No.

1765 June 1, 2004

The Laffer Curve: Past, Present, and Future

Arthur B. Laffer

The Laffer Curve illustrates the basic idea that changes in tax rates have two effects on tax revenues: the arithmetic effect and the economic effect. The arithmetic effect is simply that if tax rates are lowered, tax revenues (per dollar of tax base) will be lowered by the amount of the decrease in the rate. The reverse is true for an increase in tax rates. The economic effect, however, recognizes the positive impact that lower tax rates have on work, output, and employment and thereby the tax baseby providing incentives to increase these activities. Raising tax rates has the opposite economic effect by penalizing participation in the taxed activities. The arithmetic effect always works in the opposite direction from the economic effect. Therefore, when the economic and the arithmetic effects of tax-rate changes are combined, the consequences of the change in tax rates on total tax revenues are no longer quite so obvious. Figure 1 is a graphic illustration of the concept of the Laffer Curvenot the exact levels of taxation corresponding to specific levels of revenues. At a tax rate of 0 percent, the government would collect no tax revenues, no matter how large the tax base. Likewise, at a tax rate of 100 percent, the government would also collect no tax revenues because no one would be willing to work for an after-tax wage of zero (i.e., there would be no tax base). Between these two extremes there are two tax rates that will collect the same amount of reve-

Figure 1

B 1765

The Laffer Curve

100% Tax Rates

Prohibitive Range

0 Revenues ($)
Source: Arthur B. Laffer

nue: a high tax rate on a small tax base and a low tax rate on a large tax base. The Laffer Curve itself does not say whether a tax cut will raise or lower revenues. Revenue

This paper, in its entirety, can be found at: www.heritage.org/research/taxes/bg1765.cfm Produced by the Thomas A. Roe Institute for Economic Policy Studies Published by The Heritage Foundation 214 Massachusetts Avenue, N.E. Washington, DC 200024999 (202) 546-4400 heritage.org Nothing written here is to be construed as necessarily reflecting the views of The Heritage Foundation or as an attempt to aid or hinder the passage of any bill before Congress.

No. 1765 responses to a tax rate change will depend upon the tax system in place, the time period being considered, the ease of movement into underground activities, the level of tax rates already in place, the prevalence of legal and accounting-driven tax loopholes, and the proclivities of the productive factors. If the existing tax rate is too highin the prohibitive range shown abovethen a tax-rate cut would result in increased tax revenues. The economic effect of the tax cut would outweigh the arithmetic effect of the tax cut. Moving from total tax revenues to budgets, there is one expenditure effect in addition to the two effects that tax-rate changes have on revenues. Because tax cuts create an incentive to increase output, employment, and production, they also help balance the budget by reducing means-tested government expenditures. A faster-growing economy means lower unemployment and higher incomes, resulting in reduced unemployment benefits and other social welfare programs. Successful Examples. Over the past 100 years, there have been three major periods of tax-rate cuts in the U.S.: the HardingCoolidge cuts of the mid-1920s; the Kennedy cuts of the mid-1960s; and the Reagan cuts of the early 1980s. Each of

June 1, 2004 these periods of tax cuts was remarkably successful as measured by virtually any public policy metric. In addition, there may not be a more pure expression of the Laffer Curve revenue response than what has occurred following past changes to the capital gains tax rate. The interaction between tax rates and tax revenues also applies at the state levele.g., Californiaas well as internationally. In 1994, Estonia became the first European country to adopt a flat tax and its 26 percent flat tax dramatically energized what had been a faltering economy. Before adopting the flat tax, the Estonian economy was literally shrinking. In the eight years after 1994, Estonia experienced real economic growthaveraging 5.2 percent per year. Latvia, Lithuania, and Russia have also adopted flat taxes with similar successsustained economic growth and increasing tax revenues. Arthur B. Laffer is the founder and chairman of Laffer Associates, an economic research and consulting firm. This paper was written and originally published by Laffer Associates. The author thanks Bruce Bartlett, whose paper The Impact of Federal Tax Cuts on Growth provided inspiration.

No. 1765 June 1, 2004

The Laffer Curve: Past, Present, and Future

Arthur B. Laffer

The story of how the Laffer Curve got its name begins with a 1978 article by Jude Wanniski in The Public Interest entitled, Taxes, Revenues, and the Laffer Curve.1 As recounted by Wanniski (associate editor of The Wall Street Journal at the time), in December 1974, he had dinner with me (then professor at the University of Chicago), Donald Rumsfeld (Chief of Staff to President Gerald Ford), and Dick Cheney (Rumsfelds deputy and my former classmate at Yale) at the Two Continents Restaurant at the Washington Hotel in Washington, D.C. While discussing President Fords WIN (Whip Inflation Now) proposal for tax increases, I supposedly grabbed my napkin and a pen and sketched a curve on the napkin illustrating the trade-off between tax rates and tax revenues. Wanniski named the trade-off The Laffer Curve. I personally do not remember the details of that evening, but Wanniskis version could well be true. I used the so-called Laffer Curve all the time in my classes and with anyone else who would listen to me to illustrate the trade-off between tax rates and tax revenues. My only question about Wanniskis version of the story is that the restaurant used cloth napkins and my mother had raised me not to desecrate nice things.

Talking Points
Lower tax rates change economic behavior and stimulate growth, which causes tax revenues to exceed static estimates. Under some circumstances, tax cuts can lead to morenot lesstax revenue. The exact opposite occurs following tax increases, and revenues fall short of static projections. Because tax cuts create an incentive to increase output, employment, and production, they help balance the budget by reducing means-tested government expenditures. A faster growing economy means lower unemployment, higher incomes, and reduced unemployment benefits and other social welfare programs. Over the past 100 years, there have been three major periods of tax-rate cuts in the U.S.: the HardingCoolidge cuts of the mid1920s, the Kennedy cuts of the mid-1960s, and the Reagan cuts of the early 1980s. Each of these tax cuts was remarkably successful as measured by virtually any public policy metric.

