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Posts Tagged ‘Supply-side economics’

The good news is that Joe Biden has not embraced many of Bernie Sanders’ worst tax ideas, such as imposing a wealth tax or hiking the top income tax rate to 52 percent..

The bad news is that he nonetheless is supporting a wide range of punitive tax increases.

  • Increasing the top income tax rate to 39.6 percent.
  • Imposing a 12.4 percent payroll tax on wages above $400,000.
  • Increasing the double taxation of dividends and capital gains from 23.8 percent to 43.4 percent.
  • Hiking the corporate tax rate to 28 percent.
  • Increasing taxes on American companies competing in foreign markets.

The worst news is that Nancy Pelosi, et al, may wind up enacting all these tax increases and then also add some of Crazy Bernie‘s proposals.

This won’t be good for the U.S. economy and national competitiveness.

Simply stated, some people will choose to reduce their levels of work, saving, and investment when the tax penalties on productive behavior increase. These changes give economists the information needed to calculate the “elasticity of taxable income”.

And this, in the jargon of economists, is a measure of “deadweight loss.”

But now there’s a new study published by the Federal Reserve which suggests that these losses are greater than traditionally believed.

Authored by Brendan Epstein, Ryan Nunn, Musa Orak and Elena Patel, the study looks at how best to measure the economic damage associated with higher tax rates. Here’s some of the background analysis.

The personal income tax is one of the most important instruments for raising government revenue. As a consequence, this tax is the focus of a large body of public finance research that seeks a theoretical and empirical understanding of the associated deadweight loss (DWL). …Feldstein (1999) demonstrated that, under very general conditions, the elasticity of taxable income (ETI) is a sufficient statistic for evaluating DWL. …It is well understood that, apart from rarely employed lump-sum taxes and…Pigouvian taxes, revenue-raising tax systems impose efficiency costs by distorting economic outcomes relative to those that would be obtained in the absence of taxation… ETI can potentially serve as a perfect proxy for DWL…this result is consistent with the ETI reflecting all taxpayer responses to changes in marginal tax rates, including behavioral changes (e.g., reductions in hours worked) and tax avoidance (e.g., shifting consumption toward tax-preferred goods). …a large empirical literature has provided estimates of the individual ETI, identified based on variation in tax rates and bunching at kinks in the marginal tax schedule.

And here are the new contributions from the authors.

… researchers have fairly recently come to recognize an important limitation of the finding that the ETI is a sufficient statistic for deadweight loss… we embed labor search frictions into the canonical macroeconomic model…and we show that within this framework, a host of additional information beyond the ETI is needed to infer DWL …once these empirically observable factors are controlled for, DWL can be calculated easily and in a straightforward fashion as the sum of the ETI and additional terms involving these factors. … We find that…once search frictions are introduced, …DWL can be between 7 and 38 percent higher than the ETI under a reasonable calibration.

To give you an idea of what this means, here are some of their estimates of the economic damage associated with a 1 percent increase in tax rates.

As you peruse these estimates, keep in mind that Biden wants to increase the top income tax rate by 2.6 percentage points and the payroll tax by 12.4 percentage points (and don’t forget he wants to nearly double tax rates on dividends, capital gains, and other forms of saving and investment).

Those are all bad choices with traditional estimates of deadweight loss, and they are even worse choices with the new estimates from the Fed’s study.

So what’s the bottom line?

The political impact will be that “the rich” pay more. The economic impact will be less capital formation and entrepreneurship, and those are the changes that hurt the vast majority of us who aren’t rich.

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I’ve explained the economics of taxation, which is based on the common-sense notion that you get less productive economic activity when taxes drive a bigger wedge between pre-tax income and post-tax consumption.

Simply stated, the more you tax of something, the less you get of it, and this applies to taxes on labor and taxes on capital.

Today, let’s examine some empirical evidence. I’ve done that before (see here, here, here, here, here, here, here, here, and here), but it’s always good to expand the collection.

Three Italian professors, in a new working paper for the Centre for Economic and International Studies, investigated the relationship between taxes and growth.

We’ll start with a description of the methodology.

In this paper, we revisit a traditional issue in the empirics of growth and economic policy: whether taxation has long-lasting effects on real GDP dynamics. …we focus on the impact that taxes may have on the rates of physical and human capital accumulation. …our main departure from the existing literature is the use of a semi-parametric technique, which allows for countries’ unobserved heterogeneity in the input effects on per capita GDP. …we test our model, using a sample of 21 OECD countries over the period 1965-2010.

Here are the key findings.

Our main finding is that taxation negatively affect per capita GDP growth rates, both directly and indirectly, via physical and human capital saving rates. …Our cross-country analysis makes a clear point on this, at least for our sample of OECD countries: on average, tax cuts produce a beneficial impact on GDP dynamics but of modest size. In our baseline specification, a cut by 10% in personal income tax rate generates an change in the real per capita GDP growth rate of +1% while a cut by 10% in corporate income tax rate increases the rate of growth of real per capita GDP by 0.9%. …The main message of our empirical exercise is that, across various samples and specifications, taxes are harmful for growth.

These are very strong results.

Though I find it very interesting that the authors say they are “of modest size.”

I guess that depends on expectations and perspective. I’ll simply repeat the point I made two years ago about the importance of even small increases in the long-run growth rate.

The bottom line is that future Americans would enjoy significantly greater prosperity with better tax policy.

That’s a desirable outcome at any point in time, and it’s even more important today as we consider how to recover from the economic wreckage caused by the coronavirus.

Interestingly, the study ends with some interesting estimates on the impact of lower tax rates on labor and capital.

Table 10 reports the results of a “what if”exercise, in which we compute the change in GDP growth rate generated by a ceteris paribus cut by 10 % in τw and τk.

And here is the aforementioned Table 10 (“τw” is the tax rate on labor and “τk” is the tax rate on capital).

There are two big takeaways from this research.

First, it’s further evidence that Trump’s tax reform, which lowered the corporate tax rate from 35 percent to 21 percent, was a very good step for the American economy.

Second, it’s further evidence that it’s a big mistake for Biden and other folks on the left to push for higher tax rates, including big increases in tax rates on personal income.

P.S. Just in case those last two sentences sound overly favorable to Trump, I’ll remind people that reckless spending increases – sooner or later – will lead to punitive tax increases. In other words, if Biden wins and there are big tax hikes, Trump will deserve some of the blame (just as Bush’s irresponsible policies set the stage for some of Obama’s irresponsible policies).

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In some cases, politicians actually understand the economics of tax policy.

It’s quite common, for instance, to hear them urging higher taxes on tobacco because they want to discourage smoking.

I don’t think it’s their job to tell people how to live their lives, but I agree with their economic analysis. The more you tax something, the less you get of it.

One of my many frustrations is that those politicians then conveniently forget that lesson when it comes to taxing things that are good, such as work, saving, production, and investment.

And some countries are more punitive than others. There’s some new research from the European Policy Information Center, Timbro, and the Tax Foundation, that estimates the “effective marginal tax rate” for successful taxpayers for 41 major countries.

And they don’t simply look at the top income tax rates. They quite properly include other taxes that contribute to “deadweight loss” by driving a wedge between pre-tax income and post-tax consumption.

The political discussion around taxing high-earners usually revolves around the income tax, but in order to get a complete picture of the tax burden high-income earners face, it is important to consider effective marginal tax rates. The effective marginal tax rate answers the question, “If a worker gets a raise such that the total cost to the employer increases by one dollar, how much of that is appropriated by the government in the form of income tax, social security contributions, and consumption taxes?” …all taxes that affect the return to work should be taken into account. …Combining data mainly from international accounting firms, the OECD, and the European Commission, we are able to calculate marginal tax rates in the 41 members of the OECD and/or EU.

The main message of this research is that you don’t want to live in Sweden, where you only keep 24 percent of any additional income you produce.

And you should also avoid Slovenia, Belgium, Portugal, Finland, France, etc.

Congratulations to Bulgaria for being the anti-class warfare nation. That’s a smart strategy for a nation trying to recover from decades of communist deprivation.

American readers will be happy to see that the United States looks reasonably good, though New Zealand is the best of the rich nations, followed by Switzerland.

Speaking of which, we need a caveat for nations with federalist systems, such as the U.S., Switzerland, and Canada. In these cases, the top income tax rate is calculated by adding the central government’s top rate with the average top rate for sub-national governments.

So successful entrepreneurs in those countries actually have the ability to reduce their tax burdens if they make wise decisions on where to live (such as Texas or Florida in the case of the United States).

Let’s now shift to some economic analysis. The report makes (what should be) an obvious point that high tax rates have negative economic effects.

Countries should be cautious about placing excessive tax burdens on high-income earners, for several reasons. In the short run, high marginal tax rates induce tax avoidance and tax evasion, and can cause high-income earners to reduce their work effort or hours.

I would add another adverse consequence. Successful taxpayers can move.

That’s especially true in Europe, where cross-border tax migration is much easier than it is in the United States.

But even though there are odious exit taxes for people leaving the United States, we’ll see an exodus if we wind up with some of the crazy tax policies being advocated by Bernie Sanders and Elizabeth Warren.

P.S. Today’s column looks at how nations rank based on the taxation of labor income. For taxation of capital income, the rankings look quite different. For instance, because of pervasive double taxation, the United States gets poor scores for over-taxing dividends, capital gains, and businesses.

P.P.S. If you want to see tax rates on middle-income workers (though it omits value-added taxes), here is some OECD data.

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California is suffering a slow but steady decline.

Bad economic policy has made the Golden State less attractive for entrepreneurs, investors, and business owners.

Punitive tax laws deserve much of the blame, particularly the 2012 decision to impose a top tax rate of 13.3 percent.

I’ve already shared some anecdotal evidence that this tax increase backfired.

But now we have some scholarly evidence from two Stanford Professors. Here’s what they investigated.

In this paper we study the question of the elasticity of the tax base with respect to taxation using microdata from the California Franchise Tax Board on the universe of California taxpayers around the implementation of Proposition 30 in 2012. This ballot initiative increased marginal income tax rates… These increases came on top of the 9.3% rate that applied to income over $48,942 for singles and $97,884 for married couples, and also in addition to the 1% mental health tax that since 2004 had applied to incomes of over $1 million. The reform therefore brought the top marginal tax rate in California to 13.3% for incomes of over $1 million.

For those not familiar with economic jargon, “elasticity” is simply a term to describe how sensitive taxpayers are when there are changes in tax policy.

A high measure of elasticity means a large “deadweight loss” since taxpayers are choosing to earn and/or report less income.

And that’s what the two scholars discovered.

Some high-income taxpayers responded to the big tax increase by moving.

We first study the extensive margin response to taxation, and document a substantial one-time outflow of high-earning taxpayers from California in response to Proposition 30. Defining a departure as a taxpayer who went from resident to non-resident filing status, the rate of departures in 2013 over 2012 spiked from 1.5% after the 2011 tax year to 2.125% for those primary taxpayers earning over $5 million in 2012, with a similar effect among taxpayers earning $2-5 million in 2012.

By the way, you won’t be surprised to learn that California taxpayers increasingly opted to move to states with no income tax, such as Florida, Nevada, and Texas.

Other taxpayers stayed in California but they chose to earn and/or report less income.

We combine these results on the extensive margin behavioral response with conclusions of analysis of the intensive margin response to Proposition 30. …we use a differences-in-differences design in which we compare upper-income California resident taxpayers to a matched sample of non-resident California filers, for which there is relatively rich data… Our estimates show a substantial intensive margin response to Proposition 30, which appears in 2012 and persists… We find that California top-earners on average report $522,000 less in taxable income than their counterfactuals in 2012, $357,000 less in 2013, and $599,000 less in 2014; this is relative to a baseline mean income of $4.15 million amongst our defined group of California top-earners in 2011. …the estimates imply an elasticity of taxable income with respect to the marginal net of tax rate of 2.5-3.3.

In the world of public finance, that’s a very high measure of elasticity.

Wonky readers may be interested in these charts showing changes in income.

By the way, guess what happens when taxpayers move, or when they decide to earn less income?

The obvious answer is that politicians don’t collect as much revenue. Which is exactly what the study discovered.

A back of the envelope calculation based on our econometric estimates finds that the intensive and extensive margin responses to taxation combined to undo 45.2% of the revenue gains from taxation that otherwise would have accrued to California in the absence of behavioral responses. The intensive margin accounts for the majority of this effect, but the extensive margin comprises a non-trivial 9.5% of this total response.

We can call this the revenge of the Laffer Curve.

By the way, it’s quite likely that there has been a resurgence of both the “extensive” and “intensive” responses to California’s punitive tax regime because the 2017 tax reform restricted the deductibility of state and local taxes. This means that the federal government – for all intents and purposes – is no longer subsidizing California’s backwards fiscal system.

P.S. Makes me wonder if California politicians will turn Walter Williams’ joke into reality.

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In addition to being a contest over expanding the burden of government spending, the Democratic primary also is a contest to see who wants the biggest tax increases.

Bernie Sanders and Elizabeth Warren have made class-warfare taxation an integral part of their campaigns, but even some of the supposedly reasonable Democrats are pushing big increases in tax rates.

James Pethokoukis of the American Enterprise Institute opines about the anti-growth effect of these proposed tax hikes, particularly with regard to entrepreneurship and successful new firms.

The Democratic presidential candidates have plenty of ideas about taxes. Wealth taxes. Wall Street taxes. Inequality taxes. And probably more to come. So lots of creative thinking about wealth redistribution. Wealth creation? Not so much. …one way to look at boosting GDP growth is thinking about specific policies to boost labor force and productivity growth. But there’s another way of approaching the issue: How many fast-growing growing new firms would need to be generated each year to lift the economy-wide growth rate each year by one percent? …a rough calculation by analyst Robert Litan figures there about 15 billion-dollar (in sales) companies formed every year. But what if the American entrepreneurial ecosystem were so vibrant that it produced 60 such companies annually? …The big point here is that the American private sector is key to growth. No other large economy is as proficient as the US in creating high-impact startups. But it doesn’t appear that the Democratic enthusiasm for big and bold tax plans is matched by concern about unwanted trade-offs.

If you want a substantive economic critique of class-warfare tax policy, Alan Reynolds has a must-read article on the topic.

He starts by explaining why it’s important to measure how sensitive taxpayers are (the “elasticity of taxable income”) to changes in tax rates.

Elasticity of taxable income estimates are simply a relatively new summary statistic used to illustrate observed behavioral responses to past variations in marginal tax rates. They do so by examining what happened to the amount of income reported on individual tax returns, in total and at different levels of income, before and after major tax changes. …For example, if a reduced marginal tax rate produces a substantial increase in the amount of taxable income reported to the IRS, the elasticity of taxable income is high. If not, the elasticity is low. ETI incorporates effects of tax avoidance as well as effects on incentives for productive activity such as work effort, research, new business start-ups, and investment in physical and human capital.

Alan then looks at some of the ETI estimates and what they imply for tax rates, though he notes that the revenue-maximizing rate is not the optimal rate.

