The Truth About Taxes

Ross Douthat speaks it:

Alas for liberals, the tax debate isn’t that simple, because it’s taking place in the context of immense projected future deficits and a welfare state that seems unsustainable without substantial increases in revenue. Given these realities, fairness and progressivity are necessarily less important to liberalism over the long run than simple dollar figures, and the American left actually has a long-run incentive to make the federal tax code less progressive, because only a broader base can keep the liberal edifice solvent in the long run. [Emphasis added.]

While it may be quite pleasant to imagine that the tax code can be used to arbitrate fairness across social classes (a bullshit concept if there ever was one), the simple reality is that taxes have only one fundamental purpose:  revenue.  That’s it.
Taxes exist to generate revenue to the government.  Thus, while it may be pleasant to imagine soaking the rich with a 90% income tax rate—in the name of fairness, of course—the reality is that this attempt at soaking the rich will inevitably lead to a decrease in tax revenues for the very simple reason that people simply do not like having large portions of their income taken away from them by jack-booted parasites.  Thus, in the long run, the tax code must conform to fiscal reality instead of nebulous concepts of social fairness.  The liberal vision of social fairness is literally unaffordable, and this must inevitably be reflected in the tax code.
The more rational approach to taxation is exactly what Douthat recommends:  increase the tax base and keep rates lower.  This would effectively mean lowering marginal tax rates on the wealthy and actually imposing real income taxes on the bottom two brackets.  This won’t be fair, per the liberal definition, but it will ensure that the government remains funded.  Of course, once poor moochers have teeth in the game, they may decide that they don’t want to pay the government for overpriced, substandard services.  But then, those who are poor often tend to be short-sighted and foolish, and so it is also conceivable that they will learn nothing from history, and thus condemn themselves to a life of dependency.  But at least they’ll have skin in the game.

Tax Stupidity

There are a lot of people calling for raising taxes. Tom Coburn (a Republican, it should be noted) is in favor of increasing tax revenue by raising nominal rates on the wealthy. Daniel Berger thinks it’s unfair that the rich (himself excepted, of course) don’t pay their fair share. These two stories, then, reveal the two main arguments for increase tax rates on the wealthy: increasing revenue and making society fairer. Unfortunately, these two arguments have nothing to do with reality.

It’s surprising that anyone seriously thinks that raising relatively high tax rates to an even higher level will automatically lead to higher revenues. Britain tried this last year by raising the top income rate on millionaire earners to 50% and saw a £7 billion decrease in tax revenue. California attempted to create the highest state income tax in the nation and saw its revenue fall as well. Furthermore, federal tax revenues actually increased after the Bush tax cuts. Clearly, the argument that increasing revenue is as simple as raising tax rates is demonstrably false.*

What’s interesting, though, is that a progressive tax system doesn’t actually alleviate unfairness (aka inequality). California and New York, for example, have two of the most progressive tax codes, relative to other states. They also have a surprising amount of income inequality, relative to other states. Of course, correlation is not causation. But the absence of correlation should certainly indicate the absence of causality (since the theory is that progressive tax rates reduce income inequality, the complete absence of this theory in practice should lead to the conclusion that this theory is complete and utter bunk).

Why it is the case that progressive tax rates don’t lead to greater income equality is difficult to discern. Perhaps it is the case that, in response to increased taxes, the moderately wealthy leave while the uber-wealthy stay. Perhaps there is a connection between progressive tax rates and expansive regulation, with said regulation tending to benefit the wealthy. Perhaps the progressive tax system is a mirage of nominally tax rates coupled with lots and lots of loopholes. Perhaps God hates progressive and loves nothing more than a good joke at their expense. Perhaps the elite exploit progressive naiveté for gain. Whatever the case may be, it appears that it’s time to refrain from arguing that progressive tax rates make things fair.

At any rate, it should be clear that the two main reasons for increasing nominal tax rates are nothing more than crap. Raising rates doesn’t increase revenue, nor does it make things more fair. Now, let’s stop pretending that it does.

