WSJ: Arthur Laffer - Tax Hikes and the 2011 Economic Collapse

[IndependentlyPoor]

Let's see, Laffer looks at selected GDP and tax data and argues that Reagan's tax cut caused the economy to take off like a rocket. Barry Ritholtz cries foul and point to confounding economic events. Gone4Good looks at different time points in the same data and argues that we are to the left of the Laffer sweetspot and BikerDude cries foul and points to confounding economic events.

I think I see a pattern here.

 

[DblDoc]

Let's see, Laffer looks at selected GDP and tax data and argues that Reagan's tax cut caused the economy to take off like a rocket. Barry Ritholtz cries foul and point to confounding economic events. Gone4Good looks at different time points in the same data and argues that we are to the left of the Laffer sweetspot and BikerDude cries foul and points to confounding economic events.

I think I see a pattern here.

Sniff...Sniff... Me thinks I smell some politics..

DD

 

[kyounge1956]

If you look at a graph of revenue as a % of GDP (it's too late for me to create and post it, maybe tomorrow) I think you get a pretty good answer. What I see looking at that chart is that the very large Reagan tax cuts didn't reduce revenue that much. That argues for us being to the right of the kink in the Laffer Curve at that time.

I think a slight decrease argues for a position very close to the top of the curve, but I'm not sure it's possible to say which side of the high point we were on prior to the Reagan tax cuts. I think we were either slightly to the right, and the tax cuts overshot the high point, or slightly to the left and moved away from the high point. A big tax cut producing only a small change in revenue (either up or down) suggests to me a position on the curve where it is closest to being horizontal, and possibly that the actual curve is a different shape—much flatter on top than the diagram.

The Clinton tax increases raised revenue quite a bit, which argues for us being at the left of the curve. And the Bush tax cuts reduced revenue a bunch (tax revenues at the real-estate bubble peak were still about 200bp lower than the prior peak, if memory serves). That also argues for us being to the left of the kink.

agreed both times

Laffler doesn't seem to think so......but then again he is a world renowned economist.........

ISTM Laffer is talking about something different in the article. The diagram shows how changes in tax rate affect government revenue; the article talks about how changes in tax rate affect the growth of GDP. Though I am sure there is some relation between the two, I would not necessarily expect them to move precisely in tandem. Maybe what's really needed is a three dimensional curve.

 

[swampwiz]

I might be sounding like a couple of Germans - named Marx & Engels - but macroeconomically speaking, I don't see a problem. I've always believed that if the earning of income (here I mean earn as in the FICA & IRS sense, as opposed to unearned - i.e., by actually working instead of living off the labors of others via investment of capital) were at such a high level as to make the marginal increase in effort be not worth it to the worker, then that job must be such a highly desired job that folks with a less lucrative job doing something similar (albeit perhaps at a lower level) would be lining up to take that job. Or alternatively, if a small business owner felt that his net after tax income (and here let's say that income would be the net after opportunity cost of any investment he would have in the business) would be so small as to not make it worth it, he would similarly sell it to someone who would want to make it work (perhaps someone who would have to get a bank loan, in which a large part of the net cash flow would have to service, thereby making the net income lower, making the taxes lower, etc.), or some bigger entity which would hire a manager to take the place of the business owner. In all cases, the business stays as a working concern, someone holds the investment of the capital, some manager runs the business.

The same could be said of highly paid professions. I seriously doubt that folks would simply stop lining up to go to medical or law school just because of confiscatory tax rates at the top end. It would be laughable to think that someone would decide not to go to medical school because he might make so much money that that marginal tax rate would be super high.

And as for folks who claim that they would just up and invest their money elsewhere, hey go for it. As American citizens, the IRS will get your income. And if you decide to run away and go live and invest in some 3rd country, just try and run a small business in a place like that. OK, how about China? Fine, screw up in some way, and a you get a bullet in the back of the head! You will come back and understand that even though the taxes may be high, it is in your best business and lifestyle interest to be in the USA (or at least for legal purposes.)

Besides, if the wealthy get too out of line from the peasantry, there are solutions - e.g., France 1789, Russia 1917 ...

 

[clifp]

I tend to agree mostly with Ziggy I don't think that mostly small change in taxes rates will have much impact on behavior. Although all of the changes cumulatively very well may have me dramatically alter my portfolio and quite possible do the same for self-employed, and semi-retired people.

Capital gains 15%- 20% I still have losses from 2008 so this will have little impact on me initially and even when I have to pay it is still less than a wage earner pays.
Dividends treated as ordinary income. This will effectively double my income tax from 15%-28% and possible 31% some year.
Raising top tax rates, no impact unless I get really lucky

A subsidy for people buying their own insurance and making less than 400% of the Federal poverty level. This provides a big incentive to lower your "income" to qualify for the subsidy.

