NCPA - National Center for Policy Analysis

FACT, FICTION, AND THE LAFFER CURVE

August 19, 2009

Using real world evidence to demonstrate that certain tax cuts can have a positive impact on economic performance and that "supply-side" tax cuts do not "cost" the government much in terms of foregone tax revenue, Daniel Mitchell, a senior fellow at the Cato Institute and co-founder of the Center for Freedom and Prosperity Foundation, explains how the Joint Committee on Taxation's revenue-estimating process is based on the untenable theory that changes in tax policy -- even dramatic reforms such as a flat tax -- do not effect economic growth.

In other words, the current system assumes the tax rates have no impact on taxable income.  Because of congressional budget rules, this leads to a bias for tax increases and against tax cuts.  But if politicians increase tax rates, people will earn and report less taxable income, says Mitchell:

  • A recent example comes from the state of Maryland, which imposed a higher tax rate on the so-called rich in 2008.
  • This tax increase supposedly was going to generate an additional $100 million for the politicians.
  • Instead, tax collections from rich people fell by more than $100 million.

It is clear that tax policy affects behavior, says Mitchell; yet, amazingly, the revenue-estimating process for tax legislation ignores this fact.  Regardless of the magnitude of the reform, the revenue-estimators assume changes in tax policy have no impact on the economy and no meaningful impact on taxable income.  As a result, this bizarre approach creates a bias for bad tax policy and higher tax rates.

With Obama planning a number of anti-growth tax measures, it is especially important to educate both the general public and policy makers that the Laffer Curve is very real.  Revenues may increase, but the cost to the economy will be far higher than any gain for politicians, says Mitchell. 

Source: Daniel Mitchell, "The Laffer Curve: Understanding the Relationship Between Tax Rates, Taxable Income, and Tax Revenue," Prosperitas (Center for Freedom and Prosperity Foundation), August 2009.

 

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