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1.6.08

Argument against tax cut misunderstands economics

While the Public Affairs Research Council of Louisiana often has intelligent things to say about public policy in the state, it’s clear not only that it doesn’t know a whole lot about economics and human behavior and/or cannot think logically about these issues, but that it may see itself more as a representative of big business interests than it does the people of the state.

That’s the best one can make of its recent statement that Louisiana would act unwisely in passing SB 87 by state Sen. Buddy Shaw into law. The bill would cut taxes for middle class taxpayers and his estimated to reduce in its first year government personal income tax revenues by about $300 million (as it is intended to be amended when it appears on the floor of the House this week).

PAR says that would create a risky gap in a budget that is forecast to lose overall revenues and faces some increased spending over the next few years, an assessment consistent with past estimations of the Gov. Bobby Jindal Administration. That surface analysis, however, lacks sophistication and logic.

Part of PAR’s problem may be that its analysts do not accept the economic verity of what has come to be called the Laffer Curve. The straightforward idea is that overall taxation after a certain point becomes onerous enough that marginal increases in taxation levels begin to exceed the marginal increases in revenues derived. This is because higher rates discourage use of money for productive purposes because they reduce the rate of return investors/producers feel are necessary to offset the risk of the incremental investment. The reverse implication is that a reduction of rates can produce, as lower rates remove funds from less-efficient government use and increase relatives rates of returns, over time more revenues for government from taxation of a larger economic base than higher rates would squeeze from a base made smaller because of those higher rates.

Crucial to appropriate policy for Louisiana would be where the state resides on the curve presently – either on the left side where taxation is so low that it wouldn’t discourage investment much or put too much money into inefficient government, or on the right where taxation that is too high does discourage and remove too much money from the private sector. One indicator is whether tax policy alterations change the rate of increase in individual income tax collections relative to the overall change of the rate in increase in gross state product – the economic output of the state’s production.

From 1990 to 2002, before the “Stelly Plan” change that raised taxes on all but the lowest level of taxpayers, Louisiana’s GSP went from $91.4 billion to $134.6 billion, while its individual income tax collections went from $677 million to $1.789 billion – increases of about 50 percent and over 250 percent, respectively. But through 2006, the increases to $193.1 billion and $2.512 billion are about the same rate, just above 40 percent. This means the state is on the “wrong” side of the curve, since lower taxes had the economy grow faster and thereby got income tax revenues to grow at a faster rate.

However, PAR may recognize that a cut in marginal tax rates for middle class families will, in a few years, increase revenues beyond what would have been collected at the higher rate. Instead, they may think that the relative variability of other revenues may be such that even a tax cut that recoups revenue in a few years might contain too much risk on the front end if other revenues sources prove unstable, such as severance taxes. This is an argument of greater validity but still wanting. Any difficulties would be short term in nature and there are devices to counteract them, such as tapping the Budget Stabilization Fund, or budget cutting which already is being discussed even in these apparent flush times.

Interestingly, PAR was all in favor of reducing business taxes during the second special session despite the misgivings it now seems to have in removing revenue from government. Even thought the amount believed to be forgone was lower at $110 million for next year, individual income tax cuts probably have the potential of greater growth for the economy since they go to residents while many benefits from the elimination of three business taxes will go to out-of-state sources. One wonders whether PAR has not confused itself with the leading lobby for business in the state, the Louisiana Association for Business and Industry.

Even if it has its identity straight, it certainly is confused on economics. The only reason not to pass the original SB 87 into law would be if the budget situation is so dire that it cannot be risked even in the short term, given the options to address it. No persuasive argument has been made by PAR or anybody else on this account. Thus we must disregard such arguments in light of the realities of economics that argue for passage of SB 87.

3 comments:

T. Wong said...

Though I would support Shaw's bill, your economic analysis is very confused.

Laffer's analysis dealt with the relationship between tax rates and tax collections. His curve is based on a hypothesis of diminishing returns-- the economic effects of increasing tax rates have a chilling effect on the economy and thus, tax collections.

One does not compare tax collections to gsp to determine whether the state is on the right or left side of the Laffer curve. It does not work that way. Tax collections are compared with increases or decreases in tax rates. Laffer analyzes the effects of tax rates on the public fisc, not the effects of tax rates on gsp/gdp.

The Laffer analysis is most often used to evaluate very progressive tax rates. Louisiana's personal income tax flattens out at a relatively low rate. Furthermore, the "Stelly Tax" only affects a certain band of income.

Supply siders jumped on the economic stimulus aspects of tax cuts, and there is empirical evidence to suggest this. However, there has never been any accurate way to quantify the cause and effect relationship of tax cuts to economic stimulus.