Currently, my portfolio yields 4% (40% in tax sheltered) and consists of lots of dividend stocks, MLPs along with bonds, and CDs. If the tax cuts expired and dividends are treated as ordinary income. I will probably sell most all of my individual stocks in my taxable portfolio and invest the money in slice and dice index portfolio the dividend yield for an index funds is roughly 2%. This will reduce my income to a level where I can get a subsidy for what I figured will 2 out of 3 years. Every other or every third year I'll sell stock to rebalance and replenish my cash reserves. In those years I won't be eligible for a subsidy so I'll buy a bronze instead of a silver medical insurance.

I suspect that as Laffer suggests that cumulative changes will actually cause people who have flexibility to postpone when they recognize income may adopt this strategy. I think it is almost certain that companies that have recently embraced paying out a large portion of their profits in dividends will re-examine the policy.

 

[clifp]

I am going to try to toe the non-political line here, but it might be impossible when talking about tax policy.

I have been thinking about the financial industry and their huge compensations lately. It seems to me that the lure of hundred-million dollar bonuses is just too much for the character of many (if not most) folks to resist. The heads-I-win (hugely) tails-you lose effect seems to drive folks into irrational, immoral, and illegal actions.

This is one place where the disincentives that Ziggy pointed out might be just the thing we need. Removing the temptations for malfeasance that gazillion dollar bonuses present by taxing them at, say 80%, would probably discourage financial gurus from taking crazy risks to make such huge amounts of money. The trick would be to set the threshold for the top rate very high. I dunno, $50MM maybe.

This sort of thing has precedent. The top rate in 1937 was 79%, but look at the threshold for that rate. It was $5MM then, or more than $75MM in today's dollars.

There. My best shot at presenting a potentially controversial policy notion in a non-political fashion.

Why I can understand the appeal of this idea I think there is very little chance that more than handful of people would pay the 80% s rate and certainly no banker would. I also think it would have any even smaller chance of doing what you hope, in discouraging excessive risk taking.

I started work right before the Reagan tax cuts. Many of the engineers in my open office were quite senior. The top 3 conversations at the office were stocks, tax shelters, and sports, and I am pretty sure that sports was distant third.

Here are the top tax rates from 1980/81 49%,55%, 63%,68%, 70%. Take a guess at corresponding income levels were for a single filer. Then go to the bottom of my message, for the answer.

Pretty amazing huh, since virtually everybody in my office other than myself was in marginal tax rate well over 50% when including CA income tax, the entire department was obsessed about avoiding paying taxes. People were investing in horse farms, ranches, oil wells, natural gas wells, low income rental properties you name it. Each investment employed a CPA, a general partner, a lawyer and a sales force. None of them every made a profit (and I am not sure they ever produced a barrel of oil, a racehorse or a steak)

When income tax rates get too high (and I argue anything over 50% is to high) people will go to extraordinary lengths to avoid paying taxes. Countries like Greece and Turkey are classic examples of this.

Finally, you are crazy if you think a company like Goldman Sachs would pay its executive 50 or 100 million bonuses if they are taxed at 80%. Instead they will pay them much lower salaries, but they will also give them alternative forms of compensation. Like 5 million options on Equity Participation units for the Goldman Sachs Solar Energy Green American fund. Now the Goldman Lawyers and accounts will argue that options are only worth $1 each. But some how all perfectly legal in a few years the options will turn in $5 million in cash and $50 million in tax credits. At which point they will receive $50 million bonus but not owe taxes on it.

Now I am obviously speculating here what GS will do, but I know that nobody is making investment in any alternative energy without tax credits.

In fact tomorrow morning Nords and I are attending a seminar in on investing in renewable energy. Is it put by a Hawaii or Silicon Valley entrepreneur talking about Hawaii's wonderful physical and economic (highest energy cost in the country) for renewable energy? Nope it is put by the top CPA and legal firm in the state talking about the tax angles. An 80% tax rate would be great for bankers, accountants, and lawyers, but that is about it.

GS and Wall St. bankers may have the morality of serial killer or a politician, but they are also extremely adept at playing the system. If the system changes they adapt, and they likelihood that Congress can write a set of tax laws that will cost them 1/2 their salaries is very slim.











80/81 Tax rates 49% 34,100, 55% 41,500, 63% 55,300, 68% 88,100, 70% 108,300.

