WASHINGTON, December 28, 2014 – Forty years ago this month, Arthur Laffer grabbed a napkin at a Washington restaurant and drew one of the most contentious and influential graphs since Keynes came up with his bent aggregate supply curve.
The Laffer Curve, as it was dubbed in an article by Jude Wanniski in Public Interest, plotted tax revenues against tax rates. It showed that at a tax rate of zero, the government collects zero, at a tax rate of 100 percent, the government collects zero, and somewhere in between, the government maximizes revenues.
By itself the Laffer Curve doesn’t really show much of anything. The concept itself is intuitively obvious, and if you don’t distinguish between top marginal rates and average income tax rates and apply some data, there’s not much there to motivate fiscal policy. Most economists agree that we’re below the maximum point on the curve, and only the hoariest liberals think that setting taxes to maximize government revenue is a good idea.
The Laffer Curve’s significance goes well beyond basic economics, though. It was the loudest shot, if not the first, in the supply-side revolution. When Ronald Reagan marched triumphantly into Washington in 1981, he could have been waving a second flag below Old Glory, one emblazoned with the Laffer Curve.
“Supply-side” economics has taken a pummeling at the hands of people who don’t understand economics, and from people who still worship at the altar of Keynes. Like all economic theories, it’s taken a few knocks from the real world as well.
An economic theory or model is like a road map, a simplification of reality that is useful precisely because it is simple. When a friend sketches out a map to show you the way to his house for a party, he doesn’t include every street, tree, house, utility line, or little old lady crossing the street. He doesn’t draw streets to scale, but instead makes them wider than they really are. A map as detailed as reality is reality, and it won’t fit on your spouse’s lap or on the screen of your GPS.
That simplicity means that it’s wrong about a lot of things, and it can be misread to get you to the wrong house. Keynesian and supply-side models alike have done a poor job at predicting anything when there are unexpected problems. They assume the world will be the world that existed when their “maps” were created, not a world that’s been pummeled by asteroids and collapsing bridges.
Supply-side models are derided as “trickle down” and “voodoo” economics. Those are both political descriptions, not economic critiques. To reduce supply-side theory to the Laffer Curve is like reducing Keynes’s general theory to an IS-LM graph. The critique that the Laffer Curve doesn’t tell you anything on its own could just as easily be thrown at any supply and demand system. Demand curves slope downwards? Duh. A lot hinges on how steeply they slope and what is happening elsewhere in the system.
Supply-side economics should remind us that the world isn’t all about aggregate demand. It doesn’t tell us, as Pope Francis believes, that we must rely on the virtue of the rich and powerful. It doesn’t tell us that cutting taxes on the rich will result in their sudden urge to start new businesses and hire people. It doesn’t say what political critics think it says.
What it does say is straightforward: Production (“supply”) is the most important factor in determining economic growth. The difference between supply-side and Keynesian economics at its most basic is that Keynesians believe that consumer demand is the biggest economic driver; supply-siders don’t.
Serious supply-siders and Keynesians aren’t political caricatures. Supply-siders know very well that just because you produce goods doesn’t mean that people can or will buy them. Keynesians understand that if you’re sitting on a mountain of money and there’s nothing to buy, the money won’t make goods appear by magic. You need producers, and you need buyers.
The Reagan revolution was a political revolution, and the critique of it was political as well. There were simple slogans and gross distortions all around. But the supply-side revolution was like an intellectual bomb, blowing apart the political economic orthodoxies of the day that focused on consumption.
The supply-siders essentially said, we need stable tax, monetary and regulatory policies in order to make it easier for producers to plan in the long-run. Outside of political circles they didn’t say that the tax rate must be N%, but only that if you raise or lower tax rates, you’re going to have an impact on producers, not just on consumers, and those producer impacts will limit the rate of economic growth.
The political argument over whether government is too big or too small is not an economic argument until you answer the question, “too big for what?” What we want government to do and not do is a political issue, not an economic one. Economics can only tell you what happens when you pull that lever, not whether you should pull it or not.
The question of what government should do is a moral question. If you ask me whether raising minimum wage will produce more unemployment, I’ll answer without hesitation, “yes.” If you ask me whether we should raise minimum wage, I’ll have to ask you, is the extra unemployment a price worth paying for your goal? You have to decide that for yourself.
Should we cut taxes? Neither Keynes, Laffer, Milton Friedman, Paul Krugmann, or any other economist can tell you that. They aren’t God. They will pull out different maps and argue over the best route to get to different locations depending on what they want to see along the way and argue about whose map is most robust to a changing landscape.
Supply-side economics reminded us of some economic tools and ideas that were being ignored, and it provided a few new ones of its own. Its birthday is worth remembering and, in my opinion, celebrating. The best roadmap to take from here probably hasn’t been invented yet. Where we should go isn’t for economists to decide.