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.

Here’s a quick list of reasons to tax. Each have a bit longer explanation down below.

We tax to…

1. pay for public services that are easier or more efficient to provide as a community than to pay for individually.  (AKA public goods)
2. correct for inequalities in individual wealth or income – to provide some basic level of food, shelter, medial care, etc. (AKA welfare and other social services)
3. correct for externalities.
4. Change behavior – encourage or discourage through incentives

1. Public Services/Public Goods:  There are services that many people want, but individually we could not afford to buy them. While it is possible for groups of individuals to come together privately to pool their funds and provide the service, they often run into the free rider problem. So we give government the ability to build roads, provide police and fire protection, and many other worthwhile goods and services. Often times voters have to approve the tax to pay for these. Here are some other posts on the topic.

2. Income Redistribution / Social Services: In some economies there is an explicit goal for a Robin Hood policy (take from the rich and give to the poor) – purely to even out income or wealth. In the United States and many other countries there is a social ethic or value that says that the poorest members of society should be able to live in at least some minimum level. This ethic or value is controversial, of course. Some voters support strong government efforts to improve the lives of our poorer members – along the lines of European social democracies. Other voters prefer a self-determination, self-reliance model, where citizens have opportunities but are left to their own to survive or advance in the world. And many voters are somewhere in between. In a later post we’ll show how many tax strategies focus on extracting more tax revenue from the wealthy than from the poor.

3. Correcting Externalities: In economics we call the presence of externalities a market failure. When someone outside of a market transaction is either harmed by or benefits from that transaction, we have an externality. If there is an externality then the market will produce either too much or too little of that good, and will not reach a social optimum. The most common example is factory pollution. When the factory produces a good and pollutes while doing that, others outside the factory are affected. See more on externalities here.

4. Incentives to Change Behavior: Some times we enact taxes to discourage behavior. “Sin taxes” are one such example. Tobacco taxes can be used to defray state health care costs. Generally this is a pretty inefficient mechanism since many of the “sins” are addictive and demand for them price inelastic. More often a tax on tobacco or alcohol is just a convenient way to raise revenue, and voters are more likely to support those taxes over more general income or sales taxes. A more modern application of this category is called a Pigovian tax, and the prime example being discussed is a carbon tax. Taxing activities and products that release carbon into the atmosphere should discourage and reduce those activities.  We also give tax credits for behavior we want to encourage.

The proximate cause for these measures appearing on the ballot is a classic squeeze felt by state and local governments. During times of economic contraction state tax revenues fall quickly, particularly if their state income tax is progressive in design. Why is that? Progressive tax structures impose higher tax rates on higher income individuals. When incomes fall families pay based on those lower incomes plus they pay a lower tax rate.

The other side of the state/local squeeze is that demands on government spending go up in hard times. These increases are usually automatic. More people qualify for state assistance as their incomes fall, and programs put in place automatically have to step up.

State and local governments can’t engage in deficit spending – which is the solution used by the federal government and recommended by Keynes back in the Great Depression. They don’t have the ability to borrow for regular operating costs. (They can borrow for larger projects that have an income stream. For example, selling bonds to build a bridge and then using toll revenues to pay off the bonds.)

Oregon has a particularly progressive income tax structure, and it doesn’t have a sales tax (regressive) to add a moderating force during hard times. Its biennial (every 2 years) budget has a huge hole.

Univ. of Oregon economics professor, Mark Thoma examined the two tax measures in this opinion piece for the Portland Oregonian. There are two important pieces to his examination and I recommend you look for them in the commentary:

1. Thoma is using positive economics (rather than normative) which means he avoids adding personal values or preferences to his analysis. In an early section of the piece he compares the impact on economic efficiency between taxing more versus cutting spending to fill the budget hole. He comes out mildly on the side of increasing taxes.
2. He has some new (to me) ideas about how to escape this state squeeze between declining revenues and increasing needs. He advocates some federal solutions, including providing a loan facility for state governments at favorable interest rates, and federal grants to help states bridge this gap.

On another level but the same topic a friend of mine is likely to vote against Measures 66 & 67 – feeling that the state legislature needs to control spending, and that tax increases just reduce the pressure for more fundamental spending reform.

What do you think?