The Laffer Curve and its Roots
John F. Kennedy, Income Taxes and the Federal Deficit
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As of late October 2009, cumulative job losses since the Great Recession began total nearly 8 million and unemployment is hovering just under 10%. Many states are even higher; California is slightly over 12%. There is anecdotal evidence that suggests that this quarter will show continued weakness in economic activity that, in turn, will crater the Retail Industry’s earnings since the fourth quarter includes the holiday season and is so crucial to their success.
This evidence comes from import volume at the Los Angeles and Long Beach ports dropping to the lowest point in nine years coupled with poor prospects for seasonal hiring for the holiday period. Many current economic predictions don’t show substantial improvement until late 2011. At the same time, we are facing the highest federal deficit in history with frightening projections of federal debt and the deficit going out to 2019. There isn’t much mention anywhere about reducing income taxes, either at the federal or the state level, against a backdrop like this.However, past history has shown that tax reductions employed to stimulate the economy have been the catalyst propelling the country out of recession.
The Three Most Significant Income Tax Reductions in the US
There were three significant periods in US History where income taxes were reduced to forge an economic recovery:
- The Harding income tax cuts that were initiated in1921 and continued by President Coolidge,
- The JFK income tax reductions of the mid-1960’s and,
- The Reagan income tax cuts of the 1980’s.
In1921 President Harding convinced congress to pass income tax reductions wrapped in a package that he called “A Return to Normalcy”. One of Harding’s campaign slogans was “less government in business” and his programs were wisely continued by his successor, President Coolidge. The 1920’s saw the tax burden of middle Americans decrease while most lower income Americans were relieved of their tax burden altogether. The results were impressive: unemployment plummeted from its high in 1921 of 20% to an average of 3.3% for the remainder of the decade.
The pay-as-you-go method of withholding of income tax from payroll checks mandated by the IRS rather than lump sum payments at tax filing time was instituted in 1940. To fund the WWII effort, the number of Americans required to pay federal taxes rose from 4 million in 1939 to 43 million in 1945. The income tax rate on earnings as little as $500 per year was 23 percent rate, while those who earned more than $1 million per year paid an astounding 94 percent rate. The highest marginal tax rate continued at an oppressive 91% until President Kennedy acted to reduce it as part of his platform. As a result of the JFK’s tax cuts, unemployment dropped from a four-year average of 5.8% prior to the cuts to a four-year average of 3.9% afterward. And perhaps counterintuitive to many people, the income tax reductions actually increased government tax receipts: government tax revenue grew at an average annual rate of 9.2% during the four-year average after the tax reductions compared to an average annual rate of 2.6% in the four-year period prior to the reductions.
JFK’s Speech to the Economic Club of New York—December 14, 1962
President Kennedy’s income tax policies produced a long period of prosperity and he a keen grasp of the problems and their solutions. He gave a very focused and articulate speech to the Economic Club of New York on December 14th, 1962 and the following are direct quotes from his speech: “But the most direct and significant kind of Federal action aiding economic growth is to make possible an increase in private consumption and investment demand—to cut the fetters which hold back private spending.If Government is to retain the confidence of the people, it must not spend more than can be justified on grounds of national need or spent with maximum efficiency.The final and best means of strengthening demand among consumers and business is to reduce the burden on private income and the deterrents to private initiative which are imposed by our present tax system; and this administration pledged itself last summer to an across-the-board, top-to-bottom cut in personal and corporate income taxes to be enacted and become effective in 1963.” President Kennedy goes on to say “I am talking about the accumulated evidence of the last five years that our present tax system, developed as it was, in good part, during World War II to restrain growth, exerts too heavy a burden on growth in peace time; that it siphons out of the private economy too large a share of personal and business purchasing power; that it reduces the financial incentives for personal effort, investment, and risk-taking…In short, to increase demand and lift the economy, the Federal Government’s most useful role is not to push into a program of excessive increases in public expenditures, but to expand the incentives and opportunities for private expenditures…When consumers purchase more goods, plants use more of their capacity, men are hired instead of laid off, investment increases and profits are high. Corporate tax rates must also be cut to increase incentives and the availability of investment capital.”
In August 1981 President Reagan reduced the highest marginal tax rate from the 70% that had existed since Kennedy’s administration to 50% through the “Economic Recovery Act”, ERTA also known as the Kemp-Roth Tax Cut. The Capital Gains rate was also lowered from 28% to 20% and significantly boosted capital and investment spending. President Reagan’s Tax Reform Act of 1986 further reduced the highest marginal rate to 28%, effective by 1988. Unemployment which had reached its’ peak of 9.7% in 1982 had dropped to 5.3% by 1989. During the four years prior to the Reagan cuts government tax revenue was declining on average annual rate of 2.6% whereas after the cuts the tax revenue increased at an average annual rate of 3.5%.