The Historical Origins of the Laffer Curve

The Laffer Curve, by the way, was not invented by me. For example, Ibn Khaldun, a 14th century Muslim philosopher, wrote in his work The Muqaddimah: It should be known that at the beginning of the

This paper, in its entirety, can be found at: www.heritage.org/research/taxes/bg1765.cfm Produced by the Thomas A. Roe Institute for Economic Policy Studies Published by The Heritage Foundation 214 Massachusetts Avenue, N.E. Washington, DC 200024999 (202) 546-4400 heritage.org Nothing written here is to be construed as necessarily reflecting the views of The Heritage Foundation or as an attempt to aid or hinder the passage of any bill before Congress.

No. 1765 dynasty, taxation yields a large revenue from small assessments. At the end of the dynasty, taxation yields a small revenue from large assessments. A more recent version (of incredible clarity) was written by John Maynard Keynes:1 When, on the contrary, I show, a little elaborately, as in the ensuing chapter, that to create wealth will increase the national income and that a large proportion of any increase in the national income will accrue to an Exchequer, amongst whose largest outgoings is the payment of incomes to those who are unemployed and whose receipts are a proportion of the incomes of those who are occupied Nor should the argument seem strange that taxation may be so high as to defeat its object, and that, given sufficient time to gather the fruits, a reduction of taxation will run a better chance than an increase of balancing the budget. For to take the opposite view today is to resemble a manufacturer who, running at a loss, decides to raise his price, and when his declining sales increase the loss, wrapping himself in the rectitude of plain arithmetic, decides that prudence requires him to raise the price still moreand who, when at last his account is balanced with nought on both sides, is still found righteously declaring that it would have been the act of a gambler to reduce the price when you were already making a loss.2
Figure 1

June 1, 2004
B 1765

The Laffer Curve

100% Tax Rates

Prohibitive Range

0 Revenues ($)
Source: Arthur B. Laffer

Theory Basics
The basic idea behind the relationship between tax rates and tax revenues is that changes in tax rates have two effects on revenues: the arithmetic effect and the economic effect. The arithmetic effect is simply that if tax rates are lowered, tax revenues (per dollar of tax base) will be lowered by the amount of the decrease in the rate. The reverse is true for an

increase in tax rates. The economic effect, however, recognizes the positive impact that lower tax rates have on work, output, and employmentand thereby the tax baseby providing incentives to increase these activities. Raising tax rates has the opposite economic effect by penalizing participation in the taxed activities. The arithmetic effect always works in the opposite direction from the economic effect. Therefore, when the economic and the arithmetic effects of tax-rate changes are combined, the consequences of the change in tax rates on total tax revenues are no longer quite so obvious. Figure 1 is a graphic illustration of the concept of the Laffer Curvenot the exact levels of taxation corresponding to specific levels of revenues. At a tax rate of 0 percent, the government would collect no tax revenues, no matter how large the tax base. Likewise, at a tax rate of 100 percent, the government would also collect no tax revenues because no one would willingly work for an aftertax wage of zero (i.e., there would be no tax base). Between these two extremes there are two tax rates that will collect the same amount of revenue: a

1. Jude Wanniski, Taxes, Revenues, and the Laffer Curve, The Public Interest, Winter 1978. 2. John Maynard Keynes, The Collected Writings of John Maynard Keynes (London: Macmillan, Cambridge University Press, 1972).

page 2

No. 1765 high tax rate on a small tax base and a low tax rate on a large tax base. The Laffer Curve itself does not say whether a tax cut will raise or lower revenues. Revenue responses to a tax rate change will depend upon the tax system in place, the time period being considered, the ease of movement into underground activities, the level of tax rates already in place, the prevalence of legal and accounting-driven tax loopholes, and the proclivities of the productive factors. If the existing tax rate is too highin the prohibitive range shown abovethen a tax-rate cut would result in increased tax revenues. The economic effect of the tax cut would outweigh the arithmetic effect of the tax cut. Moving from total tax revenues to budgets, there is one expenditure effect in addition to the two effects that tax-rate changes have on revenues. Because tax cuts create an incentive to increase output, employment, and production, they also help balance the budget by reducing means-tested government expenditures. A faster-growing economy means lower unemployment and higher incomes, resulting in reduced unemployment benefits and other social welfare programs. Over the past 100 years, there have been three major periods of tax-rate cuts in the U.S.: the HardingCoolidge cuts of the mid-1920s; the Kennedy cuts of the mid-1960s; and the Reagan cuts of the early 1980s. Each of these periods of tax cuts was remarkably successful as measured by virtually any public policy metric. Prior to discussing and measuring these three major periods of U.S. tax cuts, three critical points should be made regarding the size, timing, and location of tax cuts. Size of Tax Cuts. People do not work, consume, or invest to pay taxes. They work and invest to earn after-tax income, and they consume to get the best buys after tax. Therefore, people are not concerned per se with taxes, but with after-tax results. Taxes and after-tax results are very similar, but have crucial differences. Using the Kennedy tax cuts of the mid-1960s as our example, it is easy to show that identical percentage tax cuts, when and where tax rates are high, are far larger than when and where tax rates

June 1, 2004 are low. When President John F Kennedy took . office in 1961, the highest federal marginal tax rate was 91 percent and the lowest was 20 percent. By earning $1.00 pretax, the highest-bracket income earner would receive $0.09 after tax (the incentive), while the lowest-bracket income earner would receive $0.80 after tax. These after-tax earnings were the relative after-tax incentives to earn the same amount ($1.00) pretax. By 1965, after the Kennedy tax cuts were fully effective, the highest federal marginal tax rate had been lowered to 70 percent (a drop of 23 percent or 21 percentage points on a base of 91 percent) and the lowest tax rate was dropped to 14 percent (30 percent lower). Thus, by earning $1.00 pretax, a person in the highest tax bracket would receive $0.30 after tax, or a 233 percent increase from the $0.09 after-tax earned when the tax rate was 91 percent. A person in the lowest tax bracket would receive $0.86 after tax or a 7.5 percent increase from the $0.80 earned when the tax rate was 20 percent. Putting this all together, the increase in incentives in the highest tax bracket was a whopping 233 percent for a 23 percent cut in tax rates (a tento-one benefit/cost ratio) while the increase in incentives in the lowest tax bracket was a mere 7.5 percent for a 30 percent cut in ratesa one-tofour benefit/cost ratio. The lessons here are simple: The higher tax rates are, the greater will be the economic (supply-side) impact of a given percentage reduction in tax rates. Likewise, under a progressive tax structure, an equal across-the-board percentage reduction in tax rates should have its greatest impact in the highest tax bracket and its least impact in the lowest tax bracket. Timing of Tax Cuts. The second, and equally important, concept of tax cuts concerns the timing of those cuts. In their quest to earn after-tax income, people can change not only how much they work, but when they work, when they invest, and when they spend. Lower expected tax rates in the future will reduce taxable economic activity in the present as people try to shift activity out of the relatively higher-taxed present into the relatively lower-taxed future. People tend not to shop at a store a week before that store has its well-advertised discount sale. Likewise, in the periods before