* Of course, this doesn’t mean that decreasing tax rates necessarily leads to a revenue increase. The Laffer curve suggests that there is a revenue-optimal tax rate between 0% and 100%. Where this specific point is for federal revenue is unknown, but history suggests that revenue will not generally exceed 20% of GDP, and that optimal tax rates generally tend to be below 50%. My personal opinion is that, assuming a highly simplified tax code (one or two collection points and few to zero loopholes), the optimal tax rate will be in the low to mid twenty percent range.

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Tax Myths

A somewhat strange myth has taken hold in some precincts of American conservative opinion that some vast swathe of the population isn’t paying taxes. In fact everyone pays sales taxes and other state and local taxes, and as Adam Looney and Michael Greenstone write for the Hamilton Project almost all working-age people pay federal tax on their income.

The main bloc of people who don’t pay income or payroll taxes are elderly people. Old people tend not to work, and many old people don’t have much in the way of investment income either. But it’s not like they’re freeloading, they’re just people who paid taxes in the past when they were working.

There are a couple of points worth making.

First, Yglesias is correct in noting that technically everyone pays taxes. Some taxes are direct, like fees for federal services, sales taxes, payroll taxes (which are generally only avoided by student workers, a handful of other workers, and the unemployed), and a few other taxes besides. Furthermore, everyone pays taxes indirectly, in the form of foregone goods and services. Corporate taxes are a perfect example of this, and some limited taxes (think: capital gains) also have indirect costs. Thus, to say that no one pays taxes is technically incorrect and highly misleading. If conservatives continue to say that there are a large number of people who don’t pay any taxes, they will find themselves facing political problems later.

Second, the more technically correct claim would be that there are large numbers of people who don’t have any income tax liability. This could mean that some people don’t earn enough to be charged taxes, it could mean that some people are able to claim enough deductions to avoid having to pay taxes, or it may be that someone is able to claim enough tax credits to negate their tax burden. Not having an income tax liability does not necessarily make one a parasite on the system, and given that a large number of current non-tax-payers have basically paid taxes for fifty or more years, painting them as lazy or as parasites, or as evidence that the system is on the verge of collapse is likely not going to go over very well politically.

Finally, the correct response to this issue should be two-fold. Conservatives should use this issue to argue for generally lower tax rates for all, in the name of fairness. Instead of raising taxes on current non-payers, conservatives should argue for lowering rates on current payers. In keeping with this, conservatives should also call for radical spending cuts. Ideally, conservatives would cut out all unconstitutional spending, which would cut the current budget by roughly 60%. In lieu of this, a spending cut of at least 45% would be acceptable.

At this point in time, conservatives have a good opportunity to cut taxes and reduce government spending. As long as they understand the reality of non-payers and take pains to not put their collective feet in their collective mouths, and as long as they hammer home spending cuts (hopefully in a more serious manner than Paul Ryan), they should have a chance at actually making a difference.

International Economics

In which I disagree with Captain Capitalism:

Arguably the single largest threat to freedom in the world is the “harmonization” of tax rates. Of course politicians like to use euphemisms so the ignorant masses can continue on watching their Lady Gaga or the latest professional sports competition, but trust me it is a threat. The reason why is if tax rates are “harmonized” then there is no incentive for business, investment or labor to go to one country versus another. And if tax rates are moved in conjunction with one another, then the governments essentially form an OPEC-like cartel ensuring that labor and capital are more or less trapped at their home country. Since there is no advantage to moving investment and labor to one place or another, governments (if working together) and implement whatever policies they want on their people because “where you going to go? Every place is the same.”

Tax rates are not the only concern, or even the largest, for a company looking to build overseas. Labor costs and capital costs are larger concerns for most companies since capital and labor tend to be the largest expenses a business faces. The reason companies chartered in America build crap in China isn’t because taxes are lower in China but because labor is cheaper in China.

I’m not trying to suggest, of course, that tax rates don’t factor in to the decision to locate overseas. I’m simply saying that taxes are, for the most part, a marginal concern, which in turn means that the claim that “there is no incentive for business, investment or labor to go to one country versus another” is simply economically ignorant.

What went wrong with supply-side economics?