The Laffer Curve and its Roots
Arthur Laffer, founder and chairman of Laffer Associates perhaps most known for a profound concept that bears his name, “the Laffer Curve”. An over-simplification of his analysis is that as tax rates go up beyond a certain point, actual tax receipts to the government decrease rather than increase with the reverse also being true. This is what President Kennedy referred to when speaking about the deterrents to private initiative and what actually occurred as a result of his income tax reductions. Dr. Laffer in his paper on the Laffer Curve claims that this concept dates back hundreds of years and quotes Khaldun, a 14th Century Muslim philosopher from The Muqaddimah: “It should be known that at the beginning of the dynasty, taxation yields a large revenue from small assessments. At the end of the dynasty, taxation yields a small revenue from large assessments.” He also quotes a more contemporary economist, John Maynard Keynes who said: “Nor should the argument seem strange that taxation may be so high as to defeat its object, and that, given sufficient time to gather the fruits, a reduction of taxation will run a better chance than an increase of balancing the budget”.
The Estonia Example—a Recent Success Story
In the 1990’s Estonia, a small country in Central Europe, experienced one of the greatest economic turnarounds in modern history. Estonia was occupied by the Soviet Union from 1940 until 1991. For fifty years Estonia had depended on the Soviet Unionfor its economic subsistence since almost all of its international trade was with Russia. After becoming independent, Estonia experienced a drop in production and wages of 30% and 45%, respectively, worse than the Great Depression in the US. Along with the cataclysmic drop in economic output, Estonia was experiencing runaway inflation of more than 1,000%. Fuel prices rose some 10,000% and bread and milk was rationed resulting in long lines to buy food. Estonia introduced several free-market economic initiatives:
- They introduced their own currency in 1992,
- They became a Free Trade Zone free of tariffs and barriers to trade,
- They established strong private property ownership rights, and
- They adopted a low flat-rate personal income tax.
The result was an explosion of entrepreneurship. The number of businesses grew from 2,000 in 1992 to 70,000 by 1994. The impact on GDP growth was dramatic: in 1993 GDP shrank by 9.2%. By 1995 GDP grew at 4.3% and in 1997, Estonia led Europe with 11.4% GDP growth. Both unemployment and inflation dropped sharply and in 2007, Estonia was ranked number 12 in the Index of Economic Freedom (the USA is ranked number five).
The USA’s Position in the OECD
Today, the United States currently has the dubious distinction of having the second highest corporate income tax of the 30 OECD countries. This is a result of many countries lowering their tax rates over the past several years while the US has gone in the opposite direction and raised their rates since the Reagan era’s Tax Reform Act of 1986. The following table shows the statutory corporate income tax rates in 2008 for the 30 countries that belong to the Organization for Economic Cooperation and Development (OECD):
|8||New Zealand||33.00%||18||Finland||26.00%||28||Slovak Rep.||19.00%|
The Corporate Rates in the 50 States, Ranked
High federal rates are exacerbated in certain states that significantly increase the tax burden. The following table ranks the 50 states’ corporate income tax rates from highest to lowest:
|7||Rhode Island||9.00%||24||North Dakota||7.00%||41||Ohio||5.10%|
|9||Maine||8.93%||26||North Carolina||6.90%||43||South Carolina||5.00%|
California’s Current Proposals
Governor Arnold Swarzenegger created the Commission on the 21st Century Economy through executive order S-15-09 to ” Establish 21st century tax structure that fits with the state’s 21st century economy;” among other things. The recommendations of the Commission made in September of 2009 are as follows:
- Recommendation One: Reduce and restructure the personal income tax.
- Recommendation Two: Eliminate the corporation tax and the franchise minimum tax.
- Recommendation Three: Eliminate the state general purpose sales tax.
- Recommendation Four: Establish the BNRT.
- Recommendation Five: Create an independent tax dispute forum.
- Recommendation Six: Establish a new Rainy Day Reserve Fund.
The first five recommendations require changes in statutory tax law and the sixth requires a change in the State Constitution or a state ballot initiative in order to pass. Perhaps the most controversial is the proposed Business Net Receipts Tax that taxes Gross Profits before deductions. Arguably a BNRT tax would drastically increase the tax burden on companies that are the least able to pay it and drive marginal companies out of business leading to further job losses.
The Federal Debt and the Deficit
The latest figures from the US Treasury show for the fiscal year that ended September 30th that the federal budget deficit was $1.42 trillion as compared to $459 billion in 2008. In other words the deficit has tripled over the prior year period. Moreover, the CBO forecasts that the deficit will total $7.1 Trillion within 10 years. In fact, CBO predictionsare that 15% of the federal government’s spending will go toward paying interest on the federal debt,up from the current 5%. The government forecasts also showed that the US national debt will nearly double from the $11.9 Trillion as of this writing, to $20.7 Trillion within 10 years.
Given these predictions it’s hard to imagine that income tax reductions that have proven to stimulate the economy by lowering unemployment, stimulating investment, and attracting entrepreneurship will be implemented any time soon. If President Kennedy were still among us, he might advise us to rein in spending, balance the budget and reduce taxes.
Dennis Jones resides in Orange County, California with his wife and two children and has made his living as Chief Financial Officer in the Restaurant Industry for the past 30 years. He received his MBA from Long Beach State University and has a BS degree in Finance from the same institution.