Plain Sense Economics

Arthur Laffer is credited with the eponymous theory that a decrease in tax rates can lead to an increase in tax revenues. Even if the original theory may have been scribbled on a napkin, it still holds sway with the supply side contingent. The simplified explanation is that by reducing tax rates, income earning individuals and corporations will increase their efforts to improve their income. Their incentive is that they get to keep a higher proportion of their income. The added effect of this incentive is a stimulated economy with higher incomes, which lead in turn to higher tax revenues. Presidents Reagan and GW Bush were adherents to this theory.

Thanks to a mention in Paul Krugman’s blog. we learn that Laffer Curve thinking dates back at least to post Civil War days. Author Douglas Irwin notes the application:

After the Civil War, Congress justified high import tariffs (relative to their prewar levels) as necessary in order to raise sufficient revenue to pay off the public debt. By the early 1880s the federal government was running large and seemingly intractable fiscal surpluses revenues exceeded expenditures (including debt service and repurchases) by over 40 percent during that decade. The political parties proposed alternative plans to deal with the surplus: the Democrats” proposed a tariff reduction to reduce customs revenue, the Republicans offered higher tariffs to reduce imports and customs revenue.

What’s wrong with this picture?  “Intractable surpluses?” Republicans raising tariffs?  It seems like an alternative universe.

Despite the odd and interesting historical note, the Laffer Curve and its assumptions are important elements of tax policy debate today. Supporting evidence of Laffer’s assertion is hard to find – mostly because too many other factors changed when the Reagan and Bush administrations significantly reduced tax rates. For my principles of macroeconomics students, the question of whether and by how much taxes reduce economic vitality is an important one.