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No. 1765 legislated tax cuts take effect, people will defer income and then realize that income when tax rates have fallen to their fullest extent. It has always amazed me how tax cuts do not work until they actually take effect. When assessing the impact of tax legislation, it is imperative to start the measurement of the tax-cut period after all the tax cuts have been put into effect. As will be obvious when we look at the three major tax-cut periods and even more so when we look at capital gains tax cutstiming is essential. Location of Tax Cuts. As a final point, people can also choose where they earn their aftertax income, where they invest their money, and where they spend their money. Regional and country differences in various tax rates matter.
Figure 2

June 1, 2004
B 1765

The Top Marginal Personal Income Tax Rate, 1913-2003

(When applicable, top rate on earned and/or unearned income) 100% Tax Rate 90 80 70 60 50 40 30 20 10

1917 1925 1933 1941 1949 1957 1965 1973 1981 Year
Source: Internal Revenue Service.

1989 1997

The HardingCoolidge Tax Cuts

In 1913, the federal progressive income tax was put into place with a top marginal rate of 7 percent. Thanks in part to World War I, this tax rate was quickly increased significantly and peaked at 77 percent in 1918. Then, through a series of tax-rate reductions, the HardingCoolidge tax cuts dropped the top personal marginal income tax rate to 25 percent in 1925. (See Figure 2.) Although tax collection data for the National Income and Product Accounts (from the U.S. Bureau of Economic Analysis) do not exist for the 1920s, we do have total federal receipts from the U.S. budget tables. During the four years prior to 1925 (the year that the tax cut was fully implemented), inflation-adjusted revenues declined by an average of 9.2 percent per year (See Table 1). Over the four years following the tax-rate cuts, revenues remained volatile but averaged an inflationadjusted gain of 0.1 percent per year. The economy responded strongly to the tax cuts, with output nearly doubling and unemployment falling sharply. In the 1920s, tax rates on the highest-income brackets were reduced the most, which is exactly what economic theory suggests should be done to spur the economy. Furthermore, those income classes with lower tax rates were not left out in the cold: The Hard-

ingCoolidge tax-rate cuts reduced effective tax rates on lower-income brackets. Internal Revenue Service data show that the dramatic tax cuts of the 1920s resulted in an increase in the share of total income taxes paid by those making more than $100,000 per year from 29.9 percent in 1920 to 62.2 percent in 1929 (See Table 2). This increase is particularly significant given that the 1920s was a decade of falling prices, and therefore a $100,000 threshold in 1929 corresponds to a higher real income threshold than $100,000 did in 1920. The consumer price index fell a combined 14.5 percent from 1920 to 1929. In this case, the effects of bracket creep that existed prior to the federal income tax brackets being indexed for inflation (in 1985) worked in the opposite direction. Perhaps most illustrative of the power of the HardingCoolidge tax cuts was the increase in gross domestic product (GDP), the fall in unemployment, and the improvement in the average Americans quality of life during this decade. Table 3 demonstrates the remarkable increase in American quality of life as reflected by the percentage of Americans owning items in 1930 that previously had only been owned by the wealthy (or by no one at all).

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No. 1765
Table 1

June 1, 2004
B 1765

A Look at the HardingCoolidge Tax Cut

Before and After: Federal Government Receipts (in $billions) Federal Government Fiscal Year 4-Year Average Before Tax Cut FY1920 FY1921 FY1922 FY1923 FY1924 Year-to-Year Revenue % change
$6.6 $5.6 $4.0 $3.9 $3.9 -16.2% -27.7% -4.3% 0.5%

InflationAdjusted Year-to-Year Revenue % change

$6.6 $6.2 $4.8 $4.5 $4.5 -6.1% -23.0% -6.0% 0.0%

-12.6% 4-Year Average After Tax Cut FY1925 FY1926 FY1927 FY1928
$3.6 $3.8 $4.0 $3.9 -5.9% 4.2% 5.7% -2.8% $4.2 $4.3 $4.6 $4.5

-9.2%
-8.2% 3.3% 7.8% -1.7%

0.2%

0.1%

Before and After: Revenue, Output, and Employment Annual average rate over four-year period before and four-year period after the tax cut Federal Real Revenue Growth 4% 2% 0% -2% -4% -6% -8% -10% -12% Before
Source: Fiscal year U.S. budget data.
-9.2% 0.1%

Real GDP Growth 6% 5% 4% 3% 2% 1%

2.0% 3.4%

Unemployment Rate 9% 8% 7% 6% 5% 4% 3% 2% 1%

6.5%

3.1%

After

Before

After

Before

After

The Kennedy Tax Cuts

During the Depression and World War II, the top marginal income tax rate rose steadily, peaking at an incredible 94 percent in 1944 and 1945. The rate remained above 90 percent well into President John F Kennedys term. Kennedys fiscal policy . stance made it clear that he believed in progrowth, supply-side tax measures:

