American Budgetary Politics: Taxes, Deficits, and the Notorious "Laffer Curve"

This post is part of a blogging series by economics students at the Presidio Graduate School's MBA program. You can follow along here.

By Katie Grote

“In this world nothing can be said to be certain, except death and taxes,” wrote Benjamin Franklin, but in today's America is that still true?  Even with our debt-to-GDP ratio (pdf) higher than it has been since World War II, our income tax bracket tops out at 35%.  Even more remarkably, the Republicans’ recent “Path to Prosperity” budget proposal (pdf) sought to lower tax rates further, to 25%.

However, Americans haven’t always had such low taxes.  In fact, in 1944, Allied Forces invaded Normandy on D-Day, noir thriller “Double Indemnity” won an Oscar for Best Picture... and top earning Americans paid 94% of their income as taxes.  In the past 80 years, however, the arguments of supply-side economists have been increasingly used to lower American tax rates, gaining momentum under Ronald Reagan’s presidency and continuing through today.

Supply-side economists favor a series of policy decisions that increase the aggregate supply within an economy, as opposed to typically Keynesian policies that focus on increasing aggregate demand.  Put more simply, supply-siders argue that lower taxes incentivize workers and corporations to work harder, because they get to keep more of the money they make.  In turn, jobs are created, workers have more disposable income, and the economy grows.

Using this logic, in 1982, Congress under Ronald Reagan passed the Kemp-Roth Tax Cut, which reduced the top tax bracket from 70% to 50%.  The reasons for this bill were to “stimulate productivity and innovation throughout the economy” while also creating “incentives to work, produce, save, and invest.“  In 1986, Congress under Reagan passed another tax cut that further lowered the top bracket from 50% to 28%.

Many of these tax cuts theoretically were to pay for themselves, thanks to a supply-side economic model called the Laffer Curve (pdf).  Again, supply-siders argue that lower taxes increase productivity, since (in theory) a worker will worker harder or for longer hours if she gets to keep more of her income.  If every worker and corporation works harder, overall productivity will increase and theoretically, a lower tax rate could generate more tax revenue.

In reality, the theory that tax cuts increase tax revenues has been thoroughly disproven.  Still, the myth remains a tried-and-true argument in our political debates.  Even in 1996 during the Clinton years, the Joint Economic Committee of the U.S. Congress released a report stating that “reducing excessive tax rates stimulates growth, reduces tax avoidance, and can increase the amount and share of tax payments generated by the rich,” all classic supply-side arguments.  More recently, President Bush, Vice President Cheney, and Presidential candidate John McCain all publicly stated that lowering taxes increases tax revenues.

Most politicians today would agree that our current debt-to-GDP ratio is untenable.  But given today’s supply-side rhetoric around tax policy, can we really expect higher taxes any time soon?  In early February of this year, New York Times columnist Paul Krugman blogged that Americans “want state governments to balance their budgets without cutting spending or raising taxes.”  To me, wanting both tax cuts and government spending sounds like a dysfunctional combination of supply-side policies trying to fund Keynesian policies.  As a nation, can we move away from this knee-jerk supply-side policy of tax cuts?  Or will we be stuck, as Krugman writes, with “a mandate to repeal the laws of arithmetic”?

Katie Grote, LEED AP, is a San Francisco-based green building specialist and 2012 MBA candidate at Presidio Graduate School.