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September 25, 2012
The Laffer Curve, Part 3
Bruce Bartlett

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Bruce Bartlett (Goodman/Van Riper)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.

In this third and final article on the history of the Laffer curve, Bartlett examines its 20th-century antecedents before the 1970s. Parts 1 and 2 appeared in the July 16 and September 3 issues of Tax Notes, respectively.


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At the beginning of the 20th century, income taxes were relatively rare. But tax theorists were making a strong case for those taxes in lieu of import duties and excise taxes on specific goods, which were the mainstays of the U.S. tax system in 1900. The United States adopted a permanent national income tax in 1913, and rates quickly rose to unexpectedly high levels during World War I. Economists naturally began analyzing the potential effects, with some suggesting an inverse relationship between rates and revenues.

The earliest 20th-century reference I have been able to find to a Laffer curve effect is in a 1901 article by London School of Economics professor Edwin Cannan. While conceding that a 100 percent tax rate on amounts earned that exceed £50,000 (£4.23 million today) would be fair, it would not raise any revenue, he said. After the first year, no one would earn more than that amount (at least where the state could see it), and the revenue yield would be zero.1

The top federal income tax rate rose from 7 percent to 77 percent during the war, and many key aspects of the permanent federal tax system were established.2 In his 1919 State of the Union address, President Wilson called for a reduction in tax rates partially on Laffer curve grounds. The Treasury secretary's annual report that year was more explicit on the idea that high tax rates were actually reducing federal revenue:


    The upmost brackets of the surtax have already passed the point of productivity, and the only consequence of any further increase would be to drive possessors of these great incomes more and more to place their wealth in the billions of dollars of wholly exempt securities heretofore issued and still being issued by states and municipalities, as well as those heretofore issued by the United States.3

Warren G. Harding campaigned on tax reduction in 1920. After the election, he named financier Andrew Mellon as his Treasury secretary. Mellon, who served in that position through the Harding, Coolidge, and Hoover administrations, worked hard to reduce the wartime tax rates and often invoked Laffer curve arguments.4 For example, in his second annual report, Mellon said high surtax rates were "impairing the revenues of the government" and "undoubtedly operating to reduce rather than increase the revenues."5 In his third report, he argued that tax cuts would raise revenue:

    A decrease in the surtaxes to a more reasonable amount would result not only in a more economically sound structure, but would ultimately yield more in revenue to the government out of lower taxes than the government receives out of the higher taxes.6

Through successive tax bills, Mellon ultimately brought the top income tax rate down to 24 percent in 1929 from 73 percent when he took office. However, it is seldom noted that the threshold income for paying the top rate was reduced from $1 million to $100,000 at the same time.7 Some economists argue that the Mellon tax cuts did in fact have a Laffer curve effect -- raising net federal revenue through a combination of higher economic growth and changes in the composition of investment.8

The onset of the Great Depression put unprecedented pressure on federal finances, causing revenues to fall as spending increased. Unlike today's Republicans, who think taxes must never be raised no matter how large the deficit, Mellon supported tax increases when he thought they were necessary.9 The tax policies Mellon championed during the later Hoover years laid the groundwork for those that followed in the Roosevelt administration.10

The United Kingdom raised its taxes, although to a lesser extent because it hadn't reduced its taxes nearly as much as the United States did in the 1920s. Among those who argued against a tax increase was the economist John Maynard Keynes, who said that deficit spending would better promote growth and recovery, thereby raising revenue.11 In a 1933 essay, Keynes made public the private advice he had given to the British Treasury. In it, he invoked a Laffer curve argument:


    Nor should the argument seem strange that taxation may be so high as to defeat its object, and that, given sufficient time to gather the fruits, a reduction of taxation will run a better chance than an increase of balancing the budget. For to take the opposite view today is to resemble a manufacturer who, running at a loss, decides to raise his price, and when his declining sales increase the loss, wrapping himself in the rectitude of plain arithmetic, decides that prudence requires him to raise the price still more -- and who, when at last his account is balanced with nought on both sides, is still found righteously declaring that it would have been the act of a gambler to reduce the price when you were already making a loss.12

In the United States, some economists argued that Roosevelt's "soak the rich" tax increase of 1935 actually reduced revenues. Among them was Harvard economist Joseph Schumpeter, who noted that the Roosevelt administration's own revenue estimates showed that the net revenue increase was minuscule.13 President Roosevelt probably knew that -- his motive in raising taxes on the rich was primarily political, not economic.14

During World War II, several economists wrote about the limits of taxation, especially on labor supply, as the top federal income tax rate reached 94 percent. With wartime tax rates persisting long past the end of hostilities, economists warned that those rates in peacetime might be self-defeating. In 1949 Austrian economist Ludwig von Mises suggested a Laffer curve effect, writing, "Every specific tax, as well as a nation's whole tax system, becomes self-defeating above a certain height of the rates."15

The end of the Korean War did not lead to a significant decline in tax rates, either. The 91 percent top rate established during the war remained in place until 1964. In a 1954 column, Newsweek columnist Henry Hazlitt invoked the Laffer curve to argue for rate reduction: "A sharp reduction in top tax rates below the present level of 91 percent would increase government revenues."16

