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
- Tax cuts generate a big boost in GDP growth, and
- 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:
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:
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):
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.
I have drawn some ire from fellow libertarians for my criticism of their fiscal policy priorities. My review of the book Trumponomics by Steve Moore and Art Laffer, which concluded that tax cuts have become ineffective, rendered a couple of surprising comments from fellow libertarian economists. Nevertheless, as I explained in my series Tax Cuts or Spending Cuts, facts are facts; cutting taxes to close the budget gap in a big welfare state is about as futile as ignoring gravity.
The only way to close the budget gap is by means of structural spending reductions. Since such reforms are no longer being discussed in the public discourse, nor being given attention by leading libertarian thinkers, pundits and scholars, starting today I am rolling out a series of articles on how to structurally reform away the welfare state.
In this the first installment we will condense the case for structural spending reform. I find it necessary to do so, partly – again – in response to the conventional wisdom that tax cuts can save us, but partly also in response to another idea being floated around among conservatives and libertarians: fiscal rule making.
Many people with influence have suggested that all Congress needs in order to end our deficits and prevent a debt crisis, is to follow a set of fiscal rules. A new book from the Cato Institute offers a collection of 20 essays centered around this notion; as I explained in my review of the book, for two reasons fiscal rule-making does not work:
- The rules are “Pippi rules”, i.e., they are self enforced with impunity for non-compliance;
- Without exception, the rules rely on healthy levels of GDP growth in order to work.
The last point applies not only to fiscal rule-making but also to the unending pursuit of tax cuts. In the case of rule-making, the prevailing wisdom is that GDP growth is exogenous to fiscal policy, in other words that it is not affected by the enforcement of a fiscal rule. However, as we will see in a coming article, fiscal rules can actually undermine the very basis for their own enforcement.
In other words, GDP growth is not exogenous, but endogenous to fiscal policy.
Proponents of tax cuts recognize this: in fact, the endogenity of GDP is the very life blood of the tax-cut argument. The problem here, though, is that tax cutters limit the endogenity to taxes; there is no explicit consideration of the effects of government spending on GDP growth. Right there we have the mistake that prevents the tax cutters from seeing how their budget-balancing strategy has run its course and no longer works.
It is essential for any attempt to save us from a debt crisis, that we understand why GDP growth is affected by the size of government spending. Before we get to the analytical explanation, let us start with empirical evidence. Figure 1 summarizes what this evidence says, namely:
- When government spending as share of GDP increases, i.e., when G/Y goes up (horizontal axis), initially the growth rates of taxes (t) and government spending (g) are largely similar;
- As the size of government passes a certain point, the growth rates of t and g divert, with the former declining and the latter increasing;
- when government spending grows faster than tax revenue, we get a structural budget deficit.
Let us review some data that confirm the image in Figure 1. First, Figure 2 reports data from Europe on the relationship between government spending as share of GDP, G/Y, and real GDP. Covering 31 countries, almost all of them over a 25-year period (1995-2019), it paints a stark image of the negative relationship between economic growth and the size of the welfare state:
Next up: numbers from the U.S. economy, which gives us an opportunity to link the size of government to the root cause of the budget deficit: the welfare state.
Government growth in America can be divided into five distinct phases. The first era runs from 1950 to 1963. This is the first phase of stability (Stability 1 in Figure 3 below). During this phase the welfare state was still ideologically conservative and did not engage in economic redistribution. It was, simply, confined to the provision of a safety net for the poor and needy. This was the welfare state that Congress and the Franklin Roosevelt administration created in response to the Great Depression.
The second phase of government growth begins with President Lyndon Johnson’s State of the Union speech in 1964. There, he declares his War on Poverty and marks the beginning of a fundamental overhaul and expansion of the welfare state. New entitlement programs like Medicare and Medicaid are created, others revamped for much more comprehensive purposes.
At the heart of the War on Poverty is a new, relative definition of poverty. A person is no longer poor because he lives below a certain, fixed standard of living. A person is now poor because he earns below a certain percentage of median income. When median income rises – as it does when the economy is doing well – the poverty limit rises as well. More people qualify for government handouts.
As I explained in my book The Rise of Big Government, the significance of this welfare-state metamorphosis cannot be understated.
After this roll-out phase for the new, socialist welfare state, it was time for the implementation phase: government needed to consolidate its new spending programs. Fiscally, this meant that government grew to the new, larger proportions that all the War-on-Poverty legislation prescribed. During this phase, which essentially coincided with the 1970s, government spending increased significantly.
This is also the phase during which government spending outpaced tax revenue on a permanent basis. The structural budget deficit was born.
