This paper was written for the Economic Policy Institute, and presented at a panel on Corporate and High Income Tax Cuts and The Economy:
The Economics, History, and Public Debate of Supply-Side Policies
at the Center for American Progress, Washington, DC, Sept. 12, 2008.
The author would like to Imran Khan for research assistance
and to thank Jack Frankel, Jeffrey Liebman, and EPI staff for useful suggestions.
Politicians have always faced the temptation to give their constituents tax cuts.
But in recent decades “conservative” presidents have enacted large tax cuts that have been anything but conservative fiscally, and have justified them by appealing to theory.
In particular, they have appealed to two theories: the Laffer Proposition, which says that cuts in tax rates will pay for themselves via higher economic activity, and the Starve the Beast Hypothesis, which says that tax cuts will increase the budget deficit and put downward pressure on federal spending. It is insufficiently remarked that the two propositions are inconsistent with each other: reductions in tax rates can’t increase tax revenues and reduce tax revenues at the same time. But being mutually exclusive does not prevent them both from being wrong.
The Laffer Proposition, while theoretically possible under certain conditions, does
not apply to US income tax rates: a cut in those rates reduces revenue, precisely as
common sense would indicate. As detailed in the paper, this was the outcome of the two big experiments of recent decades: the Reagan tax cuts of 1981-83 and the Bush tax cuts of 2001-03, both of which contributed to record US budget deficits. It is also the conclusion of more systematic scholarly studies based on more extensive data. Finally, it is the view of almost all professional economists, including the illustrious economic advisers to Presidents Reagan and Bush. So thorough is the discrediting of the Laffer Hypothesis, that many deny that these two presidents or their top officials could have ever believed such a thing. But abundant quotes suggest that they did. The Starve the Beast Hypothesis claims that politicians can’t spend money that they don’t have. In theory, Congressmen are supposedly inhibited from increasing spending by constituents’ fears that the resulting deficits will mean higher taxes for their grandchildren. The theory fails on both conceptual grounds and empirical grounds.
Conceptually, one should begin by asking: what it the alternative fiscal regime to which Starve the Beast is being compared? The natural alternative is the regime that was in place during the 1990s, which I call Shared Sacrifice. During that time, any congressman wishing to increase spending had to show how they would raise taxes to pay for it. Logically, a Congressman contemplating a new spending program to benefit some favored supporters will be more inhibited by fears of constituents complaining about an immediate tax increase (under the regime of Shared Sacrifice) than by fears of constituents complaining that budget deficits might mean higher taxes many years into the future. Sure enough, the Shared Sacrifice approach of the 1990s succeeded in eliminating budget deficits, and did so to a substantial degree by cutting the growth of spending. Compare this outcome to the sharp increases in spending that took place when President Reagan took office, when the first President Bush took office, and when the
second President Bush took office. As with the Laffer Hypothesis, more systematic
econometric analysis confirms the rejection that these episodes suggests.
These matters are not solely of interest to historians or economists. As of the
time of writing, the presidential campaign of Senator John McCain appears set to drive its wagon down the same road in which Reagan and Bush have already worn deep ruts. The candidate is apparently selling the same snake oil: he says he believes that tax cuts increase revenues. His principle policy director disavows the Laffer Principle, just as the economists who advised Presidents Reagan and Bush did. But the views of the economic advisers become irrelevant when the candidate takes office.
The Queen in Alice in Wonderland said that, with practice, she was able to
believe as many as six impossible things before breakfast. Most of us are more limited
in our capacity for credulity. If John McCain believes both the Laffer Proposition (tax
cuts raise revenues) and Starve the Beast (higher revenues lead to higher spending, anathema to conservatives), then as a good conservative, his duty is clear. He ought to run on a truly novel platform of higher tax rates! Why? Higher tax rates would reduce revenues (this is what Laffer says would happen) and thereby reduce spending (this is what Starve the Beast says would happen).
If McCain continues to propose extending the Bush tax cuts, he should at least be
forced to choose between the Lafferite defense and the “Starve the Beast” defense. Only then can the rest of us know which of the two mutually inconsistent propositions to refute.