Laffer Curve* refresher course

Last week, Republicans reacted with glee as the budget deficit came in lower than expected. Leading the parade was of course the Wall Street Journal, which found this to be the ultimate vindication of its economic policy. The left side of the spectrum met this news with deafening silence. Who could blame us? We've got bigger fish to fry, between Rove, the SCOTUS nominee and the seemingly ever-worse situation in Iraq.

Maybe it's because I'm cruel and want to rain on the one bit of good news the Repubs got last week. Maybe I just enjoy taking apart Wall Street Journal editorials. Whatever the reason, I thought this would be a good time for a refresher on the idiocy of supply side economics. The column starts simply enough: Why are those rotten Democrats so angry when there was finally good news about the economy?

At least that seems to be the way a sizable chunk of Washington is reacting to this week's report from the White House budget office that the federal deficit is down by nearly $100 billion this fiscal year, that the deficit as a share of GDP is down to 2.7% (very near its historical average), and that this is all happening because tax receipts are surging by more than 14%. Uncle Sam is having a better year so far than even Paris Hilton, but half of the Beltway is depressed.

OK, that's cool, but only if finally getting back to average can be considered good. To average out the egregious deficits Bush has run up during the past 4 years, we need a lot better than "almost average." I'm nice, though, so I'm going to chalk it up to the dubious conclusion that the cause of these deficits was Clinton and his irresponsible handling of the 1990s economy leading to a recession in Bush's first term. So on to those pouting Democrats, who just can't see success when it smacks them in the face:

John Spratt, the ranking Democrat on the House Budget Committee, seems especially upset that this revenue surge isn't coming from wage income, but rather from investment income--that is, the so-called non-withholding income tax collections, which have skyrocketed by some 30% this year. "These are typically taxes paid on one-time capital gains, bonuses, stock-options income that may not recur," he laments.

Well, sure, Congressman, the 2003 reductions in the tax rates on dividends and capital gains seem to be resulting in much higher tax revenues on . . . dividends and capital gains. This is called the Laffer Curve effect, and we thank Mr. Spratt for validating it. If he wants those revenues to "recur," maybe he'll even vote to make those tax cuts permanent.

Besides the fact that the Wall Street Journal actually has the ability to be snarky, what we find here is an egregious misinterpretation of what Mr. Spratt means. Consider this scenario: I own 20 shares of company X stock. I was planning on selling them at the rate of two per year over the next ten years, but Congress made these capital gains tax cuts that allow me to sell the stock and pay less taxes on the appreciation. I don't know if this tax cut will be made permanent, so I run and sell all 20 shares. This would result in an increase in capital gains tax revenue, but it would certainly not recur, regardless of whether or not the capital gains tax cut were made permanent. I can't sell stock I don't have (I could short, but that doesn't really count). Capital gains tax might result in more investment, and some of the gains might be the result of the Laffer Curve. However, Spratt's assertion is certainly plausible, and there is reason to consider it. Plus, as we'll find out later, the Wall Street Journal itself seems to be a little confused about the utility of the Laffer Curve, so they shouldn't be snarky like its effect is self evident.

Of course, our boys at the Wall Street Journal know that the one thing that can screw up the government in the face of the wonder of the Laffer Curve are those big spenders in Washington:

There is a looming budget problem, but it has nothing to do with the Bush tax cuts or insufficient tax revenue. It is a government spending crisis, especially the liabilities that politicians have promised to retirees in Social Security and Medicare. The Congressional Budget Office predicts that spending as a share of our national output based solely on current promises will surge from about 20% today, to 25% in 2025 and to 34% by 2040.

And who knows what services the government should be in the business of providing? Ah, yes, of course. Why don't we just let the Wall Street Journal decide which popular entitlement programs are worth keeping? There's a big democratic deficit when it comes to the Supreme Court, which won't let the people ban abortion and sodomy. But when those dumbasses want programs, screw them. Of course, if we have to raise more revenue, the government ought to cut taxes, right? I mean, with the Laffer curve and all? If we just cut taxes a little bit more, that should cover it all? No:

In order to balance the budget at those spending totals, we would have to double the highest income tax rate to 70%, raise payroll taxes to 30%, and the corporate income tax rate would rise to twice the average of U.S. trading partners.

But wait, if we raise taxes all the way up there, revenue will go in the toilet! Are you crazy? The Laffer Curve was responsible for all that capital gains tax revenue! It should work here, as well. And here's the real lesson: the Laffer Curve isn't real. Of course there's a point at which raising the tax rate will decrease the amount of revenue for the government. We're almost certainly not past the point of diminishing returns. Some economists have put that at 80% taxation. And it's complicated; every change in the economy, taxation, government spending, individual investment and so forth causes shifts in the Laffer Curve. As David Stockman, an architect of supply side economics, wrote:

[T]he whole California gang had taken [the Laffer curve] literally (and primitively). The way they talked, they seemed to expect that once the supply-side tax cut was in effect, additional revenue would start to fall, manna-like, from the heavens. Since January, I had been explaining that there is no literal Laffer curve.

Here's another question: even if we could determine the optimum rate of taxation, would we really want that? Should the government really get as much of our money as possible? Obviously, this is a theoretical question, because it's already difficult enough to fund the popular programs that the Wall Street Journal wants to eliminate. However, it seems that if all the needs of the public are being met, the government should go ahead and allow revenue to slide.

There's one more suggestion that this article makes as a way to cover all those unnecessary but popular programs if they don't get cut:

Or if we tried to borrow to finance all this spending, our debt ratings would slip to junk bond status, according to an analysis by Standard and Poor's.

Of course, those wily fiscal conservatives don't really like this option very much. But why wait until 2040 for the budget to be all screwed up? Why don't we try borrowing trillions of dollars to privatize Social Security right now, when we're already in a ton of debt? If we want to go for junk bonk status, that might be a good way to go (in all fairness, I think the Wall Street Journal has opposed Social Security privatization).

So clearly, the Laffer Curve has been in effect in capital gains revenue, but in order to cover all our entitlement spending, we'd have to raise taxes. Or do we? I'll let the enemy have the final word:

So thank heaven for the tax cuts that have helped to spur the economy that is now throwing off higher tax revenues. As the chart shows, those revenues are now rising back to their modern average as a share of GDP, just as supporters of the tax cuts predicted. And if the tax cuts are made permanent, and as the economy grows and incomes continue to rise, Americans will be paying even more in taxes as they move into higher tax brackets. The real windfall here isn't for the rich but for Washington. Instead of griping, Mr. Spratt ought to be doing cartwheels.

*The Laffer Curve is a registered trademark of Fallacious Republican Arguments, Inc.