The Limits to the Laffer Curve

Santa Claus is for small children, not Congress

This is Part 2 of Rule 9: Debt is Dumb

Supply Side Economics worked for John F. Kennedy because he was a Democrat, had the press on his side, and had a way with the ladies.

Scratch that. Supply Side Economics worked for John F. Kennedy because he was starting with a criminal 90% top tax bracket for earned income. When he [posthumously] cut the top bracket to 70% he tripled the amount that top earners got to keep. It was enough to entice a movie star to make an extra movie, or for a Rockefeller to invest in the private sector instead of municipal bonds. On the other hand, the government needed a mere 29% increase in taxable earnings from top bracket earners for the government to break even.

It worked. The economy boomed and revenues rolled in, but not enough to pay for the Vietnam War, the Great Society, and a trip to the moon. Deficits went up and Nixon had to abandon the international gold standard. Inflation picked up and Nixon did the idiot Leftist thing: price controls. Gas lines grew long, ties and lapels grew wide, and blue collar real wages flatlined. The Era of Disco and Stagflation had begun.

Ronald Reagan tried to pull us out with additional Supply Side magic. But he started closer to the Laffer Curve peak; most of the magic was already used up. Reagan, like Kennedy, called for a 20 percentage point drop in the top tax bracket for earned income. But for high earners, the take home pay increased by a factor of 50/30 or 167%, which was respectable but rather less than the 30/10 or 300% factor that the Kennedy tax cuts produced. Indeed, Reagan would have had to cut the top tax rate down to 10% in order to have the same boost effect(!) Meanwhile, top earners needed to earn 40% more taxable income for Reagan's Supply Side tax cuts to break even.

I haven't proved where the Laffer Curve maximum is in this analysis; I have simply shown that the slope is likely to be much steeper at the far right hand side of the curve. Exactly where the maximum is depends on the alternatives to earning taxable income. To that subject we turn next.

The Laffer Curve for Low Risk Passive Income

Suppose you have a billion dollars sitting in the vault of your underground lair. You have another billion dollars already invested in a manner which yields enough taxable income to put you in the top tax bracket. You have the option to invest the cash in your vault at 4% with no risk. The top tax rate is 40%, so your net yield is 60% of 4% or 2.4%, which nets you 24 million dollars/year. Do you invest or do you let the dollars collect dust in your vault?

What if the top rate was 80%? Now your effective rate is 20% of 4% or 0.8%. This nets you 8 million dollars per year. Do you invest? What if the top rate was 90%? Now you get only 4 million dollars/year. How about 95%? That still nets you 2 million dollars per year. At what point do you leave the money in the vault and make Keynesian economics sad?

In the absence of risk or investment alternatives, it still makes economic sense to invest spare cash as long as the top tax rate is less than 100%! The only reason to leave the money in the vault is anger at the IRS (not a trivial factor!) or the bother of making the transfer (which does match the net yield at some point of extreme taxation).

But there is a longer term Laffer Curve factor: anyone who has a vault with a billion dollars in it is likely to be someone who saves more than they spend. If you let them keep more of their passive income, then they will roll over a goodly portion of their earnings which increases the overall passive investment pool.

However, if brutal taxes on these high income Paint-by-Numbers investors went to lowering the federal budget deficit, then the capital pool would increase just about as much! (Exactly as much if the top zero risk investment rate was the same as what the government pays for its bonds. A teeny bit less if there are better zero risk investments.)

Thomas Piketty, author of Capital in the Twenty First Century and darling of liberals prior to the Great Awokening, would approve of this line of reasoning. In chapter sixteen of his subjectively immense tome (Capital is the My Pillow for Leftists) he advocates some pretty brutal wealth taxes to quickly pay down government debts. His idea would work if (and only if):

• Governments would use the windfall just to pay down debt, and would refrain from running their debts back up,

• The ultra rich thus taxed are simply making money via near zero risk Paint by Numbers passive investments,

• Capital could not quickly flee in the face of such brutal taxes.

None of these conditions are true. Piketty displays both the intelligence and lack of practical wisdom which is all too prevalent in academia. (Actually, U.S. academia has been jettisoning the intelligence part lately...)