Once the new welfare state was consolidated, government went into a new phase of relative stability. It lasted from 1980 to 2007, the year before the Great Recession started. During this Stability 2 phase (again, see Figure 3 below), government spending remained largely constant as share of GDP, but that stability was attainable thanks only to two tax reforms. Government spending was still small enough to let tax cuts work – there was a Laffer effect to be counted on.
If it had not been for the Reagan tax cuts fundamentally overhauling the tax code, there would not have been a long, stable growth period through the 1990s; the Bush tax cuts generated a more limited, yet visible growth spurt that helped carry the economy through most of his presidency.
With their growth record, these two tax reforms generated enough growth to essentially keep steady the ratio of government spending to GDP.
It is easy to get the impression from this long phase of stability that America had struck a golden balance between the welfare state and free-market capitalism. That was not the case, as evidenced by the perpetuated deficit. The Reagan and Bush tax reforms were not enough to close the budget gap, and the difference in effect of the two, with the first having stronger effects than the second, remains unrecognized in the literature.
The reason why the two reforms failed to fully fund the welfare state is simply that this structure of government spending grows by its own volition. Government spending is exogenous to economic growth, a fact that originates in the very ideological design of the welfare state.
Phase five, the Stagnation phase in Figure 3, is when the welfare state has grown big enough to permanently depress economic growth. This phase provides ample evidence of how the welfare state overpowers its host economy. During this phase, which begins in 2008 with the Great Recession, total government outlays average more than 37 percent of GDP. Economic growth is so poor that its annual average for the entire period is only 1.7 percent:
Predictably, the decline in growth has taken a toll on government revenue. When taxes have not delivered sufficient money to fund the growing welfare state, government – especially states and municipalities – have resorted to non-tax revenue. As Figure 4 explains, the rise of fees, charges and other revenue sources has coincided in time with the transformation, implementation and growth of the socialist welfare state. However, not even the rise of non-tax revenue has been enough: the deficit reported in Figure 4 (red) is mostly federal but also includes overspending by state governments.
De facto, deficits have become a permanent source of government funding:
It is worth noting that as taxes become less important as a revenue source for government, the effectiveness of tax cuts also declines.
With declining GDP growth under an increasingly burdensome welfare state, government debt keeps rising. Figure 5 compares the debt-to-GDP ratio to real GDP growth. To highlight trends, the numbers are reported as five-year moving averages:
Let us now add together everything we have learned so far about the interaction between government spending, GDP growth and tax revenue, and add one more twist to the tax-or-spending-cuts debate. Figure 6 reports a total of 262 quarterly observations of annual growth rates in all three variables, from 1954 to Q2 of 2019. The observations are not reported chronologically, but are instead organized by GDP growth, from high to low (blue).
Tax revenue correlates positively with GDP growth (black dashed), which is not surprising. What does stand out, however, is the turn upward of government spending growth (red dashed) when GDP growth falls below three percent per year. As GDP growth gets weaker, government spending accelerates:
We have now learned three important things about the government budget:
- As spending grows, GDP growth declines;
- As GDP growth declines, spending growth accelerates; and
- With declining GDP growth, tax revenue slacks off as well.
There is more to be said about the first two points; for now, let us note the conspicuous divergence between GDP and government spending toward the right end of Figure 6. That gap alone explains our structural budget deficit.
However, first, we need to add one last point about taxes. As Figure 6 tells us, tax revenue fluctuates with GDP growth, but the fluctuation is higher in tax revenue. This means, plainly, that tax revenue is a volatile source of revenue. Figure 7 extracts the equations defining the trend lines in Figure 6 and plots them strictly as analytical representations of how these two variables correlate:
The problem with Figure 7 is that the volatility in tax revenue has increased with each supply-side tax reform. This means, in turn, that tax revenue plunges more violently in recessions, but since the long-term growth trajectory for GDP – and therefore the tax base – is lower than it used to be, this volatility is not symmetrical. We don’t get enough of a compensating “Keynesian” surge in tax revenue at the peak of the business cycle.
In other words, we are left with a structural deficit.
But why, then, do we actually have this structural deficit? This question is of course essential to our discussion of structural spending reform. Figure 8 has the answer. It reports the share of the federal budget that is dedicated to entitlement spending, i.e., the welfare state. The blue function represents the welfare state’s share of the budget in 1964, when the War on Poverty began. Today, two thirds of all federal spending goes toward entitlements, from education to Social Security, from the Earned Income Tax Credit to Medicaid and Medicare:
To highlight, Figure 9 divides the 2019 federal budget by major program category. Notice the share that goes to national defense: in 1960 that share was 50 percent.
Spending on entitlement programs grows for reasons that are inherent to the programs themselves. This growth causes a depression in GDP growth, which in turn causes a structural budget deficit. The only way we can close the budget deficit is by reforming away the welfare state.
How? Please proceed to Part 2.
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 For a more detailed discussion of the ideological character of the American welfare state, see Larson (2018) and Larson (2020f).
