Saturday, January 26, 2008

The Laffer Curve in the 1920s

During the 1920s, The Revenue Acts of 1921, 1924, and 1926 reduced the top marginal income tax rate from 73% to 25% (see top chart, blue line). Did the drastic cut in tax rates cause tax revenues to fall? No, just the opposite. Personal income tax revenues increased substantially during the 1920s, rising from $719 million in 1921 to $1.16 billion in 1928 (see top chart, red line), an increase of more than 61% (this was a period of no inflation).The share of the tax burden borne by the rich rose dramatically. As seen in the bottom chart above, taxes paid by the rich (those making $50,000 and up in those days) climbed from 44.2% of the total tax burden in 1921 to 78.4% in 1928.

Source: Heritage Foundation, "The Historical Case for Supply-Side Economics," by Dan MitchellBottom Line: The significant cuts in marginal income tax rates in the 1920s increased tax revenues collected, and the share of taxes paid by "the rich" increased.

5 Comments:

Is this what passes for serious economic analysis at the University of Michigan-Flint campus? It certainly wouldn't cut it at the Ann Arbor campus.

Repeat after me 1000 times:"Correlation does not equal causation"

Have these graphs been corrected for income growth over the period? For example, increasing tax revenues aren't so special if income is increasing quickly. In addition, are they corrected for inflation? If not, inflation combined with fast growth makes these graphs look much better than they actually are.

There is a perfectly reasonable explanation for both graphs without resorting to supply-side economics: income of everyone increased very quickly during the 1920's, but the income of the "rich" grew faster. Thus, tax revenues increase despite the cut in marginal rates, and the rich pay a larger share of total taxes.

If the effects of the Laffer curve are so easy to find, why must we go back to the 1920's to find pretty pictures?

Let's examine all recent tax cuts and find out how real tax collection fared, after correcting for income growth and inflation. Better yet, let's find evidence of declining revenues when taxes are raised!

The truth is that some serious latitude must be given to show that the Laffer curve holds at all, even when marginal tax rates are as high as 70%.

Again, if you want taxes on the rich lowered, fine, just say so. Actually, I'd probably be in favor of it too, but PLEASE quit dragging out bad arguments to justify it.

Ah, I see. I may have been misinterpreted. I don't dispute that tax cuts may spur the economy and income growth may result, which may result in more tax revenue, although I seriously doubt at current levels this will apply. Perhaps the 70% tax rates would have caused this, but not now.

What I am saying is that to test the "tax avoidance" part of the theory, you must correct for other sources of tax revenue growth to show that all else equal, that cutting taxes rates encourages people to pay more of their taxes. That is all. You can't simply show that cutting taxes at one point correlates with increased tax revenue at another point, because there are several other economic trends which influence tax collections.

Mr. Bull, people's incomes increased precisely because they had more of their income left over due to the tax cuts. With that extra revenue people, as well as businesses, could expand instead of having bean counters micro manage every penny. You asked if the graph was corrected for inflation, when in fact during that period there was no inflation. Also you raised the idea that just because the tax rates were cut, it wouldn't necessarily encourage people to stop avoiding taxes. I believe just the opposite is true, that once taxes are cut there is no incentive to hide your money, and this in turn encourages growth. The evidence bears this out. Repeat 1000 times "cause and effect" ;) Also check out the Cato institute, they have an interesting article on the subject. http://www.cato.org/pub_display.php?pub_id=3015