Tax reduction thus sets off a process that can bring gains for everyone, gains won by marshalling resources that would otherwise stand idleworkers without jobs and farm and factory capacity without markets. Yet many taxpayers seemed prepared to deny the nation the fruits of tax reduction

page 5

No. 1765 because they question the financial soundness of reducing taxes when the federal budget is already in deficit. Let me make clear why, in todays economy, fiscal prudence and responsibility call for tax reduction even if it temporarily enlarged the federal deficitwhy reducing taxes is the best way open to us to increase revenues.3 Kennedy reiterated his beliefs in his Tax Message to Congress on January 24, 1963: In short, this tax program will increase our wealth far more than it increases our public debt. The actual burden of that debtas measured in relation to our total output will decline. To continue to increase our debt as a result of inadequate earnings is a sign of weakness. But to borrow prudently in order to invest in a tax revision that will greatly increase our earning power can be a source of strength. President Kennedy proposed massive tax-rate reductions, which were passed by Congress and became law after he was assassinated. The 1964 tax cut reduced the top marginal personal income tax rate from 91 percent to 70 percent by 1965. The cut reduced lower-bracket rates as well. In the four years prior to the 1965 tax-rate cuts, federal government income tax revenueadjusted for inflationincreased at an average annual rate of 2.1 percent, while total government income tax revenue (federal plus state and local) increased by 2.6
Table 2 B 1765
Table 3

June 1, 2004
B 1765

Percentage of Americans Owning Selected Items

Item Autos Radios Electric lighting Washing machines Vacuum cleaners Flush toilets 1920
26% 0% 35% 8% 9% 20%

1930
60% 46% 68% 24% 30% 51%

Source: Stanley Lebergott, Pursuing Happiness: American Consumers in the Twentieth Century (Princeton: Princeton University Press, 1993), pp. 102, 113, 130, and 137.

Percentage Share of Total Income Taxes Paid by Income Class: 1920, 1925, and 1929
Income Class Under $5,000 $5,000-$10,000 $10,000-$25,000 $25,000-$100,000 Over $100,000 1920
15.4% 9.1% 16.0% 29.6% 29.9%

1925
1.9% 2.6% 10.1% 36.6% 48.8%

1929
0.4% 0.9% 5.2% 27.4% 62.2%

Source: Internal Revenue Service.

percent per year (See Table 4). In the four years following the tax cut, federal government income tax revenue increased by 8.6 percent annually and total government income tax revenue increased by 9.0 percent annually. Government income tax revenue not only increased in the years following the tax cut, it increased at a much faster rate. The Kennedy tax cut set the example that President Ronald Reagan would follow some 17 years later. By increasing incentives to work, produce, and invest, real GDP growth increased in the years following the tax cuts: More people worked, and the tax base expanded. Additionally, the expenditure side of the budget benefited as well because the unemployment rate was significantly reduced. Using the Congressional Budget Offices revenue forecasts (made with the full knowledge of the future tax cuts), revenues came in much higher than had been anticipated, even after the cost of the tax cut had been taken into account (See Table 5). Additionally, in 1965one year following the tax cutpersonal income tax revenue data exceeded expectations by the greatest amounts in the highest income classes (See Table 6). Testifying before Congress in 1977, Walter Heller, President Kennedys Chairman of the Council of Economic Advisers, summarized: What happened to the tax cut in 1965 is difficult to pin down, but insofar as we are able to isolate it, it did seem to have a

3. The White House, Economic Report of the President, January 1963.

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No. 1765
Table 4

June 1, 2004
B 1765

A Look at the Kennedy Tax Cut

Before and After: Total Income Tax Revenue (Personal and Corporate) (in $billions) Federal Government Year-to-Year % change InflationAdjusted Revenue
$63.2 1.6% 7.5% 6.8% -2.2% $63.5 $67.5 $71.2 $68.8 0.5% 6.2% 5.5% -3.4%

Total Government (Federal, State, and Local) Year-to-Year % change Year-to-Year Revenue % change
$67.0 $68.3 $73.7 $78.7 $78.0 1.9% 7.9% 6.8% -0.9%

Fiscal Year 4-Year Average Before Tax Cut FY 1960 FY 1961 FY 1962 FY 1963 FY 1964

Revenue
$63.2 $64.2 $69.0 $73.7 $72.1

InflationAdjusted Year-to-Year % change Revenue

$67.0 $67.6 $72.1 $76.0 $74.4 0.9% 6.6% 5.5% -2.1%

3.3% 4-Year Average After Tax Cut FY 1965 FY 1966 FY 1967 FY 1968
$80.0 $90.0 $94.4 $112.5 11.0% 12.5% 4.9% 19.2% $75.1 $82.0 $83.7 $95.7

2.1%
9.2% 9.2% 2.1% 14.3% $86.4 $97.7

3.9%
10.8% 13.1% 5.6% 19.8% $81.1 $89.1 $91.5 $105.1

2.6%
9.0% 9.8% 2.8% 14.9%

11.8%

8.6%

12.2%

9.0%

Before and After: Revenue, Output, and Employment Annual average rate over four-year period before and four-year period after the tax cut Real Income Tax Revenue Growth
8.6% 9.0%

11% 10 9 8 7 6 5 4 3 2 1

6% 5 4 3

Real GDP Growth 7%

5.1% 4.6%

Unemployment Rate 6 5 4 3
3.9% 5.8%

2.1%

2.6%

2 1

2 1

Federal Before After

Total Before After

Before

After

Before

After

Source: U.S. Department of Commerce, Bureau of Economic Analysis, National Income and Product Accounts dataset.

tremendously stimulative effect, a multiplied effect on the economy. It was the major factor that led to our running a $3 billion surplus by the middle of 1965 before escalation in Vietnam struck us. It was a $12 billion tax cut, which would be about $33 or $34 billion in todays terms, and within one year the revenues into the

Federal Treasury were already above what they had been before the tax cut. Did the tax cut pay for itself in increased revenues? I think the evidence is very strong that it did.4

The Reagan Tax Cuts

In August 1981, President Reagan signed into law the Economic Recovery Tax Act (ERTA, also