Diamond and Saez claim that, if the relevant ETI is 0.25, then the revenue-maximizing top tax rate is 73 percent. Such estimates, however, do not refer to the top federal income tax rate, …but to the combined marginal rate on income, payrolls, and sales at the federal, state, and local level. …with empirically credible changes in parameters, the Diamond-Saez formula can more easily be used to show that top U.S. federal, state, and local tax rates are already too high rather than too low. By also incorporating dynamic effects — such as incentives to invest in human capital and new ideas — more recent models estimate that the long-term revenue-maximizing top tax rate is between 22 and 49 percent… Elasticity of taxable, or perhaps gross income…can be “a sufficient statistic to approximate the deadweight loss” from tax disincentives and distortions. Although recent studies define revenue-maximization as “optimal,” Goolsbee…rightly emphasizes, “The fact that efficiency costs rise with the square of the tax rate are likely to make the optimal rate well below the revenue-maximizing rate.”

These excerpts only scratch the surface.

Alan’s article extensively discusses how high-income taxpayers are especially sensitive to high tax rates, in part because they have considerable control over the timing, level, and composition of their income.

He also reviews the empirical evidence from major shifts in tax rates last century.

All told, his article is a devastating take-down of the left-of-center economists who have tried to justify extortionary tax rates. Simply stated, high tax rates hinder the economy, create deadweight loss, and don’t produce revenue windfalls.

That being said, I wonder whether his article will have any impact. As Kevin Williamson points out is a column for National Review, the left isn’t primarily motivated by a desire for more tax money.

Perhaps the strangest utterance of Barack Obama’s career in public office…was his 2008 claim that raising taxes on the wealthy is a moral imperative, even if the tax increase in question ended up reducing overall federal revenue. Which is to say, Obama argued that it did not matter whether a tax increase hurt the Treasury, so long as it also hurt, at least in theory and on paper, certain wealthy people. …ideally, you want a tax system with low transaction costs (meaning a low cost of compliance) and one that doesn’t distort a lot of economic activity. You want to get enough money to fund your government programs with as little disruption to life as possible. …Punitive taxes aren’t about the taxes — they’re about the punishment. That taxation should have been converted from a technical question into a moral crusade speaks to the basic failure of the progressive enterprise in the United States…the progressive demand for a Scandinavian welfare state at no cost to anybody they care about…ends up being a very difficult equation to balance, probably an impossible one. And when the numbers don’t work, there’s always cheap moralistic histrionics.

So what leads our friends on the left to pursue such misguided policies? What drives their support for punitive taxation?

Is is that they’re overflowing with compassion and concern for the poor?

Hardly.

Writing for the Federalist, Emily Ekins shares some in-depth polling data that discovers that envy is the real motive.

Supporters often contend their motivation is compassion for the dispossessed… In a new study, I examine…competing explanations and ask whether envy and resentment of the successful or compassion for the needy better explain support for socialism, raising taxes on the rich, redistribution, and the like. …Statistical tests reveal resentment of the successful has about twice the effect of compassion in predicting support for increasing top marginal tax rates, wealth redistribution, hostility to capitalism, and believing billionaires should not exist. …people who agree that “very successful people sometimes need to be brought down a peg or two even if they’ve done nothing wrong” were more likely to want to raise taxes on the rich than people who agree that “I suffer from others’ sorrows.” …I ran another series of statistical tests to investigate the motivations behind the following beliefs: 1) It’s immoral for our system to allow the creation of billionaires, 2) billionaires threaten democracy, and 3) the distribution of wealth in the United States is “unjust.” Again, the statistical tests find that resentment against successful people is more influential than compassion in predicting each of these three beliefs. In fact, not only is resentment more impactful, but compassionate people are significantly less likely to agree that it’s immoral for our system to allow people to become billionaires.

Here’s one of her charts, showing that resentment is far and away the biggest driver of support for class-warfare proposals.

These numbers are quite depressing.

They suggest that no amount of factual analysis or hard data will have any effect on the debate.

And there is polling data to back up Emily’s statistical analysis. Heck, some folks on the left openly assert that envy should be the basis for tax policy.

In other words, Deroy Murdock and Margaret Thatcher weren’t creating imaginary enemies.

P.S. If you think Kevin Williamson was somehow mischaracterizing or exaggerating Obama’s spiteful position on tax policy, just watch this video.

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The New York Times is going overboard with disingenuous columns.

A few days ago, I pointed out the many errors in David Leonhardt’s column extolling the wealth tax.

I also explained back in August how Steven Greenhouse butchered the data when he condemned the American economy.

And Paul Krugman is infamous for his creative writing.

But Mr. Leonhardt is on a roll. He has a new column promoting class warfare tax policy.

Almost a decade ago, Warren Buffett made a claim that would become famous. He said that he paid a lower tax rate than his secretary, thanks to the many loopholes and deductions that benefit the wealthy.oct-8-19-nyt …“Is it the norm?” the fact-checking outfit Politifact asked. “No.” Time for an update: It’s the norm now. …the 400 wealthiest Americans last year paid a lower total tax rate — spanning federal, state and local taxes — than any other income group, according to newly released data. …That’s a sharp change from the 1950s and 1960s, when the wealthy paid vastly higher tax rates than the middle class or poor.

Here’s the supposed proof for Leonhardt’s claim, which is based on a new book from two professors at the University of California at Berkeley, Emmanuel Saez and Gabriel Zucman.

Here are the tax rates from 1950.

oct-8-19-1950

And here are the tax rates from last year, showing the combined effect of the Kennedy tax cut, the Reagan tax cuts, the Bush tax cuts, and the Trump tax cut (as well as the Nixon tax increase, the Clinton tax increase, and the Obama tax increase).

oct-8-19-2018

So is Leonhardt (channeling Saez and Zucman) correct?

Are these charts evidence of a horrid and unfair system?

Nope, not in the slightest.

But this data is evidence of dodgy analysis by Leonhardt and the people he cites.

First and foremost, the charts conveniently omit the fact that dividends and capital gains earned by high-income taxpayers also are subject to the corporate income tax.

Even the left-leaning Organization for Economic Cooperation and Development acknowledges that both layers of tax should be included when measuring the effective tax rate on households.

Indeed, this is why Warren Buffett was grossly wrong when claiming he paid a lower tax rate than his secretary.

But there’s also another big problem. There’s a huge difference between high tax rates and high tax revenues.

feb-4-19-perrySimply stated, the rich didn’t pay a lot of tax when rates were extortionary because they can choose not to earn and declare much income.

Indeed, there were only eight taxpayers in 1960 who paid the top tax rates of 91 percent.

Today, by contrast, upper-income taxpayers are paying an overwhelming share of the tax burden.

It’s especially worth noting that tax collections from the rich skyrocketed when Reagan slashed the top tax rate in the 1980s.

Let’s close by pointing out that Saez and Zucman are promoting a very radical tax agenda.

Saez and Zucman sketch out a modern progressive tax code. The overall tax rate on the richest 1 percent would roughly double, to about 60 percent. The tax increases would bring in about $750 billion a year, or 4 percent of G.D.P…. One crucial part of the agenda is a minimum global corporate tax of at least 25 percent. …Saez and Zucman also favor a wealth tax

Punitive income tax rates, higher corporate tax rates, and a confiscatory wealth tax.

Does anybody think copying France is a recipe for success?

P.S. I pointed out that Zucman and Saez make some untenable assumptions when trying to justify how a wealth tax won’t hurt the economy.

P.P.S. It’s also worth remembering that the income of rich taxpayers will be subject to the death tax as well, which means Leonhardt’s charts are doubly misleading.

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At the risk of over-simplifying, the difference between “supply-side economics” and “demand-side economics” is that the former is based on microeconomics (incentives, price theory) while the latter is based on macroeconomics (aggregate demand, Keynesianism).

When discussing the incentive-driven supply-side approach, I often focus on two key points.

  • Marginal tax rates matter more than average tax rates because the incentive to earn additional income (rather than enjoying leisure) is determined by whether the government grabs a small, medium, or large share of any extra earnings.
  • Some taxpayers such as investors, entrepreneurs, and business owners are especially sensitive to changes in marginal tax rates because they have considerable control over the timing, level, and composition of their income.

Today, let’s review some new research from Spain’s central bank confirms these supply-side insights.

Here’s what the authors investigated.

The impact of personal income taxes on the economic decisions of individuals is a key empirical question with important implications for the optimal design of tax policy. …the modern public finance literature has devoted significant efforts to study behavioral responses to changes in taxes on reported taxable income… Most of this work focuses on the elasticity of taxable income (ETI), which captures a broad set of real and reporting behavioral responses to taxation. Indeed, reported taxable income reflects not only individuals’ decisions on hours worked, but also work effort and career choices as well as the results of investment and entrepreneurship activities. Besides these real responses, the ETI also captures tax evasion and avoidance decisions of individuals to reduce their tax bill.

By the way, “elasticity” is econ-speak for sensitivity. In other words, if there’s high elasticity, it means taxpayers are very responsive to a change in tax rates.

Anyhow, here’s how authors designed their study.

In this paper, we estimate the elasticity of taxable income in Spain, an interesting country to study because during the last two decades it has implemented several major personal income tax reforms… In the empirical analysis, we use an administrative panel dataset of income tax returns… We calculate the MTR as a weighted average of the MTR applicable to each income source (labor, financial capital, real-estate capital, business income and capital gains).

You can see in Figure 1 that the 2003 reform was good for taxpayers and the 2012 reform was bad for taxpayers.

If nothing else, though, these changes created the opportunity for scholars to measure how taxpayers respond.

And here are the results.

We obtain estimates of the ETI around 0.35 using the Gruberand Saez (2002) estimation method, 0.54 using Kleven and Schultz (2014)’s method and 0.64 using Weber (2014)’s method. …In addition to the average estimates of the ETI, we analyze heterogeneous responses across groups of taxpayers and sources of income. …As expected, stronger responses are documented for groups of taxpayers with higher ability to respond. In particular, self-employed taxpayers have a higher ETI than wage employees, while real-estate capital and business income respond more strongly than labor income. …we find large responses on the tax deductions margin, especially private pension contributions.

In other words, taxpayers do respond to changes in tax policy.

And some taxpayers are very sensitive (high elasticity) to those changes.

Here’s Table 6 from the study. Much of it will be incomprehensible if you’re not familiar with econometrics. But all that matters is that I circled (in red) the measures of how elasticities vary based on the type of income (larger numbers mean more sensitive).

I’ll close with a very relevant observation about American fiscal policy.

Currently, upper-income taxpayers finance the vast majority of America’s medium-sized welfare state.

But what if the United States had a large-sized welfare state, like the ones that burden many European nations?

If you review the data, those large-sized welfare states are financed with stifling tax burdens on lower-income and middle-class taxpayers. Politicians in Europe learned that they couldn’t squeeze enough money out of the rich (in large part because of high elasticities).

Indeed, I wrote early this year about how taxes are confiscating the lion’s share of the income earned by ordinary workers in Spain.

And if we adopt the expanded welfare state envisioned by Bernie Sanders, Alexandria Ocasio-Cortez, and Kamala Harris, the same thing will happen to American workers.

P.S. I admire how Spanish taxpayers have figured out ways of escaping the tax net.

P.P.S. There’s also evidence about the impact of Spain’s corporate tax.

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Assuming the goal is faster growth and higher living standards, there are three core principles of good tax policy.

You could call this list the Holy Trinity of supply-side economics. Simply stated, incentives matter, so it makes no sense for government to discourage the things that make a nation more prosperous.

Regarding low marginal tax rates, my left-leaning friends sometimes dismiss the importance of this principle by pointing out that they don’t pay much attention to their marginal tax rates.

I can sympathize with their skepticism. When I was first learning about public finance and studying supply-and-demand curves showing deadweight loss, I also wondered about the supply-side claim that marginal tax rates mattered. Even after I started working, I had doubts. Would I somehow work harder if my tax rate fell? Or goof off if my tax rate went up? It didn’t make much sense.

What I didn’t recognize, however, is that I was looking at the issue from the perspective of someone working a standard, 9-to-5 job with a modest income. And it is true that such workers are not very responsive (especially in the short run) to changes in tax rates.

In the real world, though, there are lots of people who don’t fit that profile. They have jobs that give them substantial control over the timing, level, and composition of their income.

And these people – such as business owners, professionals, second earners, investors, and entrepreneurs – often are very responsive to changes in marginal tax rates.

We have a new example of this phenomenon. Check out these excerpts from a story in the U.K.-based Times.

About three quarters of GPs and hospital consultants have cut or are planning to cut their hours… About 42 per cent of family doctors and 30 per cent of consultants have reduced their working times already, claiming that they are being financially penalised the more they work. A further 34 per cent and 40 per cent respectively have confirmed that they plan to reduce their hours in the coming months… The government has launched an urgent consultation over the issue, which is the result of changes to pension rules limiting the amount that those earning £110,000 or more can pay into their pensions before they are hit with a large tax bill.

In other words, high tax rates have made leisure more attractive than work. Why work long hours, after all, if the tax authority is the biggest beneficiary?

There are also indirect victims of these high tax rates.

Last month figures from NHS Providers, which represents hospitals, showed that waiting lists had climbed by up to 50 per cent since April as doctors stopped taking on extra shifts to avoid the financial penalties. Richard Vautrey, chairman of the BMA GPs’ committee, said: “These results show the extent to which GPs are being forced to reduce their hours or indeed leave the profession altogether because of pension taxes. …swift and decisive action is needed from the government to end this shambolic situation and to limit the damage that a punitive pensions taxation system is inflicting on doctors, their patients and across the NHS as a whole.”

The U.K.’s government-run health system already has plenty of problems, including long wait times and denial of care. The last thing it needs is for doctors and other professionals to cut back their hours because politicians are too greedy.

The moral of the story is that tax rates matter. Depending on the type of person, they can matter a lot.

This doesn’t mean tax rates need to be zero (though I like that idea).

It simply means that taxes impose costs, and those costs become increasingly apparent as tax rates climb.

P.S. If you want a horror story about marginal tax rates, check out what happened to Cam Newton, the quarterback of the Carolina Panthers.

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Yesterday’s column weighed in on the debate whether Jesus was a socialist.

Like Cal Thomas, I don’t think the Bible supports coercive redistribution by government.

Today, let’s look at the same issue, but from a humorous perspective.

For those on the other side of the debate, Socialist Jesus has a very efficient mechanism to collect alms for the poor.

This approach is supported by some parishoners.

From Babylon Bee, we have a story about a disciple of Socialist Jesus.

A lot of Christians are criticized for not being very compassionate to the poor. But you can’t say that about Larry DeManson, a local believer who is so committed to charity for those less fortunate than himself that he always votes for government to steal money from his neighbor and give it to the impoverished. …DeManson no longer has a guilty conscience whenever he sees people in need. “I don’t personally have to do anything,” he said. “The government does it for me.” The man cites the verse “somewhere in James” that says that “true religion before the Father is to forcibly redistribute money from those wealthier than you in order to take care of the poor.”

Now let’s look at an alternative approach.

Except we won’t be sharing insights from Libertarian Jesus.

Instead, courtesy of Imgur, we have the story of Supply-Side Jesus.

And this Supply-Side Jesus is an advocate of trickle-down economics.

He creates lots of jobs.

And he believes in self-sufficiency.

He also opposes class warfare.

Supply-Side Jesus is a fan of the entrepreneur class.

And he understands self-promotion.

But not everyone is happy.

Supply-Side Jesus was in trouble.

But he avoided trouble, thanks to majoritarianism.

Supply-Side Jesus then decided to enter politics.

I don’t know who created this cartoon strip, but kudos for some clever humor (though I imagine practitioners of the “Prosperity Gospel” won’t be amused).

