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The End of Prosperity: How Higher Taxes Will Doom the Economy.

The End of Prosperity: How Higher Taxes Will Doom the Economy

By Arthur B. Laffer, Stephen Moore, and Peter J. Tanous. 2009. New York, NY: Threshold Editions, (Simon and Schuster). Pp. 352, $27.00 hardcover, $16.00 paperback.

Business Economics (2009) 44, 239--240. doi:10.1057/be.2009.31

The Laffer Curve is a controversial idea. But it's not clear why. Economists from Adam Smith to John Maynard Keynes understood the concept and wrote about it. Even so, there are modern day deniers. In 1989, Sen Bob Packwood asked the Joint Economic Committee on Taxation how much revenue could be raised with a 100 percent tax rate on people earning more than $200,000 a year. Answer: enough revenue to balance the budget. In exasperation, Packwood exclaimed, "Our models assume people will work ... forever and pay all of their money to the government. Clearly, anyone in their right mind will not."

The Laffer Curve is also popularly associated with Republican politicians. But it's not clear why that is either. The original supply-sider in the modern era was John F. Kennedy, who cut tax rates for the rich by more than either Ronald Reagan or George W. Bush. Although Republicans at the time attacked the idea as irresponsible, government revenues subsequently went up, not down; and Kennedy's economic advisors claimed the tax cuts were self-financing. Ironically, the economist who has produced the most convincing evidence on the power of the tax policy is Christina Romer--head of Barack Obama's Council of Economic Advisors. Moreover, Laffer himself voted for Bill Clinton not once, but twice. And the presidential candidate who has been the most vocal advocate of his concept of a flat tax is former California Governor Jerry Brown.

Even so, when Laffer and coauthor Steve Moore produced a series of TV ads noting that the Bush tax cuts were part of the Reagan-Kennedy legacy, Senator Ted Kennedy and his niece Caroline asked them to cease and desist. It appears the Kennedy family does not celebrate the full Kennedy legacy.

This book is polemical. And because the authors are such good writers it is, for me, enjoyable. Throughout the history of the income tax, a lowering of the top rate has usually been followed by higher tax payments by the wealthiest taxpayers and vice versa. Similarly, a lower capital gains tax rate has usually been followed by higher capital gains tax revenues. Of course, post hoc does not mean propter hoc. But the authors make a strong case that these events are causally related.

The first half of the book is organized around modern presidents and their economic policies. If you want to keep score, it goes something like this: Kennedy (good), Johnson/ Nixon/Ford/Carter (bad), Reagan (good), Bush 41 (bad), Clinton (mixed), Bush 43 (good on taxes, bad on spending). Obama gives rise to the authors' fear for the future, summarized by the title of the book.

In the chapter on the Kennedy Administration, the authors make a strong case that the President and House Ways and Means Committee Chairman Wilbur Mills knew exactly what they were doing when they lowered the top income tax rate from 90 percent to 71 percent. The Kennedy tax cuts (actually enacted under Johnson) were no fluke--although almost everyone was surprised by the magnitude of the revenue increases following the tax cuts.

When Ronald Reagan (Kemp-Roth Act) cut the top income tax rate from 50 percent to 28 percent, he ushered in what the authors call a 25-year economic boom. Although the Reagan tax cuts did not pay for themselves, the authors cite a Larry Lindsey finding that revenues from the richest taxpayers were actually higher than they otherwise would have been. Moreover, the Reagan years illustrate a feature that describes nearly all supply-side tax cuts--the tax system becomes more progressive as a result.

Interestingly, throughout the Reagan years--and certainly at the end tax revenues (at 19 percent of GDP) were above the postwar average (as they also were after George W.'s tax cuts). The Reagan deficits were produced not by tax cuts but by spending increases--mainly on national defense.

The authors are less convincing on their treatment of the increases in the top tax rate under George H.W. Bush (from 28 percent to 31 percent) and Bill Clinton (all the way to 39.6 percent). Yet after coming out of the mild recession in the early 1990s, the economy kept right on booming and so did tax revenues. Basically, they treat the period from 1981 to 2004 as one continuous, 25-year experiment in supply-side policy including Bill Clinton's push for free trade, welfare reform, and spending control (from 1995 to 2000, spending growth was lower than under any president since Calvin Coolidge). Still, if the tax cuts are powerful stimulants, why weren't these tax increases more of a depressant?

The evidence gets strong again during the administration of George W. Bush. The "middle class" tax cut did nothing to improve incentives and, overall, may have done more harm than good. But the response to the cut in the top rate on capital gains (from 20 percent to 15 percent) and on dividends (from 40 percent to 15 percent) appear to have stimulated significant behavioral responses. From 2003 to 2007, capital gains tax revenues increased 70 percent and dividend tax revenue increased by 31 percent. The upshot: "George Bush soaked the rich by lowering tax rates."

Internationally, it's probably fair to say that the supply-siders have carried the argument in spades. Some 24 countries have adopted the flat tax (including Russia) and almost every country has lowered its top tax rate. The authors cite an Alan Reynolds finding that private consumption and investment in "supply-side economies" has grown at three times the rate as in "demand-side economies."

Back home, however, tax policy is moving in the opposite direction. If President Obama proceeds as promised, the combined federal and state marginal tax rate will exceed 57 percent in New York, California, New Jersey, Iowa, and Ohio. Whereas the authors celebrate a $5.2 trillion inflow of capital since 1980 (thus fueling U.S. economic expansion), they now see foreigners pulling their funds out of the country in response to a fiscal policy more hostile to investment. They are also concerned about rising protectionist pressures--noting that the last protectionist president was Herbert Hoover.

The authors conclude by proposing their own version of the flat tax: a 12.1 percent personal income tax (with a deduction only for rent) and a 12.1 percent value-added tax, for a total tax on consumption of 24.2 percent. I find this proposal attractive, but it would eliminate the use of the tax system to achieve social goals--the two most important of which are saving for retirement and health insurance. Larry Kotlikoff and I discovered that if you want to "force" people to buy health insurance and save for their own retirement, the potential tax threat has to be as high as 30 percent.

Even if they disagree with the policy recommendations, 1 think business economists will enjoy this book. The reason: the author's approach to public policy is purely economic. Economics is the science that studies incentives, and the authors of this book clearly think incentives matter a lot. It is a refreshing read in light of the tendency of political discourse these days to ignore incentives altogether.

John C. Goodman

National Center for Policy Analysis

President & CEO

Kellye Wright Fellow
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Comment:The End of Prosperity: How Higher Taxes Will Doom the Economy.
Author:Goodman, John C.
Publication:Business Economics
Article Type:Book review
Date:Oct 1, 2009
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