The economic crisis of 2008/2009 had confronted the mainstream economic theory with an unpalatable task of revisiting the notions and perils of the ideas which dominated the course of economic theory in the last few decades. In 2003, delivering a speech to the American Economic Association, Robert Lucas famously noted that the central problem of depression prevention had been solved by mainstream macroeconomic theory which was built by combining the rational expectation hypothesis with New Keynesian macroeconomics. Although one should not obscure the achievements of new classical macroeconomics and new Keynesian macroeconomics, the criticism of contemporary macroeconomic theory is not uniform. It stems from the unrecognized role of systemic shocks in the financial sector and the spillovers from Wall Street to the Main Street. In contemplating the the linkages of over-leveraging and biased financial deregulation, it should not come as a surprise that early warnings of the financial crisis, mainly leveraged borrowing in the U.S subprime mortgage market, were earmarked in the mainstream economic theory.

In fact, in 1970, George Akerlof’s influential paper on the issue of adverse selection in the market for lemons, was a landmark achievement in the economic theory since it demonstrated the fallacies of perfectly competitive market mechanism when the information on quality of various commodities is distributed unevenly. In addition, a series of papers in 1970s by Joseph Stiglitz on screening theory and asymmetric information, has dealt exactly with the central origins of the 2008/2009 financial crisis. Subprime loans and highly-complex derivative schemes which enabled the exponential growth of overleveraging of the banking sector were most likely to be used by the least sophisticated and accordingly the most risky borrowers. The only difference is that in normal circumstance, banks would recognize adverse selection by rationing credit to risky borrowers but the continuous obsession with home-ownership and the reluctance of the Federal Reserve to “remove the bowl of punch when the party started” – to use the analogy of Preston Martin, former Vice President of the FED – added to the turbulence of overleverage that turned into the most disastrous financial meltdown after the Great Depression.

The fact is that contemporary macroeconomics had little to offer to predict the subsequent financial meltdown although Robert Shiller of Yale University has repeatedly warned against unstable stock market fundamentals, particular notorious price-earnings ratios after the dot-com bubble came to burst. However, the central element of the critic of mainstream economic theory should revisit the notorious paradigm of supply-side economics whose intellectual melange of fervent belief in tax cuts and a dangerous preoccupation with deregulation as the cure of the malaise which led to stagflation in early 1970s, have proved how dangerous the conclusions could become.

First, the rise of the supply-side economics in the political economy began in early 1980s. But the intellectual influence of the supply-side economics should not be confined to the theoretical paradigm itself. The field of the political economy of taxation manifested itself as the intellectual triumph of supply-side economics. The original idea of the Laffer curve, the relationship between tax rate and tax revenues, was not disputable after all. In fact, if tax rates reached predatory levels, decreases in total tax burden would yield considerable gains, not only in total tax revenue but also in terms of higher level of productivity. However, when average and marginal tax rates were at moderate levels, it would be foolish to believe immense revenue gains would ensue by reducing the rates of taxation to bottom-levels, arguing for significant gains in terms of employment growth, productivity boost and total tax revenues. Even though cross-country empirical evidence does suggest an increase in tax revenues amid the decline in average tax rate, the pattern is confined to the episodes where average and marginal tax rates were very high, exceeding 70 percent threshold. Once tax rates were reduced, there is no evidence of higher revenue gains.

