Wednesday, September 3, 2008

Tax Cuts

The promise of tax cuts contributed significantly to Reagan's victory in 1980 and Bush II's victory in 2000. I opposed most initiatives of these two administrations because they eroded opportunities for many Americans and planted seeds of America's eventual decline, so I bristle at the tax-cut mantra now adopted also by Democrats.
Moreover, I was suspicious of the intellectual underpinnings of the tax cuts, the Laffer Curve (google: Laffer Curve past present future). According to Laffer, taxing an economic activity steers people away from that activity, so reducing the tax rate will increase the activity; and, if the tax rate is above optimal, then the increased economic activity will outweigh the reduced tax rate, so tax revenue will increase. Reductions of tax rate below optimal will reduce revenue as expected. This implies an arch-shaped dependence of revenue on rate.
While this theory is unimpeachable, I doubt that tax cuts of Reagan and Bush II were justified by Laffer's theory, and I suspect that those cuts were harmful. The dependence of economic activity on tax rate is inherently insensitive, since ordinary workers and most entrepreneurs do not avoid or diminish their efforts because their earnings are taxed. Investor choices may be more sensitive to tax environment but still constrained by market realities. On the other hand, globalization makes investor choice more sensitive to taxes.
Some of the modern examples cited by Laffer, as demonstrating effects of tax cuts to increase tax revenues, seem questionable. First, increases of revenue following tax cuts were similar regardless of starting point, not as expected of an arch-shaped dependence. Second, the increases of revenue might be attributed to concomitant increases of federal spending, some of which would bounce back directly as income tax on recipients, some of which would come from economic activity initiated by the recipients. How else could the deficit rise when revenue increased? Ninety percent of the federal debt has accumulated since Reagan cut taxes. Also, economic activity following tax cuts may have been influenced by Federal Reserve actions, new technologies, new business strategies and new investment vehicles.
I wonder whether the changes of economic activity following tax cuts have been subjected to sensitivity analysis based on a model that includes factors mentioned above and others not mentioned. I also wonder whether Laffer approves of the economic trajectory that we are on, essentially a Reaganomic trajectory.

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