, yet it keeps trying. Instead of demagoguing tax cuts for the rich, Democrats should try embracing them for a change.

"It's in everyone's interest that the economy do as well as it can so that the government can fulfill the promises it's made," Glassman says. If the trade-off is between fairness and dynamism, dynamism should win every time.

I, for one, would like to see the debate shift from class warfare over tax rates and targeted tax relief to tax reform. Either scrap the tax code and introduce a simple flat tax with no deductions, or scrap the IRS and move to a consumption tax. If you want to get money out of politics, there's only one way to do it. Take the tax code out of Congress' hands.

Caroline Baum, author of "Just What I Said," is a Bloomberg News columnist.

Tax cuts on rich pay for themselves 08/10/10 [Last modified: Tuesday, August 10, 2010 7:38pm]

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