As a general rule, I find that leftists are too dour to create effective political humor (see the Black NRA, for instance). But when they come up with something clever (see here, here, and here), I’m more than willing to applaud.

Even when they mock libertarians!

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There’s general agreement among public finance experts that personal income taxes and corporate income taxes, on a per-dollar-collected basis, do the most economic damage.

And I suspect there’s a lot of agreement that this is because these levies often have high marginal tax rates and often are accompanied by a significant bias against income that is saved and invested.

Payroll tax and consumption taxes, by contrast, are thought to be less damaging because they generally don’t have “progressive rates” and they are “neutral,” meaning they rarely involve any double taxation of saving and investment.

But “less damaging” is not the same as “no damage.”

Such taxes still drive a wedge between pre-tax income and post-tax consumption, so they do result in less economic activity (what economists refer to as “deadweight loss“).

And the deadweight loss can be significant if the overall tax burden is sufficiently onerous (as is the case in many European nations).

Interestingly, the (normally pro-tax) International Monetary Fund just released a study on this topic. It looked at the impact of taxes on work in the new member states (NMS) of the European Union. Here’s a summary of what the authors wanted to investigate.

Given demographic and pension pressures facing many EU28 countries amidst low labor market participation rates together with still high tax wedges, the call to review public policies has gained renewed prominence in the EU political debate. …tax wedges remain high and participation rates, while having increased importantly in a few countries over 2000-17 , are still around or below 70 percent in many of them. This hints at the need for addressing structural problems to improve economic fortunes. In this paper we focus our attention on hours worked (per working age population). …At country level, hours worked reflect labor supply decisions and could be thought of a measure of labor utilization. Long-run changes in labor supply are driven by incentives, of which taxes are perceived to be central. Assessing the importance of taxation on hours is key to provide new insights for potential policy actions.

And here’s what they found.

We study the role of taxes in accounting for differences in hours worked across NMS over the 1995-17 period… We find that consumption and labor taxes significantly discourage labor supply and can explain close to 21 percent of the observed variation of hours across NMS. …Higher tax rates reduce households’ net labor income and real purchasing power, inducing them to substitute consumption for leisure, which cannot be taxed. …Our findings show that, conditional on other factors, taxes are an important determinant of hours. Point estimates suggest a high elasticity of hours to taxes (close to 0.5), which is robust to the inclusion of other factors.

What’s interesting about the new member states of Eastern Europe is that many of them have flat taxes and low corporate rates.

So the personal and corporate income taxes are not a major burden.

But they so have relatively high payroll taxes (a.k.a., social insurance taxes) and relatively onerous value-added taxes.

So it’s hardly a surprise that these levies are the ones most associated with deadweight loss.

We find that social security contributions deter hours the most, followed by consumption taxes and, to a lesser extent, personal income taxes. …Consumption and personal income taxes are found to affect hours per worker, but not employment rates. On the other hand, social security contributions are negatively associated with employment rates, but do not seem to affect hours per worker. …In line with the literature, we document that women’s employment rate is more sensitive to changes in tax policies. We find the elasticity of employment rate to social security contributions to be 7 percent larger for women vis-à-vis men.

Here’s one of the charts from the study.

And here’s an explanation of what it means.

Figure 4 shows the evolution of hours and effective taxes. Hours worked increased substantially for Group 1, while it remained stable in Group 2 (Panel (a)). In both groups, the effect of the GFC is noticeable as hours sharply declined after 2008. Panel (b) shows the evolution of the average effective tax rate in each group. Interestingly, countries in Group 1, which observed an increase in hours, had lower effective tax rates (below 40 percent) throughout the period. In addition, we observe a negative correlation between hours and taxes for most of the sample. For Group 1, the large increase in hours – between year 2000 and the GFC – happened at the same time taxes declined

Here’s another chart from the IMF report.

And here’s some of the explanatory text.

Figure 5 depicts the relationship between hours worked and taxes across countries. In Panel (a), we observe a negative correlation between hours and taxes in levels for each group, with the negative correlation being stronger in Group 2 than in Group 1 (it has a steeper slope). Panel (b) shows total log changes in hours and taxes throughout the period. It also displays a negative correlation.

Looking at the conclusion, a key takeaway from the study is that there is a substantial loss of economic activity because of theoretically benign (but in reality onerous) taxes on consumption and labor.

Our modelling exercise shows that taxes influence the long-run trend in hours and our econometric exercise shows that the findings are robust to the inclusion of other labor market determinants. Furthermore, we document an elasticity of hours to overall taxes close to 0.5. We find that differences in tax burden can explain up to 21 percent in the variation of hours worked across NMS. The main takeaway of this study is that excessive tax burden, either in the form of consumption or labor taxes, can lead to substantial deadweight losses in terms of labor supply. .. overall tax burden – and not only labor taxes – should be considered when thinking about incentives from tax schemes.

Yes, incentives do matter.

And it’s good that an IMF report is providing good evidence for lower tax rates.

But I’m not optimistic we’ll get pro-growth changes. There’s been a lack of good reform this decade from the new member states from Eastern Europe. Combined with demographic decline (and the associated pressure for higher tax rates), this does not bode well.

P.S. While the professional economists at the IMF often produce good research and sensible advice, the bureaucracy’s political leaders almost always ignore those findings and instead push for bad tax policy. Including in the new member states from Eastern Europe.

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I’m a big fan of the Laffer Curve, which is simply a graphical representation of the common-sense notion that punitively high tax rates can result in less revenue because of reductions in the economy-wide level of work, saving, investment, and entrepreneurship.

This insight of supply-side economics is so obviously true that even Paul Krugman has acknowledged its veracity.

What’s far more important, though, is that Ronald Reagan grasped the importance of Art’s message. And he dramatically reduced tax rates on productive behavior during his presidency.

And those lower tax rates, combined with similar reforms by Margaret Thatcher in the United Kingdom, triggered a global reduction in tax rates that has helped boost growth and reduce poverty all around the world.

In other words, Art Laffer was a consequential man.

So it was great news that President Trump yesterday awarded Art with the Presidential Medal of Freedom.

Let’s look at some commentary on this development, starting with a column in the Washington Examiner by Fred Barnes.

When President Trump announced he was awarding the Presidential Medal of Freedom to economist Arthur Laffer, there were groans of dismay in Washington… Their reaction was hardly a surprise. Laffer is everything they don’t like in an economist. He’s an evangelist for tax cuts. He believes slashing tax rates is the key to economic growth and prosperity. And more often than not, he’s been right about this. Laffer emerged as an influential figure in the 1970s as the champion of reducing income tax rates. He was a key player in the Reagan cuts of 1981 that touched off an economic boom lasting two decades. …Laffer, 78, is not a favorite of conventional, predominantly liberal economists. Tax cuts leave the job of economic growth to the private sector. Liberal economists prefer to give government that job. Tax cuts are not on their agenda. Tax hikes are. …His critics would never admit to Laffer envy. But they show it by paying attention to what he says and to whom he’s affiliated. They rush to criticize him at any opportunity. …Laffer was right…about tax cuts and prosperity.

And here are some excerpts from a Bloomberg column by Professor Karl Smith of the University of North Carolina.

Most important, he highlights how supply-side economics provided a misery-minimizing way of escaping the inflation of the 1970s.

President Donald Trump’s decision to award Arthur Laffer the Presidential Medal of Freedom has met with no shortage of criticism… Laffer was a policy entrepreneur, and his..boldness was crucial in the development of what came to be known as the “Supply Side Revolution,” which even today is grossly underappreciated. In the 1980s, the U.S. economy avoided the malaise that afflicted Japan and much of Western Europe. The primary reason was supply-side economics. …Reducing inflation with minimal damage to the economy was the central goal of supply-side economics. …most economists agreed that inflation could be brought down with a severe enough recession. …Conservative economists argued that the long-term gain was worth that level of pain. Liberal economists argued that inflation was better contained with price and income controls. Robert Mundell, a future Nobel Laureate, argued that there was third way. Restricting the money supply, he said, would cause demand in the economy to contract, but making large tax cuts would cause demand to expand. If done together, these two strategies would cancel each other out, leaving room for supply-side factors to do their work. …Laffer suggested that permanent reductions in taxes and regulations would increase long-term economic growth. A faster-growing economy would increase foreign demand for U.S. financial assets, further raising the value of the dollar and reducing the price of foreign imports. These effects would speed the fall in inflation by increasing the supply of goods for sale. In the early 1980s, the so-called Mundell-Laffer hypothesis was put to the test — and it was, by and large, successful.

I’ve already written about how taming inflation was one of Reagan’s great accomplishments, and this column adds some meat to the bones of my argument.

And it’s worth noting that left-leaning economists thought it couldn’t be done. Professor Bryan Caplan shared this quote from Paul Samuelson.

Today’s inflation is chronic.  Its roots are deep in the very nature of the welfare state.  [Establishment of price stability through monetary policy would require] abolishing the humane society [and would] reimpose inequality and suffering not tolerated under democracy.  A fascist political state would be required to impose such a regime and preserve it.  Short of a military junta that imprisons trade union activists and terrorizes intellectuals, this solution to inflation is unrealistic–and, to most of us, undesirable.

It’s laughable to read that today, but during the Keynesian era of the 1970s, this kind of nonsense was very common (in addition to the Samuelson’s equally foolish observations on the supposed strength of the Soviet economy).

The bottom line is that Art Laffer and supply-side economics deserve credit for insights on monetary policy in addition to tax policy.

But since Art is most famous for the Laffer Curve, let’s close with a few additional observations on that part of supply-side economics.

Many folks on the left today criticize Art for being too aggressive about the location of the revenue-maximizing point of the Laffer Curve. In other words, they disagree with him on whether certain tax cuts will raise revenue or lose revenue.

While I think there’s very strong evidence that lower tax rates can increase revenue, I also think it doesn’t happen very often.

But I also think that debate doesn’t matter. Simply stated, I don’t want politicians to have more revenue, which means that I don’t want to be at the revenue-maximizing point of the Laffer Curve.

Moreover, there’s a lot of economic damage that occurs as tax rates approach that point, which is why I often cite academic research confirming that one additional dollar of tax revenue is associated with several dollars (or more!) of lost economic output.

Call me crazy, but I’m not willing to destroy $5 or $10 of private-sector income in order to increase Washington’s income by $1.

The bottom line is that the key insight of the Laffer Curve is that there’s a cost to raising tax rates, regardless of whether a nation is on the left side of the curve or the right side of the curve.

P.S. While I’m a huge fan of Art Laffer, that doesn’t mean universal agreement. I think he’s wrong in his analysis of destination-based state sales taxes. And I think he has a blind spot about the danger of a value-added tax.

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My friends on the left hold two impossible-to-reconcile views about taxation.

  • First, they say taxes don’t really have any effect on incentives to work, save and invest, and that governments can impose high tax rates and punitive double taxation without causing meaningful economic damage or loss of national competitiveness.
  • Second, they say differences in taxes between jurisdictions will cause massive tax-avoidance behavior as jobs and investment migrate to places with lower taxes, and that national and international tax harmonization is required to prevent that ostensibly horrible outcome.

Huh?!? They’re basically asserting that taxes simultaneously have no effect on taxpayer behavior and lots of effect on taxpayer behavior.

Well, they’re half right.

Taxpayers do respond to incentives. And when tax rates are too high, both money and people will escape high-tax regimes.

In other words, people do “vote with their feet.”

And it seems pro athletes are not “dumb jocks” when contemplating the best places to sign contracts.

Looking at baseball, taxes presumably had an effect on Bryce Harper’s decision to play for the Phillies.

For Major League Baseball players, three teams are at the bottom of the standings on state taxes: the Los Angeles Dodgers, San Diego Padres and San Francisco Giants. That’s because California is in a league of its own on personal income taxes. We’ve got by far the highest state rate in the nation, topping out at 13.3%. By contrast, Pennsylvania has a low flat rate for every taxpayer regardless of income. It’s just 3.07%. That’s one reason why superstar slugger Bryce Harper signed an eye-popping 13-year, $330-million contract last week with the Philadelphia Phillies, spurning the Dodgers and Giants. …Harper will save tens of millions in taxes by signing with the Phillies instead of a California team. …“The Giants, Dodgers and Padres are in the worst state income tax jurisdiction in all of baseball,” Boras adds. “Players really get hit.” …To what extent do California’s sky-high taxes drive players away? “It’s a red light,” agent John Boggs says. “I’ve had players in the past say they don’t want to go to certain states because they’re going to get hammered by taxes. Obviously, that affects the bottom line.”

Another argument for states to join the flat tax club!

If we cross the Atlantic Ocean, we find lots of evidence that high tax rates in Europe create major headaches in the world of sports.

For example, I’ve previously written about how the absence of an income tax gives the Monaco team a significant advantage competing in the French soccer league.

And there are many other examples from Europe dealing with soccer and taxation.

According to a BBC report, we should highlight the impact on both players and management in Spain.

Ex-Manchester United boss José Mourinho has agreed a prison term in Spain for tax fraud but will not go to jail. A one-year prison sentence will instead be exchanged for a fine of €182,500 (£160,160). That will be added to a separate fine of €2m. …He was accused of owing €3.3m to Spanish tax authorities from his time managing Real Madrid in 2011-2012. Prosecutors said he had created offshore companies to manage his image rights and hide the earnings from tax officials. …In January, Cristiano Ronaldo accepted a fine of €18.8m and a suspended 23-month jail sentence, in a case which was also centred around tax owed on image rights. …Another former Real Madrid star, Xabi Alonso, is also facing charges over alleged tax fraud amounting to about €2m, though he denies any wrongdoing. Marcelo Vieira, who still plays for the club, accepted a four-month suspended jail sentence last September over his use of foreign firms to handle almost half a million euros in earnings. Barcelona’s Lionel Messi and Neymar have also found themselves embroiled in legal battles with the Spanish tax authorities.

Let’s cross the Atlantic again and look at the National Football League.

Consider Christian Wilkins, who was just drafted in the first round by the NFL’s Miami Dolphins. He’s very aware of how lucky he is to have been picked by a football team in a state with no income tax.

The Miami Dolphins picked Clemson defensive tackle Christian Wilkins with the 13th overall pick in Thursday night’s first round of the NFL draft. …He’ll be counted on to help usher in a new era of Miami football under first-year head coach Brian Flores. …Wilkins said he “knew they were interested” in him and is happy to be headed to Miami. He also joked that he’s happy he’ll be playing football in Florida, where there is no state income tax. “Pretty excited about them taxes,” he said. “A lot of guys who went before me, I might be making just a little bit more, but hey, it is what it is.”

As he noted, his contract may not be as big as some of the players drafted above him, but he may wind up with more take-home pay since Florida is a fiscally responsible state.

College players have no control over which team drafts them, so Wilkins truly is lucky.

Players in free agency, by contrast, can pick and choose their new team.

And if we travel up the Atlantic coast from Miami to Jacksonville, we can read about how the Jaguars – both players and management – understand how they’re net beneficiaries of being in a no-income tax state.

Hayden Hurst got excited after he received a phone call from someone he trusted who told him the Jaguars were targeting him with the No. 29 overall pick. …Though Hurst…was happy when the Baltimore Ravens took him four slots before the Jaguars, he also knew in advance of the financial consequences that most rookies don’t notice. Since Florida is one of four NFL states (Tennessee, Texas and Washington being the others) with no state income tax, Hurst, who played at South Carolina, understood he’d see a big chunk of his $6.1 million signing bonus disappear on the deduction line when he received his first bonus check. …“I thought about how much of my money was going to be impacted depending on which state I played in,” Hurst said. “I’m paying a pretty hefty percent up in Maryland. To see the amount get taken away right off the bat kind of hurt, it was pretty sickening.” With the NFL free agent market set to open Wednesday, Hurst’s situation illustrates a potential competitive advantage for the Jaguars of being in an income tax-free state when they court free agents.