The major peril of supply-side economics is the claim that tax reduction would boost the aggregate supply and stimulate productivity growth. On the other hand, the valuable contribution of supply-side economics is the notion that additional tax increases do not generate much higher revenue. One should not feel reluctant to recall the 1964 Kennedy-Johnson tax cut which decreased marginal tax rates substantially. Although supply-side economics has repeatedly blasted the intelectual heritage of Keynesian macroeconomics, the 1964 tax reform was itself a Keynesian prescription for the U.S recession in the years prior to Vietnam war. Back in early 1960s, Paul Samuelson wrote that “Congress could legislate, for example, a cut of three or four percentage points in the tax applicable to every income class, to take effect immediately under our withholding system in March or April, and to continue to the end of the year.” (link). Therefore, Samuelson’s mindful observation that additional spending would not automatically counteract the recession unless complemented by tax reductions, probably would not come due in the framework of supply-side economics. Moreover, what distinguished the supply-side economics from the framework of sound economic analysis taught in microeconomic and macroeconomic textbooks, was adverse propensity to enforce tax cuts for the rich while leaving the middle class and low-income households no pie from tax reductions. The striking features of income inequality in the U.S. suggest that from 1970s, median household income stagnated (link) while top 5 percent of households have received disproportionately windfall gains from tax reductions up the point where more than 85 percent of total income was earned by top 5 percent of households (link). Moreover, one should distinguish between patterns of good and bad inequality as Gary Becker recently suggested (link). It is envitable that income inequality has some great value in the society when market outcomes lead to better overall health, less stress and higher standard of living and the evidence is yet inconclusive whether the narrowing of income inequality would return health improvements for the poor – since poor health outcomes of low-income households are mainly attributed to deteriorating dietary habits and dangerous lifestyle.

While bad inequality, especially rents from non-market outcomes, have precipitated the decline in good inequality in the last two decades, there is an overwhelming evidence that stagnation of median household income (despite moderate productivity improvements) caused a somehow lower quality of the U.S. labor force and a widening gap in educational achievements of American children. The drawbacks of widening inequality were largely ignored by supply-side economics or justified on the hands-off approach to the issues of the poor. It should not be forgotten that negative income tax, which favored low-income families, was suggested by Milton Friedman, whom supply-siders have taken for the intellectual father without a detailed knowledge of his precious contribution to economics.

Second, supply-side economics has been perhaps known for favoring the deregulation as the cure for social ills and staggering income growth. Despite substantial euphoria caused by the pioneers of deregulation of banking and financial sector, the regulatory framework eventually jeopardized sound regulation that could prevent hazardous outcomes as shown in the seminal work of George Akerlof and Joseph Stiglitz. In fact, deregulation of the banking sector, hailed by supply-side economics as the triumph of its own ideology, laid the basis for rigorous financial innovation by special investment vehicles (SIV) and shadow banking institutions.

In fact, deregulation of the banking and financial sector was not the central issue per se. The main systemic flaw was rather the adoption of unsound regulation that did not predict the perils of over-leveraged banking sector and especially the system-wide spillovers during the financial crisis. Moreover, the loosening of the monetary policy and the series of fiscal stimulus have notified two main drawbacks in the macroeconomic outlook. The first is the invariant postponement of taxation fuelled by the mountain of government debt. And the second is the hidden explosive potential for inflation following the flood of money supply in the balance sheet of the banking sector.

Generally speaking, the intellectual adventure of supply-side economics has overlooked the possibility of pitfalls brought up by rigorous tax cuts to the wealthy and deregulation of banking and financial sector. It would not come due to label mainstream economic theory as a cataclysm which the financial crisis proved accordingly. It would be either insensible to tarnish the useful contribution of supply-side economics. In fact, tax cuts do generate systemic incentives, particularly in the response of the labor supply to tax reductions. However, the elusive quest for higher growth and job creation after reducing tax rates for the wealthy, is an important lesson we should learned from the unfortunate turn of supply-side economics in favoring deregulation without acknowledging the possibility of systemic banking collapse and the consequences carried over by society at large.

Bush Tax Cuts and Economic Growth

In 2001 and 2003, former U.S president George W. Bush signed Economic Growth and Tax Relief Act (EGTRAA) and Jobs and Growth Tax Relief Reconciliation Act (JGTRAA). EGTRAA reduced personal income tax rates, increased child tax credit, decreased estate tax and introduced a various range of tax-favored retirement savings plans. In 2003 when EGTRAA was enacted, the Congress cut the top capital gains tax rate from 20 percent to 15 percent while the individual dividend tax rate was reduced from 35 percent to 15 percent.

