Laffer Curve: Use with Caution

There is a tradition among Republicans to try to fix budget deficits with tax cuts. Three times in the past 40 years they have deployed this strategy, each time with largely the same results: a solid rise in tax revenue but no budget balance.

Now there are rumblings about an even bolder plan. Steve Moore, an economist with President Trump’s economic recovery task force, has suggested that Congress suspend federal personal and corporate income taxes for 2021. By 2022 taxes would revert back to their normal levels.

As with the Reagan, Bush and Trump tax cuts, the idea is to exploit the Laffer effect, according to which the initial loss of tax revenue from a tax cut is made up for with growth in the tax base. As a result, government collects more tax revenue down the road than it would have done at the initial, higher rates.

There is a fair amount of evidence to support the Laffer effect. However, it does not apply in Steve Moore’s case, and the reason is simple: temporary tax cuts have no lasting effect on economic growth. The only effect of Moore’s proposal would be an even bigger deficit hole in the federal budget.

With the experience that Moore has, you would have expected him to have kept this in mind while designing his proposal. As it is now, his tax holiday would only result in a massive increase in our already oversized money supply. No sane investor is going to lend even remotely enough money to the Treasury if it expands an already-gargantuan budget deficit by temporarily giving up 55 percent of its tax revenue.

More than anything, Moore’s proposal would accelerate us into an acute fiscal crisis. At that point, anything can happen – even Republican tax hikes.

In other words, the Laffer Curve is not to be taken lightly. You cannot throw it around like candy and hope for the best. That said, there is no doubt that the curve exists. Figure 1 reports data from 30 European countries from 1996-2019.* Two time series are compared:

  1. T/GDP, i.e., the ratio of total tax-revenue collections from all levels of government to GDP. Both variables are in current prices.
  2. T Growth, i.e., annual growth in current-price tax revenue.

The variables are paired by year, by country, then organized as two time series based on the second variable. The red-gray columns represent growth rates in tax revenue, while the green curve is a polynomial trend line for the tax-to-GDP ratio (representing 719 observations for T/GDP). Behold the Laffer Curve:

Figure 1: Euro-Laffer

Source of raw data: Eurostat

It is worth noting the up-sloping segment of the curve, giving the impression that it is good to raise taxes. That is not the case, however: the upslope is associated with declining tax revenue or revenue growth rates that are tepid at best. This indicates that we are looking at economies in recession; tax revenue only plummets during recessions or in the first year of a Laffer-driven reduction in taxes. Europe has seen practically nothing of the latter, so the cause of this decline is to be found in the former.

But why, then, is there an upslope in the Laffer curve? Simple: during recessions the total tax collection from the economy declines faster than GDP. In almost every mature welfare state – of which there is plenty in Europe – the tax burden is disproportionately placed on higher incomes. Those are the first to take a beating when the economy tanks. Therefore, at constant tax rates the tax-to-GDP ratio falls in a recession and rises as the economy revs up again.

Once the economy is out of a recession, however, high taxes stifle economic growth. This is visible in the peak of the Laffer Curve; the only way to increase the annual growth rate in tax revenue is to actually cut taxes.

To see how the Laffer Curve works in practice, let us take a look at one of the worst examples of bad tax policy in modern times, namely Greece in the aftermath of the Great Recession. Figure 2 reports the same variables as in Figure 1, though the T/GDP ratio is reported as actual data, not a trend line.

During the austerity episode after the 2008-2010 Great Recession, the Greek government raised taxes significantly. As a result, the average growth rate in tax revenue almost ground to a halt:

Figure 2: The Laffer Effect in Greece

Source of raw data: Eurostat

To summarize the two periods in the Greek economy:

If the Greeks did the opposite now, returning taxes to pre-austerity rates, they would spark a significant rise in GDP growth. Tax revenue would surge in the backwater of that growth. However, it would have to be permanent tax cuts, not some silly one-year holiday.

There is another side to the Laffer Curve, of course. If government does not cut spending in tandem with the tax cuts, but if entitlement programs are allowed to continue to grow, then the rise in revenue collections will be inadequate and fail to fully fund the welfare state. Therefore, the Laffer Curve must not be used as a simple go-to solution when deficits get out of hand; it is an instrument that should only be applied as part of a structural transition from a big welfare state to a small government focused on its core functions.

On the other hand, when used properly, the Laffer Curve works just fine.

*) All raw data numbers are sourced from the Eurostat databases on national accounts and government finances. The countries are: Belgium, Bulgaria, the Czech Republic, Denmark, Germany, Estonia, Ireland, Greece, Spain, France, Croatia, Italy, Cyprus, Latvia, Lithuania, Luxembourg, Hungary, Malta, the Netherlands, Austria, Poland, Portugal, Romania, Slovenia, Slovakia, Finland, Sweden, the U.K., Norway and Switzerland. For Switzerland, data is only available for 1996-2018.