Yes, the flat tax club is good, but the no-income-tax club is even better.

I’ll close with an observation. Way back in 2009, I speculated that high tax rates could actually hurt the performance of teams in high-tax states.

It turns out I was right, as you can see from academic research I cited in 2017 and 2018.

The bottom line is that teams in high-tax states can still sign big-name players, but they have to pay more to compensate for taxes. And this presumably means less money for other players, thus lowering overall quality (and also lowering average win totals).

P.S. I normally only cheer for NFL athletes who played for my beloved Georgia Bulldogs, but I now have a soft spot in my heart for Christian Wilkins (just like Evan Mathis).

P.P.S. I also have plenty of sympathy for Cam Newton, who paid a tax rate of almost 200 percent on the income he earned for playing in the 2016 Super Bowl.

P.P.P.S. Taxes also impact choices on how often to box and where to box.

P.P.P.P.S. And where to run track.

P.P.P.P.P.S. And where to play basketball.

P.P.P.P.P.P.S. While one can argue that there are no meaningful economic consequences if athletes avoid jurisdictions with bad tax law, can the same be said if we have evidence that high tax burdens deter superstar inventors and entrepreneurs?

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Mark Perry of the American Enterprise Institute is most famous for his Venn diagrams that expose hypocrisy and inconsistency.

But he also is famous for his charts.

And since I’m a big fan of sensible tax policy and the Laffer Curve, we’re going to share Mark’s new chart looking at the inverse relationship between the top tax rate and the share of taxes paid by the richest Americans.

Examining the chart, it quickly becomes evident that upper-income taxpayers started paying a much greater share of the tax burden after the Reagan tax cuts.

My left-leaning friends sometimes look at this data and complain that the rich are paying more of the tax burden only because they have grabbed a larger share of national income. And this means we should impose punitive tax rates.

But this argument is flawed for three reasons.

First, there is not a fixed amount of income. The success of a rich entrepreneur does not mean less income for the rest of us. Instead, it’s quite likely that all of us are better off because the entrepreneur created some product of service that we value. Indeed, data from the Census Bureau confirms that all income classes tend to rise and fall simultaneously.

Second, it’s not even accurate to say that the rich are getting richer faster than the poor are getting richer.

Third, one of the big fiscal lessons of the 1980s is that punitive tax rates on upper-income taxpayers backfire because investors, entrepreneurs, and business owners will choose to earn and report less taxable income.

For my contribution to this discussion, I want to elaborate on this final point.

When I give speeches, I sometimes discover that audiences don’t understand why rich taxpayers can easily control the amount of their taxable income.

And I greatly sympathize since I didn’t appreciate this point earlier in my career.

That’s because the vast majority of us get the lion’s share of our income from our employers. And when we get this so-called W-2 income, we don’t have much control over how much tax we pay. And we assume that this must be true for others.

But rich people are different. If you go the IRS’s Statistics of Income website and click on the latest data in Table 1.4, you’ll find that wages and salaries are only a small fraction of the income earned by wealthy taxpayers.

These high-income taxpayers may be tempting targets for Alexandria Ocasio-Cortez, Elizabeth Warren, Bernie Sanders and the other peddlers of resentment, but they’re also very elusive targets.

That’s because it’s relatively easy – and completely legal – for them to control the timing, level, and composition of business and investment income.

When tax rates are low, this type of tax planning doesn’t make much sense. But as tax rates increase, rich people have an ever-growing incentive to reduce their taxable income and that creates a bonanza for lawyers, accountants, and financial planners.

Needless to say, there are many loopholes to exploit in a 75,000-page tax code.

P.S. There’s some very good evidence from Sweden confirming my point.

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Like most taxpayer-supported international bureaucracies, the Organization for Economic Cooperation and Development (OECD) has a statist orientation.

The Paris-based OECD is particularly bad on fiscal policy and it is infamous for its efforts to prop up Europe’s welfare states by hindering tax competition.

It even has a relatively new “BEPS” project that is explicitly designed so that politicians can grab more money from corporations.

So it’s safe to say that the OECD is not a hotbed of libertarian thought on tax policy, much less a supporter of pro-growth business taxation.

Which makes it all the more significant that it just announced that supporters of free markets are correct about the Laffer Curve and corporate tax rates.

The OECD doesn’t openly acknowledge that this is the case, of course, but let’s look at key passages from a Tuesday press release.

Taxes paid by companies remain a key source of government revenues, especially in developing countries, despite the worldwide trend of falling corporate tax rates over the past two decades… In 2016, corporate tax revenues accounted for 13.3% of total tax revenues on average across the 88 jurisdictions for which data is available. This figure has increased from 12% in 2000. …OECD analysis shows that a clear trend of falling statutory corporate tax rates – the headline rate faced by companies – over the last two decades. The database shows that the average combined (central and sub-central government) statutory tax rate fell from 28.6% in 2000 to 21.4% in 2018.

So tax rates have dramatically fallen but tax revenue has actually increased. I guess many of the self-styled experts are wrong on the Laffer Curve.

By the way, whoever edits the press releases for the OECD might want to consider changing “despite” to “because of” (writers at the Washington Post, WTNH, Irish-based Independent, and Wall Street Journal need similar lessons in causality).

Let’s take a more detailed look at the data. Here’s a chart from the OECD showing how corporate rates have dropped just since 2000. Pay special attention to the orange line, which shows the rate for developed nations.

I applaud this big drop in tax rates. It’s been good for the world economy and good for workers.

And the chart only tells part of the story. The average corporate rate for OECD nations was 48 percent back in 1980.

In other words, tax rates have fallen by 50 percent in the developed world.

Yet if you look at this chart, which I prepared using the OECD’s own data, it shows that revenues actually have a slight upward trend.

I’ll close with a caveat. The Laffer Curve is very important when looking at corporate taxation, but that doesn’t mean it has an equally powerful impact when looking at other taxes.

It all depends on how sensitive various taxpayers are to changes in tax rates.

Business taxes have a big effect because companies can easily choose where to invest and how much to invest.

The Laffer Curve also is very important when looking at proposals (such as the nutty idea from Alexandria Ocasio-Cortez) to increase tax rates on the rich. That’s because upper-income taxpayers have a lot of control over the timing, level, and composition of business and investment income.

But changes in tax rates on middle-income earners are less likely to have a big effect because most of us get a huge chunk of our compensation from wages and salaries. Similarly, changes in sales taxes and value-added taxes are unlikely to have big effects.

Increasing those taxes is still a bad idea, of course. I’m simply making the point that not all tax increases are equally destructive (and not all tax cuts generate equal amounts of additional growth).

P.S. The International Monetary Fund also accidentally provided evidence about corporate taxes and the Laffer Curve. And there was also a little-noticed OECD study last year making the same point.

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Steve Moore and Art Laffer are the authors of Trumponomics, a largely favorable book about the President’s economic policy.

I have a more jaundiced view about Trump.

I’m happy to praise his good policies (taxes and regulation), but I also condemn his bad policies (spending and trade).

And as you might expect, some people are completely on the opposite side from Moore and Laffer.

Writing for New York, Jonathan Chait offers a very unfriendly review of the book. He starts by categorizing Steve and Art (as well as Larry Kudlow, who wrote the foreword) as being fixated on tax rates.

The authors of Trumponomics are Larry Kudlow (who left in the middle of its writing to accept a job as director of the National Economic Council), Stephen Moore, and Arthur Laffer. The three fervently propound supply-side economics, a doctrine that holds that economic performance hinges largely on maintaining low tax rates on the rich. …Kudlow, Moore, and Laffer are unusually fixated on tax cuts, but they are merely extreme examples of the entire Republican Establishment, which shared their broad priorities.

For what it’s worth, I think low tax rates are good policy. And I suspect that the vast majority of economists will agree with the notion that lower tax rates are better for growth than high tax rates.

But Chait presumably thinks that Larry, Steve, and Art overstate the importance of low rates (hence, the qualification about “economic performance hinges largely”).

To bolster his case, he claims advocates of low tax rates were wrong about the 1990s and the 2000s.

In the 1990s, the supply-siders insisted Bill Clinton’s increase in the top tax rate would create a recession and cause revenue to plummet. The following decade, they heralded the Bush tax cuts as the elixir that had brought in a glorious new era of prosperity. …The supply-siders have maintained absolute faith in their dogma in the face of repeated failure by banishing all doubt. …they have confined their failed predictions to the memory hole.

If Chait’s point is simply that some supply-siders have been too exuberant at times, I won’t argue. Exaggeration, overstatement, and tunnel vision are pervasive on all sides in Washington.

Heck, I sometimes fall victim to the same temptation, though I try to atone for my bouts of puffery by bending over backwards to point out that taxation is just one piece of the big policy puzzle.

Which is why I want to focus on this next excerpt from Chait’s article. He is very agitated that the book praises the economic performance of the Clinton years and criticizes the economic performance of the Bush years.

A brief economic history in Trumponomics touts the gains made from 1982 to 1999, and laments “those gains stalled out after 2000 under Presidents George W. Bush and Barack Obama.” Notice, in addition to starting the Reagan era in 1982, thus absolving him for any blame for the recession that began a year into his presidency, they have retroactively moved the hated leftist Bill Clinton into the right-wing hero camp and the beloved conservative hero George W. Bush into the failed left-wing statist camp.

Well, there’s a reason Clinton is in the good camp and Bush is in the bad camp.

As you can see from Economic Freedom of the World (I added some numbers and commentary), the U.S. enjoyed increasing economic liberty during the 1990s and suffered decreasing economic liberty during the 2000s.

For what it’s worth, I’m not claiming that Bill Clinton wanted more economic liberty or that George W. Bush wanted more statism. Maybe the credit/blame belongs to Congress. Or maybe presidents get swept up in events that happen to occur when they’re in office.

All I’m saying is that Steve and Art are correct when they point out that the nation got better overall policy under Clinton and worse overall policy under Bush.

In other words, Clinton’s 1993 tax increase was bad, but it was more than offset by pro-market reforms in other areas. Likewise, Bush’s tax cuts were good, but they were more than offset by anti-market policies in other areas.

P.S. Chait complained about Moore and Laffer “starting the Reagan era in 1982, thus absolving him for any blame for the recession that began a year into his presidency”.

Since I’m a fan of Reaganomics, I feel compelled to offer three comments.

  • First, the recession began in July 1981. That’s six months into Reagan’s presidency rather than one year.
  • Second, does Chait really want to claim that the downturn was Reagan’s fault? If so, I’m curious to get his explanation for how a tax cut that was signed in August caused a recession that began the previous month.
  • Third, the recession almost certainly should be blamed on bad monetary policy, and even Robert Samuelson points out that Reagan deserves immense praise for his handling of that issue.

P.P.S. Bill Clinton’s 1993 tax hike didn’t produce the budget surpluses of the late 1990s. If you don’t believe me, check out the numbers from Bill Clinton’s FY1996 budget.

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The central argument against punitive taxation is that it leads to less economic activity.

Here’s a visual from an excellent video tutorial by Professor Alex Tabarrok. It shows that government grabs a share of private output when a tax is imposed, thus reducing the benefits to buyers (“consumer surplus”) and sellers (“producer surplus).

But it also shows that some economic activity never takes place (“deadweight loss”).

When discussing the economics of taxation, I always try to remind people that deadweight loss also represents foregone taxable activity, which is why the Laffer Curve is a very real thing (as even Paul Krugman admits).

To see these principles at work in the real world, let’s look at a report from the Washington Post. The story deals with cigarette taxation, but I’m not sharing this out of any sympathy for smokers. Instead, the goal is to understand and appreciate the broader point of how changes in tax policy can cause changes in behavior.

The sign on the window of a BP gas station in Southeast Washington advertises a pack of Newports for $10.75. Few customers were willing to pay that much. But several men in the gas station’s parking lot had better luck illegally hawking single cigarettes for 75 cents. The drop in legal sales and spike in black market “loosies” are the result of $2-a-pack increase in cigarette taxes that took effect last month… Anti-tobacco advocates hailed the higher legal age and the tax increase as ways to discourage smoking. But retailers say the city has instead encouraged the black market and sent customers outside the city.

Since I don’t want politicians to have more money, I’m glad smokers are engaging in tax avoidance.

And I feel sympathy for merchants who are hurt by the tax.

Shoukat Choudhry, the owner of the BP and four other gas stations in the city, says he does not see whom the higher taxes are helping. His customers can drive less than a mile to buy cheaper cigarettes in Maryland. He says the men in his parking lot are selling to teenagers. And the city is not getting as much tax revenue from his shops. Cigarette revenue at the BP store alone fell from $63,000 in September to $45,000 in October, when the tax increase took effect on the first of the month. …The amateur sellers say the higher cigarette tax has not been a bonanza for them. They upped their price a quarter for a single cigarette.

It’s also quite likely that the Laffer Curve will wreak havoc with the plans of the D.C. government.

Citywide figures for cigarette sales in October — as measured by tax revenue — will not be available until next month, city officials said. The District projected higher cigarette taxes would bring in $12 million over the next four years. Proceeds from the tax revenue are funding maternal and early childhood care programs. The Campaign for Tobacco-Free Kids says the fear of declining tax revenue because of black market sales has not materialized elsewhere.

Actually, there is plenty of evidence – both in America and elsewhere – that higher cigarette taxes backfire.

I would be shocked if D.C. doesn’t create new evidence since avoidance is so easy.

…critics of the tax increase say the District is unique because of how easy it is to travel to neighboring Virginia, which has a 30-cent tax, and Maryland, with a $2 tax. “What person in their right mind is going to pay $9 or $10 for a pack of cigarettes when they can go to Virginia?” said Kirk McCauley of the WMDA Service Station and Automotive Repair Association, a regional association for gas stations. …Ronald Jackson, who declined to buy a loose cigarette from the BP parking lot, says he saves money with a quick drive to Maryland to buy five cartons of Newport 100s, the legal limit. “After they increased the price, I just go over the border,” said Jackson, a 56-year-old Southeast D.C. resident. “They are much cheaper.”

An under-appreciated aspect of this tax is how it encourages the underground economy.

Though I’m happy to see (especially remembering what happened to Eric Garner) that D.C. police have no interest in hindering black market sales.

The D.C. Council originally set aside money from the cigarette tax increase for two police officers to crack down on illegal sales outside of stores. But that funding was removed amid concerns about excessive enforcement and that it would strain police relations with the community. On a Tuesday morning, Choudhry, the owner of the Southeast BP, stopped a police officer who was filling up his motorcycle at the BP station to point out a group of men selling cigarettes in his parking lot. The officer drove off without action. …On a good day, he can pull about $70 in profit. “Would you rather that we rob or steal,” said Mike, who said he has spent 15 years in jail. “Or do you want us out here selling things?”

Kudos to Mike. I’m glad he’s engaging in voluntary exchange rather than robbing and stealing. Though maybe he got in trouble with the law in the first place because of voluntary exchange (a all-too-common problem for people in Washington).

But now let’s zoom out and return to our discussion about economics and taxation.