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No. 1765
Table 6

June 1, 2004
B 1765

known as the KempRoth Tax Cut). The ERTA slashed marginal earned Actual vs. Forecasted Personal Income Tax Revenue by Income Class, 1965 (calendar year, revenue in $millions) income tax rates by 25 percent across the board over a three-year period. Adjusted Gross Actual Forecasted Percentage Actual Revenue Income Class Revenue Collected Revenue Exceeded Forecasts The highest marginal tax rate on $4,337 $4,374 -0.8% $0 - $5,000 unearned income dropped to 50 per$5,000 - $10,000 $15,434 $13,213 16.8% cent from 70 percent (as a result of $10,000 - $15,000 $10,711 $6,845 56.5% the Broadhead Amendment), and the $15,000 - $20,000 $4,188 $2,474 69.3% tax rate on capital gains also fell $20,000 - $50,000 $7,440 $5,104 45.8% $50,000 - $100,000 $3,654 $2,311 58.1% immediately from 28 percent to 20 $100,000+ $3,764 $2,086 80.4% percent. Five percentage points of Total $49,530 $36,407 36.0% the 25 percent cut went into effect on Source: Estimated revenues calculated from Joseph A. Pechman, Evaluation of Recent Tax Legislation: Individual October 1, 1981. An additional 10 Income Tax Provisions of the Revenue Act of 1964, Journal of Finance, Vol. 20 (May 1965), p. 268. Actual revenues are from Internal Revenue Service, Statistics of Income1965, Individual Income Tax Returns, p. 8. percentage points of the cut then went into effect on July 1, 1982. The final 10 percentage points of the cut began on July 1, 1983. These across-the-board marginal tax-rate cuts Looking at the cumulative effects of the ERTA in resulted in higher incentives to work, produce, terms of tax (calendar) years, the tax cut reduced and invest, and the economy responded (See Table tax rates by 1.25 percent through the entirety of 7). Between 1978 and 1982, the economy grew at 1981, 10 percent through 1982, 20 percent through a 0.9 percent annual rate in real terms, but from 1983 to 1986 this annual growth rate increased to 1983, and the full 25 percent through 1984. 4.8 percent. A provision of ERTA also ensured that tax brackPrior to the tax cut, the economy was choking ets were indexed for inflation beginning in 1985. on high inflation, high interest rates, and high To properly discern the effects of the tax-rate unemployment. All three of these economic bellcuts on the economy, I use the starting date of Janwethers dropped sharply after the tax cuts. The uary 1, 1983when the bulk of the cuts were unemployment rate, which peaked at 9.7 percent already in place. However, a case could be made in 1982, began a steady decline, reaching 7.0 perfor a starting date of January 1, 1984when the cent by 1986 and 5.3 percent when Reagan left full cut was in effect. office in January 1989.
Table 5 B 1765

Actual vs. Forecasted Federal Budget Receipts, 1964-1967 (in $billions)

Actual Forecasted Fiscal Year Budget Receipts Budget Receipts 1964 1965 1966 1967
$112.7 $116.8 $130.9 $149.6 $109.3 $115.9 $119.8 $141.4

Difference
+$3.4 +$0.9 +$11.1 +$8.2

Percentage Actual Revenue Exceeded Forecasts

3.1% 0.7% 9.3% 5.8%

Source: Congressional Budget Office, A Review of the Accuracy of Treasury Revenue Forecasts, 19631978, February 1981, p. 4.

Inflation-adjusted revenue growth dramatically improved. Over the four years prior to 1983, federal income tax revenue declined at an average rate of 2.8 percent per year, and total government income tax revenue declined at an annual rate of 2.6 percent. Between 1983 and 1986, federal income tax revenue increased by 2.7 percent annually, and total government income tax revenue increased by 3.5 percent annually. The most controversial portion of Reagans tax revolution was reducing the highest mar-

4. Walter Heller, testimony before the Joint Economic Committee, U.S. Congress, 1977, quoted in Bruce Bartlett, The National Review, October 27, 1978.

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No. 1765
Table 7

June 1, 2004
B 1765

A Look at the Reagan Tax Cut

Before and After: Total Income Tax Revenue (Personal and Corporate) (in $billions) Federal Government Fiscal Year FY1978 4-Year Average Before Tax Cut FY1979 FY1980 FY1981 FY1982 Year-to-Year Revenue % change
$260.3 $299.0 $320.3 $356.3 $344.0 14.9% 7.1% 11.2% -3.5%

Total Government (Federal, State and Local) Year-to-Year Revenue % change

$307.4 3.2% -5.7% 0.8% -9.0% $350.8 $377.4 $419.6 $410.0 14.1% 7.6% 11.2% -2.3%

InflationAdjusted Year-to-Year Revenue % change

$260.3 $268.7 $253.5 $255.6 $232.5

InflationAdjusted Revenue
$307.4 $315.3 $298.7 $301.0 $277.1

Year-to-Year % change

2.6% -5.3% 0.8% -7.9%

7.2% 4-Year Average After Tax Cut FY1983 FY1984 FY1985 FY1986
$347.5 $376.6 $412.3 $433.9 1.0% 8.4% 9.5% 5.2% $227.6 $236.5 $250.0 $258.2

-2.8%
-2.1% 3.9% 5.7% 3.3% $421.7 $462.9 $504.6 $534.0

7.5%
2.9% 9.8% 9.0% 5.8% $276.2 $290.7 $306.0 $317.8

-2.6%
-0.3% 5.2% 5.3% 3.9%

6.0%

2.7%

6.8%

3.5%

Before and After: Revenue, Output, and Employment Annual average rate over four-year period before and four-year period after the tax cut Real Income Tax Revenue Growth 6% 5 4 3 2 1 0 -1 -2 -3 -4 6%
3.5% 2.7%

Real GDP Growth 5 4 3 2 1

0.9% 4.8%

Unemployment Rate 9% 8 7 6 5 4 3 2 1
7.6% 7.8%

-2.8%

-2.6%

Federal Before After

Total Before After

Before

After

Before

After

Source: U.S. Department of Commerce, Bureau of Economic Analysis, National Income and Product Accounts dataset.

ginal income tax rate from 70 percent (when he took office in 1981) to 28 percent in 1988. However, Internal Revenue Service data reveal that tax collections from the wealthy, as measured by personal income taxes paid by top percentile earners, increased between 1980 and 1988despite significantly lower tax rates (See Table 8).

