Monday, December 10, 2007

The Laffer Curve Showdown at the Mark Thoma Corral

Okay, it is not quite a showdown at the OK Corral, but Mark Thoma comes out swinging in a response to Justin Fox and Brad DeLong who suggest there is some truth to the Laffer curve. First, a recap of the statements that caused Mark to respond:

Brad DeLong: "As I read the evidence, Arthur Laffer is probably right at the top end: reducing the top tax rate from 70% to 50% is probably a revenue gainer and surely not much of a loser. From 50% to 28% is, I think, very different: a big revenue loser."

Justin Fox
: (from initial posting) "Some tax cuts do raise revenues, of course.... (later posting) Just two off the top of my head: The 1964 Kennedy reduction of the top marginal income tax rate from 91% to 70% (it was enacted after JFK's assassination, but it was his bill), the 1981 Reagan reduction of the top marginal rate from 70% to 50%. I'm not at all an expert on this, but I don't think it's too controversial among economists to assert that those particular changes (but not the rest of the of Kennedy and Reagan tax legislation) were a break-even or better for the Treasury... The common thread is that these were cuts in punitively high marginal rates. They paid off in large part because they removed incentives to shelter income from taxes."

Mark begins his response by quoting two intermediate macroeconomic texts that essentially say "large budget deficits of the early 1980s = failure of the Laffer curve." He then goes on to say that one cannot look at the 1960s tax cut in isolation since the Fed monetized the public debt, providing an added economic stimulus that masks the true budget deficit reality. What I believe Mark is getting at here in this latter point--and something that is too often glossed over in these Laffer curve debates--is that one should distinguish between the structural budget balance and the cyclical budget balance when passing judgement on the merits of the Laffer curve. Okay, I will give him that point, but it cuts both ways. The Reagan budget deficits--that are supposedly evidence against the Laffer curve according to the cited textbooks--must also be parsed for the structural and cyclical components. After all, the sharpest post-WWII economic downturn occured during Reagan's tax cuts. What part of Reagan's deficits were due to the double-dip recessions in the early 1980s versus his tax policy?

The Congressional Budget Office provides data to answer this and other structural vs. cyclical budget balance questions. The figure below (click here for a larger picture) shows this decomposition as a percent of GDP from 1962 to 2006. (Other adjustments in figure consist of deposit insurance, receipts from auctions of licenses to use the electromagnetic spectrum, timing adjustments, and contributions from allied nations for Operation Desert Storm.)

Consistent with Mark's claim, this figure does show a positive cyclical contribution to the overall budget balance following the 1964 tax cut. The cyclical contribution, however, only turns positive in 1964 so one could argue it came from the tax cut itself. Regarding Reagan, the cyclical component clearly dragged down the budget balance during the early-to-mid 1980s, although the structural budget balance was the most important component overall. This figure also makes clear that both cyclical and structural forces were at work with Clinton--it was a combination of his tax policies and a booming economy that generated the budget surplus.

I am not sure this figure settles any questions, but it does highlight the importance of distinguishing between a structural budget balance and a cyclical budget balance. Personally, I find the nuanced Laffer curve view--if I can call it that--of Justin Fox, Brad DeLong, and Greg Mankiw a reasonable position to hold.


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