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POLICY PERSPECTIVES

tax notes
The Laffer Curve, Part 1
By Bruce Bartlett
Bruce Bartlett is a former Treasury deputy assistant secretary for economic policy. His latest book is The Benefit and the Burden: Tax Reform Why We Need It and What It Will Take (2012). In this article, the first of two, Bartlett examines the origins of the Laffer curve.

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Bruce Bartlett

According to legend, the economist Arthur Laffer first drew his famous curve on a napkin in 1974 for then-White House Chief of Staff Donald Rumsfeld and his deputy, Dick Cheney. The curve shows that there are two tax rates that collect no revenue: 0 percent and 100 percent. Somewhere in between is a rate that maximizes revenue collection. Below that rate, tax rate increases will raise revenue; above it, they will lose revenue. Conversely, on the low end of the Laffer curve, tax rate reductions will lose revenue, and rate reductions for those on the upper end will raise revenue. Laffer has never claimed to have been the first to observe that tax rate increases may lose revenue or that tax rate reductions might raise revenue. Nor is there any evidence that those points were topics of Laffers research before the mid-1970s. Although Laffer had served as chief economist for the Office of Management and Budget during the Nixon administration, his academic work was almost entirely devoted to international economic policy before his infamous curve was born. Its possible that Laffers napkin drawing was the first time he had even thought of the idea.1 As a pedagogical device, no one has ever disputed the curves essential truth that tax or tariff rates can be too high to maximize revenue. The problem has always been calculating where a na-

tion or class of taxpayers is on the curve, empirically; when the Laffer curve achieved its greatest notoriety, that had never been done. Rather, advocates of tax rate reductions, such as former Rep. Jack Kemp, simply asserted their beliefs that the United States was on the high end of the Laffer curve and that much, if not all, of the revenue loss from a tax rate cut would be recouped through greater work, saving, and investment. At the same time, faster economic growth and lower unemployment would reduce the demand for government services and automatically reduce spending to some extent. In fairness, computers and analytical techniques were somewhat primitive in those days. It wasnt really possible to properly analyze a large tax cut. Sufficient computing power and proper statistical data were only just coming into existence. The best that could be done was to use a general macroeconomic forecasting model, such as that maintained by Data Resources Inc. (DRI). Those models were mainly used by corporations to calculate the effect of different economic assumptions on their sectors of the economy. The first economist to use such a model to show that tax cuts might pay for themselves was Norman Ture. He had been an economist at Treasury and for the Joint Economic Committee during the 1950s, where he served as principal economic adviser to House Ways and Means Committee Chair Wilbur Mills, also a member of the JEC. In the 1960s, Ture became director of tax studies for the National Bureau of Economic Research.2 In the 1970s, Ture had his own economic consulting company, where he built a macroeconomic model that he used to analyze tax policies for corporate clients. In 1975 the Business Roundtable contracted with Ture to analyze a tax bill drafted by Kemp and Sen. James McClure, known as the Jobs

1 The first published paper I have found in which Laffer presents his famous curve is Arthur B. Laffer, An Equilibrium Rational Macroeconomic Framework, in Economic Issues of the Eighties 44 (1979).

Among Tures projects at the JEC was the compilation of a still-useful guide to the history and development of the federal tax system. He also acted as an adviser on tax policy to President Kennedy and was part of a group that recommended creation of the investment tax credit. See Bernard D. Nossiter, Business Tax Break Urged, The New York Times (Jan. 28, 1961). Details on Tures career can be found in the hearing on his nomination as Treasury undersecretary in 1981; Senate Finance Committee, Nominations of Norman B. Ture and Beryl Wayne Spinkel (Mar. 30, 1981). See also Irvin Molotsky, Norman B. Ture, Architect of the 1981 Tax Cut, Dies at 74, The New York Times (Aug. 13, 1997), at A21.

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Table 1. Economic Effects of the Jobs Creation Act, 1975 (in billions of 1974 dollars unless indicated)
Years After Enactment
1 2 3 *In thousands.