Bush tax cuts are set to expire in 2011. Hence, a bold increase in marginal tax rates is expected. David Leonhardt recently asked whether the Bush tax cuts were good for economic growth amid the fact that under Bush administration, the U.S economic growth was the lowest since the World War II. Eight years of Bush administration were known for the largest expansion of federal government spending compared to the six preceding presidents. In eight years, President Bush increased discretionary federal outlays by 104 percent compared to 11 percent increase under President Clinton.

Under Bush tax cuts, the reduction in personal income tax rates was imposed across all income brackets. Tax Policy Center estimated that extending Bush tax cuts in 2011 would increase the after-tax income across all income quintiles but it differed substantially. For instance, the increase in after-tax income in the lowest quintile would represent 12.19 percent of the increase in after-tax income of the highest quintile. The average federal tax rate would decrease by 2.5 percentage points. The reduction in average federal tax rate would be the most significant for top 1 percent and 0.1 percent cash income percentile, -3.8 percentage points and -4.4 percentage points respectively. Assuming the extension of the Bush tax cuts, the average federal tax rate, which includes individual income tax rate, corporate income tax rate, social security, Medicare and estate tax, would be substantially lower compared to Obama Administration’s FY2011 Budget Proposal. The increase in the average federal tax rate would be roughly proportional across the cash income distribution. The federal tax rate would increase by 1 percentage point for the lowest quintile and 3.1 percentage point for the top quintile. The federal tax rate would for earners in top 1 percent of cash income distribution would increase by 4.2 percentage point. The chart shows the distribution of average effective tax rates and current law and current policy of Bush tax cuts not assumed to expire in 2011. The current proposal would increase the effective tax rate across all income quintiles. The highest increase (3.3 percentage points) would hit the earners in top 20 percent of income distribution.

Effective Tax Rates: A Comparison
Source: Urban-Brookings Tax Policy Center Microsimulation Model

The expiration of the Bush tax cuts would substantially increase the effective tax burden across the cash income distribution. Recently, Center on Budget and Policy Priorities estimated that letting the Bush tax cuts expire would create a net gain of $22 billion in economic activity. Hence, allowing high-income tax cuts expire would, on impact, result in a net gain of $42 billion in economic activity which is about five times the economic stimulus from extending high-income tax cuts.

The years of the Bush administration were earmarked by the escalation of federal government spending both in absolute and relative terms. The growth in federal government spending was driven mostly by discretionary defense spending while non-discretionary federal outlays increased as well. Since 2001, the federal government spending in the Bush administration increased by 28.8 percent with a 35.7 percent growth in non-defense discretionary spending. The growth of the federal government under Bush administration was the highest since the presidency of Lyndon B. Johnson and Richard Nixon. The Independent Institute compared the growth of federal government spending from Lyndon B. Johnson onwards.

Letting the Bush tax cuts expire would probably not impose a negative effect on small businesses since less than 2 percent of tax returns in the top 2 income brackets are filed by taxpayers reporting small business. William Gale contends that the Bush tax cuts significantly raised the government debt. The economic consequences of the 9/11 and wars in Iraq and Afghanistan were detrimental. William Nordhaus estimated that the total cost of war in Iraq between 2003 and 2012 could exceed $1 trillion in 2002 dollars considering unfavorable and protracted cost scenario. To a large extent, the wars in Iraq and Afghanistan have added substantially to the increase in government spending. However, even after excluding defense outlays from the spending structure, the increase in non-defense discretionary spending exceeded the growth of the federal government spending by 5.6 percentage points. Between 2000 and 2008, the number of federal subsidy programs increased from 1,425 to 1,804 – a 26 percent increase compared to 21 percent increase during Clinton years.

The Bush tax cuts failed to result in a Laffer curve effect mostly because they were implemented alongside a bold and significant increase in federal government spending. Had a substantial reduction in government spending been enforced, the tax cuts would not place should an enormous weight in the growth of federal debt. Higher federal debt would inevitably ponder the structural fiscal imbalance. Since debt interest payments would increase, a combination of tax cuts and spending growth would stimulate investment demand, creating an upward pressure on interest rates, especially during the economic recovery when the difference between potential output and real output is expected to diminish.

