Laffer All the Way to the Bank

May 15, 2003

Confused by all the arguing over President Bush's proposed tax cuts, I paid a visit to my accountant Vinny the Number Cruncher for some perspective.

"Vinny, Republicans think the best way to help the economy is to cut taxes, whereas Democrats think tax cuts will be the ruin of America. Who is right?"

"Kid, I'd love to offer up my opinion on the subject, but in my line of work it's best to stick with the facts."

"So what are the facts?"

"You ever hear of a fellow called Arthur Laffer, kid? He created the Laffer Curve, which pretty much shows this: If the income tax rate is zero, the government gets no revenue. But if the tax rate is 100%, the government gets no revenue. That's because people won't bother doing any work if they don't get to keep any of their hard-earned dough."

"Makes perfect sense to me."

"Well, the Laffer Curve says that there is an optimum tax rate in between zero and 100 percent at which the government is able to collect the maximum amount of revenue without impeding work incentives. If tax history is our guide, the optimum rate tends to be on the lower end of the scale."

"Interesting."

"The Heritage Foundation does a terrific job documenting this story, kid. In 1921, the top income tax rate was 71 percent, a rate left over from the effort to finance the first World War."

"That was awfully high."

"Yeah, and the economy was suffering as a result. But when the top rate was reduced to 24 percent, the economy boomed, growing by 59 percent between 1921 and 1929."

"But didn't that era lead up to the Great Depression?"

"Good question, kid, and I got a good answer for you. In 1930, Herbert Hoover raised taxes to a maximum of 63 percent. A good argument can be made that high taxes were a key contributor to that dismal economic period."

"I didn't know that."

"Now let's go to the 1960's. Again tax rates were high, a leftover from WWII. The top tax rate was a whopping 91 percent. President Kennedy reduced that down to 70 percent. He also reduced taxes on savings and investment. The result: one of the longest periods of economic expansion."

"Not too shabby."

"That brings us to the 1980's. President Reagan reduced the top rate to 28 percent, and the economy exploded. We enjoyed the longest peacetime expansion in American history."

"But some people argue that the deficit spending during that period also stimulated the economy. Reagan spent billions on the military and Democrats and the Congress spent money like drunken sailors."

"I'll let the economists argue that one, kid. The fact is lower taxes always result in economic expansion and higher government revenue, and higher taxes tend to bring about the opposite result."

"But what about the deficit, Vinny? If we cut taxes now, won't that increase the deficit and drive up the cost of borrowing?"

"That is precisely what the Democrats are trying to argue. But if history is our guide, that won't be the case. The Bush team believes that lower taxes will unlock the energy of our dormant economy, which will cause businesses to invest in new equipment and consumers to spend, which will result in jobs, which will result in higher receipts to the government, which will reduce the deficit."

"So you're saying that Bush's tax cuts are what we need right now?"

"Well, kid, let's look back to recent history. Since Reagan left office, taxes were raised three times. Once during the first President Bush's term and twice during the Clinton years."

"But why? If lower taxes allow the economy to breathe, that means more people will be working and the government will end up with far more revenue."

"So naïve, kid. The reason is that some people, usually Democrats, believed it wasn't fair that some people made a lot of money and only paid a top tax rate of 28 percent."

"And as a result, we've kept getting further away from what appears to be the optimum tax rate on the Laffer Curve?"

"Precisely, kid."
 
"And if that is the case, then the best action now is to lower taxes and get them closer to a level that, historically, has resulted in robust economic expansion and high revenues for the government. And we'll 'Laffer' all the way to the bank!"

"Kid, I couldn't have said it better myself."

Tom Purcell