The Laffer Curve and the Capital Gains Tax

Changes in the capital gains maximum tax rate provide a unique opportunity to study the effects of taxation on taxpayer behavior. Taxation of capital gains is different from taxation of most other sources of income because people have more control over

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No. 1765

June 1, 2004

B 1765 Table 9 the timing of the realization of capital gains (i.e., when the gains are actually taxed). 1997 Capital Gains Tax Rate Cut: Actual Revenues vs. Government Forecast The historical data on changes in the (in $billions) capital gains tax rate show an incredibly consistent pattern. Just after a capital 1996 1997 1998 1999 2000 gains tax-rate cut, there is a surge in reveLong-Term Capital Gains Tax Rate 28% 20% 20% 20% 20% nues: Just after a capital gains tax-rate increase, revenues take a dive. As would Net Capital Gains: also be expected, just before a capital Pre-Tax Cut Estimate (January 1997) - - $205 $215 $228 n/a gains tax-rate cut there is a sharp decline Actual $644 $261 $365 $455 $553 in revenues: Just before a tax-rate increase there is an increase in revenues. Capital Gains Tax Revenue: Timing really does matter. Pre-Tax Cut Estimate (January 1997) -$55 $65 $75 n/a This all makes total sense. If an investor could choose when to realize capital gains Actual $66 $79 $89 $112 $127 for tax purposes, the investor would clearly realize capital gains before tax rates are Source: Congressional Budget Office, and U.S. Department of the Treasury, Office of Tax Analysis. raised. No one wants to pay higher taxes. In the 1960s and 1970s, capital gains tax receipts averaged around 0.4 percent of GDP, mately 0.6 percent of GDP Reducing income and . with a nice surge in the mid-1960s following Pres- capital gains tax rates in 1981 helped to launch ident Kennedys tax cuts and another surge in what we now appreciate as the greatest and longest 19781979 after the SteigerHansen capital gains period of wealth creation in world history. In 1981, tax-cut legislation went into effect (See Figure 3). the stock market bottomed out at about 1,000 Following the 1981 capital gains cut from 28 compared to nearly 10,000 today (See Figure 4). percent to 20 percent, capital gains revenues leapt As expected, increasing the capital gains tax rate from $12.5 billion in 1980 to $18.7 billion by from 20 percent to 28 percent in 1986 led to a 1983a 50 percent increaseand rose to approxisurge in revenues prior to the increase ($328 billion in 1986) and a collapse in revenues after the increase took effect ($112 billion in 1991). Percentage of Total Personal Income Taxes Paid by Reducing the capital gains tax rate Percentile of Adjusted Gross Income (AGI) from 28 percent back to 20 percent in 1997 was an unqualified success, and Calendar Top 1% Top 5% Top 10% Top 25% Top 50% Year of AGI of AGI of AGI of AGI of AGI every claim made by the critics was 1980 19.1% 36.8% 49.3% 73.0% 93.0% wrong. The tax cut, which went into 1981 17.6% 35.1% 48.0% 72.3% 92.6% effect in May 1997, increased asset val1982 19.0% 36.1% 48.6% 72.5% 92.7% ues and contributed to the largest gain 1983 20.3% 37.3% 49.7% 73.1% 92.8% in productivity and private sector capital 1984 21.1% 38.0% 50.6% 73.5% 92.7% investment in a decade. It did not lose 1985 21.8% 38.8% 51.5% 74.1% 92.8% revenue for the federal Treasury. 1986 25.0% 41.8% 54.0% 75.6% 93.4% 1987 24.6% 43.1% 55.5% 76.8% 93.9% In 1996, the year before the tax rate cut 1988 27.5% 45.5% 57.2% 77.8% 94.3% and the last year with the 28 percent rate, total taxes paid on assets sold was $66.4 Source: Internal Revenue Service. billion (Table 9). A year later, tax receipts
Table 8 B 1765

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No. 1765
Figure 3 B 1765

June 1, 2004

itself to Laffer Curve types of analyses.5 During periods of tax Top Capital Gains Tax Rate and Inflation-Adjusted Federal Revenue increases and economic slowTax Rate Billions of 2000 dollars downs, the states budget office $130 100% 1997 almost always overestimates rev120 Archer-Roth 90 1986 enues because they fail to conCut Reagan 110 Increase sider the economic feedback 80 100 1981 effects incorporated in the Laffer Reagan 70 90 Cut Curve analysis (the economic 80 effect). Likewise, the states bud60 1978 Steigerget office also underestimates 70 1965 Hansen 50 Kennedy revenues by wide margins durCut 60 Tax Cut ing periods of tax cuts and eco40 50 nomic expansion. The con40 30 sistency and size of the mis-esti30 mates are quite striking. Figure 20 20 5 demonstrates this effect by 10 showing current-year and bud10 get-year revenue forecasts taken 60 64 68 72 76 80 84 88 92 96 00 from each years January budget Year proposal and compared to Capital gains tax rate, Inflation-adjusted taxes paid actual revenues collected. long-term gains on capital gains State Fiscal Crises of 2002 2003. The National Conference Source: U.S. Department of the Treasury, Office of Tax Analysis. of State Legislatures (NCSL) conducts surveys of state fiscal conditions by contacting legislative fiscal directors from each jumped to $79.3 billion, and in 1998, they jumped state on a fairly regular basis. It is revealing to look again to $89.1 billion. The capital gains tax-rate at the NCSL survey of November 2002, at about reduction played a big part in the 91 percent the time when state fiscal conditions were hitting increase in tax receipts collected from capital gains rock bottom. In the survey, each states fiscal direcbetween 1996 and 2000a percentage far greater tor reported his or her states projected budget than even the most ardent supply-siders expected. gapthe deficit between projected revenues and Seldom in economics does real life conform so projected expenditures for the coming year, which conveniently to theory as this capital gains examis used when hashing out a states fiscal year (FY) ple does to the Laffer Curve. Lower tax rates 2003 budget. As of November 2002, 40 states change peoples economic behavior and stimulate reported that they faced a projected budget deficit, economic growth, which can create morenot and eight states reported that they did not. Two lesstax revenues. states (Indiana and Kentucky) did not respond. Figure 6 plots each states budget gap (as a share The Story in the States of the states general fund budget) versus a meaCalifornia. My home state of California has an sure of the degree of taxation faced by taxpayers in extremely progressive tax structure, which lends each state (the incentive rate). This incentive rate
5. Laffer Associates most recent research paper covering this topic is Arthur B. Laffer and Jeffrey Thomson, The Only Answer: A California Flat Tax, Laffer Associates, October 2, 2003.
Revenue