An under-appreciated point to consider is that deadweight loss grows geometrically larger as tax rates go up. In other words, you don’t just double damage when you double tax rates. The consequences are far more severe.

Here are two charts that were created for a chapter I co-authored in a book about demographics and capital taxation. This first chart shows how a $1 tax leads to 25-cents of deadweight loss.

But if the tax doubles to $2, the deadweight loss doesn’t just double.

In this hypothetical example, it rises to $1 from 25-cents.

For any given tax on any particular economic activity, the amount of deadweight loss will depend on both supply and demand sensitivities. Some taxes impose high costs. Others impose low costs.

But in all cases, the deadweight loss increases disproportionately fast as the tax rate is increased. And that has big implications for whether there should high tax rates on personal income and corporate income, as well as whether there should be heavy death taxes and harsh tax rates on capital gains, interest, and dividends.

Some of my left-wing friends shrug their shoulders because they assume that rich people bear the burden. But remember that the reduction of “consumer surplus” is a measure of the loss to taxpayers. The deadweight loss is the foregone output to society.

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I’ve written about how taxes have a big impact on soccer (a quaint game with little or no scoring that Europeans play with their feet).

Taxes affect both the decisions of players and the success of teams.

Grasping and greedy governments also have an impact on football. Especially if teams play in Europe.

…the Los Angeles Chargers and Tennessee Titans traveled across the Atlantic to play a game in London’s Wembley Stadium. …Players spoke of the burdens of traveling so far to play a game, especially the team from California that had to cross eight time zones. Players also spoke out about the tax nightmare they faced when they got to the UK. …players talked ahead of time to their CPAs to determine the tax hit they’d take for the privilege of such a long road trip… Great Britain…levies high taxes on athletes who visit for an athletic match. Teams from California — the Raiders, Chargers, and Rams — already face the highest state income tax in the nation with a top rate of 13.3 percent. Of course, players also have to pay federal income tax. …To top it all off, those players who receive one of their 16 paychecks in London pay a 45 percent tax on a prorated amount based on the number of days they spend in the country. Bottom line: Players on California teams could end up paying 60 percent or more in income taxes for that game check. …For non-resident foreign athletes, HM Revenue and Customs (HMRC) reserves the right to tax not only the income they earn from competing in the match but a portion of any endorsement money they earn worldwide.

No wonder some of the world’s top athletes don’t want to compete in the United Kingdom.

And what about the NFL players, who got hit with a 60 percent tax rate for one game?

Those players are lucky they’re not Cam Newton, who paid a 198.8 percent tax for playing in the 2016 Super Bowl.

Last year’s tax bill also impacts professional football in a negative way. The IRS has decided that sports teams don’t count as “pass-through” businesses, as noted by Accounting Today.

Two major sports franchises might soon be on the auction block following Microsoft Corp. co-founder Paul Allen’s death last week. But a recent Internal Revenue Service rule could cut the teams’ sales prices. Allen died with no heirs and a $26 billion estate, including the National Football League’s Seattle Seahawks… The teams together are worth more than $3 billion, according to the Bloomberg Billionaires Index. …the IRS said in August that team owners would be barred from the write-off — one of the biggest benefits in the law — that allows owners of pass-through entities such as partnerships and limited liability companies to deduct as much as 20 percent of their taxable income. …Arthur Hazlitt, a tax partner at O’Melveny & Myers LLP in New York who provided the tax structure and planning advice for hedge fund manager David Tepper’s acquisition of the Carolina Panthers, estimates the IRS rules could spur potential bidders to offer at least tens of millions of dollars less.

Gee, what a surprise. Higher tax burdens lower the value of income-producing assets.

Something to keep in mind next them there’s a debate on whether we should be double-taxing dividends and capital gains.

Or the death tax.

Let’s close with a report from Bloomberg about some new research about the impact of taxes on team performance.

The 2017 law could put teams in states with high personal income tax rates at a disadvantage when negotiating with free agents thanks to new limits on deductions, including for state and local taxes, according to tax economist Matthias Petutschnig of the Vienna University of Economics and Business. Petutschnig’s research into team performance over more than two decades shows that National Football League franchises based in high-tax states lost more games on average during the regular season compared to teams in low or no-tax states. That’s because of the NFL’s salary cap for teams, according to Petutschnig; if they have to give certain players more money to compensate for higher taxes, it reduces how much they pay other players and lowers the team’s overall talent level. “The new tax law exacerbates my findings and makes it harder for high-tax teams to put together a high-quality roster,” Petutschnig said.

Here’s a chart from the article.

And here are more details.

A player for the Miami Dolphins or Houston Texans, where no state income taxes are levied, “was always going to come out a whole lot better than somebody playing in New York,” said Jerome Glickman, a director at accounting firm Friedman LLP who works with professional athletes. “Now, it’s worse.” …a free agent considering a California team compared to a team in Texas or Florida would need to make 10 percent to 12 percent more to compensate for his state tax bill, said NFL agent Joe Linta… the Raiders — who will eventually move to Las Vegas in no-tax Nevada — have often made the case that unequal tax rates create an uneven playing field. Quarterback Jimmy Garoppolo’s five-year $137.5 million contract with the San Francisco 49ers will mean an additional $3 million tax bill under the new tax law… Garoppolo would have saved $2 million in taxes under the new code had he instead signed with the Denver Broncos in lower-tax Colorado.

By the way, other scholars have reached similar conclusions, so Professor Petutschnig’s research should be viewed as yet another addition to the powerful body of evidence about the harmful effect of punitive tax policy.

P.S. I think nations have the right to tax income earned inside their borders, so I’m not theoretically opposed to the U.K. taxing athletes who earn income on British soil. But I don’t favor punitive rates. And I don’t think the IRS should add injury to injury by then taxing the same income. That lesson even applies to royalty.

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As illustrated by this video tutorial, I’m a big advocate of the Laffer Curve.

I very much want to help policy makers understand (especially at the Joint Committee on Taxation) that there’s not a linear relationship between tax rates and tax revenue. In other words, you don’t double tax revenue by doubling tax rates.

Having worked on this issue for decades, I can state with great confidence that there are two groups that make my job difficult.

  • The folks who don’t like pro-growth tax policy and thus claim that changes in tax policy have no impact on the economy.
  • The folks who do like pro-growth tax policy and thus claim that every tax cut will “pay for itself” because of faster growth.

Which was my message in this clip from a recent interview.

For all intents and purposes, I’m Goldilocks in the debate over the Laffer Curve. Except instead of stating that the porridge is too hot or too cold, my message is that it is that changes in tax policy generally lead to more taxable income, but the growth in income is usually not enough to offset the impact of lower tax rates.

In other words, some revenue feedback but not 100 percent revenue feedback.

Yes, some tax cuts do pay for themselves. But they tend to be tax cuts on people (such as investors and entrepreneurs) who have a lot of control over the timing, level, and composition of their income.

And, as I said in the interview, I think the lower corporate tax rate will have substantial supply-side effects (see here and here for evidence). This is because a business can make big changes in response to a new tax law, whereas people like you and me don’t have the same flexibility.

But I don’t want this column to be nothing but theory, so here’s a news report from Estonia on the Laffer Curve in action.

After Estonia raised its alcohol excise tax rates considerably in 2017, Estonian daily Postimees has estimated that the target of the money the alcohol excise tax would bring into state coffers could have been missed by at least EUR 40 million. …Initially, in the state budget of 2017, the ministry had been planned that proceeds from the alcohol excise tax would bring EUR 276.4 million, but last summer, it cut the forecast to EUR 237.5 million.

I guess I’ll make this story Part VII in my collection of examples designed to educate my friends on the left (here’s Part I, Part II, Part III, Part IV, Part V, and Part VI).

But there’s a much more important point I want to make.

The fact that most tax increases produce more revenue is definitely not an argument in favor of higher tax rates.

That argument is wrong in part because government already is far too large. But it’s also wrong because we should consider the health and vitality of the private sector. Here’s some of what I wrote about some academic research in 2012.

…this study implies that the government would reduce private-sector taxable income by about $20 for every $1 of new tax revenue. Does that seem like good public policy? Ask yourself what sort of politicians are willing to destroy so much private sector output to get their greedy paws on a bit more revenue. What about capital taxation? According to the second chart, the government could increase the tax rate from about 40 percent to 70 percent before getting to the revenue-maximizing point. But that 75 percent increase in the tax rate wouldn’t generate much tax revenue, not even a 10 percent increase. So the question then becomes whether it’s good public policy to destroy a large amount of private output in exchange for a small increase in tax revenue. Once again, the loss of taxable income to the private sector would dwarf the new revenue for the political class.

The bottom line is that I don’t think it’s a good trade to reduce the private sector by any amount simply to generate more money for politicians.

P.S. I’m also Goldilocks when considering the Rahn Curve.

P.P.S. For what it’s worth, Paul Krugman (sort of) agrees with me about the Laffer Curve.

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When I write about the economics of fiscal policy and need to give people an easy-to-understand explanation on how government spending affects growth, I share my four-part video series.

But. other than a much-too-short primer on growth and taxation from 2016, I don’t have something similar for tax policy. So I have to direct people to various columns about marginal tax rates, double taxation, tax favoritism, tax reform, corporate taxation, and tax competition.

Today’s column isn’t going to be a comprehensive analysis of taxes and growth, but it is going to augment the 2016 primer by taking a close look at how some taxes are more destructive than others.

And what makes today’s column noteworthy is that I’ll be citing the work of left-leaning international bureaucracies.

Let’s look at a study from the OECD.

…taxes…affect the decisions of households to save, supply labour and invest in human capital, the decisions of firms to produce, create jobs, invest and innovate, as well as the choice of savings channels and assets by investors. What matters for these decisions is not only the level of taxes but also the way in which different tax instruments are designed and combined to generate revenues…investigating how tax structures could best be designed to promote economic growth is a key issue for tax policy making. … this study looks at consequences of taxes for both GDP per capita levels and their transitional growth rates.

For all intents and purposes, the economists at the OECD wanted to learn more about how taxes distort the quantity and quality of labor and capital, as illustrated by this flowchart from the report.

Here are the main findings (some of which I cited, in an incidental fashion, back in 2014).

The reviewed evidence and the empirical work suggests a “tax and growth ranking” with recurrent taxes on immovable property being the least distortive tax instrument in terms of reducing long-run GDP per capita, followed by consumption taxes (and other property taxes), personal income taxes and corporate income taxes. …relying less on corporate income relative to personal income taxes could increase efficiency. …Focusing on personal income taxation, there is also evidence that flattening the tax schedule could be beneficial for GDP per capita, notably by favouring entrepreneurship. …Estimates in this study point to adverse effects of highly progressive income tax schedules on GDP per capita through both lower labour utilisation and lower productivity… a reduction in the top marginal tax rate is found to raise productivity in industries with potentially high rates of enterprise creation. …Corporate income taxes appear to have a particularly negative impact on GDP per capita.”

Here’s how the study presented the findings. I might quibble with some of the conclusions, but it’s worth noting all the minuses in the columns for marginal tax, progressivity, top rates, dividends, capital gains, and corporate tax.

This is all based on data from relatively prosperous countries.

A new study from the International Monetary Fund, which looks at low-income nations rather than high-income nations, reaches the same conclusion.

The average tax to GDP ratio in low-income countries is 15% compared to that of 30% in advanced economies. Meanwhile, these countries are also those that are in most need of fiscal space for sustainable and inclusive growth. In the past two decades, low-income countries have made substantial efforts in strengthening revenue mobilization. …what is the most desirable tax instrument for fiscal consolidation that balances the efficiency and equity concerns. In this paper, we study quantitatively the macroeconomic and distributional impacts of different tax instruments for low-income countries.

It’s galling that the IMF report implies that there’s a “need for fiscal space” and refers to higher tax burdens as “strengthening revenue mobilization.”

But I assume some of that rhetoric was added at the direction of the political types.

The economists who crunched the numbers produced results that confirm some of the essential principles of supply-side economics.

…we conduct steady state comparison across revenue mobilization schemes where an additional tax revenues equal to 2% GDP in the benchmark economy are raised by VAT, PIT, and CIT respectively. Our quantitative results show that across the three taxes, VAT leads to the least output and consumption losses of respectively 1.8% and 4% due to its non-distorting feature… Overall, we find that among the three taxes, VAT incurs the lowest efficiency costs in terms of aggregate output and consumption, but it could be very regressive… CIT, on the other hand, though causes larger efficiency costs, but has considerable better inequality implications. PIT, however, deteriorates both the economic efficiency and equity, thus is the most detrimental instrument.

Here’s the most important chart from the study. It shows that all taxes undermine prosperity, but that personal income taxes (grey bar) and corporate income tax (white bar) do the most damage.

I’ll close with two observations.

First, these two studies are further confirmation of my observation that many – perhaps most – economists at international bureaucracies generate sensible analysis. They must be very frustrated that their advice is so frequently ignored by the political appointees who push for statist policies.

Second, some well-meaning people look at this type of research and conclude that it would be okay if politicians in America imposed a value-added tax. They overlook that a VAT is bad for growth and are naive if they think a VAT somehow will lead to lower income tax burdens.

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I’ve been writing about the Laffer Curve for decades, making the simple point that there’s not a linear relationship between tax rates and tax revenue.

To help people understand, I ask them to imagine that they owned a restaurant and decided to double prices. Would they expect twice as much revenue?

Of course not, because people respond. Customers would go to other restaurants, or decide to eat at home. Depending on how customers reacted, the restaurant might even wind up with less revenue.

Well, that’s how the Laffer Curve works. When tax rates change, that alters incentives to engage in productive behavior (i.e., how much income they earn). In other words, to figure out tax revenue, you have to look at taxable income in addition to tax rates.

For some odd reason, this is a controversial issue.

My wayward buddy Bruce Bartlett posted a video on Facebook from Samantha Bee’s Full Frontal show. The goal was to mock the Laffer Curve, and here’s the part of the video featuring economists dismissing the concept as a “joke.”

Wow, that’s pretty damning. Economists from Stanford, Harvard, MIT, and the University of Chicago are on the other side of the issue.

Should I give up and retract all my writings and analysis?

Fortunately, that won’t be necessary since I have an unexpected ally. As shown in this excerpt from the video, Paul Krugman agrees with me about the Laffer Curve.

And Krugman’s not alone. Many other left-leaning economists also admit there is a Laffer Curve.

To be sure, as Krugman noted, there is considerable disagreement about the revenue-maximizing tax rate. Folks on the left often say tax rates could be 70 percent while folks on the right think the revenue-maximizing rate is much lower.

I have two thoughts about this debate. First, if the revenue-maximizing rate is 70 percent, then why did the IRS collect so much additional revenue from upper-income taxpayers when Reagan lowered the top rate from 70 percent to 28 percent?

Second, I don’t want to maximize revenue for government. That’s why I always make sure my depictions of the Laffer Curve show both the revenue-maximizing point and the growth-maximizing point. At the risk of stating the obvious, I prefer the growth-maximizing point.

The bottom line is that I think the revenue-maximizing point is probably closer to 30 percent, as shown in my chart. Especially in the long run.

But I wouldn’t care if the revenue-maximizing rate was actually 50 percent. Politicians should only collect the relatively small amount of revenue that is needed to finance the growth-maximizing level of government spending.

P.S. As tax rates get closer and closer to the revenue-maximizing point, that means an increasing amount of economic damage per dollar collected.

