Can Trump’s Tax Plan Bend the Laffer Curve?

The only thing harder than fixing health care is tax reform, but President Donald Trump means to try. The proposal the White House unveiled today is short on specifics, long on aspirations. Trump’s plan includes:

  • A 15% corporate tax rate, which would also apply to “pass-throughs” – business structures like LLCs used by many small businesses, hedge funds and real estate partnerships.
  • A tax reduction for middle income tax payers in the form of a higher standard deduction.
  • Elimination of most tax preference, but not the popular ones like deductions for charitable contributions and mortgages.

These are ambitious goals. But, paying for them is another matter. On face value they would add trillions to the deficit. But, Trump’s team is counting on massive economic growth they hope the tax cuts will spur to fill the shortfall. 

While Trump’s tax cuts would certainly spur economic growth, it is it is far from certain that they would do so at the levels required to pay for themselves. It is more likely that the White House views the principals announced today as a starting point for negotiations rather than a realistic end goal.

Bending the Laffer Curve

Backers of Trump’s plan point to the Laffer Curve, an economic concept developed by economist Arthur Laffer. The basic premise is that higher tax rates impede economic activity. The Laffer Curve illustrates that there is a point of diminishing returns at which marginal increases in tax rates generate less revenue by impeding economic activity and incentivizing tax avoidance behavior.

If tax rates reached 100%, there would clearly be no reason to work, so there would be no revenue generated to the government either – exactly the same as if the tax rate were zero.

On the front end of the curve, reducing tax rates will generate more income. On the back end, less. Whether tax cuts can pay for themselves depends on where the tipping point on the curve occurs.

Most, but not all, estimates put the peak of the curve higher than current rates.  Unsurprisingly, economists on the left see the revenue-maximizing tax rate quite a bit higher than current marginal tax rates, while credible estimates from right leaning economists range from somewhere slightly below current tax rates to slightly above.

Left-leaning economist see the curve peaking around 60-70%. Economists on the right put it as low as 19%, but most would say it’s somewhere between 35% to 50%. So, it seems likely that Trump’s tax cuts are likely on the back end of the curve where they will generate less new income from economic growth than they lose from rate reductions.

According to Gregory Mankiw, who was chairman of President George W. Bush’s Council of Economic Advisers, “A reasonable rule of thumb, in my judgment, is that about one-third of the cost of tax cuts is recouped via faster economic growth.”

Some economists argue that the revenue-maximizing rate shouldn’t matter. The point should not be to make the government as flush with cash as possible, but to drive the strongest economic growth possible. As Marty Feldstien, chairman of President George W. Bush’s Council of Economic Advisors put it:

“Why look for the rate that maximizes revenue? As the tax rate rises, the “deadweight loss” (real loss to the economy rises) so as the rate gets close to maximizing revenue the loss to the economy exceeds the gain in revenue…. I dislike budget deficits as much as anyone else. But would I really want to give up say $1 billion of GDP in order to reduce the deficit by $100 million? No. National income is a goal in itself. That is what drives consumption and our standard of living.”

All fair points. But, it does matter if you are worried about exploding deficits and unwilling to reduce spending to compensate for the lost revenue. Given President Trump’s ambitions for large investments in infrastructure and reluctance to pair back entitlements, meaningful spending reductions are probably not on the table. The White House seems to be willing to roll the dice and hope economic growth will fill the gap. As Earnest Hemingway’s protagonist Jake Barnes muses to Lady Brett in The Sun Also Rises, “isn’t it pretty to think so.”

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