Critics of the Bush tax cuts often claim that cuts amassed a growing fiscal deficit. However, in 2007, the fiscal deficit stood at 1.2 percent of the U.S GDP while in 2009, the deficit increased to 9.9 percent of the GDP as a result of $787 billion fiscal stimulus from Obama Administration. Since tax cuts were enacted in 2001 and 2003 respectively, something else is to blame for the deficit.

U.S Federal Debt: Long-Term Forecast
Source: Office of Budget and Management; author’s own estimate

The main premise of the economic policy of the Bush administration had been a significant increase in federal government spending. Spending policies were mostly aimed at covering the growing cost of the Iraqi war. In addition, domestic non-defense outlays on social security and domestic priorities grew significantly, creating an upward pressue on federal debt. The growth of entitlments such as Social Security and Medicare poses a serious long-term risk regarding the sustainability of federal government spending. In the upper chart built a simple forecasting framework to estimate the long-run level of U.S federal government debt as a percent of the GDP. Surprisingly, time trend accounts for 85 percent of the variability of the share of federal debt in the GDP. A more robust framework would include the lagged dependent variable and several regressors in the set of explanatory variables to increase the share of variance explained by independent effects of regressors. The results indicate that by 2020, the federal debt could easily reach the 90 percent thresold.

The growing stock of entitlements such as Social Security and Medicare are central to understanding the looming pressure on federal budget to tackle the challenges of ageing population and demand for health care. The tax cuts imposed by the Bush administration reduced average federal tax rates across quintiles in cash income distribution. However, tax cuts were no supplemented by the reduction in federal government spending. Consequently, the growth of federal government spending increased future interest debt payments and failed to take into account the long-term pressure of Medicare and Social Security on federal budget set. Extending the Bush tax cuts would be superior to letting them expire. But lowering tax burden should nevertheless be comprehended by the reduction in federal government spending.

The Lesson of Warren Harding Revisited

Though I have written extensively about the Recession of 1920, it is worth revisiting it per Glenn Beck’s show last night.  Beck rightly pointed out that the policies of decreased taxes and decreased government spending implemented by both Harding and Coolidge paved the way for the dramatic economic growth of the roaring 20s. What Beck didn’t mention was that prior to this period of unprecedented economic expansion, President Warren Harding had inherited one of the worst recessions in American history.   This Recession of 1920-21 is another one of the dirty secrets glossed over in the Progressive history books.

By late 1919, America was facing inflation in prices as measured by CPI of 20%.  Between 1920 and 1921, unemployment doubled from 5.2 to 11.7%.  During this same period, from their peak in June of 1920, prices declined by 15.8% on a year-over-year basis, a 50% greater deflation in prices than during ANY 12-month period during the Great Depression.  So what was Harding’s proposal to deal with this mess? To understand how to get out of recession, Harding looked towards how we got into it in the first place.

For America was coming out of World War I.  Government was controlling huge swaths of the economy, as it had mobilized land, labor and capital towards war production and away from normal commerce as dictated by consumer demand.  In addition to the mass of resources that needed to be reallocated according to market forces, the economy had been further distorted due to the policies of the Federal Reserve which had inflated the money supply by 71% from 1913-1919 (while the physical volume of business had only increased by 9.6%), and whose policies had led to an increase in prices of a staggering 234% between 1914 and 1920.  Prices needed to readjust according to the reallocation of resources.  In addition, not surprisingly, due to the costs of war, the federal budget had grown to $18.5bn.

One will note the parallels to our economic situation today.  Just as war led resources to be allocated away from where an unfettered economy would have directed them, so too did the artificial boom fueled by the Federal Reserve and various government policies lead resources to be misallocated towards assets such as houses and stocks during our most recent boom and bust cycle.  While unsustainable businesses and concomitant rises in prices developed in the private sector, the government too drastically increased.

Harding understood the root cause of recession.  As he noted in his inaugural address:

The economic mechanism is intricate and its parts interdependent, and has suffered the shocks and jars incident to abnormal demands, credit inflations, and price upheavals. The normal balances have been impaired, the channels of distribution have been clogged, the relations of labor and management have been strained. We must seek the readjustment with care and courage…All the penalties will not be light, nor evenly distributed. There is no way of making them so. There is no instant step from disorder to order. We must face a condition of grim reality, charge off our losses and start afresh. It is the oldest lesson of civilization.