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Private GNP
151.4 200.5 248.9

Employment*
7,180 9,020 10,910

Capital Outlays
74.6 77.9 81.1

Federal Revenue
5.2 14.6 25.2

Creation Act (JCA). The bill consisted of several targeted business tax cuts designed to stimulate growth and investment, including inflation adjustments for depreciation, an increase in the investment tax credit, and a cut in the statutory corporate tax rate.3 The Kemp-McClure bill was designed to be the Republican alternative to the Democrats Humphrey-Hawkins bill, which would have amended the Employment Act of 1946 to require that federal economic policy be directed toward reducing the national unemployment rate to 4 percent, which was then a common definition of full employment. Tures analysis predicted an extraordinary impact. Table 1 shows that private GDP would rise more than $150 billion in the first year. To put that in context, in January 1976, the gross national product for 1975 was estimated to be $1.5 billion. Netting out government purchases to get private GNP yields a figure of $1.17 billion. Thus, Ture was projecting a 13 percent increase in private GNP the first year that the Kemp-McClure bill was in effect. The impact was so large that the federal government was expected to gain $5.2 billion in net revenue. Total federal receipts in fiscal 1975 were $279 billion; the static revenue loss from the legislation was estimated to be between $12.2 billion and $20.2 billion, according to a 1975 analysis by the Congressional Research Service.4 The JCA was a precursor to the tax bill introduced in 1977 by Kemp and Sen. Bill Roth, which abandoned the business tax provisions of the Kemp-McClure bill in favor of a 30 percent acrossthe-board reduction in statutory federal income tax rates. I joined Kemps staff in early 1977 and inherited the JCA from my predecessor, economist Paul Craig Roberts. I quickly came into contact with

3 The JCA was drafted by Kemps administrative assistant, Randal Teague. He once told me that he compiled its provisions simply by asking corporate lobbyists for their tax wish list. 4 All estimated impact figures are taken from the American Enterprise Institute, Reducing Unemployment: The Humphrey-Hawkins and Kemp-McClure Bills (May 1976). Contemporaneous GNP figures are from the Economic Report of the President, January 1976.

Laffer and Ture. The three of us were instrumental in designing the Kemp-Roth bill. In early work for Kemp, we always emphasized the positive revenue potential of tax cuts based on Tures projections. The Laffer curve often was used to explain how it was possible for tax cuts to increase revenue, a view that most Republicans were highly skeptical of in those days. The real importance of being able to project positive revenues, or at least a lower revenue loss than that projected by standard revenue-estimating models, such as those used by the Joint Committee on Taxation, is that the Budget Act of 1974 had lately come into existence. Unless there was provision in the budget resolution for the revenue loss from a tax cut, it was impossible to even bring one up for consideration in Congress, because it would be subject to a point of order. Thus, by asserting that a tax cut might be selffinancing, we could theoretically skirt the Budget Acts constraints. Of course, that wasnt practically possible, because the only revenue estimates that could be used were those from the JCT or the Congressional Budget Office. Kemp argued that the Kemp-Roth bill was designed to be identical to the Kennedy-Johnson tax cut of the 1960s; therefore, similar results could be expected. He often made reference to an August 1976 CRS memo that supported the idea that the Kennedy-Johnson tax cut paid for itself.5 According to the memo, the estimated revenue loss from the 1964 tax cut was $39 billion over five years. Over that same period, actual revenues rose by $46 billion. Therefore, Kemp said, the tax cut paid for itself. Of course, that was just a claim. For one thing, we had no estimates of what federal revenues would have been in the absence of the tax cut. And of course, inflation was a growing factor in nominal revenue growth at that time. Nevertheless, the raw data were suggestive enough that the JEC, the House Budget Committee, and the CRS contracted with DRI and Wharton Econometric Forecasting

