About 40 years ago, the economist Arthur Laffer drew a backwards "c" on a napkin to illustrate to his dinner companions -- Donald Rumsfeld, then-chief of staff to President Gerald Ford, and Dick Cheney, Rumsfeld's deputy -- the trade-off between tax rates and government tax revenues. The outer peak of the curve represented the top tax rate that would yield the most revenue. As Laffer explained, a higher rate would stifle economic activity and thus lower government revenue, and a tax rate below the peak would simply result in less revenue. It came to be called the Laffer Curve, an idea that public policy officials have been debating ever since.
Laffer went on to advise Republican President Ronald Reagan in the 1980s. Believing the tax rate was too high and was suppressing economic activity, he helped Reagan enact major tax reforms that cut and simplified taxes. Republican President George W. Bush also pushed through income tax cuts in the early 2000s. Indeed, a recent paper from the liberal-leaning Urban Institute and the Brookings Institution notes that ever since the idea of what is now called supply-side economics took off, "conservative politicians have been unable to resist the siren song of tax cuts for high-income households."
But do cuts to income taxes really spur economic growth? The problem with marrying public policy to the Laffer Curve, says Andrew Thompson, revenue supervisor for the city of San Rafael in Northern California, is that "the theory isn't really prescriptive." There are too many variables affecting taxes and the economy to draw a straight line between the two, he said.
The Urban/Brookings authors are the latest to weigh in on the issue and they take on the work of economist W. Robert Reed, who in 2008 authored one of the most thorough studies on taxes and economic growth across the states. Reed found a negative relationship over time between tax burden and economic growth between 1970 and 1999. The Urban/Brookings authors extended Reed's research into the 21st century and found that relationship turned positive over the past two decades. "States have no good reasons to believe that income tax cuts will bring the desired benefits," the authors concluded. "Yet, states continue to erode their tax bases in the name of economic growth during a time when few states can afford to cut services."
To emphasize their point, they also highlight tax cuts across more than a dozen states over the past 30 years, and found that none resulted in higher than average economic output. In the 1990s, for example, six states cut income taxes. In Connecticut, New Jersey and New York, output grew faster than the national average. But, the authors caution, that growth could be attributed to the booming financial sector, which plays an outsized role in those states. Meanwhile, economic activity was below the national average in the other three states that cut taxes. "The divergent records indicate that something other than state tax policy drove economic growth," the authors wrote.
In more recent examples, the paper singles out Kansas' income tax cuts in 2012 and 2013. The state has grappled with budget deficits ever since, had its credit rating downgraded, and "failed to keep up with the region's pace of job growth or increase its job growth relative to the previous period," according to the paper. Louisiana also enacted income tax cuts following the post-Hurricane Katrina construction boom. Those cuts and a decline in construction are contributing to that state's projected $1.6 billion deficit, the authors said.
Instead of arguing economic theory, San Rafael's Thompson said policymakers should instead look at their own region's data over time to determine trends and inform their decisions. "People need to stop simply using the theory to push for lower taxes," he said.