Sunday, March 8, 2009

How the Laffer Curve fundamentally undermined fiscal conservatism

Just about everyone knows the basic idea behind the Laffer curve: at both 0% and 100% taxation, the government gets no tax revenues, meaning that decreasing taxes can theoretically lead to increased revenues. The resultant theory of supply-side economics helped catapult Ronald Reagan to the Presidency in the 1980s, and controlled GOP economic policy for a generation. It also crippled economic conservatism on the national stage, perhaps beyond our ability to heal.

But wait, you say. Isn't lower taxation in line with the goals of fiscal conservatism? Well, yes and no. To economic conservatives, lower taxation is a desirable but secondary byproduct of lower spending. This unremarkable revelation came to me when I was thinking about the California budget deficit (see two posts down) and realized that the debate was framed incorrectly.

We don't have a budget deficit. Wait, don't leave, let me explain! The term "budget deficit" implies that the problem is insufficiency; specifically, that tax revenues are insufficient to cover spending programs. But this is an absurd way to view the problem. For starters, tax revenues have consistently increased relative to inflation over any period of time you care to name. Some data: here are historical records of tax revenues over the last 75 years and an inflation calculator. I challenge readers to find any time period 10 years or longer where real tax revenues decreased. Factor in population growth if you like; it doesn't matter. America's government, just like California's, has generally taken in more money from its citizens each year.

Furthermore, tax revenue is, by and large, the independent variable in this equation. The only government that has absolute control over how much money it gets is a dictatorship. More to the point, changes in tax policy don't have any real long-term effects on tax revenues, which have hovered around 18% of GDP for at least 30 years and probably much longer (here's some historical GDP data for curious readers to play with). George Bush's much-reviled (or much-vaunted, in the right crowd) tax cuts led to a short, sharp fall (>10%) in tax revenues as a percentage of GDP between 2000 and 2004 - but by 2007, revenues were right back on the long-term trend line. The limited effect of political decisions on tax revenues is amply illustrated by this graph from Paul Krugman's 1/16/08 NY Times editorial, "Taxes and revenues - another history lesson." Krugman contends that this graph shows the benefits of increasing taxes, but fails to note that the graph correlates much more closely to GDP than to either Clinton's or Bush's tax policies.

Clearly, tax revenues aren't the problem - they're perhaps the last consistent performer in Washington. Hence I repeat my point: we do not have a budget deficit. Rather, what we have is a spending surplus. Basic economics teaches us that we have limited resources to satisfy unlimited needs; but when politicians can punt scarcity into the national debt, they tend to spend beyond their means in attempting to deliver instant gratification of their constituents' demands. This leads right into the basic tenet of fiscal conservatism: the key to responsible governance is restraint in government spending. In short, the problem isn't how much money government takes in, it's how much money government puts out.

In this sense, the Laffer curve is nothing but trouble for economic conservatives. Here's the core of the problem: the Laffer curve diverts focus from the problem of excessive spending by dangling the dual carrot of lower taxes and higher revenues. Supply-side economics is only useful insofar as it suggests that raising taxes is not necessarily an efficient revenue collection instrument; taken any further, it generally becomes an argument for lower taxes in order to spend more. Hence absurdities like conservatives compromising with liberals by spending money on social programs as well as the war effort; like the "compromise" between tax cuts and increased spending in the recent trillion-dollar stimulus bill; like the generation-old tendency of the opposition party to accuse the majority party of indiscriminate spending, ignoring its own indiscretions when it was the majority party (blatantly evident in both parties over the past three years). Rather than measuring our wish-list against our budget, we measure our budget against our wish-list. Then we wonder how it is that so many people bought houses they couldn't afford to keep, caught up in the dream of a permanent real-estate boom.

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