And so what was his big Keynesian stimulus plan to bring the economy back from the abyss?  He argued during his Republican nomination speech:

Gross expansion of currency and credit have depreciated the dollar just as expansion and inflation have discredited the coins of the world. We inflated in haste, we must deflate in deliberation. We debased the dollar in reckless finance, we must restore in honesty. Deflation on the one hand and restoration of the 100-cent dollar on the other ought to have begun on the day after the armistice, but plans were lacking or courage failed. The unpreparedness for peace was little less costly than unpreparedness for war. We can promise no one remedy which will cure an ill of such wide proportions, but we do pledge that earnest and consistent attack which the party platform covenants. We will attempt intelligent and courageous deflation, and strike at government borrowing which enlarges the evil, and we will attack high cost of government with every energy and facility which attend Republican capacity. We promise that relief which will attend the halting of waste and extravagance, and the renewal of the practice of public economy, not alone because it will relieve tax burdens, but because it will be an example to stimulate thrift and economy in private life.

And so, shockingly Harding practiced what he preached.  Regarding deflation, the Federal Reserve jacked up interest rates from 4.75% in January 1920 to 7% in June 1920, and held this rate through the aforementioned major drop in prices through May of 1921.  Harding slashed the federal budget from $18.5bn in 1919 to $6.4bn in 1920 all the way down to $5.1bn in 1921.  Meanwhile, the government actually ran surpluses during these years, allowing them to pay down the debt by $300mm from 1920-21.  The Chief Economist of Chase National Bank of the era, Benjamin Anderson summed Harding’s philosophy and his attack on the recession as follows:

The idea that a balanced budget with vast pump-priming government expenditure is a necessary means of getting out of a depression received no consideration at all. It was not regarded as the function of the government to provide money to make business activity. It was rather the business of the US Treasury to look after the solvency of the government, and the most important relief that the government felt that it could afford to business was to reduce as much as possible the amount of government expenditure, which had risen to great heights during the war; to reduce taxes—but not much; and to reduce public debt.

Nor did the government increase public employment with a view to taking up idle labor. There was a reduction in the army and navy in the course of these years, and there was a steady decline in the number of civilian employees of the federal government. This policy on the part of the government generated, of course, a great confidence in the credit of the government, and the strength of the gold dollar was taken for granted. The credit of the government and confidence in the currency are basic foundations for general business confidence. The relief to business through reduced taxes was extremely helpful.

According to Anderson, how did the recession end?

…we took our losses, we readjusted our financial structure, we endured our depression and in August 1921 we started up again. The rally in business production and employment that started in August 1921 was soundly based on a drastic cleaning up of credit weakness, a drastic reduction in the costs of production, and on the free play of private enterprise. It was not based on governmental policy designed to make business good.  (See Benjamin Anderson’s Economics and the Public Welfare or his gratisThe Return to Normal“)

Now we can debate fiscal and economic policy all day, but across the spectrum, it should be clear to all that a government that intervened and created the conditions for economic crisis will not be able to solve it.  If government’s can create prosperity when the private sector is imperiled, then why would Americans be against government central planning when all is rosy?  Do the rules of economics not apply during downturns?

If we can agree that recessions are the result of resources being improperly allocated, then we can also agree that the only way to return to economic health is to allow for their reallocation according to the market.  This involves allowing nonproductive business ventures to go belly-up, prices to naturally fall where they have unjustifiably risen and reduction in the size of government allowing resources to be released to entrepreneurs to reverse the ills of the artificial boom and spur growth.  All measures that impede the natural cleansing of an economy will only ensure pain and suffering like that witnessed over the last few decades in Japan.  Harding had things right and it would do our lawmakers good to follow his lesson: central planning and government control creates problems; innovative Americans are the only ones who can solve them.