P.P.S. Paul Krugman is also right that value-added taxes are not good for exports.

Addendum: This post was updated on August 12 to add the clip of selected economists mocking the Laffer Curve.

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In the past few years, I’ve bolstered the case for lower tax rates by citing country-specific research from Italy, Australia, Germany, Sweden, Israel, Portugal, South Africa, the United States, Denmark, Russia, France, and the United Kingdom.

Now let’s look to the north.

Two Canadian scholars investigated the impact of provincial tax policy changes in Canada. Here are the issues they investigated.

The tax cuts introduced by the provincial government of British Columbia (BC) in 2001 are an important example… The tax reform was introduced in two stages. In an attempt to make the BC’s economy more competitive, the government reduced the corporate income tax (CIT) rate initially by 3.0 percentage points with an additional 1.5 percentage point reduction in 2005. The government also cut the personal income tax (PIT) rate by about 25 percent. …The Canadian provincial governments’ tax policies provide a good natural experiment for the study of the effects of tax rates on growth. …The principal objective of this paper is to investigate the effects of taxation on growth using data from 10 Canadian provinces during 1977-2006. We also explore the relationship between tax rates and total tax revenue. We use the empirical results to assess the revenue and growth rate effects of the 2001 British Columbia’s incentive-based tax cuts.

And here are the headline results.

The results of this paper indicate that higher taxes are associated with lower private investment and slower economic growth. Our analysis suggests that a 10 percentage point cut in the statutory corporate income tax rate is associated with a temporary 1 to 2 percentage point increase in per capita GDP growth rate. Similarly, a 10 percentage point reduction in the top marginal personal income tax rate is related to a temporary one percentage point increase in the growth rate. … The results suggest that the tax cuts can result in significant long-run output gains. In particular, our simulation results indicate that the 4.5 percentage point CIT rate cut will boost the long-run GDP per capita in BC by 18 percent compared to the level that would have prevailed in the absence of the CIT tax cut. …The result indicates that a 10 percentage point reduction in the corporate marginal tax rate is associated with a 5.76 percentage point increase in the private investment to GDP ratio. Similarly, a 10 percentage point cut in the top personal income tax rate is related to a 5.96 percentage point rise in the private investment to GDP ratio.

The authors look specifically at what happened when British Columbia adopted supply-side tax reforms.

…In this section, we attempt to gauge the magnitude of the growth effects of the CIT and PIT rate cuts in BC in 2001… the growth rate effect of the tax cut is temporary, but long-lasting. Figure 2 shows the output with the CIT rate cut relative to the no-tax cut output over the 120 years horizon. Our model indicates that in the long-run per capita output would be 17.6 percent higher with the 4.5 percentage point CIT rate cut. …We have used a similar procedure to calculate the effects of the five percentage point reduction in the PIT rate in BC. …The solid line in Figure 3 shows simulated relative output with the PIT rate cut compared to the output with the base line growth rate of 1.275. Our model indicates that per capita output would be 7.6 percent higher in the long run with the five percentage point PIT rate cut.

Here’s their estimate of the long-run benefits of a lower corporate tax rate.

And here’s what they found when estimating the pro-growth impact of a lower tax rate on households.

In both cases, lower tax rates lead to more economic output.

Which means that lower tax rates result in more taxable income (the core premise of the Laffer Curve).

The amount of tax revenue that a provincial government collects depends on both its tax rates and tax bases. Thus one major concern that policy makers have in cutting tax rates is the implication of tax cuts for government tax receipts. …The true cost of raising a tax rate to taxpayers is not just the direct cost of but also the loss of output caused by changes in taxpayers’ economic decisions. The Marginal Cost of Public Funds (MCF) measures the loss created by the additional distortion in the allocation of resources when an additional dollar of tax revenue is raised through a tax rate increase. …if…government is on the negatively-sloped section of its present value revenue Laffer curve…, a tax rate reduction would increase the present value of the government’s tax revenues.

And the Canadian research determined that, measured by present value, the lower corporate tax rate will increase tax revenue.

…computations indicate that including the growth rate effects substantially raises our view of the MCF for a PIT. Our computations therefore support previous analysis which indicates that it is much more costly to raise revenue through a PIT rate increase than through a sales tax rate increase and that there are potentially large efficiency gains if a province switches from an income tax to a sales tax. When the growth rate effects of the CIT are included in the analysis, …a CIT rate reduction would increase the present value of the government’s tax revenues. A CIT rate cut would make taxpayers better off and the government would have more funds to spend on public services or cut other taxes. Therefore our computations provide strong support for cutting corporate income tax rates.

Needless to say, if faced with the choice between “more funds to spend” and “cut other taxes,” I greatly prefer the latter. Which is why I worry that people learn the wrong lesson when I point out that the rich paid a lot more tax after Reagan lowered the top rate in the 1980s.

The goal is to generate more prosperity for people, not more revenue for government. So if a tax cut produces more revenue, the immediate response should be to drop the rate even further.

But I’m digressing. The point of today’s column is simply to augment my collection of case studies showing that better tax policy produces better economic performance.

P.S. The research from Canada also helps to explain the positive effect of decentralization and federalism. British Columbia had the leeway to adopt supply-side reforms because the central government in Canada is somewhat limited in size and scope. That’s even more true in Switzerland (where we see the best results), and somewhat true about the United States.

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I’ve been in China this week, giving lectures about economic policy at Northeastern University in Shenyang.

I’ve explained that China has enjoyed reasonably impressive growth in recent decades thanks to pro-market reforms. But I’ve also pointed out that further economic liberalization is needed if China wants to avoid the middle-income trap.

That won’t be easy. Simply stated, I don’t think it’s possible to become a rich nation without free markets and small government.

The good news is that China’s economic freedom score has increased dramatically since reforms began, rising from 3.64 in 1980 to 6.40 in the latest edition of Economic Freedom of the World. And there’s been a dramatic increase in prosperity and a dramatic reduction in poverty.

The bad news is that a score of 6.40 means that China is only ranked #112 in the world. That’s way too low. The country needs a new burst of pro-market reform (especially since it also faces serious demographic challenges in the not-too-distant future).

In other words, China should strive to be more like #1 Hong Kong, which has a score of 8.97, or #4 Switzerland, with a score of 8.44.

Or even the #11 United States, which has a score of 7.94, or also #19 Netherlands, with a score of 7.74.

The bottom line is that China won’t become a rich nation so long as it has a score of 6.40 and a ranking of #112.

Fortunately, there is a pre-existing recipe for growth and prosperity. China needs to change the various policies that undermine competitiveness.

Since I’m a public finance economist, I told the students how China’s fiscal score (“size of government”) could be improved.

I recommended a spending cap, of course, but I also said the tax system needed reform to enable more prosperity.

Part of tax reform is low marginal tax rates on productive behavior.

Chinese academic experts agree. As reported by the South China Morning Post, they’re urging the government to significantly reduce the top rate of the personal income tax.

China needs to slash its highest tax levy on the nation’s top income earners in its upcoming individual tax code review, or risk seeing an unprecedented talent exodus, argued eight academics… They called for authorities to scrap the top two tax brackets of 35 per cent and 45 per cent in the current seven brackets progressive tax system on individuals, granting high income earners more leeway with a five tax brackets system that will be capped at 30 per cent.

The scholars pointed out that high tax rates are especially harmful in a world where high-skilled people have considerable labor mobility.

The academics from esteemed mainland universities called for further revision of the code, as the current draft failed…high income earners, a group that is often highly skilled professionals China wants to attract and retain in the global fight for talent. …For the “highly intelligent groups”, remunerations and royalties were likely to surpass the monthly salary, meaning that the combination can add up to a higher taxable income base and “seriously restrain them from” pursuing innovation, the academics argued. “In a global environment [when tax cuts become mainstream], if China maintains its high individual income tax rates … it will push the high-income, high-intelligent group overseas,” they said.

Needless to say, I’ll be very curious to see what happens. I’ve now been to China several times and I think the country has huge potential.

But achieving that potential requires reforms that will reduce the size and scope of government.

Here’s a chart I shared with the students, which shows that Taiwan has much more economic freedom and is much richer (basically an updated version of some numbers I put together in 2014).

The bottom line is that the country can become a genuine “Chinese Tiger” rather than a “paper tiger” with the right policies.

P.S. Some people actually think China should become more statist. Both the Organization for Economic Cooperation and Development and the International Monetary Fund have urged staggering tax increases in China.

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Three years ago, I shared two videos explaining taxation and deadweight loss (i.e., why high tax burdens are bad for prosperity).

Today, I have one video on another important principle of taxation. To set the stage for this discussion, here are two simple definitions

  • The “average tax rate” is the share of your income taken by government. If you earn $50,000 and your total tax bill is $10,000, then your average tax rate is 20 percent.
  • The “marginal tax rate” is the amount of money the government takes if you earn more income. In other words, the additional amount government would take if your income rose from $50,000 to $51,000.

These definitions are important because we want to contemplate why and how a tax cut helps an economy.

But let’s start by explaining that a tax cut doesn’t boost growth because people have more money to spend.

I want people to keep more of their earnings, to be sure, but that Keynesian-style explanation overlooks the fact that the additional “spending power” for taxpayers is offset when the government borrows more money to finance the tax cut.

Instead, when thinking about taxes and prosperity, here are the three things you need to know.

1. Economic growth occurs when we increase the quantity and/or quality of labor and capital.

2. Taxes increase the cost of whatever is being taxed, and people respond by doing less of whatever is being taxed.

3. To get more prosperity, lower tax rates on productive behaviors such as work, saving, investment, and entrepreneurship.

All this is completely correct, but there’s one additional point that needs to be stressed.

4. The tax rate that matters is the marginal tax rate, not the average tax rate.

I discussed the importance of marginal tax rates in 2016, pointing out that Cam Newton of the Carolina Panthers was going to lose the Super Bowl (from a financial perspective) because the additional tax he was going to pay was going to exceed the additional income he would earn. In other words, his marginal tax rate was more than 100 percent.

Mon Dieu!

But I also included an example that’s more relevant to the rest of us, looking at our aforementioned hypothetical taxpayer with a 20 percent average tax rate on annual earnings of $50,000. I asked about incentives for this taxpayer to earn more money if the marginal tax rate on additional income was 0 percent, 20 percent, or 100 percent.

Needless to say, as shown in this expanded illustration, the incentive to earn $51,000 will be nonexistent if all of the additional $1,000 goes to government.

That’s why “supply-side economics” is focused on marginal tax rates. If we want more productive behavior, we want the lowest-possible marginal tax rates so people have the greatest-possible incentive to generate more prosperity.

Here’s a very short video primer on this issue.

One very important implication of this insight is that not all tax cuts (or tax increases) are created equal. For instance, as I explained in a three-part series (here, here, and here), there will be very little change in incentives for productive activity if the government gives you a tax credit because you have kids.

But if the government reduces the top tax rate or lowers the tax bias against saving and investment, the incentive for additional productive behavior will be significant.

And this helps to explain why the country enjoyed such positive results from the supply-side changes to tax policy in the 1920s, 1960s, and 1980s.

Let’s close with some good news (at least relatively speaking) for American readers. Compared to other industrialized countries, top marginal tax rates in the United States are not overly punitive.

Admittedly, this is damning with faint praise. Our tax system is very unfriendly if you compare it to Monaco, Hong Kong, or Bermuda.

But at least we’re not France, where there’s a strong argument to be made that the national sport is taxation rather than soccer.

P.S. I’m not saying tax preferences for kids are wrong. But I am saying they’re not pro-growth.

P.P.S. I mentioned above that Cam Newton – based on his personal finances – lost the Super Bowl even before the opening kickoff. Well, there’s scholarly evidence that teams in high-tax states actually win fewer games.

P.P.P.S. Today’s analysis focuses on the individual income tax, but this analysis also applies to corporate taxation. A company with clever lawyers and accountants may have the ability to lower its average tax rate, but the marginal tax rate is what drives the incentive to earn more income. Which is why reducing the federal corporate rate from 35 percent to 21 percent was the best part of last year’s tax bill.

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One of the core principles of economics is that prices are determined by supply and demand. That includes the price of labor – i.e., the wages received by workers.

Another core principle is that taxes create distortions by reducing demand and supply. Which is why it’s not a good idea to impose high tax rates on behaviors that contribute to prosperity, such as work, saving, investment, and entrepreneurship.

That’s the theory. Now let’s consider some real-world implications of taxes on work.

Here are some excerpts from new research by the European Central Bank.

Several reforms can be enacted to reduce the unemployment rate in the euro area. Among them is a permanent reduction in the labour tax. Typically, a decrease in labour taxes reduces labour costs to employers and increases the net take-home pay of employees, positively impacting both labour demand and labour supply. Reducing taxes on labour can contribute to increase employment and activity rates in the EA, by increasing incentives to hire, to look for, and take up, work. …In this paper we contribute to the debate on those issues by evaluating the macroeconomic effects of a fiscal reform in the EA countries.

The study look at what happens with employment-related taxes are lowered at either the employer level or the employee level.

Permanently reducing labour tax rates paid by Home firms would have stimulating effects on economic activity and employment, and would permanently reduce the unemployment rate. The same is true when tax rates paid by Home households are reduced.

Here are some of the specific estimates of the positive impact of lower labor taxes at the firm level.

The tax rate is reduced by almost 2 p.p. (trough level). The reduction of labour taxes paid by firms reduces the gross wage bill of firms and hence increases the value of having a worker. Workers are able to obtain part of the increase in firms’ surplus in the bargaining process, which results in a real wage increase. Nevertheless, the wage increase is not sufficient to undo the increase in the value of having a worker for firms, which leads to an increase in labour demand through vacancy posting. The number of matches increases as well and, consistently, the probability of finding a job and that of filling a vacancy increases and decreases, respectively. Employment increases (and unemployment rate decreases) by roughly 0.3 p.p. after two years and 0.4 p.p. in the medium and in the long run, respectively. …Home GDP increases by 0.5% after two years. Both consumption and investment increase. Consumption increases because of households’ larger permanent income, associated with the increase in employment, hours and production. Investment increases because firms augment physical capital to accompany the rising employment.

I’ve combined some of the key results from Figures 3 and 4, all of which show the benefits over time of lower tax rates on work (the horizontal axis is quarters, so 20 quarters equals five years).

And here are the specific estimates of the good outcomes when labor tax are reduced at the household level.

Qualitatively, results are similarly expansionary as those obtained when reducing labour taxes paid by firms. Hours worked, employment, matches, and the probability of finding a job increase, while the probability of filling a vacancy decreases. …hours worked now increase by 0.4% (0.3% in the previous simulation), employment by almost 0.5% (0.35% in the previous simulation), while the unemployment rate falls by almost 0.5 p.p. (0.4 p.p. in the previous simulation). …Home GDP increases by around 0.7% after two years.

Once again, let’s look at some charts showing the benefits over time of lower tax rates on workers.

Interestingly, it appears that there are slightly better outcomes if labor taxes are reduced for workers rather than employers, but the wage numbers are better if the tax cuts take place at the business level.

I’ll take either approach, for what it’s worth.

Let’s close with one additional excerpt. The study incorporated the impact of government employment, which can have a very distorting effect on private employment given the excessive size of the bureaucracy and above-market compensation for bureaucrats.

