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.

Now comes the incredibly difficult climb out of the recession trough. We’ve started climbing, with two successive quarters of positive real GDP growth. The newspapers, cable, talk shows, and blogosphere are filled with opinions, warnings, and predictions. I’m in no position to give a complete prescription for future economic policy, but this is an excellent time for students to be thinking through the issues. They need to separate out the fundamental building blocks of a strong economy and push aside alarmist claims.  Here’s a list of things to think about:

1. Monetary policy and the Federal Reserve: In a mild recession the Fed is our policy instrument of choice. They loosen the money supply, which in turn lowers interests rates a bit, which in turn  helps consumers buy goods and businesses to invest in the future. In the recession that started December 2007, the Fed started with this response but the depth and seriousness of the downturn outstripped the ability of routine monetary policy. They then turned to extraordinary steps to provide stability and liquidity in the financial markets, and have worked to maintain a banking system that will receive deposits from trusting depositors and make loans to worthwhile borrowers. To do this they pumped billions (over a trillion) of dollars into our system.They are now focused on how to retrieve that excess money, so that a more active economy doesn’t use it to spur inflation. They’ve been thinking about this a lot, and Chairman Bernanke insists they will be able to gradually reverse the steps they took, without sending the economy in a tailspin. The Fed also has to decide when to reverse the “normal” monetary policy and started pushing interest rates up. As I see it they are working in kind of a LIFO (last in; first out) order. The most serious and unusual interventions will be corrected first, and then the milder interest rate policies will be corrected as the economy approaches a more normal course.
2. Fiscal Policy and the Congress and Administration: Congress correctly passed a large stimulus spending bill over a year ago. The economy  needed it; routine monetary policy was not going to be sufficient to end the recession; and it would have been political suicide not to take action. The stimulus bill was not perfect. It was probably not large enough. It had some favorite son policy objectives that hindered speedy impact of the spending on the economy, and it had some not very effective tax cuts in order to garner bipartisan support.I’ve learned to appreciate a “prime the pump” analogy for fiscal policy actions like this. If you’ve ever had to use a hand pump you know that sometimes you have to add water in the top in order to get the process working. Government stimulus funds are like priming the pump. They immediately add something to the GDP, since government spending is one component of GDP. The real test of a fiscal stimulus is whether the priming works. In an ideal case, the initial injection of spending prompts a cascading series of new spending decisions in the private sector. This is the essence of what my students learn as the multiplier effect. New spending on roads means more wages for road workers, who hopefully become more likely to spend, and the establishments where those workers spend have the same opportunity. There are plenty of signs that the initial stimulus money started improving GDP. Whether that money has successfully primed the pump is an open question. Some policy experts are calling for more stimulus – a second priming. Others (not including those who object on philosophical grounds to more government spending) worry that another fiscal stimulus would boost the economy just as it is getting better on its own, and could spark an inflationary spiral.There has been a flurry of “job bills” discussed by the administration and Congress. Many of these are responses to a perceived (probably real) concern among the American voter that jobs aren’t coming back quickly enough and something needs to be done about it. I don’t know enough about them to comment thoughtfully. Based on past performance it is easy to guess that some proposals will do little to make a permanent shift in the employment picture, and that some will have serious side effects. One quick example – just about any “Buy American” restrictions will hurt our economy in the long run and have minimal benefits in the short run. The Smoot-Hawley act passed in the early years of the recession is our number one example of the problems of drawing up the bridges and protecting our own workers at the expense of other world markets. On the other hand jobs bills that can reduce structural unemployment through retraining, relocation, and other adaptive strategies are money well spent.
3. Federal Deficit and Debt: This is the trickiest balancing act. It also has the most heat and the least amount of light in media discussions. Here’s what the Congressional Budget Office says about the near term situation:

CBO projects, that if current laws and policies remained unchanged, the federal budget would show a deficit of $1.3 trillion for fiscal year 2010. At 9.2 percent of gross domestic product (GDP), that deficit would be slightly smaller than the shortfall of 9.9 percent of GDP ($1.4 trillion) posted in 2009. Last year’s deficit was the largest as a share of GDP since the end of World War II, and the deficit expected for 2010 would be the second largest.

One way to look at this issue is represented by Paul Krugman:

Contrary to what you often hear, the large deficit the federal government is running right now isn’t the result of runaway spending growth. Instead, well more than half of the deficit was caused by the ongoing economic crisis, which has led to a plunge in tax receipts, required federal bailouts of financial institutions, and been met — appropriately — with temporary measures to stimulate growth and support employment.

Gregory Mankiw is less happy about projected deficits:

The troubling feature of Mr. Obama’s budget is that it fails to return the federal government to manageable budget deficits, even as the wars wind down and the economy recovers from the recession. According to the administration’s own numbers, the budget deficit under the president’s proposed policies will never fall below 3.6 percent of G.D.P. By 2020, the end of the planning horizon, it will be 4.2 percent and rising.

My own take? Closer to Krugman than Mankiw, but I worry that a partial economic recovery or some call for fiscal stimulus will produce not-well-thought-out-spending plans. These won’t help much, in terms of recovery, they are likely to be persistent beyond the current economic problems, and they won’t help re-establish a deficit closer to 4-5% of GDP.

Gregory Mankiw leans more towards the supply side argument, and is concerned that the current healthcare reform bill has very high marginal tax rates. You can read his analysis from The New York Times here.

New York Times - Sunday, November 1

However, let’s put aside the specifics of the healthcare reform proposals and go to the heart of the supply side argument. From Mankiw,

[S]ubstantial evidence supports the more modest proposition that high marginal tax rates discourage people from working to their full potential.

The phrase marginal tax rates means the rate applied to an additional amount of income. It is different from average tax rate which applies to the family’s entire income. Imagine that you are earning $30,000 currently and have a chance to earn an extra $10,000  by taking a night job. If, though, your marginal tax rate is 20 percent, the tax on that additional $10,000 is $2,000. So your take home page as a result of taking the second job is $8,000.

Now the questions start lining up. Would you be less willing to take that job if you knew your marginal tax rate would be so high? And if you take that second job, will the economy benefit from your added participation? The answer to the first question lies in your opportunity cost – what you give up, in the form of leisure, to take the job, and what you give up, in the form of added income, if you decided to spend your evenings at home. The impact on the economy comes from your higher income, some of which you would spend. What is harder to estimate is whether your participation is more effective than someone else who might take the job if you did not.

As Mankiw reminds us, “the verdict on supply side economics is mixed.” Some argue that there is no compelling evidence to support supply side strategies, while at least two Presidential administrations (Reagan and George W. Bush) based their economic platform on this principle. To my mind, supply side strategies are not very effective in stimulating demand, and have earned political support mostly as a justification for a less-government-is-better-government platform.