 

[shotgunner]

The responses are interesting. Politics as it affects the tax code is a Fire and Money issue. It seems to me that the sunsetting of the Bush tax cuts will have an effect on early retirees and ER wannabee's. Many of us who are LBYM live on a relatively small income stream and most likely will be affected by the loss of the 10% income tax rate and many us will most likely pay more in Cap Gains taxes. I have enjoyed the 0% rate myself. I personally benefitted from doing a 1035 exchange moving moneys out of a 403b which I believe will now incur a tax hit after 1/1. Finally, the estate tax comes back. Now that may not be our problem per se but many us here do hope to leave more rather than less to our children. Additionally I believe the estate tax was forcing the liquidation of small business upon the owners death to pay taxes and especially hard hit was family farms.

I don't know about economic collapse, trigger for a double dip recession or whether federal revenues will go up or down. I do think it will affect ER's in a negative way to some extent and those who want to be ER'd.

 

[Gone4Good]

Laffler doesn't seem to think so......but then again he is a world renowned economist.........

Who are you going to believe, him or your lyin eyes?

Explanatory Edit: Obviously tax revenues are impacted by economic cycles. But look peak to economic peak and trough to trough. We took in 240bp less in revenue as a % of GDP (~$350B) at the peak of the housing bubble than we did at the peak of the dot-com bubble (even though the housing bubble was larger). And look at the troughs. Unemployment peaked in the '81 recession a touch higher than the current one, and yet revenue was a whopping 480 bp higher then versus now (BTW, if we were taking in that level of revenue now, the Federal deficit would be cut by more than half and be a much more manageable 4.5% of 2010 GDP, all else being equal).

 

[Gone4Good]

Sniff...Sniff... Me thinks I smell some politics..

DD

Except I'm arguing that both the Reagan tax cuts and the Clinton tax increases worked as advertised. It's only recently that we've run off the rails (could it be because when Reagan cut taxes top rates were 70% which is quite different from cutting them when rates are about half that level? There is danger in extrapolating linearly along a curve . . . in this case, Laffer's Curve)

 

[BTravlin]

Where would they move? The US (even if we were to go back to pre Bush rates) has lower tax rates than most other industrialized nations. I'm sure there are third world countries with lower tax rates but then you may get into quality of life and cultural issues. Its one thing to go on vacation quite another to move lock stock and barrel to another country ( I know, I've done it).

well to get out from under the US income taxes by moving they would also have to give up US citizenship, do you really think there would be alot of people who would do that?

There are two types of wealthy: the merely wealthy and the uber wealthy. The merely wealthy will double up on tax avoidance plans. The uber wealthy can find sanctuaries where they are welcome and have the means to enjoy quality of life just about anywhere they desire.

 

[Gone4Good]

A big tax cut producing only a small change in revenue (either up or down) suggests to me a position on the curve where it is closest to being horizontal

Not necessarily. A large cut that moves you from Point B to Point A is revenue neutral, according to the graph. I think that's what we did in the 80's. That would also explain the big swings in revenue from both the Clinton increases and the Bush cuts (whereas a move along a horizontal line would produce little change in revenues). Judging from the impact recent tax changes have had on receipts, it seems we're on a very steep, upward sloping point on the curve. That means we should have little economic cannibalization of tax increases from current levels.

 

[fritz]

Ever wonder if articles like these are published just to sell advertising space, and increase readership

Kind of like taking something simple and turning it into rocket surgery. Nothing like being gobsmacked with incorrectly attributed statements in a screed. Have to admit – it makes for good cannon fodder. Just goes to show that even though things may be eloquently written – doesn't mean that they are anywhere near correct, or make any sense.

As I see it – referenced article(s) pretty much only confirms that when the government attempts to tinker with accepted standardized methods (tax rates) – it invariably has unintended consequences, as people attempt to manipulate the system to skirt (if only temporarily) the upcoming changes.

One would also have to be blind to not see that somebody (everybody) will have to pay for the flights of fancy in the financial industry that resulted in the government having to pump money into the system to prevent total collapse. The bill for the emergency repair of our economy (a big one) is coming due, and we'll have to pay it in the form of higher taxes/inflation. Of course we could have put this tab on the specific doers of the deeds, but they have more clout in Washington, so we get the bill....

 

[REWahoo]

Kind of like taking something simple and turning it into rocket surgery.

 

[fritz]

Kind of like taking something simple and turning it into rocket surgery.


I was having a little fun with the nitwittydom article(s), and attempting to impersonate Mrs. Malaprop. Barney Fife would have called me "factitious"

Rocket "surgery" is actually stated by Laffer in the article. "Gobsmacked" and "creed" are from Ritholz. Thank God I have WordWeb installed on my computer and can quickly and easily understand what the carefully interjected words mean. Always makes me think the author is trying to pump up their literary knowledge. Texans refer to this type of pulling the wool over your eyes as "Big Hat - No Cattle" (from the Millionaire Next Door).