5 For a reprint of the CRS memo, see Bruce Bartlett, Reaganomics: Supply-Side Economics in Action, 226 (1981).

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Associates to retrospectively analyze the revenue effect of the 1964 tax cut. Economists Arthur Okun and Alan Greenspan reviewed the results and commented on them. The joint analysis was published in November 1978.6 Both the DRI and Wharton studies showed the Kennedy-Johnson tax cut to have been highly stimulative, but not enough to offset all the revenue loss. The CBO summarized the results: The direct effect of the tax cut was to reduce revenues by some $12 billion (annual rate) after the initial buildup. The increase in output and later in prices produced by way of the tax cut, according to the models, recaptured $3 [billion] to $9 billion of this revenue at the end of two years. The result was a net increase in the federal deficit of only about 25 to 75 percent of the full $12 billion.7 That analysis appears to have had a profound effect on how the CBO analyzed the Kemp-Roth bill in 1978. Table 2 shows the estimated impact.8
Table 2. Estimated Economic Impact of the Roth-Kemp Tax Cut, 1978 (in billions of 1977 dollars unless indicated)
Indicator
Nominal GNP Percent change Real GNP Percent change CPI inflation Employment* Unemployment rate Direct budget cost Net budget cost *In thousands.

1979
13.4 1.2% 8.3 1% 0.1 169 -0.1 21 16

1980
55 2.1% 30.7 1.8% 0.2 892 -0.5 58 38.4

1981
118.3 2.3% 54.5 1.2% 1 1,803 -1.2 105.7 64.4

1982
185.2 1.5% 62.8 -0.2% 1.7 2,257 -1.5 138.1 74.8

1983
253.7 1.5% 53.3 -1.1% 2.7 2,012 -1.3 164.6 79.1

As can be seen, the CBO estimated that about half the static revenue cost of the Kemp-Roth bill would ultimately be recouped, but largely at the expense of higher inflation. It is forgotten now, but

economists principal criticism of the Kemp-Roth bill was that it would fuel inflation at a time when that was the nations number one problem. In 1978 the Ways and Means and House Budget committees surveyed a large number of prominent economists regarding their opinions on the impact of the Kemp-Roth bill. The overwhelming criticism was that it would be dangerously inflationary.9 Laffer himself never said that the Kemp-Roth tax cut would pay for itself with higher revenues. The most he would say was that if one included the reduction in spending for things like unemployment compensation resulting from faster growth and lower unemployment and the increased revenues that would accrue to state and local governments, then it would come close to being selffinancing within a few years.10 In contrast to his earlier, highly robust revenue forecast of the JCA, Ture was more sanguine about the impact of the Kemp-Roth bill, largely because he always thought that tax cuts for businesses were much more powerful than those for individuals. Even 10 years out, net revenues would be $53 billion lower (in 1977 dollars), according to Tures model. However, he thought private saving would increase far more than that, so that higher deficits would not crowd out private investment. Ture also believed that the Kemp-Roth bill would not be inflationary.11 In 1980 Ronald Reagan endorsed the Kemp-Roth bill and sent a version to Congress, which was enacted in August 1981. In a previous article, I discussed the revenue effects of the Reagan tax cut, showing that they were never projected to pay for themselves and that they did not. Importantly, that tax cut did not stoke inflation, as mainstream economists widely predicted. Ironically, that is a key reason why the 1981 tax cut lost as much revenue as it did; administration economists were depending on bracket creep to offset much of the revenue loss.12 Part 2 will further examine the Laffer curve.

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6 Economic Stabilization Policies: The Historical Record, 1962-76 (1978). 7 CBO, Understanding Fiscal Policy (Apr. 1978), at 25. Note that much of the reflow came from higher inflation resulting from the tax cut. Because the government is more concerned with nominal revenues than real revenues, any increase in inflation was as good as an increase in growth insofar as revenues are concerned. 8 CBO, An Analysis of the Roth-Kemp Tax Cut Proposal (Oct. 1978), at 45.

9 House Budget Committee, Leading Economists Views of Kemp-Roth (Aug. 1978); House Ways and Means Committee, Economists Comments on H.R. 8333 and S. 1860 (Sept. 8, 1978). 10 Bartlett, The New American Economy, 113 (2009). 11 Ways and Means Committee, supra note 9, at 96. 12 Bartlett, The 1981 Tax Cut After 30 Years: What Happened to Revenues? Tax Notes, Aug. 8, 2011, p. 627, Doc 2011-16766, 2011 TNT 152-7. See also Bartlett, Why the GOP Should Stop Invoking Reaganomics, The Washington Post (Feb. 3, 2012).

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