A Modest Proposal for a Move to the Left

The “Laffer Curve” first came to public prominence back in the heyday of Reaganomics and “supply side” ideas. The concept is simple and, once you think about it, obvio

us (I say “once you think about it,” because even though it’s been around since the 14th century, it took Arthur Laffer to get people thinking about it).

What the Laffer Curve tells us is that the “optimal” tax rate t — the rate which will produce the most revenue for government — is less than 100%. There’s a tipping point in tax rates beyond which people work less and produce less, creating less wealth to tax, than they otherwise would have. This is because they’re not keeping as much of what they earn, making the earning of it less attractive. If the tax rate is x%, you get out of bed and go to work even if you have the flu; if the tax rate is x%+1, you take a sick day if you wake up with the sniffles, or maybe you pad your week of paid vacation out with a couple of unpaid days off on either side. The Laffer Curve treats that in the aggregate — everyone’s “tipping point” can be different, but there’s still an overall tipping point at which increasing taxes would decrease, rather than increase, government revenues and vice versa.

One problem with the Laffer Curve as illustrated: 100% taxation would probably not produce zero government revenue. Even in the most complete state socialist system — a system where every dime you earn goes to the government, which doles part of it back out to you in “benefits” — some people would continue working right up to the minute the system was overthrown.

Anyway, here’s the thing: Reaganites and other “conservative” politicians love the Laffer Curve because it allows them to promise tax cuts and maintenance of the welfare state. That’s been the mantra since the 1980s: “We can cut taxes and still grow the federal budget — our revenues will go up, not down, because we’re on the right side of the Laffer Curve!” This is a great way to sell tax cuts (and the politicians who promise them) to those who are directly employed by government or who depend on a government check, a government contract, etc. for their livings.


Reducing the size, scope and power of government is a worthwhile end aside from the issue of how heavy the tax burden is. Increased government revenues are a bad thing, because most of what government gets up to is mischief of one sort or another.

More government revenue means more drug warriors prowling the streets and locking people up for possession of unapproved plants.

More government revenue means more education bureaucrats sending more money to more “public” schools to teach our sons and daughters how to not read, not do math, not learn science and not know history.

More government revenue means more “national greatness” idiots sending more troops to far-off places to prove how big America’s penis is.

More government revenue means more money coming out of your pockets and flowing into the bank accounts of the various privileged elites who lobby Congress for subsidies, protections and other favors.

More government revenue means more government.

So, when someone tells me that a tax cut will enhance government revenues, my reaction is “the tax cut you’re proposing isn’t big enough.” There may even be a point at which a tax cut which keeps the rate to the right of the Laffer Curve’s t is a bad idea because the evils the enhanced government revenue will pay for outweigh the evil of the marginally higher taxes themselves. I don’t see that point as calculable, so it’s not worth belaboring, but it seems theoretically likely.

Setting aside the possibility of abolishing taxation entirely (a worthy goal!), the least we can do is work to get taxation over to the left side of the Laffer Curve — to the point where politicians who want to grow government have to try to sell the public on a tax increase to pay for that growth, instead of being able to have it both ways.

How do we know that we’re to the left of t? Once again, there’s that calculation problem — this isn’t a zero sum game, since tax cuts feed money back into the economy and strengthen it. The best we can do (as long as we insist on keeping government around, anyway) is cut taxes and then cut taxes, and then cut taxes some more, while keeping an eye on government revenues to see when they start going down (and then keeping an eye on them after that, too — t will probably move downward as lower taxes improve the economy, making more people more prosperous and thus more able to say “screw it, I’m taking the day off — government would just take x% of what I earned anyway”).

My income tax cut proposal (in lieu of repeal of the tax until we can get that) is for a regular, annual increases to the personal exemption. Tying that into a project to get us onto the left side of the Laffer Curve would entail reviewing the results of the increased exemption each year. Did government revenues go up, or did they go down? If they went up, then the exemption needs to be increased even more. If they went down, hey, we’re on the left side of t! We’re actually cutting government, not just taxes! At that point, some will argue that it’s time to stop cutting taxes. But (I say, with a cryptic politician’s smile) let’s cross that bridge when we come to it.