There is a tradition among Republicans to try to fix budget deficits with tax cuts. Three times in the past 40 years they have deployed this strategy, each time with largely the same results: a solid rise in tax revenue but no budget balance.
Now there are rumblings about an even bolder plan. Steve Moore, an economist with President Trump’s economic recovery task force, has suggested that Congress suspend federal personal and corporate income taxes for 2021. By 2022 taxes would revert back to their normal levels.
As with the Reagan, Bush and Trump tax cuts, the idea is to exploit the Laffer effect, according to which the initial loss of tax revenue from a tax cut is made up for with growth in the tax base. As a result, government collects more tax revenue down the road than it would have done at the initial, higher rates.
There is a fair amount of evidence to support the Laffer effect. However, it does not apply in Steve Moore’s case, and the reason is simple: temporary tax cuts have no lasting effect on economic growth. The only effect of Moore’s proposal would be an even bigger deficit hole in the federal budget.
With the experience that Moore has, you would have expected him to have kept this in mind while designing his proposal. As it is now, his tax holiday would only result in a massive increase in our already oversized money supply. No sane investor is going to lend even remotely enough money to the Treasury if it expands an already-gargantuan budget deficit by temporarily giving up 55 percent of its tax revenue.
More than anything, Moore’s proposal would accelerate us into an acute fiscal crisis. At that point, anything can happen – even Republican tax hikes.
In other words, the Laffer Curve is not to be taken lightly. You cannot throw it around like candy and hope for the best. That said, there is no doubt that the curve exists. Figure 1 reports data from 30 European countries from 1996-2019.* Two time series are compared:
- T/GDP, i.e., the ratio of total tax-revenue collections from all levels of government to GDP. Both variables are in current prices.
- T Growth, i.e., annual growth in current-price tax revenue.
The variables are paired by year, by country, then organized as two time series based on the second variable. The red-gray columns represent growth rates in tax revenue, while the green curve is a polynomial trend line for the tax-to-GDP ratio (representing 719 observations for T/GDP). Behold the Laffer Curve:
Figure 1: Euro-Laffer
It is worth noting the up-sloping segment of the curve, giving the impression that it is good to raise taxes. That is not the case, however: the upslope is associated with declining tax revenue or revenue growth rates that are tepid at best. This indicates that we are looking at economies in recession; tax revenue only plummets during recessions or in the first year of a Laffer-driven reduction in taxes. Europe has seen practically nothing of the latter, so the cause of this decline is to be found in the former.
But why, then, is there an upslope in the Laffer curve? Simple: during recessions the total tax collection from the economy declines faster than GDP. In almost every mature welfare state – of which there is plenty in Europe – the tax burden is disproportionately placed on higher incomes. Those are the first to take a beating when the economy tanks. Therefore, at constant tax rates the tax-to-GDP ratio falls in a recession and rises as the economy revs up again.
Once the economy is out of a recession, however, high taxes stifle economic growth. This is visible in the peak of the Laffer Curve; the only way to increase the annual growth rate in tax revenue is to actually cut taxes.
To see how the Laffer Curve works in practice, let us take a look at one of the worst examples of bad tax policy in modern times, namely Greece in the aftermath of the Great Recession. Figure 2 reports the same variables as in Figure 1, though the T/GDP ratio is reported as actual data, not a trend line.
During the austerity episode after the 2008-2010 Great Recession, the Greek government raised taxes significantly. As a result, the average growth rate in tax revenue almost ground to a halt:
Figure 2: The Laffer Effect in Greece
To summarize the two periods in the Greek economy:
If the Greeks did the opposite now, returning taxes to pre-austerity rates, they would spark a significant rise in GDP growth. Tax revenue would surge in the backwater of that growth. However, it would have to be permanent tax cuts, not some silly one-year holiday.
There is another side to the Laffer Curve, of course. If government does not cut spending in tandem with the tax cuts, but if entitlement programs are allowed to continue to grow, then the rise in revenue collections will be inadequate and fail to fully fund the welfare state. Therefore, the Laffer Curve must not be used as a simple go-to solution when deficits get out of hand; it is an instrument that should only be applied as part of a structural transition from a big welfare state to a small government focused on its core functions.
On the other hand, when used properly, the Laffer Curve works just fine.
*) All raw data numbers are sourced from the Eurostat databases on national accounts and government finances. The countries are: Belgium, Bulgaria, the Czech Republic, Denmark, Germany, Estonia, Ireland, Greece, Spain, France, Croatia, Italy, Cyprus, Latvia, Lithuania, Luxembourg, Hungary, Malta, the Netherlands, Austria, Poland, Portugal, Romania, Slovenia, Slovakia, Finland, Sweden, the U.K., Norway and Switzerland. For Switzerland, data is only available for 1996-2018.