 

[REWahoo]

Texans refer to this type of pulling the wool over your eyes as "Big Hat - No Cattle" (from the Millionaire Next Door).

That's not the only way we refer to it...

 

[ESRwannabe]

My monetary needs are low enough that I have zero fear about means testing, or any tax changes for that matter. If I had a paid off house then I would need only $20k or so to maintain my current standard of living, which I am very happy with.

Whatever new taxes they come up with it probably won't have much affect on people in the $30k or lower range. So, I'm confident I'll be able to ESR by age 45 or so. I'll need $15k from my taxable investments and $15k from part-time work. Then at 65 or so I can ER and replace the w-2 income with 401k, roth, soc sec, and pension money.

 

[IndependentlyPoor]

(snip)
I started work right before the Reagan tax cuts.
(snip)
80/81 Tax rates 49% 34,100, 55% 41,500, 63% 55,300, 68% 88,100, 70% 108,300.

Yep, I started work in 1977, about the same time as you. We didn't have state income tax in Texas, but folks were still pretty crazy about tax rates. Funny thing though, few seem to remember the Tax Reform Act of 1986. Here are the rates and income thresholds.
15% $0 - $29,750
28% $29,750 - $71,900
33% $71,900 - $149,250
28% $149,250 -
source: The Tax Foundation - U.S. Federal Individual Income Tax Rates History, 1913-2010
Lemme tell ya, as a Dilbert type engineer, I did not appreciate paying a higher marginal rate than the president of the MegaCorp I worked for. It kind of soured me on politicians who promised to lower my taxes.

GS and Wall St. bankers may have the morality of serial killer or a politician, but they are also extremely adept at playing the system. If the system changes they adapt, and they likelihood that Congress can write a set of tax laws that will cost them 1/2 their salaries is very slim.

Golly, and I thought that I was a pessimist. Do you mean to say that GS is so smart that there is nothing that we as a people can do to restrain them? Should we, as a Texas governor once famously said "just lie back and enjoy it"?

 

[M Paquette]

The real question then is... At what taxation level does the curve peak ? The answer is not very clear. The data supports a variety of taxation positions.

The other questions are... Where are we on a Laffer-like curve ? What is it's shape ? and will increased taxation levels from where we are now actually increase government income ?

http://economics.missouri.edu/seminars/files/2008/030708.pdf

The paper sheds a bit of light on the shape of the curve, and the slope and peak, based on a quantitative assessment of the EU-15 and the US economies. One thing I found interesting was how advance knowledge of a tax change affected government spending and revenue (pages 27-28).

Skipping to the conclusion... (SPOILER WARNING!)

We show that there exist robust steady state Laffer curves for labor taxes as well as capital taxes. According to the model the US and the EU-15 area are located on the left side of their Laffer curves. However the EU-15 countries are much closer to the slippery slopes than the US. Our results show that if taxes in the EU-15 area continue to rise as they have done in the past, the peak of the Laffer curve becomes very close. By contrast, tax cuts will boost the incentives to work and invest in the EU-15 economy.

In addition, our results indicate that tax cuts in the EU-15 area are to a much higher degree self-financing compared to the US which again reflects higher incentive effects from tax cuts in the EU-15 economy compared to the US. We therefore conclude that there rarely is a free lunch due to tax cuts. However, a large fraction of the lunch will be paid for by the efficiency gains in the economy due to tax cuts.

 

[Pete]

As I recall, the deficit tripled while Reagan was in. Economic growth as a result?...no surprise. The old cliche of burning the furniture to stay warm...It feels good at first, but there might be consequences down the road.
Laffer might have gotten there the wrong way, but I think he might have gotten it right in the end.

If you thought deficits and unemployment have been bad lately, you ain't seen nothing yet.-Laffer

Higher taxes are just one more reason to short the market.

 

[W2R]

Since some of those posting on this thread persist in posting on political matters, the thread has been moved to FIRE Related Political Topics.

Please remember that discussions relegated to this forum must be clearly related to FIRE. Thank you.

 

[ESRwannabe]

There are two types of wealthy: the merely wealthy and the uber wealthy. The merely wealthy will double up on tax avoidance plans. The uber wealthy can find sanctuaries where they are welcome and have the means to enjoy quality of life just about anywhere they desire.

I think the uber wealthy usually form non-profits for their pet cause and then employ their children, grand-children and so on down the line, as a way to pass on the wealth.