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No. 1765
Figure 4 B 1765

June 1, 2004

tion, some states may have taken significant budget steps U.S. Stock Market: "Bull vs. Bear" (such as cutting spending) Nominal and Inflation-Adjusted Appreciation prior to FY 2003 and elimi1600 1600 nated problems for FY 2003. Furthermore, each state has a unique reliance on various 800 800 taxes, and the incentive rate does not factor in property taxes and a myriad of minor 400 400 taxes. Even with these limitations, FY 2003 was a unique 200 200 period in state history, given the degree that the states 100 100 almost without exception experienced budget difficulties. Thus, it provides a good 50 50 opportunity for comparison. In Figure 6, states with high rates of taxation tended to 1960 1964 1960 1972 1976 1980 1984 1988 1992 1996 2000 have greater problems than S&P 500 Index, S&P 500 Index states with lower tax rates. Inflation-Adjusted California, New Jersey, and Source: Author's calculations using data from Standard & Poor's and Bureau of Labor Statistics. New Yorkthree large states with relatively high tax rateswere among those states with the largest budget gaps. In contrast, is the value of one dollar of income after passing Florida and Texastwo large states with no perthrough the major state and local taxes. This mea- sonal income tax at allsomehow found themsure takes into account the states highest tax rates selves with relatively few fiscal problems when on corporate income, personal income, and sales.6 preparing their budgets. (These three taxes account for 73 percent of total Impact of Taxes on State Performance Over state tax collections.)7 Time. Over the years, Laffer Associates has chroniThese data have all sorts of limitations. Each cled the relationship between tax rates and ecostate has a unique budgeting process, and no one nomic performance at the state level. This knows what assumptions were made when prorelationship is more fully explored in our research jecting revenues and expenditures. As California covering the Laffer Associates State Competitive has repeatedly shown, budget projections change Environment model.8 Table 10 demonstrates this with the political tides and are often worth less relationship and reflects the importance of taxathan the paper on which they are printed. In additionboth the level of tax rates and changes in
6. For our purposes here, we have arrived at the value of an after-tax dollar using the following weighting method: 80 percentvalue of a dollar after passing through the personal tax channel (personal and sales taxes); 20 percentvalue of a dollar after passing through the corporate tax channel (corporate, personal, and sales taxes). Alaska is excluded from consideration due to the states unique tax system and heavy reliance on severance taxes. 7. U.S. Census Bureau, State Government Tax Collections Report, 2002.

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No. 1765 relative competitiveness due to changes in tax rateson economic perforance. Combining each states current incentive rate (the value of a dollar after passing through a states major taxes) with the sum of each states net legislated tax changes over the past 10 years (taken from our historical State Competitive Environment rankings) allows a composite ranking of which states have the best combination of low and/or falling taxes and which have the worst combination of high and/ or rising taxes. Those states with the best combination made the top 10 of our rankings (1 = best), while those with the worst combination made the bottom 10 (50 = worst). Table 10 shows how the 10 Best States and the 10 Worst States have fared over the past 10 years in terms of income growth, employment growth, unemployment, and population growth. The 10 best states have outperformed the bottom 10 states in each category examined.
Figure 5

June 1, 2004
B 1765

California Budget: General Fund Revenues, Actual vs. Projected*

$85 California Budget, $Billions
Current and Upcoming Year Revenue Forecast Actual Revenues

$85

75

May-03 Revision Jan-03 Budget

75

65
Pete Wilson's Tax Increases Temporary Tax Increases Removed

65

55

55

45

45

35
Overforecasted Revenues Underforecasted Revenues Overforecasted Revenues

35

25 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 Year of January Budget Forecast for Current and Upcoming Fiscal Year

25

Revenue Estimates as of
Jan-01 May-01 Jan-02 May-02 Jan-03 May-03 00-01 Revenues 01-02 Revenues 02-03 Revenues 03-04 Revenues
$76.9 $79.4 $78.0 $74.8 $77.1 $79.3 $73.8 $78.6

Actual
$77.6 $66.1 $70.9 ??

$73.1 $69.2

$70.8 $70.9

Looking Globally

*Projections are released six months prior to the start of the fiscal year in question. Projected percentage changes calculated as projected revenue divided by previous year's actual revenue as estimated at that time.

Source: California Governor's Budget Summaries, various editions. For all the brouhaha surrounding the Maastricht Treaty, budget deficits, and the like, it countries with the highest tax rates probably also is revealingto say the leastthat G-12 countries have the highest unemployment rates. High tax with the highest tax rates have as many, if not rates certainly do not guarantee fiscal solvency. more, fiscal problems (deficits) than the countries with lower tax rates (See Figure 7). While not shown here, examples such as Ireland (where tax Tax Trends in Other Countries: rates were dramatically lowered and yet the budget The Flat-Tax Fever For many years, I have lobbied for implementmoved into huge surplus) are fairly commonplace. Also not shown here, yet probably true, is that ing a flat tax, not only in California, but also for

8. See Arthur B. Laffer and Jeffrey Thomson, The 2003 Laffer State Competitive Environment, Laffer Associates, January 31, 2003, and previous editions.

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Table 10

B 1765

Performance of the 10 Best and 10 Worst States

The 10 Best States Overall Rank 1 Washington 1 Connecticut 2 Hawaii 3 Colorado 4 Florida 5 Wisconsin 6 Massachusetts 7 Delaware 8 Georgia 9 Virginia 10 10 Best Average U.S. Average 10 Worst Average Michigan California Rhode Island Maine Louisiana Oklahoma Idaho Alabama Vermont Arkansas
41 42 43 44 45 46 47 48 49 50 $0.87 $0.82 $0.82 $0.85 $0.84 $0.83 $0.83 $0.83 $0.83 $0.82 18 48 45 32 38 42 43 44 41 47 $10.93 $0.30 $0.64 $3.30 $2.63 $4.22 $4.54 $6.86 $12.01 $7.72 48 20 23 37 34 40 41 45 49 46