Interestingly, on page 545 of his pillow book, Piketty cites Great Britain during the nineteenth century as an example of a country that resorted to austerity to deal with the immense debt racked up during the Napoleonic Wars:

"The most interesting historical example of a prolonged austerity cure can be found in nineteenth-century Britain. As noted in Chapter 3, it would have taken a century of primary surpluses (of 203 points of GDP from 1815 to 1914) to rid the country of the enormous public debt left over from the Napoleonic wars. Over the course of this period, British taxpayers spent more on interest on the debt than on education. The choice to do so was no doubt in the interest of government bondholders but unlikely to have been in the general interest of the British people. It may be that the setback to British education was responsible for the country's decline in the decades that followed."

Hmmm. During that century of austerity, Great Britain industrialized and built an empire on which the sun never sets. It wasn't all Objectivist ponies and fairy dust, as writers like Charles Dickens were long winded to point out. But maybe that constraint on socialist spending restrained the British government from socialist stupidities, even as it also constrained the government from providing a better social safety net. Maybe it was a coincidence, but the British Empire started going into decline after Britain gave up on austerity and resorted to inflation after World War I.

Anyway, I could go for some fairly high tax rates for Paint by Numbers investments for the ultra rich, but my weapon would be to close loopholes. For example, make municipal bonds taxable. Use them as Paint by Numbers investments for retirement accounts of people who cannot afford to hire investment wizards. I want the Ultra Rich to be the source of high risk venture capital; the rich can afford to take more risks, and I could use some angel investments to do some Rule 2 projects...

But I also want austerity. I'm populist and paleo, not liberal. I want some higher taxes on those who can pay them to pay down some federal debt, not add to the alphabet soup of government programs.

The Laffer Curve and High Risk Investments

Many potentially worthwhile ventures are risky: you cannot tell which ones are actually worthwhile until you try. This means many losses. The gain on those which do pan out has to compensate for the losses of the investments in the same class that didn't work out. While it's true that I want to back up the clock for a do-over, for the do-over I want some real progress -- albeit human compatible progress. (More spaceships, less robots.) And here is where a progressive tax system can cause some serious mischief: it clobbers those who are "lucky" and make the correct high risk investments.

I put "lucky" in quotes because what we observe as luck is a combination of true luck and wise speculation. (And also skill in doing business for those who mix their labor with their investments.) A government or a non profit can make risky investments for the future which are useful: space travel and the Internet come to mind. But there is real power in having long shots funded by for-profit entrepreneurs who have Skin in the Game. Compare SpaceX with NASA. Elon Musk has a better cost/benefit focus than NASA administrators pestered by congresscritters.

While Elon Musk was already rich, his funds were finite, even after getting other investors and government help. So he focused on the cost bottleneck: disposable booster engines (or overheated booster engines which needed an overhaul after every flight, which was the case for the Space Shuttle). By figuring out how to reuse the booster engines, SpaceX reduced the cost of satellite launches considerably.

The theoretical ideas were around long before. You can see them in action in old science fiction and even Bugs Bunny cartoons. You could see them on Jerry Pournelle's blog decades ago. But SpaceX made them happen.

Perhaps I am being unfair. SpaceX has the benefit of modern computer technology. But NASA had robots able to land on Mars back in the 1970s. And even if landing an entire booster module on a ship was impossible in the 1970s, how about just the engines (with smaller landing tanks)? How about engines which parachute down to be picked up by a naval ship? Fuel tanks are much cheaper than the engines themselves.

There were people in NASA who knew these things back in the day. But they didn't have their own money. They were spending other people's money with all the strings that entails. And handing out government money without strings creates a different set of big problems.

Wise risk needs adequate rewards. If a project has a ten percent chance of success, then success needs a 900% profit just for the idea to break even. (Academics and bureaucrats often have a hard time thinking in these terms because they took the low risk career path themselves.)

