Sunday, August 1, 2010

The Misunderstood Laffer Curve, How Deep a Recession?

How Conservatives Misunderstood Arthur Laffer
The story is one of conservative economic lore. At some unnamed cocktail party, Arthur Laffer drew an inverted parabola on a napkin that became the foundation for modern supply side economics. The concept of the Laffer curve shaped Reaganomics, was the basis for the Bush tax cuts and continues to be the foundation from which Republicans argue against allowing them to expire. The Laffer curve is also completely misunderstood. Laffer himself is on record opposing extensions of the Bush tax cuts and supporting higher taxes generally to reduce the deficit. So how does the Laffer curve work and why is it so misunderstood?

The concept behind the Laffer curve is fairly simple. The horizontal axis represents the effective tax rate in a country. The vertical axis represents that amount of tax revenue that a government receives. The curve basically portrays that revenues rise from zero as you begin to impose taxes, but that the rate of growth in revenue gradually slows as rates get higher and at some point, governments hit an inflection point, where raising taxes actually depresses revenue. By the time you reach 100% taxation, revenues are again at zero.

Intellectually, the notion is actually fairly easy to agree with. It's hard to argue with the fact that government revenue would be zero if we had no taxes. Likewise, it's pretty easy to see if we had 100% taxation on all income, how economic activity would grind to a complete halt and we would once again have zero revenue. It's also inarguable that there are points in between that produce positive revenue. Therefore, some sort of Laffer curve MUST exist.

The devil is in the details, as Laffer himself would later admit. The going assumption that Ronald Reagan and George W. Bush ran with was that we were past the apex, that is, that cutting taxes would actually increase government revenue. This was a heck of an assumption, when, in both cases the total federal tax burden was about a fifth of the economy. George H.W. Bush famously called Reagan's scheme to boost revenue by cutting taxes "Voodoo Economics" -- he later got with the program as Reagan's VP, but clearly was never a true disciple of Reagonomics, as he famously cut a deal to raise taxes and close the deficit with congressional Democrats. Us cynics would call it "free lunch" economics.

Did revenue rise after the tax cuts in the 80s and 00s? Depends on how you measure them. Tease out inflation and revenues went up in the 80s and down in the 00s. The problem is that it is very difficult to know what the baseline of economic activities would have been without the changes in tax policy. But, by far the most compelling proof that we are nowhere near the apex of the curve is the explosion in government revenue and economic growth that took place in the 1990s, after Bill Clinton signed the largest tax increase (on a dollar basis, not on an absolute percentage basis) in U.S. history. Clearly, revenues shouldn't have shot up by double digits year after year if we were truly past the apex.

These days, Arthur Laffer, if you can find him, will tell you that we need to raise taxes to close the deficit. Yet Congressional Republicans are still clinging to the notion that we cannot raise any taxes because of the Laffer curve. I invite them to show me their list of Defense and Entitlement cuts that will get us to a balanced budget without allowing the Bush cuts to expire.

How Bad a Recession?
The second quarter GDP report from the Bureau of Economic Analysis came out Friday and confirmed a couple of things:
1. The recovery has continued -- GDP grew at 2.4% in the second quarter, marking a full year of economic growth, following a deep recession.
2. The recovery is still painfully slow -- 2.4% GDP growth is not going to cause a rapid drop in unemployment...the economic conditions of 2007 aren't coming back anytime soon.

Prior to this recession, the most severe recession that a lot of us had lived through was the 1990-1991 recession that threw George H.W. Bush from office and vaulted Bill Clinton to national prominence. Sure, a lot of us were alive for the nasty double-dip recession of '81-'82, but those of us who were in the workforce then and are still in the workforce now, were just starting out then and probably couldn't appreciate the full impact of what was unfolding. There was also that mini-recession associated with the tech crash in 2000, but it scarcely bares mentioning next to this one, other than for the damage it did to our 401K balances.

So, I thought I'd take one more look at the severity of both recessions in terms of GDP and job losses.

In terms of loss of economic output, this recession has been 3 times as severe as the 1990-1991 recession, with a peak-to-trough economic contraction of 4.2% versus 1.4%. In the 1990-1991 recession, the economy was back to its starting point in terms of size 16 months after the start of the contraction. We are now 33 months in and the economy is still 1.1% smaller than when we started.

In terms of job losses, the effect is even more profound. Peak-to-trough job losses in 1990-1991 were 1.6 million jobs. In this recession, we lost 8.4 million jobs. In 1990-1991 it took 32 months from the start of the job losses to when employment was back to the starting point. We are 30 months in and still 7.5 million jobs in the hole, not to mention the added jobs that would be needed just to make up for population growth.

It's a long, sobering road back. I drastically underestimated how long and how painful this recession would be. It may not yet be morning in America, however the sun IS starting to peak out.

Next up...back to the 2010 races.

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