Incentive Rate Net Change in 10-Year 10-Year Current 10-Year and Rank 2 Taxes and Rank 3 Personal Employment Unemployment Population Income Growth 4 Growth 5 Rate 6 Growth 7 2003 1994-2003
$0.91 $0.88 $0.87 $0.87 $0.91 $0.87 $0.88 $0.91 $0.86 $0.89 8 14 20 19 5 22 13 7 23 11 -$5.74 -$4.91 -$11.56 -$7.96 -$0.13 -$5.73 -$0.78 $0.54 -$1.69 $0.79 4 7 2 3 17 5 14 22 10 25 75.3% 56.9% 33.9% 91.5% 72.3% 61.6% 65.2% 62.7% 84.8% 67.8% 17.5% 7.4% 6.7% 27.1% 30.4% 13.8% 11.3% 18.5% 25.3% 19.7% 6.8% 5.0% 4.1% 5.6% 4.7% 5.0% 5.4% 4.1% 4.2% 3.6% 16.8% 6.4% 8.3% 27.8% 24.1% 8.2% 7.0% 16.9% 26.0% 14.3%

67.2% 63.5% 60.0%

52.2% 66.2% 55.6% 61.2% 54.1% 54.4% 74.8% 55.3% 66.0% 60.3%

17.8% 16.3% 15.3%

8.5% 20.2% 11.5% 15.1% 13.0% 17.0% 29.4% 8.3% 16.0% 13.7%

4.9% 5.9% 5.5%

7.0% 6.4% 4.9% 4.9% 5.5% 5.3% 5.1% 5.8% 4.0% 6.0%

15.6% 12.8% 9.8%

5.8% 13.9% 7.8% 5.4% 4.9% 8.8% 24.1% 7.3% 7.9% 12.5%

The 10 Worst States

1 2

Ranking based on equal-weighted average of each states incentive rank and net change in taxes rank. The incentive rate is the value of an after-tax dollar using the following weighting method: 80 percent of the value of a dollar after passing through the personal tax channel (personal and sales taxes) and 20 percent of the value of a dollar after passing through the corporate tax channel (corporate, personal, and sales taxes). Equals the sum of Laffer Associates relative tax burden rankings (change in legislated tax burden per $1,000 of personal income relative to the U.S. change) over the 1994-2003 period. A negative number indicates decreasing in taxes; a positive number indicates increasing taxes. November 1993 through November 2003 (Bureau of Economic Analysis). November 1993 through November 2003 (Bureau of Labor Statistics). As of November 2003 (Bureau of Labor Statistics). July 1, 1993 though July 1, 2003 (U.S. Bureau of the Census).

4 5 6 7

Sources: Author's calculations using data from CCH Incorporated; U.S. Department of Commerce, Bureau of Economic Analysis; U.S. Department of Labor, Bureau of Labor Statistics; U.S. Bureau of the Census; and the National Conference of State Legislatures.

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No. 1765
Figure 6 B 1765

June 1, 2004

Figure 7

the entire U.S. Hong Kong adopted a flat tax ages ago and has performed Incentive Rate vs. Initial FY 2003 Projected Budget Gaps: like gangbusters ever since. Seeing a The 50 States flat-tax fever seemingly infect Europe Incentive Rate $0.75 in recent years is truly exciting. In 1994, Estonia became the first EuroNY pean country to adopt a flat tax, and 0.80 its 26 percent flat tax dramatically CA energized what had been a faltering economy. Before adopting the flat tax, 0.85 NJ Estonia had an impoverished economy that was literally shrinkingmaking 0.90 the gains following the flat tax impleTX FL mentation even more impressive. In the eight years after 1994, Estonia sus0.95 tained real economic growth averaging 5.2 percent per year. Latvia followed Estonias lead one 1.00 5% 10% 15% 20% 25% 30% year later with a 25 percent flat tax. In Budget Gap as a Percent of General Fund Budget the five years before adopting the flat tax, Latvias real GDP had shrunk by more than 50 percent. In the five years Source: Author's calculations using data from National Conference of State Legislatures and CCH Incorporated. after adopting the flat tax, Latvias real GDP has grown at an average annual rate of 3.8 percent (See Figure 8). Lithuania has followed Degree of Taxation vs. Five-Year Government Budget Surplus/Deficit as a with a 33 percent flat tax and has Percent of GDP: The G-12 experienced similar positive results. $0.05 Incentive Rate Russia has become one of the latest Eastern Bloc countries to France 0.10 institute a flat tax. Since the Belgium advent of the 13 percent flat perSweden Italy 0.15 sonal tax (on January 1, 2001) and the 24 percent corporate tax Spain Netherlands Germany 0.20 Japan (on January 1, 2002), the Russian economy has had amazing 0.25 results. Tax revenue in Russia has U.K. U.S. Switzerland increased dramatically (See FigCanada 0.30 ure 9). The new Russian system Australia is simple, fair, and much more 0.35 rational and effective than what 4% 2% 0% -2% -4% -6% -8% they previously used. An individBudget Suplus / GDP Budget Deficit / GDP ual whose income is from wages only does not have to file an annual return. The employer Source: Author's calculations using data from PricewaterhouseCoopers and Haver Analytics. deducts the tax from the
B 1765

Lower Taxes

Higher Taxes

Lower Taxes

Higher Taxes

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No. 1765 employees paycheck and transfers it to the Tax Authority every month. Due largely to Russias and other Eastern European countries successes with flat tax reform, Ukraine and the Slovak Republic implemented their own 13 percent and 19 percent flat taxes, respectively, on January 1, 2004. Arthur B. Laffer is the founder and chairman of Laffer Associates, an economic research and consulting firm. This paper was written and originally published by Laffer Associates. The author thanks Bruce Bartlett, whose paper The Impact of Federal Tax Cuts on Growth provided inspiration.
Figure 8

June 1, 2004
B 1765

Average Annual Real GDP Growth in Select Countries Before and After Flat Tax Implementation
12 Real GDP Growth Estonia
4.3

8 4

Latvia
3.8 1.1

Russia
4.7

-4

-8
-8.0

-12

-11.3

-16

5 Years Before

5 Years After

Source: Haver Analytics and the statistical offices of various countries.

Figure 9

B 1765

Annual Russian Tax Revenue

2200 Tax Revenue, billions of rubles 2000 1800 1600
1461 1696 1892

1400 1200 1000 800 600 400 200 2000 2001 Year 2002 2003
965

Source: Haver Analytics.

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