Dissecting Mitt’s Intellectually Dishonest Tax Policy

Posted by Bob Lord

This post gets a bit geeky, but hopefully makes a worthwhile point. 

In an effort to prop up his his crazy tax proposals without having to explain the details, Mitt now is pointing to "studies" that supposedly support his claim that he won't have to raise taxes on the middle class. You can read the details here:

http://www.huffingtonpost.com/2012/09/14/romney-tax-policy_n_1884527.html

Inferentially, it seems ole Mitt is relying on the age old conservative theory that reducing tax rates actually causes revenue to increase. The idea is that everyone is so deleriously happy with their reduced tax rates that they work harder and longer, such that the increase in the size of the economy more than offsets the reduced rates. It goes back to a concept coined by Arthur Laffer, known as the "Laffer Curve," which was the theoretical underpinning for the 1981 Reagan tax cuts.

There is some logic to the Laffer Curve, but it depends on where the tax rates are before the cut. The best way to understand this is to consider the relationship between rates and revenue at the far extremes. If the tax rate is entirely confiscatory, 100%, nobody would work, and revenues would be zero. If you decrease the rate to 99%, a few people might be willing to work, because they at least will be able to keep something. So, Laffer's principle applies: lower rates create more revenue. If you reduce the rate to 98%, the Laffer principle likely still applies. After all, you've now doubled each worker's after tax income, with only a 1.01% loss of revenue per worker. If the number of work hours increases by just 2%, revenue increases. 

Now go to the other extreme. Say tax rates are at 1%. If you reduce them to zero, revenues must decrease. Thus, at the far extreme, the Laffer principle cannot apply. What if you reduce rates from 2% to 1%? You're reducing revenue by 50% per worker. In order for the Laffer principle to apply, the incentive of keeping 99% of pre-tax income as opposed to 98% of pre-tax income would have to cause the number of work hours to double. Unlikely. 

Thus, the closer you get to 100% tax rates as a starting point, the more likely it is that a rate cut actually will increase revenue. The closer you get to a zero rate as a starting point, the more likely it is that a rate cut will reduce revenue. Somewhere in between, there must be a point at which rate cuts cease to result in more reveune and start to reduce revenue. Indeed, Laffer recognized this. It's why he called it the Laffer curve, rather than the Laffer slope. The tipping point, by the way, is not static. For example, the more affluent society is as a whole, the lower the rate at which a reduction no longer will translate into increased revenue. After all, if you need your income to eat, you'll tolerate a higher tax rate before you say it's not worth it to work. 

This point never gets recognized in the ongoing tax debate. Conservatives keep pushing the idea that rate cuts will magically grow revenue. Democrats argue that if you cut rates revenues decrease. Neither side is entirely correct. 

However, becuase of where income tax rates currently are, the Democrats have the winning argument. It was one thing when Reagan cut the top rate from 70% to 50%, but quite another when Bush 43 cut it from 39.6% to 35%. It took 6 years of ordinary growth for the economy to reach the same level of income tax revenue it enjoyed prior to the Bush tax cuts. There was no magical revenue increase, because tax rates were low enough before the Bush tax cuts that the cuts had little impact on work habits. Obviously, then, the tax cuts Romney and Ryan propose won't increase revenue either, and Romney's belief that the budget can be balanced under his plan is delusional. 

Of course, nobody really believes that Romney or Ryan or any of the Republicans really care all that much about the deficit anyhow.