And this is where we run into big problems with a progressive tax system. Consider ten different multi millionaires staking large portions of their fortunes on projects which have a ten percent chance of success. Place them at the edge of a tax bracket in a really progressive system to make the math dramatic. The nine that lose money get tax write-offs in the lower bracket. The winner pays tax in the higher bracket. Let the lower bracket be 50% and the higher bracket be 90% just for giggles. Suppose each invests one million dollars. The nine losers lose 9 million dollars but get 4.5 million dollars of tax writeoff, for a net loss of 4.5 million dollars. The winner earns 9 million dollars of profit, but since that profit is taxed at 90%, he only nets $900,000. The expectation value of the ventures is thus a negative $3.6 million. For 10% probability of success ventures to be worthwhile at this income range, the value of success has to be five times higher.

And thus a progressive tax system discourages risk-taking. And note that it is the progressive nature of the tax system, not the top bracket which makes this so. If (heaven forbid) the millionaires above were in the 90% bracket for both gain and loss, then the expectation value of the investment would still net out at a 900% profit rate. (Note: this analysis applies to people who can make use of tax write-offs. For a small timer betting the farm on a risky business venture, this is not the case.)

To avoid this problem and avoid having an oligarchy, we need to space the tax brackets far apart, close tax loopholes such as tax free municipal bonds, and have some special provision to keep robber barons from buying up mass quantities of farmland or single family housing.

The Laffer Curve and Labor

Ronald Reagan famously made fewer movies than he could have because the top marginal income tax for earned income was so high that making a third movie in a particular year was not worth the bother. He had an alternative "investment": doing nothing. Leisure time is valuable; the ultimate income tax loophole is simply not working. If we want our most glittery movie starts to work to the max and still have a punitive top top tax rate, we would need a special conscription for movie stars or a modification of the 13th Amendment.

While the thought of enslaving some of our overpriced virtue-signaling hypocritical Hollywood ninnies warms my spleen, I fear that the precedent set could bleed over into more important sectors of our society. Also, America can survive top actors taking sabbaticals in lieu of extra millions of dollars. The number of talented actors greatly exceeds the number of top featured movie stars. The top stars are paid to be brands as much as for their actual acting ability. (There have been some exceptions such as Peter Sellers and Eddie Murphy who truly did/do have astounding acting talent, or Arnold Schwarzenegger and Julia Roberts who have unique physical attributes for portraying terrifying cyborgs.)

The problems with heavily taxing top laborers grow worse when we look past movie and pop music stars. What happens when we overly tax top corporate executives? Based on what I see in Hollywood portrayals of the days of peak taxation, top executives were paid in power, perks, and nubile secretaries. And the truly wealthy were either Old Money or Texas oil men.

This is yet another problem with brutal top tax rates for earned income: they clobber those who are getting rich. I want a mix of meritocracy and tradition in my economic elite. Let the old money elite preserve parks and monuments, and let the meritocratic elite build spaceships and electric cars.

With the exception of inheritance and estate taxes, the "progressive" tax system of yesteryear favored unearned income over earned income. Today, the tax gap between earned and unearned income is less bad, but we have those immense deficits supporting the passive profit floor. Some people consider the arrangement to be unfair -- because it is.

Finally, let us look at the Laffer Curve for bottom tier workers -- those who have easy-to-master skills or those who compete with underpriced foreign labor. For some strange reason the voters insist on having a social safety net. Maybe it's all that Christian propaganda: Love thy Neighbor and all that. Or maybe it is Rational Self-Interest: it is better to pay taxes for a safety net than to wade through beggars, or worry about being kidnapped. Henchmen cost money and privacy.

As long as we have democracy, the Safety Net will be with us. Back in my Libertarian days, I did the polling and focus groups: eliminating the Safety Net in return for lower taxes is harder to sell than okra and asparagus flavored ice cream.

Here comes the collision between the Safety Net and the Laffer Curve: it is politically impossible to sort between the Truly Needy and the Rationally Lazy. Suppose we as a society decide that anyone who receives less than $1000/month is truly poor and worthy of help. (Adjust this number as you see fit. I chose $1000 as it is a nice round number.) How should that help be delivered?