Individual stocks also get a stepped up cost basis I think when inherited. So, stocks like BRK are probably a good way to pass on wealth and to also accumulate wealth with minimum taxes.

Too bad, I prefer to invest in dividend growth stocks. The tax man loves me. About 30% of my expenses last year were taxes (pay roll taxes included).

 

[beowulf]

All this means that the average Joe will end up paying more as the government is running out of willing taxpayers to take money from. My single kids who rent and have no income other W-2 wages and maybe a tiny amount of interest pay about 16% of their income in federal taxes, another 7.3 in SS and a small amount in state taxes. Neither earns more than $50K. They have 401Ks and Roth IRAs, but the tax hit on their earned income is high compared to what they earn (in terms of effect - 20% of $1M still leaves to $800K to spend; 20% of $50K leaves you $40K).

For those of us near or at retirement, a lot of our savings is deferred - 401Ks, IRAs, I bonds, etc. If we are still working, shifting income to 2010 (virtually impossible) or converting to Roths makes little sense as it pushes our rates really high.

Unfortunately, I see no solution to this problem in the short term. We can't milk the uber rich, they know how to avoid taxes, we don't tax the poor (whose no tax threshhold keeps going up), and that leaves the middle class. Oh, well, we will find out what happens in about a year.

 

[ziggy29]

For those of us near or at retirement, a lot of our savings is deferred - 401Ks, IRAs, I bonds, etc. If we are still working, shifting income to 2010 (virtually impossible) or converting to Roths makes little sense as it pushes our rates really high.

Unfortunately, I see no solution to this problem in the short term. We can't milk the uber rich, they know how to avoid taxes, we don't tax the poor (whose no tax threshhold keeps going up), and that leaves the middle class. Oh, well, we will find out what happens in about a year.

I think it just adds credence to the strategy of living simply, being debt-free, saving until it hurts, learning to enjoy a simple lifestyle and such so you can be one of the few people who have the option to "starve the beast."

 

[FUEGO]

It is a fine theory, but I don't think it accurately describes human behavior, even for the wealthy. I have been in the very highest marginal tax bracket. Taxes were the least of my motivations -- my efforts were driven by the demands of my practice. I suspect that other high earners are similar in that they do what they do because that is the life they have chosen, not because their tax bracket is x% or y%. At best, my tax bracket influenced my investment choices (e.g. - I was much more likely to put money in a municipal bond fund).

But how many are deterred from high income professional tracks due to lack of incentives? I count myself as one "deterred". I could make a whole lot more, but why bother when I can have a comfortable living while paying almost zero federal income tax and still support my family in the manner to which we are accustomed?

Maybe because I am FIRE-oriented I am a very rare unique case and most others make life decisions regarding professions without looking at the marginal cost of increased effort and hours working vs. marginal after tax benefits received. I didn't really figure this out until part of the way through law school, so I can't really fault anyone for not taking my analytical approach.

It further shapes my outlook on the future. Where do I guide my children? A stable low(ish) income career doing something relatively stress free and enjoyable or an intense high stress environment that pays a lot (to the employee and to the taxman)?

 

[Independent]

Good move.

From an investor's perspective, I follow (what I believe is) the conventional wisdom. When the tax cuts expire in 2011, federal revenue will go up.* The resulting decrease in the deficit will act as a drag on the economy, and this will increase the chance of another dip.

Now, since all conventional economists already know about the increased tax rates, they have probably factored this into their models, so there are no easy pickings if you agree that this is the conventional wisdom.

I saw a non-economist columnist who says that Americans are so spooked by the deficit that any reduction would have a positive psychological effect that might outweigh the standard economic argument. I wish that were true, but I doubt that it is.

Laffer's other factors don't impress me.
- Someone with unrealized gains in a stock might decide to sell in Dec 2010 instead of Jan 2011. That money is probably being rolled into another stock either way. I don't see any significant impact on the macro economy.
- Somewhere a corporation chooses to pay dividends a month early to save investors some tax money. I don't see a big impact.
- Somone retires early because 39% is so much more than 35%. I suppose that will happen somewhere, but with unemployment nearly double digits, there will be a whole line of people ready to jump into that job.
- Stocks become less desirable as investments, suggesting that some people will move to bonds. I don't see any near term impacts on the whole economy.

The drag due to higher gov't revenue may be a real issue, the others just don't impress me.

* The Treasury Dept under GW Bush did a "dynamic" study of extending the tax cuts. They said that lower taxes increased economic activity and therefore partially financed themselves. But the numbers were dramatically left side of L-curve. IIRC, a cut that cost $100 dollars on a "static" basis, still cost $93 after dynamic effects.