Also, you are comparing a 12 year period to a 4 year period. Can you say that the increases over the 12 year period were linear, or in fits and starts? And what does it mean that increasing income taxe collections by a factor of 5 only doubled the gsp? What would be so bad about doubling the gsp by only doubling income tax collections?

And guess what? If you multiply the 40% gsp increase by 3, since your first period takes in 12 years as opposed to 4, you get a 120% increase in gsp.

Also, the Laffer analysis cannot possibly isolate all of the other economic effects. For goodness' sake, Katrina and Rita hit in that four year period.

So even though PAR may not "know a whole lot about economics (I cannot personally say), your analysis is rank b.s.

Jeff Sadow said...

>One does not compare tax collections to gsp to determine whether the state is on the right or left side of the Laffer curve. It does not work that way.

Indeed it does; follow the logic. Income tax revenues, according to Laffer, will have varying rates of increases (including negative) depending upon where you are on the curve. At a certain (low) rate, the rate of increase in revenues would exceed the rate of growth in the economy. At a higher rate (near the apex) you would find the rate of increased growth lower than that of marginal rates. Higher rates still would have revenues actually fall (negative growth rate). I apologize for not being precise enough in the posting: when I mean "wrong" side of the curve I don't mean just the negative side, but the portion of the left side where growth of government revenues because of higher rates begins to lag GSP. In other words, where tax rates are high enough that they begin to erode economic growth.

GSP is the appropriate measure because observing its changes gives us a metric by which to compare growth rates of revenues. After all, the theory is that you get the higher revenues even with lower relative rates of taxation because the base on which the revenues are derived (measured by GSP) becomes larger and throws off greater streams of revenue than with higher rates capturing that revenue up front before it is sent to more productive uses. The two necessarily are related.

>Supply siders jumped on the economic stimulus aspects of tax cuts, and there is empirical evidence to suggest this. However, there has never been any accurate way to quantify the cause and effect relationship of tax cuts to economic stimulus.

There is an empirical verification. See http://online.wsj.com/article/SB121124460502305693.html?mod=googlenews_wsj

>Can you say that the increases over the 12 year period were linear, or in fits and starts?

For the record, mostly linear but some backing and filling in the mid 90's.

>And what does it mean that increasing income taxe collections by a factor of 5 only doubled the gsp?

You have it backwards, GSP causes collections, not the reverse. It is marginal tax rates that "cause" GSP (among other things).

>What would be so bad about doubling the gsp by only doubling income tax collections?

Correctly stated, what is so bad about doubling GSP to double collections? Because a lower rate might triple collections when GSP only doubles.

>And guess what? If you multiply the 40% gsp increase by 3, since your first period takes in 12 years as opposed to 4, you get a 120% increase in gsp.

For the record, the ratios of GSP growth to collection growth in four-year segments starting and going backwards from 2006 are 0.93, 5.68, 1.90, and 3.47. Between 2002 and 2003 definitely seems to be a cutpoint -- right when higher rates for many taxpayers hit.

>Also, the Laffer analysis cannot possibly isolate all of the other economic effects. For goodness' sake, Katrina and Rita hit in that four year period.

GSP would be affected by such an event, but since collections vary with it, they would mirror that. But it is worth noting that individual income tax rates would have a smaller effect on GSP than at the federal level because they make up a smaller portion of claims on the economy since the rates are lower and other taxes would have more significant effects (such severance taxes) because they make relatively larger claims than at the federal level.

>your analysis is rank b.s.

Disproven.

T. Wong said...

Nope, the Laffer Curve is mostly a pedagogical device, and you have tried to use it to quantify something it was never meant to quantify. The analysis was never meant to quantify relatively small changes in tax rates. Your colleagues in the ECON department will tell you that your analysis is no good.

Yes, there is empirical evidence supporting that tax cuts affect gsp/gdp positively, but you simply cannot use Laffer's analysis to justify the conclusions you want to make.

Ever seen a pubic interest group, a fiscal note, or anything that attempts to predict the effects of a tax cut on gsp? If it were that easy to quantify the gsp results of a tax cut, do you really think you would have been the first one to have done so?

Never mind! Forget that I asked that.

By the way, the only study I have found suggests that the US Govt would need to raise marginal tax rates to over 80% to be on the "wrong" side of the Laffer curve. Let's hope nobody thinks that's a good idea.

And while we're at it, how do you figure that collections are going to mirror Katrina? A lot of the $ spent was paid to corporations and low wage earners, and a lot of the salaries that went out of LA were probably from lower income folks to whom Stelly doesn't much matter.

Your analysis has more holes than a swiss cheese.