…we allow for public sector employment and for the possibility of directed search between the private and public sector labour market… In fact, a proper assessment of the impact of the labour market reforms on private-sector employment should take into account that a common characteristic of the EA labour market is the important share of the public employment in total employment, which is, according to OECD (2015), around 20% in France, 15% in Spain, Italy and Portugal, and 13% in Germany. Thus, this component is important to understand the labour market dynamics in the EA, given also that, during a crisis period, public and private labour markets tend to be more inter-related (when the unemployment rate is high, the number of applicants to the public sector is larger).

P.S. I’m periodically asked whether I’m exaggerating when I assert that something (such as taxes distorting the supply and demand for labor) is a “core principle” in economics. But I don’t think left-leaning economists (and there are plenty) would disagree about taxes impacting supply and demand. But they presumably would quibble about the “elasticity” of supply and demand curves (in other words, how sensitive are people to changes in tax rates). Moreover, they surely would claim in some instances that any “deadweight loss” would be offset by supposed economic benefits of government spending (and pro-market people acknowledge that’s possible, at least when government is small). And, when push comes to shove, some folks on the left would openly argue that it’s okay to have less prosperity if there’s more equality.

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I’ve written dozens of columns about the Laffer Curve and its implications.

My favorite may be the one that pointed out why it generally is misguided to raise tax rates even if the government would collect more revenue (i.e., don’t give politicians $1 if it means reducing the private economy by $5).

And I’m always reminding people that the goal is to maximize growth rather than revenue.

I’ve even written about how the Laffer Curve relates to issues as diverse as sex and ISIS.

But I haven’t paid much attention to the history of the issue. Now, thanks to some great research from Nima Sanandaji, we can investigate that topic.

…the Laffer Curve has been used by supporters of low taxes around the world to reinforce their ideas. …it has helped to inspire a downward shift in taxation. Ronald Reagan’s administration introduced massive changes, which dropped the marginal tax rate to 28 percent. …even the proponents of high tax policy are aware of Laffer’s warnings: there is a limit to how high taxes can be raised.

All that’s true.

Reagan’s lower tax rates did produce a windfall of tax revenue from the rich.

And even folks on the left admit that the revenue-maximizing tax rate is below 100 percent, so they acknowledge the Laffer Curve is real.

But what many people don’t know is that the concept of the Laffer Curve existed long before Art drew his famous curve on a napkin.

Nima points to the example of Ibn Khaldun.

…Laffer’s theory was far from new. …Laffer has himself explained that he didn’t invent the curve, but took it from Ibn Khaldun, a 14th-century Muslim, North African philosopher. …Born in 14th-century Tunisia, Khaldun was a prominent scholar and one of the founders of economics and social sciences. Khaldun believed that a just government should only, in accordance with Islamic law, impose low taxes. …However, rulers tend to increase the tax to benefit themselves. High taxes hurt commerce and trade. When tax rates are raised to pay for a bloated government, it will finally cause the tax base to shrink so much that the government cannot meet its obligations. …at this point the state would often implode under its own weight, leading to a period of chaos and the rise of a new state.

Here’s Khaldun’s most famous statement on tax rates and tax revenue.

By the way, there were plenty of people between Khaldun and Laffer who understood why punitive tax rates are foolish, including Alexander Hamilton and John Maynard Keynes(!).

P.S. Perhaps because they’re exposed to the real-world impact, America’s CPAs also understand the Laffer Curve is very real.

P.P.S. Nima has just written a fascinating new book, The Birthplace of Capitalism – The Middle East, which can be ordered here.

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Last November, I wrote about the lessons we should learn from tax policy in the 1950s and concluded that very high tax rates impose a very high price.

About six months before that, I shared lessons about tax policy in the 1980s and pointed out that Reaganomics was a recipe for prosperity.

Now let’s take a look at another decade.

Amity Shlaes, writing for the City Journal, discusses the battle between advocates of growth and the equality-über-alles crowd.

…progressives have their metrics wrong and their story backward. The geeky Gini metric fails to capture the American economic dynamic: in our country, innovative bursts lead to great wealth, which then moves to the rest of the population. Equality campaigns don’t lead automatically to prosperity; instead, prosperity leads to a higher standard of living and, eventually, in democracies, to greater equality. The late Simon Kuznets, who posited that societies that grow economically eventually become more equal, was right: growth cannot be assumed. Prioritizing equality over markets and growth hurts markets and growth and, most important, the low earners for whom social-justice advocates claim to fight.

Amity analyzes four important decades in the 20th century, including the 1930s, 1960s, and 1970s.

Her entire article is worth reading, but I want to focus on what she wrote about the 1920s. Especially the part about tax policy.

She starts with a description of the grim situation that President Harding and Vice President Coolidge inherited.

…the early 1920s experienced a significant recession. At the end of World War I, the top income-tax rate stood at 77 percent. …in autumn 1920, two years after the armistice, the top rate was still high, at 73 percent. …The high tax rates, designed to corral the resources of the rich, failed to achieve their purpose. In 1916, 206 families or individuals filed returns reporting income of $1 million or more; the next year, 1917, when Wilson’s higher rates applied, only 141 families reported income of $1 million. By 1921, just 21 families reported to the Treasury that they had earned more than a million.

Wow. Sort of the opposite of what happened in the 1980s, when lower rates resulted in more rich people and lots more taxable income.

But I’m digressing. Let’s look at what happened starting in 1921.

Against this tide, Harding and Coolidge made their choice: markets first. Harding tapped the toughest free marketeer on the public landscape, Mellon himself, to head the Treasury. …The Treasury secretary suggested…a lower rate, perhaps 25 percent, might foster more business activity, and so generate more revenue for federal coffers. …Harding and Mellon got the top rate down to 58 percent. When Harding died suddenly in 1923, Coolidge promised to “bend all my energies” to pushing taxes down further. …After winning election in his own right in 1924, Coolidge joined Mellon, and Congress, in yet another tax fight, eventually prevailing and cutting the top rate to the target 25 percent.

And how did this work?

…the tax cuts worked—the government did draw more revenue than predicted, as business, relieved, revived. The rich earned more than the rest—the Gini coefficient rose—but when it came to tax payments, something interesting happened. The Statistics of Income, the Treasury’s database, showed that the rich now paid a greater share of all taxes. Tax cuts for the rich made the rich pay taxes.

To elaborate, let’s cite one of my favorite people. Here are a couple of charts from a study I wrote for the Heritage Foundation back in 1996.

The first one shows that the rich sent more money to Washington when tax rates were reduced and also paid a larger share of the tax burden.

And here’s a look at the second chart, which illustrates how overall revenues increased (red line) as the top tax rate fell (blue).

So why did revenues climb after tax rates were reduced?

Because the private economy prospered. Here are some excerpts about economic performance in the 1920s from a very thorough 1982 report from the Joint Economic Committee.

Economic conditions rapidly improved after the act became law, lifting the United States out of the severe 1920-21 recession. Between 1921 and 1922, real GNP (measured in 1958 dollars) jumped 15.8 percent, from $127.8 billion to $148 billion, while personal savings rose from $1.59 billion to $5.40 -billion (from 2.6 percent to 8.9 percent of disposable personal income). Unemployment declined significantly, commerce and the construction industry boomed, and railroad traffic recovered. Stock prices and new issues increased, with prices up over 20 percent by year-end 1922.8 The Federal Reserve Board’s index of manufacturing production (series P-13-17) expanded 25 percent. …This trend was sustained through much of 1923, with a 12.1 percent boost in GNP to $165.9 billion. Personal savings increased to $7.7 billion (11 percent of disposable income)… Between 1924 ‘and 1925 real GNP grew 8.4 percent, from $165.5 billion to $179.4 billion. In this same period the amount of personal savings rose from an already impressive $6.77 billion to about $8.11 billion (from 9.5 percent to 11 percent of personal disposable income). The unemployment rated dropped 27.3 percents interest rates fell, and railroad traffic moved at near record levels. From June 1924 when the act became law to the end of that year the stock price index jumped almost 19 percent. This index increased another 23 percent between year-end 1924 and year-end 1925, while the amount of non-financial stock issues leapt 100 percent in the same period. …From 1925 to 1926 real GNP grew from $179.4 billion to $190 billion. The index of output per man-hour increased and the unemployment rate fell over 50 percent, from 4.0 percent to 1.9 percent. The Federal Reserve Board’s index of manufacturing production again rose, and stock prices of nonfinancial issues increased about 5 percent.

Now for some caveats.

I’ve pointed out many times that taxes are just one of many policies that impact economic performance.

It’s quite likely that some of the good news in the 1920s was the result of other factors, such as spending discipline under both Harding and Coolidge.

And it’s also possible that some of the growth was illusory since there was a bubble in the latter part of the decade. And everything went to hell in a hand basket, of course, once Hoover took over and radically expanded the size and scope of government.

But all the caveats in the world don’t change the fact that Americans – both rich and poor – immensely benefited when punitive tax rates were slashed.

P.S. Since Ms. Shlaes is Chairman of the Calvin Coolidge Presidential Foundation, I suggest you click here and here to learn more about the 20th century’s best or second-best President.

P.P.S. I assume I don’t need to identify Coolidge’s rival for the top spot.

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Adopting tax reform (even a watered-down version of tax reform) is not easy.

  • Some critics say it will deprive the federal government of too much money (a strange argument since it will be a net tax increase starting in 2027).
  • Some critics say it will make it more difficult for state and local governments to raise tax rates (they’re right, but that’s a selling point for reform).
  • Some critics say it will make debt less attractive for companies compared to equity (they’re right, though that’s another selling point for reform).
  • Some critics say it will cause capital to shift from residential real estate to business investment (they’re right, but that’s a good thing for the economy).

Now there’s a new obstacle to tax reform. Senator Marco Rubio says he wants some additional tax relief for working families. And he’s willing to impose a higher corporate tax rate to make the numbers work.

That proposal was not warmly received by his GOP colleagues since the 20-percent corporate rate was perceived as their biggest achievement.

But now Republicans are contemplating a 21-percent corporate rate so they have wiggle room to lower the top personal tax rate to 37 percent. Which prompted Senator Rubio to issue a sarcastic tweet about the priorities of his colleagues.

Since tax reform is partly a political exercise, with politicians allocating benefits to various groups of supporters, there’s nothing inherently accurate or inaccurate about Senator Rubio’s observation.

But since I inhabit the wonky world of public finance economics, I want to explain today that there are some adverse consequences to Rubio’s preferred approach.

Simply stated, not all tax cuts are created equal. If the goal is faster economic growth, lawmakers should concentrate on “supply-side” reforms, such as reducing marginal tax rates on work, saving, investment, and entrepreneurship (in which case, it’s a judgement call on whether it’s best to lower the corporate tax rate or the personal tax rate).

By contrast, family-oriented tax relief (a $500 lower burden for each child in a household, for instance) is much less likely to impact incentives to engage in productive behavior.

Most supporters of family tax relief would agree with this economic analysis. But they would say economic growth is not the only goal of tax reform. They would say that it’s also important to make sure various groups get something from the process. So if big businesses are getting a lower corporate rate, small businesses are getting tax relief, and investors are getting less double taxation, isn’t it reasonable to give families a tax cut as well?

As a political matter, the answer is yes.

But here’s my modest contribution to this debate. And I’m going to cite one of my favorite people, myself! Here’s an excerpt from a Wall Street Journal column back in 2014.

The most commonly cited reason for family-based tax relief is to raise take-home pay. That’s a noble goal, but it overlooks the fact that there are two ways to raise after-tax incomes. Child-based tax cuts are an effective way of giving targeted relief to families with children… The more effective policy—at least in the long run—is to boost economic growth so that families have more income in the first place. Even very modest changes in annual growth, if sustained over time, can yield big increases in household income. … long-run growth will average only 2.3% over the next 75 years. If good tax policy simply raised annual growth to 2.5%, it would mean about $4,500 of additional income for the average household within 25 years. This is why the right kind of tax policy is so important.

Now let’s put this in visual form.

Let’s imagine a working family with a modest income. What’s best for them, a $1,000 tax cut because they have a couple of kids or some supply-side tax policy that produces faster growth?

In the short run, compared to the option of doing nothing (silver line), both types of tax reform benefit this hypothetical family with $25,000 of income in 2017.

But the family tax relief (blue line) is better for their household budget than supply-side tax cuts (orange line).

But what if we look at a longer period of time?

Here’s the same data, but extrapolated for 50 years. And since there’s universal agreement that the status quo is not good for our hypothetical family, let’s simply focus on the difference between family tax relief (again, blue line) and supply-side tax cuts (orange line).

And what we find is that the family actually has more income with supply-side reform starting in 2026 and the gap gets larger with each subsequent year. In the long run, the family is much better off with supply-side tax policies.

To be sure, I’ve provided an artificial example. If you assume growth only increases to 2.4 percent rather than 2.5 percent, the numbers are less impressive. Moreover, what if the additional growth only lasts for a period of time and then reverts back to 2.3 percent?

And keep in mind that money in the future is not as valuable as money today, so the net benefit of picking supply-side tax cuts would not be as large using “present value” calculations.

Last but not least, the biggest caveat is that these two charts are based on the example in my Wall Street Journal column and are not a comparison of the different growth rates that might result from a 20-percent corporate tax rate compared to a 21-percent rate (even a wild-eyed supply-side economist wouldn’t project that much additional growth from a one-percentage-point difference in tax rates).

In other words, I’m not trying to argue that a supply-side tax cut is always the answer. Heck, even supply-side reform plans such as the flat tax include very generous family-based allowances, so there’s a consensus that taxpayers should be able to protect some income from tax and that those protections should be based on family size.

Instead, the point of this column is simply to explain that there’s a tradeoff. When politicians devote more money to family tax relief and less money to supply-side tax cuts, that will reduce the pro-growth impact of a tax plan. And depending on the level of family tax relief and the amount of foregone growth, it’s quite possible that working families will be better off with supply-side reforms.

P.S. A separate problem with Senator Rubio’s approach is that he wants his family tax relief to be “refundable,” which is a technical term for a provision that gives a tax cut to people who don’t pay tax. Needless to say, it’s impossible to give a tax cut to someone who isn’t paying tax. The real story is that “refundable tax cuts” are actually government spending. But instead of having a program where people sign up for government checks, the spending is laundered through the tax code.

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In my decades of trying to educate policy makers about the downsides of class-warfare tax policy, I periodically get hit with the argument that high tax rates don’t matter since America enjoyed a golden period of prosperity in the 1950s and early 1960s when the top tax rate was more than 90 percent.

Here’s an example from Politico of what I’m talking about.

Well into the 1950s, the top marginal tax rate was above 90%. …both real GDP and real per capita GDP were growing more than twice as fast in the 1950s as in the 2000s.

This comparison grates on me in part because both Bush and Obama imposed bad policy, so it’s no surprise that the economy did not grow very fast when they were in office.

But I also don’t like the comparison because the 1950s were not a halcyon era, as Brian Domitrovic explains.

…you may be thinking, “But wait a minute. The 1950s, that was the greatest economic era ever. That’s when everybody had a job. Those jobs were for life. People got to live in suburbia and go on vacation and do all sorts of amazing things. It was post-war prosperity, right?” Actually, all of these things are myths. In the 1950s, the United States suffered four recessions. There was one in 1949, 1953, 1957, 1960 — four recessions in 11 years. The rate of structural unemployment kept going up, all the way up to 8% in the severe recession of 1957-58. …there wasn’t significant economic growth in the 1950s. It only averaged 2.5 percent during the presidency of Dwight D. Eisenhower.

