As Congress begins a debate that is supposed to result in tax reform legislation, once again we hear the calls from GOP leadership to pass a “revenue neutral” bill. Some members, including apparently the leadership, are advancing the notion that tax reform should not be passed that isn’t revenue neutral. This is exactly the position taken by the losing side in this debate among Republicans before Congress passed President Ronald Reagan’s tax reform plan that lead to the greatest economic expansion in our life times. The supply-side deniers were wrong then and they are just as wrong now.
Liberal Democrats and the moderate Republicans view economics in a very static and simplistic way. They think if something is taxed at 15 percent and brings in x level of revenue, that to simply double that rate on the same thing to 30 percent will bring in a 2x level of revenue. That assumes that no one involved in the economic activity being targeted by that tax will change any decisions or actions they take if the tax rate on it is doubled. But this is purely delusional, because in the real world we know rational human beings change economic decisions to reduce the burden of taxes. Doubling a tax rate will almost never double revenues, in fact, it might decrease revenues if it suppresses economic activity to the degree that double the rate of tax causes the activity to decline to less than half its previous total. For example, if doubling the tax rate on digital cameras causes sales to decline by more than 50 percent, that higher tax rate will bring in less revenue than it did before it was doubled.
The key to understanding this, which many Democrats and supply-side deniers among Republicans either do not get or do not want to understand, is knowing how the Laffer Curve works, developed by economist Arthur Laffer. The theory behind the Laffer Curve quite reasonably assumes that a zero tax rate will bring in zero revenue, and that a 100 percent tax rate, because no one will work for zero compensation, will create full unemployment and likewise lead to zero revenue. Between those highest and lowest possible tax rates, Laffer suggested some rate between them would maximum revenue levels, and he drew the curve with the highest point in that curve corresponding with the theoretical point of a tax rate that would obtain the highest level of revenue. The picture above shows the Laffer Curve.
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While attempting to measure what tax rate would likely be at the top of the Laffer Curve, a subject of detailed econometric study. But we do know, in general, that tax rates above the optimum rate must be lowered to increase revenues. Given the penchant for raising taxes shown by most politicians, the odds are that most of our tax rates are to the right of the top of the Laffer curve, which means lowering those rates will increase the revenues obtained from those taxes.
Given the lowering our already too-high tax rates will increase revenues, we can see that those who always call for tax reform demand it be “revenue neutral” clearly show they do not understand economics. This idea that tax reform must be revenue neutral by raising taxes on something to make up for cutting taxes in another area is not only self-defeating, it is not economically viable. Why eliminated the revenue increasing advantage of cutting taxes by raising taxes in other areas of the tax code? This clearly defies what we know about economics.
Congress should reject this static and simplistic ideas that tax reform should be revenue neutral. Tax cuts properly done will not be revenue neutral, but revenue increasing at lower tax rates. Those who do not understand simply don’t understand how to pass effective tax reform that grows the economy.