The Laffer Curve and the Flat Tax Paradox

A just nation prospers. Nations built on lies contend with just nations, just laws, and just men. The highest just tax on “the rich” is the flat tax because any law that treats any group or person arbitrarily is unjust. Statistics do show, however, that just laws work far better at taxing the “rich” than lies. How weird is that? Despite the seeming paradox, taxing each person a percentage of his total earnings results in top earners the paying more taxes than when they are unjustly targeted.

Studies of the four key eras in which tax rates on top earners were reduced are conclusive: lower rates for the top income earners increase the total revenue the top earners pay. Even more importantly, the same studies show that narrowing the difference in rates paid by all tax payers results in the top earners paying the lion’s share of the total tax. This paradox cannot be overlooked by those seeking social justice, for the inverse is also the case. The more the government targets the top income brackets the more of the total tax is paid by the poor.

The chart below shows two immense drop offs in rates paid by the top income earners:

What is implicit in the dramatic drop off in tax rates for “the rich” between 1925 and 1931 and between 1980 and 1989 is that the difference between the rates paid by all narrowed. In 1918 the top rate was 77% and the lowest rate was 6%. By the time the five tax cuts of the 1920’s we completed, the top rate was 25% and the lowest rate was 1% (“Fact Sheet on the History of the U.S. tax system” IRS). An untrained eye must conclude that, since the top rate was reduced far more than the lowest rates, the booming economy of the 1920’s was paid for by the poor. Likewise, Marxist demagogues can teach that, despite the fact that everyone’s taxes were reduced, the top earners were given a “pass.” Surely, a college graduate in macro-economics might conclude this was a trade off. The government revenues were increased by the economic boom, but the rich paid less of the total tax burden.

That assumption, however, as the following chart shows, is incorrect:

The truth of the matter is that the narrowing of the income tax rate differential between the rich and the poor resulted in an increase in the total aggregate taxes paid by the rich. Even more telling, while the total of the aggregate taxes paid by the rich increased 100%, the decrease in the rates of total tax paid by the poor was over 1,000%. These figures are especially important because the 1920’s experienced a deflation of about 1% a year (“Deflation Nation.” Newsweek). That means that those making under $5,000 a year were not inflated out of existence.

The other pronounced tax rate valley shown above, the Reagan era, began with a reduction of the top rate from 70% to 50% and a reduction of the lowest rates from 15% to 11% (Economic Recovery Tax Act of 1981). This narrowing of the tax rates culminated with a reduction of the top rate from 50% to 28% and an increase in the lowest rates from 11% to 15% (Tax Reform Act of 1986). These incremental moves towards a flat tax rate did indeed increase growth and, thereby, the total revenue the federal government received from income taxes. However, this increased private sector vitality did not come because the top income earners were let off the hook. No, as the chart below show, the moves towards a flat tax rate increased the total amount of the federal income tax burden shouldered by the rich:

Some defenders of the Reagan era cuts, in a desperate plea for allowing the small businessman to have money to invest in the competitive economy of the future, have pointed to the increased standard deduction for the lowest income earners as both the reason for the rich paying more and as the model for future tax cuts. McKenzie, in What Went Right in the 1980s is quick to trumpet the fact that Reagan’s tax policy was egalitarian precisely because over his decade “… the average effective tax rate for the top 1 percent fell by 30 percent between 1980 and 1992, … by 35 percent for the top 20 percent of income earners, (and)… by 44 percent for the second-highest quintile, 46 percent for the middle quintile, 64 percent for the second-lowest quintile, and 263 percent for the bottom quintile (p. 277).” In the 1920’s the lowest rates fell by as much as five-hundred percent but the total income tax burden fell by over a thousand percent. The egalitarian methods of the Reagan era actually failed to reduce the burden on the poor as much as the simple narrowing of the margins that took place in the Roaring Twenties.

