The Decline of the Laffer Curve

Part of my review of tax cuts and spending cuts consisted of some conditional criticism of the Laffer Curve. I have pointed out that it should be used with caution and that it is downright irresponsible to assume that there is no correlation between the Curve’s effectiveness and the size of government spending. On the contrary: the bigger government grows, the weaker the Laffer Effect will be. It never goes away, but there comes a point when it is necessary to re-direct the political energy spent on tax cuts, and focus it on spending reform instead.

It is essential for anyone interested in limited government to understand in detail why the Laffer Curve loses its prowess with bigger government. We have already established that the bigger government spending gets, the weaker is economic growth. The next step toward understanding the limitations of the Laffer Curve is to see how weaker growth means weaker tax revenue.

The link is private-sector employment. Since the private sector is our actual tax base, and since the federal government collects more than 80 percent of its revenue from personal income taxes, it is essential for the Laffer Curve that

  1. Tax cuts generate a big boost in GDP growth, and
  2. The growth boost leads to a significant rise in private-sector employment.

The good news for our supply-siders is that there is a tight, clearly visible correlation between real GDP growth and growth in private-sector employment. Figure 1 reports annual rates, quarterly, for the two variables, from 1948 to 2019:

Figure 1

Sources of raw data:
Bureau of Labor Statistics (Employment)
Bureau of Economic Analysis (GDP)

In other words, plain and simple: when the economy is doing well, the private sector hires more people.

Technically, the causality from GDP growth to employment growth is driven by average workforce productivity (Y/L). Figure 2 reports how changes in GDP per employee in the private sector varies with the employment level itself. When average productivity increases, d(Y/L), employment rises with about a two-quarter lag. The arrows in Figure 2 highlights eight such episodes since 1950:

Figure 2

Sources of raw data:
Bureau of Labor Statistics (Employment)
Bureau of Economic Analysis (GDP)

Two noteworthy episodes in Figure 2 (dashed ellipses) mark exceptions to the rule highlighted by the arrows. Toward the end of the 1990s productivity was rising, but the economy still shifted from jobs growth to rising unemployment.

The second episode is the late Obama recovery and the beginning of the Trump economy, where productivity gains were weak. There is a peak associated with the investment boom following the Trump tax cuts, but it is hardly visible compared to previous productivity spikes.

We cannot learn anything definitively from these two exceptional episodes, but they are nevertheless worth noting and something we should return to for future reference. What matters in Figures 1 and 2, and especially in Figure 1, is how GDP growth has weakened over time. For the past decade, the economy has struggled to reached three percent in any four-quarter period.

Since private-sector employment is so closely linked to growth, and since growth in tax revenue tracks very closely with employment numbers, this overall weakness in our economy rapidly translates into weakness in tax revenue.

However, it is actually even worse. Courtesy of my first article on structural spending reform, consider this compelling relationship between employee compensation (Y) and revenue from personal federal income taxes (T):

Figure 3

This image has an empty alt attribute; its file name is spending-reform-3.png
Source of raw data: Bureau of Economic Analysis

Not only does tax revenue weaken with weaker growth, but it is also volatile in comparison. This volatility increases for each new tax reform, as the tax burden is pushed higher up in the income layers, where the tax base fluctuates more violently with the ups and downs in the economy. As GDP growth gets weaker, for reasons we will elaborate on later there is a “drift” of the tax base into these higher, more volatile income layers.

In short: tax cuts in an economy with big government spending

  • are less effective than when government is moderately sized;
  • generate inadequate increases in revenue; and
  • make the tax base more volatile.

The Laffer Curve still works, but it has become much weaker over the years. If we want to save America from perennial economic stagnation, we need to take our eyes off taxes and start working on spending reform instead.

2 comments

  1. friedmont

    Interesting – I hadn’t learned about this before, so this is new to me. Essentially, is the data showing that reducing spending is more effective than reducing tax cuts, in big governments at least?

    • S R Larson

      Yes, that’s correct. All other things equal (political preferences, etc.) there is a trade-off point where spending cuts are more effective than tax cuts. I can’t nail down that point exactly, not until I have done more statistical analysis, but I think it is a safe bet to say we have passed that point now.