Everything you know (about tax cuts) is wrong.

One of the oddest ideas of America’s economic right-wing (the so-called supply siders) is the notion that by reducing tax rates, the government can increase tax revenues. On the surface, this seems plainly bonkers. It’s such a deranged notion that iconic one-term Republican President George Bush called it “voodoo economics,” insinuating in his fashion that there was no reason to expect it to work. So why is this crazy idea so widely accepted and preached?

It turns out it’s based (with a few problematic twists and turns) on a fairly sober economic theory. This original idea is called the Laffer Curve, pictured below:

Famously making his calculations on the back of a diner napkin, economist Arthur Laffer (most significantly a Reagan economic advisor) sketched out his curve (representing tax revenues) on the basis of three notions:

1) If the tax rate is 0%, no one pays taxes. Or rather everyone does, but 0% of anything is nothing.

2) If the tax rate is 100%, no one pays taxes. Because presumably they would rather set fire to anyone attempting to collect taxes at that rate.

3) There is some point between 0% and 100% (he called it t*%) at which tax revenues are optimized — extraction is perfectly balanced with disincentivization and the government is getting as much money out of the economy as it possibly can.

The only one of these notions that’s even remotely controversial is the second, and the controversy is so mild as to be entirely negligible.

Laffer made three crucial mistakes in the construction of his curve:

1) He assumed there was only one optimum position.

2) He drew the curve as a parabola.

3) He tried to explain the curve to a bunch of simpletons.

There’s no reason to suppose that the curve would have the gentle regularity of a parabola, nor to suppose that only one optimum taxation point exists. There’s certainly no reason to suppose that t* would lie precisely in the middle between 0% and 100%. But the mistake made by the simpletons is far more grave. They accepted the notion that the current tax rate was well to the right of t*. History has shown that it was not.

 Now some of you have been following me thus far, you know these “voodoo economics”  were a cornerstone of Reagan’s campaign in 1980 and that he slashed the top marginal rate by a full 20% in 1981. You may even have been taught that this action was responsible for the economic recovery of the 1980s.

You have been mislead.

So what did happen when Reagan cut taxes in 1981? Tax revenues dropped, the economy hit the second dip of a double-dip recession, and Ronald Reagan never cut taxes again, aggressively raising them throughout the remainder of his career. The economy didn’t recover until his second term in 1986, and probably through no fault of his.

Nevertheless, “tax cuts increase revenues/help the economy” is firmly cemented in the deranged psyche of the American right, when that’s not even what Laffer said in the first place.

He said that, under certain conditions (which, for the record, have never been shown to exist in the “western” world) it was possible to increase tax revenues by cutting tax rates.

 

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