For today’s purposes, though, I want to focus solely on tax policy. And my leftist friends are correct that the United States had a punitive top tax rate in the 1950s.

This chart from the Politico story shows the top tax rate beginning on that dark day in 1913 when the income tax was adopted. It started very low, then jumped dramatically during the horrible presidency of Woodrow Wilson, followed by a big reduction during the wonderful presidency of Calvin Coolidge. Then it jumped again during the awful presidencies of Herbert Hoover and Franklin Roosevelt. The rate stayed high in the 1950s before the Kennedy tax cuts and Reagan tax cuts, which were followed by some less dramatic changes under George H.W. Bush, Bill Clinton, George W. Bush, and Barack Obama.

What do we know about the impact of the high tax rates put in place by Hoover and Roosevelt? We know the 1930s were an awful period for the economy, we know the 1940s were dominated by World War II, and we know the 1950s was a period of tepid growth.

But we also know that high tax rates don’t result in high revenues. I don’t think Hauser’s Law always applies, but it’s definitely worked so far in the United States.

This is because highly productive taxpayers have three ways to minimize and/or eliminate punitive taxes. First, they can simply choose to live a more relaxed life by reducing levels of work, saving, and investment. Second, they can engage in tax evasion. Third, they can practice tax avoidance, which is remarkably simple for people who have control over the timing, level, and composition of their income.

All these factors mean that there’s not a linear relationship between tax rates and tax revenue (a.k.a., the Laffer Curve).

And if you want some evidence on how high tax rates don’t work, Lawrence Lindsey, a former governor at the Federal Reserve, noted that extortionary tax rates are generally symbolic – at least from a revenue-raising perspective – since taxpayers will arrange their financial affairs to avoid the tax.

…if you go back and look at the income tax data from 1960, as a place to start, the top rate was 91 percent. There were eight — eight Americans who paid the 91 percent tax rate.

Interestingly, David Leonhardt of the New York Times inadvertently supported my argument in a recent column that was written to celebrate the era when tax rates were confiscatory.

A half-century ago, a top automobile executive named George Romney — yes, Mitt’s father — turned down several big annual bonuses. He did so, he told his company’s board, because he believed that no executive should make more than $225,000 a year (which translates into almost $2 million today). …Romney didn’t try to make every dollar he could, or anywhere close to it. The same was true among many of his corporate peers.

I gather the author wants us to think that the CEOs of the past were somehow better people than today’s versions.

But it turns out that marginal tax rates played a big role in their decisions.

The old culture of restraint had multiple causes, but one of them was the tax code. When Romney was saying no to bonuses, the top marginal tax rate was 91 percent. Even if he had accepted the bonuses, he would have kept only a sliver of them. The high tax rates, in other words, didn’t affect only the post-tax incomes of the wealthy. The tax code also affected pretax incomes. As the economist Gabriel Zucman says, “It’s not worth it to try to earn $50 million in income when 90 cents out of an extra dollar goes to the I.R.S.”

By the way, Zucman is far from a supply-sider (indeed, he’s co-written with Piketty), yet he’s basically agreeing that marginal tax rates have a huge impact on incentives.

The only difference between the two of us is that he thinks it is a good idea to discourage highly productive people from generating more income and I think it’s a bad idea.

Meanwhile, Leonhardt also acknowledges the fundamental premise of supply-side economics.

For more than 30 years now, the United States has lived with a top tax rate less than half as high as in George Romney’s day. And during those same three-plus decades, the pay of affluent Americans has soared. That’s not a coincidence.

But he goes awry by then assuming (as is the case for many statists) the economy is a fixed pie. I’m not joking. Read for yourself.

..,the most powerful members of organizations have fought to keep more money for themselves. They have usually won that fight, which has left less money for everyone else.

A market economy, however, is not a zero-sum game. It is possible for all income groups to become richer at the same time.

That’s why lower tax rates are a good idea if we want more prosperity – keeping in mind the important caveat that taxation is just one of many policies that impact economic performance.

P.S. Unbelievably, President Franklin Roosevelt actually tried to impose a 100 percent tax rate (and that’s not even the worst thing he advocated).

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Earlier this year, I pointed out that Trump and Republicans could learn a valuable lesson from Maine Governor Paul LePage on how to win a government shutdown.

Today, let’s look at a lesson from North Carolina on how to design and implement pro-growth tax policy.

In today’s Wall Street Journal, Senator Thom Tillis from the Tarheel State explains what happened when he helped enact a flat tax as Speaker of the State House.

In 2013, when I was speaker of the state House, North Carolina passed a serious tax-reform package. It was based on three simple principles: simplify the tax code, lower rates, and broaden the base. We replaced the progressive rate schedule for the personal income tax with a flat rate of 5.499%. That was a tax-rate cut for everyone, since the lowest bracket previously was 6%. We also increased the standard deduction for all tax filers and repealed the death tax. We lowered the 6.9% corporate income tax to 6% in 2014 and 5% in 2015. …North Carolina’s corporate tax fell to 3% in 2017 and is on track for 2.5% in 2019. We paid for this tax relief by expanding the tax base, closing loopholes, paring down spending, reducing the cost of entitlement programs, and eliminating “refundable” earned-income tax credits for people who pay no taxes.

Wow, good tax policy enabled by spending restraint. Exactly what I’ve been recommending for Washington.

Have these reforms generated good results?  The Senator says yes.

More than 350,000 jobs have been created, and the unemployment rate has been cut nearly in half. The state’s economy has jumped from one of the slowest growing in the country to one of the fastest growing.

What about tax revenue? Has the state government been starved of revenue?

Nope.

…a well-mobilized opposition on the left stoked fears that tax reform would cause shrinking state revenues and require massive budget cuts. This argument has been proved wrong. State revenue has increased each year since tax reform was enacted, and budget surpluses of more than $400 million are the new norm. North Carolina lawmakers have wisely used these surpluses to cut tax rates even further for families and businesses.

Senator Tillis didn’t have specific details on tax collections in his column. I got suspicious that he might be hiding some unflattering numbers, so I went to the Census Bureau’s database on state government finances. But it turns out the Senator is guilty of underselling his state’s reform. Tax revenue has actually grown faster in the Tarheel State, compared the average of all other states (many of which have imposed big tax hikes).

Another example of the Laffer Curve in action.

And here’s a chart from North Carolina’s Office of State Budget and Management. As you can see, revenues are rising rather than falling.

By the way, I’m guessing that the small drop in 2014 and the big increase in 2015 were caused by taxpayers delaying income to take advantage of the new, friendlier tax system. We saw the same thing in the early 1980s when some taxpayer deferred income because of the multi-year phase-in of the Reagan tax cuts.

But I’m digressing. Let’s get back to North Carolina.

Here’s what the Tax Foundation wrote earlier this year.

After the most dramatic improvement in the Index’s history—from 41st to 11th in one year—North Carolina has continued to improve its tax structure, and now imposes the lowest-rate corporate income tax in the country at 4 percent, down from 5 percent the previous year. This rate cut improves the state from 6th to 4th on the corporate income tax component, the second-best ranking (after Utah) for any state that imposes a major corporate tax. (Six states forego corporate income taxes, but four of them impose economically distortive gross receipts taxes in their stead.) An individual income tax reduction, from 5.75 to 5.499 percent, is scheduled for 2017. At 11th overall, North Carolina trails only Indiana and Utah among states which do not forego any of the major tax types.

And in a column for Forbes, Patrick Gleason was even more effusive.

…the Republican-controlled North Carolina legislature enacted a new budget today that cuts the state’s personal and corporate income tax rates. Under this new budget, the state’s flat personal income tax rate will drop from 5.499 to 5.25% in January of 2019, and the corporate tax rate will fall from 3% to 2.5%, which represents a 16% reduction in one of the most harmful forms of taxation. …This new budget, which received bipartisan support from a three-fifths super-majority of state lawmakers, builds upon the Tar Heel State’s impressive record of pro-growth, rate-reducing tax reform. …It’s remarkable how much progress North Carolina has made in improving its business tax climate in recent years, going from having one of the worst businesses tax climates in the country (ranked 44th), to one of the best today (now 11th best according to the non-partisan Tax Foundation).

Most importantly, state lawmakers put the brakes on spending, thus making the tax reforms more political and economically durable and successful.

Since they began cutting taxes in 2013, North Carolina legislators have kept annual increases in state spending below the rate of population growth and inflation. As a result, at the same time North Carolina taxpayers have been allowed to keep billions more of their hard-earned income, the state has experienced repeated budget surpluses. As they did in 2015, North Carolina legislators are once again returning surplus dollars back to taxpayers with the personal and corporate income tax rate cuts included in the state’s new budget.

Last but not least, I can’t resist sharing this 2016 editorial from the Charlotte Observer. If nothing else, the headline is an amusing reminder that journalists have a hard time understanding that higher tax rates don’t necessarily mean more revenue and that lower tax rates don’t automatically lead to less revenue.

A curious trend you might have noticed of late: North Carolina’s leaders keep cutting taxes, yet the state keeps taking in more money. We saw it happen last year, when the state found itself with a $400 million surplus, despite big cuts in personal and corporate tax rates. …Now comes word that in the first six months of the 2016 budget year (July to December), the state has taken in $588 million more than it did in the same period the previous year. …the overall surge in tax receipts certainly shouldn’t go unnoticed, especially since most of the increased collections for the 2016 cycle so far come from higher individual income tax receipts. They’re up $489 million, 10 percent above the same period of the prior year.

Though the opinion writers in Charlotte shouldn’t feel too bad. Their counterparts at the Washington Post and Wall Street Journal have made the same mistake. As did a Connecticut TV station.

P.S. My leftist friends doubtlessly will cite Kansas as a counter-example to North Carolina. According the narrative, tax cuts failed and were repealed by a Republican legislature. I did a thorough analysis of what happened in the Sunflower State earlier this year. I pointed out that tax cuts are hard to sustain without some degree of spending restraint, but also noted that the net effect of Brownback’s tenure is a permanent reduction in the tax burden. If that’s a win for the left, I hope for similar losses in Washington. It’s also worth comparing income growth in Kansas, California, and Texas if you want to figure out what tax policies are good for ordinary people.

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Why were the Reagan tax cuts so successful? Why did the economy rebound so dramatically from the malaise of the 1970s?

The easy answer is that we got better tax policy, especially lower marginal tax rates on personal and business income. Those lower rates reduced the “price” of engaging in productive behavior, which led to more work, saving, investment, and entrepreneurship.

That’s right, but there’s a story behind the story. Reagan’s tax policy (especially the Economic Recovery Tax Act of 1981) was good because the President and his team ignored the class-warfare crowd. They didn’t care whether all income groups got the same degree of tax relief. They didn’t care about static distribution tables. They didn’t care about complaints that “the rich” benefited.

They simply wanted to reduce the onerous barriers that the tax system imposed on the economy. They understood – and this is critically important – that faster growth was the best way to help everyone in America, including the less fortunate.

Kimberley Strassel of the Wall Street Journal thinks that Donald Trump may be taking the same approach. Her column today basically argues that the President is making a supply-side case for growth. She starts by taking a shot at self-styled “reform conservatives.”

In May 2014, a broad collection of thinkers and politicians gathered in Washington to celebrate a new conservative “manifesto.” The document called for replacing stodgy old Reaganite economics with warmer, fuzzier handouts to the middle class.

She’s happy Trump isn’t following their advice (and I largely agree).

Donald Trump must have missed the memo. …Mr. Trump wants to make Reagan-style tax reform great again.

The class-warfare crowd is not happy about Trump’s pro-growth message, Kimberley writes.

The left saw this clearly, which explains its furious and frustrated reaction to the speech. …Democratic strategist Robert Shrum railed in a Politico piece that the “plutocrat” Mr. Trump was pitching a tax cut for “corporations and the top 1 percent” yet was getting away with a “perverted populism.” …Mr. Trump is selling pro-growth policies—something his party has forgotten how to do. …The left has defined the tax debate for decades in terms of pure class warfare. Republicans have so often been cast as stooges for the rich that the GOP is scared to make the full-throated case for a freer and fairer tax system. …Mr. Trump isn’t playing this game—and that’s why the left is unhappy. The president wants to reduce business tax rates significantly… He wants to simplify the tax code in a way that will eliminate many cherished carve-outs. …his address was largely a hymn to supply-side economics, stunning Democrats who believed they’d forever dispelled such voodoo. …Mr. Trump busted up the left’s class-warfare model. He didn’t make tax reform about blue-collar workers fighting corporate America. Instead it was a question of “our workers” and “our companies” and “our country” competing against China. He noted that America’s high tax rates force companies to move overseas. He directly and correctly tied corporate rate cuts to prosperity for workers, noting that tax reform would “keep jobs in America, create jobs in America,” and lead to higher wages.

Amen. That’s the point I made last week about investment being the key to prosperity for ordinary people.

Ms. Strassel concludes by putting pressure on Congress to do its job and get a bill to the President’s desk.

His opening salvo has given Republicans the cover to push ahead, as well as valuable pointers on selling growth economics. If they can’t get the job done—with the power they now have in Washington—they’d best admit the Democrats’ class-warfare “populism” has won.

I largely agree with Kimberley’s analysis. Trump’s message of jobs, growth, and competitiveness is spot on. His proposal for a 15 percent corporate rate would be very good for the economy. And I also agree with her that it’s up to congressional Republicans to move the ball over the goal line.

But I also think she’s giving Trump too much credit. As I point out in this interview, the Administration isn’t really playing a major role in the negotiations. The folks on Capitol Hill are doing the real work while the President is waiting around for a bill to sign.

Moreover, I’ve been repeatedly warning that there are some very difficult issues that Congress needs to decide.

Since big companies will benefit from a lower corporate rate, will there be similar tax relief for small businesses that file using “Schedule C” of the individual income tax? That’s a good idea, but there are big revenue implications.

Since Republicans (and this definitely includes Trump) are weak on spending, will they achieve deficit neutrality (necessary for permanent reform) by eliminating loopholes? That’s a good idea, but interest groups will resist.

Unfortunately, the White House isn’t offering much help on these issues. The President simply wants big tax cuts and is leaving these tough decisions to everyone else.

P.S. I should have been more specific in the interview. I said we would have a flat tax in my “fantasy world” but that I would settle for partial reform in my “ideal world.” I was grading on a curve, so I want to redeem myself. Here’s how things really rank.

P.P.S. I’m very hopeful that lawmakers will get rid of the deduction for state and local taxes. Not only would that provide some revenue that can be used for pro-growth changes, but it also would get rid of a very unfair distortion that enables higher taxes in states such as Illinois, California, New York, New Jersey, and Connecticut.

P.P.P.S. I have no objection to family-oriented tax relief and other policies that target middle-class taxpayers. Such provisions are politically useful since they expand the coalition of supporters. But I want policy makers to understand that economic growth is the best way of helping everyone – including the poor. That’s why supply-side provisions should be the primary focus of any tax package.

P.P.P.P.S. The class-warfare crowd doesn’t like lower tax rates on upper-income taxpayers. They argue that rich people won’t pay enough and that the government will be starved of revenue. Yet they have no answer when I show them this IRS data. Or this data from the United Kingdom. Or this data from France.

P.P.P.P.P.S. Notwithstanding the title of today’s column, I don’t think Trump is a principled supply-sider like Reagan. But it might be accurate to say he’s a practical supply sider like President John F. Kennedy.

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