Suppose we had a safety net such that anyone who makes less than $1000/month gets a welfare check to make up the difference. Someone who can only earn $500/month gets $500/month from the government. Someone who can only earn $200/month gets $800/month from the government, etc. Poverty ended! And affordably at that.

Um, wait a minute! Under such a system why should a low income worker work at all? Earning $10/month nets the same income as earning $1000/month. This "ideal" social safety net has the same demotivation effect as a 100% marginal tax rate! This has consequences. And the problem remains for those who can earn more than $1000/month but not a whole lot more. Consider someone who can earn $1500/month. They would really be working for only $500/month because the first $1000 they could get by doing nothing. Yes, the marginal "tax" rate is zero once the worker gets over the $1000/month hump (assuming a zero bottom actual tax rate), but that 67% average "tax" rate is a quite a temptation to reconsider working at all.

If we could hire a bunch of angelic welfare case workers who could objectively determine how much their charges could work, and adjust the supplemental incomes accordingly, we could have a fairly cheap welfare system and balance the budget without raising taxes. But we don't have those angels to run our welfare system, and attempts to run a need-based welfare system have created immense perverse incentives, destroying family values and the work ethic among our lower classes. At times we even had welfare case workers going into homes to verify that there was no father in the house. This business of paying people not to work and not to marry has created large zones in our cities filled with fatherless men with few positive role models and no clear path for advancement other than through crime or professional sports. Instead of reducing the excuse for engaging in crime, our welfare system is breeding generations of criminals. And trying to contain the problem with police action results in riots, an explosion in the prison population, and a perception of immense racial persecution. The decline of American traditional values began with a poorly designed welfare system.

Since we don't have mind-reading angels, we need economic means to separate the truly needy from the lazy. One solution is Milton Friedman's Negative Income Tax. Start with the income floor as above ($1000/month in our example), but phase out the subsidy at a rate determined by the very bottom tax rate. For example, if the bottom tax rate is 20%, a worker who earns $1000/month only gets an $800/month. A worker who earns $2000/month gets $600/month. A worker who earns $5000/month gets no subsidy, and a worker who earns more becomes a net taxpayer.

If that example seems too generous, we could crank up the bottom tax bracket. Suppose we claw back the subsidy at a 50% marginal rate. A worker who earns $1000/month gets $500/month from the government. A worker who earns $2000/month gets nothing and pays nothing. Above that, we might go to a much lower tax bracket! (See Charles Murray's In Our Hands, where he calls for something like this, but treats the bottom bracket as a clawback instead of a bottom tax bracket in an attempt to appease Establishment Republican sensibilities.)

Here comes the paradox: the faster we claw back the welfare benefits, the less incentive marginal workers have to go to work. If you don't like this, there are three options:

1. Lower the poverty floor by having the government provide lots of "free" stuff: free education, free healthcare, public housing, federal bailouts for poor towns, etc. If this is your preferred solution, we cannot be friends. This is way too much socialism and moral hazard for my taste.

2. Put a price on receiving welfare benefits. Make welfare recipients take a drug test. Require vasectomies for able bodied men to collect welfare. Require that welfare recipients endure a session on the Rotary Agonizer before receiving their weekly check. House unwed welfare moms in orphanages....Just don't expect to get elected on such a platform. Newt tried pushing the last option and went from Speaker of the House to private citizen in short order.

3. Raise the market minimum wage so that few people of sound mind and body have an excuse to go on the dole. Both the tariff reforms of Rule 1 and balancing the federal budget are moves in this direction. I'll suggest others later.

It is possible to mix portions of the above three options with a partial implementation of a Negative Income Tax. For example, there could be a Citizen Dividend that is less than the poverty floor but high enough that the market minimum wage plus the Dividend add up to a living wage. And instead of a high bottom income tax bracket, we could tax the masses with consumption taxes, like the tariffs and poison taxes suggested in prior Rules.

I'll go into detail on my preferred options later. For now, just mull this Inconvenient Truth in your mind: Need-based welfare has terrible perverse incentives and reducing those incentives can be expensive. In other words don't expect to balance the budget by simplistically slashing welfare.