One of the Reagan compromises of the 1980’s, the use of an earned income tax credit, did indeed serve as a model for the Bush tax cuts of twenty-first century. Bush’s 2001 EGTRRA tax cuts actually increased the rate differences between the rich and the poor. They did so directly by reducing the lowest rates from 15% to 10% while reducing the highest rates from 39.6 to 35%. Meanwhile, the middle rates were reduced by as little as 2%. However, secondly, applying the Reagan model, tax credits and standard deductions were accelerated so that the lowest effective rates were actually much smaller than the stated 10%. This complicated attempt at “fairness” may have significantly reduced the growth rates of the economy. Certainly, however, the total income tax burden did not shift to the top earners as much as it should have. As the chart below demonstrates, the shift between top income earners and the lowest earners that actually paid taxes (the middle 20%) is very slight.

 

The negative percents in the second lowest 20 percent and in the lowest 20 percent are the results of “tax credits.” These “refunds” were actually Keynesian stimulus policies. Any tax refund, whether considered a Wal-Mart subsidy, a consumer stimulus, or a welfare payment compromise ought to be “paid for” in accordance with CBO scoring. Whatever these government rebates were, they were not tax cuts. These, like other Keynesian policies, actually have an effect opposite of what is intended. These tax stimulus packages did not forestall the mortgage crisis. They, perhaps, may have accelerated the disaster by providing down payments or savings account rationale for additional imprudent Fannie or Freddie loans.

The American economists of the Bush era had been training themselves in their political ideology since Reagan. They lay in wait for Bush to try his cuts, and the noise of the thunderous herd almost drowned out the moderate success of his policies. One of the weapons the Harvard Nobel Prize types came up with were models that showed who had the most after tax income. Yes, the top wage earners had the most take home pay after the tax rate decrease. This may well be because the middle tax rates were not properly flattened. A tax increase barrier separated the very rich from the very poor.

In every generation, the economy must be remade to be competitive and effective. This process does not require winners and loser, but it does require winners. If we will not allow the winners to become top wage earners, then, by definition the lowest wage earners will be all of us, and the poor will have to bare the lion’s share of the income tax burden.

The Laffer Curve is a paradox. Up to a certain point the more tax rates are reduced, the more tax revenues are raised. Beyond the prosperity that results from finding the correct tax rate, every era of tax reform in the twentieth century has shown that the top earners pay the most when the tax rates are closest to being flat. This flat tax paradox is as significant to governments that seek the prosperity of the private sector as it is to those who seek social justice. The recognition of this paradox is as essential to good governance as the recognition of supply and demand curves are to proper free market pricing.

Here comes the revolutionary free market theory: the best way to discover the optimal Laffer tax rate is with a flat tax, or a tax that is as nearly flat as can be dared. As with pricing goods in a free market, only tests give us certainty. When reducing prices fails to raise demand, prices may be raised. Likewise, when lower taxes on top income earners fails to produce more revenue, the optimal point on the Laffer Curve has been passed. However, to properly test the Laffer Curve, the flattest tax that can be designed should be used.

Certainly, the notions behind the Laffer Curve (that of risk, sweat equity, investment, and return on investment) are notions that apply to those who labor for more than essential needs. Food, housing, and transportation, at bare minimum levels, are largely inelastic demand curves. Laffer motivation will not apply there. However, without actual experimentation no one knows how far down into the middle class the Laffer Curve applies. How rapidly would those currently making $100,000 excel to $175,000 if their tax brackets didn’t change? How much more growth and prosperity would result from lower income brackets not being afraid to work, save and invest? This cannot be known without experiment.

As in the 1920’s, everyone should pay some tax. The top fifty percent, simply because they are the top fifty percent, should not be the only members of a free society paying income tax. The optimal Laffer Curve revenue line will be skewed by a continued practice of man-made egalitarianism. If economic history is to be believed, the flatter the tax the more egalitarian the outcome; targeting top earners actually ends up causing more of the tax burden to be paid by the lowest income earners. In other words, a lower tax rate on only the top 50% of tax payers may result in barely noticeable economic growth and barely noticeable increases in tax revenue. The application of the Laffer Curve in ways that increase the difference in income tax rates may, ultimately, result in mixed evidence that big government fanatics can use to discredit the Reagan-Kennedy revolution. If the Bush tax cuts did far less to stimulate the economy than did the Reagan-Kennedy cuts, it was because these cuts, in practice, moved away from a flatter tax, not towards it.

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