In the 1960s President Kennedy argued that cutting tax rates could raise revenue. In a December 1962 speech he said, "It is a paradoxical truth that tax rates are too high today and tax revenues are too low and the soundest way to raise the revenues in the long run is to cut the rates now." In Congress, supporters of the Kennedy tax cut often defended it against Republican charges that it would raise the deficit by saying that it would in fact raise revenues.17 Liberals even teased Republicans by invoking Mellon's arguments from the 1920s.18 As early as 1966, the media reported evidence that the Kennedy tax cut may have paid for itself.19

In 1969 Herbert Stein published a history of fiscal policy stating that in the 1920s, a reduction in tax rates would have raised revenue.20 In 1973 Richard McKenzie published an academic journal article arguing for a Laffer curve. "It is distinctly possible on theoretical grounds that statutory rate increases may result in lower tax collections for some groups," he wrote.21

In short, long before Laffer drew his famous curve, it was well established, historically and theoretically, that tax rates may be so high as to diminish revenue and that a rate reduction could raise revenue. The real question has always been where we are on the curve. Republicans implicitly believe we are always on the high end of the curve, while careful empirical analysis says we have a long ways to go before higher tax rates would begin to reduce revenue.22


FOOTNOTES

1 Edwin Cannan, "Equity and Economy in Taxation," Econ. J. 473 (Dec. 1901).

2 Ajay K. Mehrota, "Lawyers, Guns, and Public Moneys: The U.S. Treasury, World War I, and the Administration of the Modern Fiscal State," L. & Hist. Rev. 173 (Feb. 2010).

3 Treasury, "Annual Report of the Secretary of the Treasury, 1919" (1920), at 24.

4 Historians now recognize that the Wilson administration actually laid much of the groundwork for Mellon's efforts. See Benjamin G. Rader, "Federal Taxation in the 1920s: A Re-examination," The Historian 415 (May 1971); Lawrence L. Murray, "Bureaucracy and Bi-partisanship in Taxation: The Mellon Plan Revisited," Bus. Hist. Rev. 200 (Summer 1978); M. Susan Murname, "Selling Scientific Taxation: The Treasury Department's Campaign for Tax Reform in the 1920s," L. & Social Inquiry 819 (Fall 2004).

5 Treasury, "Annual Report of the Secretary of the Treasury, 1922" (1923), at 12.

6 Treasury, "Annual Report of the Secretary of the Treasury, 1923" (1924), at 5.

7 For specifics on the various tax reduction bills of the 1920s, see Roy G. Blakey's articles in the American Economic Review: "The Revenue Act of 1921," 75 (Mar. 1922); "The Revenue Act of 1924," 475 (Sept. 1924); "The Revenue Act of 1926," 401 (Sept. 1926); and "The Revenue Act of 1928," 428 (Sept. 1928).

8 Robert B. Ekelund Jr. and Mark Thornton, "Schumpeterian Analysis, Supply-Side Economics and Macroeconomic Policy in the 1920s," Rev. Social Econ. 221 (Dec. 1986); Gene Smiley and Richard H. Keehn, "Federal Personal Income Tax Policy in the 1920s," J. Econ. Hist. 285 (June 1995).

9 Joseph J. Thorndike, "Was Andrew Mellon the Supply-Sider Conservatives Like to Believe?" Tax Notes, Mar. 24, 2003, p. 1807.

10 Thorndike, "The Republican Roots of New Deal Tax Policy," Tax Notes, Sept. 1, 2003, p. 1201, Doc 2003-19534 , 2003 TNT 170-30 .

11 Martin Daunton, Just Taxes: The Politics of Taxation in Britain, 1914-1979 164 (2002).

12 John Maynard Keynes, "The Means to Prosperity," The Collected Writings of John Maynard Keynes, Vol. IX, 338 (1972).

13 Truman C. Bigham, "Economic Effects of the New Deal Tax Policy," S. Econ. J. 276 (Jan. 1937); Joseph Schumpeter, Business Cycles, Vol. II, 1039 (1939).

14 Raymond Moley, After Seven Years 310 (1939); Arthur Schlesinger Jr., The Politics of Upheaval 325 (1960).

15 Ludwig von Mises, Human Action 734 (1949).

16 Henry Hazlitt, "High Taxes vs. Revenues," Newsweek, Apr. 26, 1954, at 82 (emphasis in original).

17 Congressional Research Service, "Evidence on the Anticipated and Actual 'Feedback Effects' of the 1964 Tax Cut" (Mar. 14, 1977).

18 Donald F. Swanson, "Andrew Mellon on Tax Cuts," The New Republic, Mar. 23, 1963, at 22.

19 "After Tax Cuts -- More Prosperity, Higher Revenue," U.S. News & World Report, June 13, 1966, at 103.

20 Herbert Stein, The Fiscal Revolution in America 9 (1969). Jude Wanniski, one of those for whom Laffer first drew his curve, once told me that Stein's book was the first place he ever encountered the notion that tax cuts could increase revenue.

21 Richard B. McKenzie, "The Micro and Macro Economic Effects of Changes in the Statutory Tax Rates," Rev. Social Econ. 20 (Apr. 1973).

22 Bruce Bartlett, "What Is the Revenue-Maximizing Tax Rate?" Tax Notes, Feb. 20, 2012, p. 1013, Doc 2012-3109 , 2012 TNT 34-24 .


END OF FOOTNOTES