Tuesday, September 28, 2010

The Laffer Cliff

The idea for this post has been bouncing around in my head for months, delayed by life beyond the blog. Hopefully, the idea aged well.

Who'd have thunk it? At least one practitioner of the dismal "science" can be both entertaining and informative.

Allow me to introduce Dr. Arthur Laffer of Laffer Curve fame, an economic theory that Ben Stein used as material in his classic portrayal of a deadly boring economics teacher in Ferris Bueller's Day Off.

[The movie clip may not appear until after the jump.]

But Dr. Laffer is neither boring nor deadly. In March, I was privileged to attend a lecture by Dr. Laffer. It was an hour well spent. He was the complete opposite of the boring economics teacher.

The simple idea behind the Laffer Curve is that at some point raising taxes becomes counterproductive because people will react to the higher tax rate by producing less, which will mean the government will have less to tax and therefore receive less revenue.

In his lecture, Laffer applied this idea to the upcoming massive cumulative tax hikes on January 1, 2011. He listed a number of the tax increases. The tax rates on personal income, dividends, capital gains, and estate will go up, in some cases sharply, unless Congress extends the Bush tax cuts, which seems unlikely. Unlike in past years, Congress has not adjusted the AMT (alternative minimum tax) for inflation, meaning that it will affect more taxpayers next year--another tax increase. The Medicare tax rate will also go up, and many other tax increases or policies that have essentially the same effects as a tax rate increase will go into effect on the first of the year. Of course, Obamacare will add additional taxes on top. The net effect is a rather large tax increase on January 1, 2011--what I (and apparently others) call the Laffer Cliff. (I suppose there could be two interpretations of what the cliff represents: If the cliff is the rise in tax rates, the economy will run into its face on January 1. If the cliff depicts economic activity, the economy will run over the edge of cliff on January 1.)

Contrary to most economic models, people and businesses change their behavior in response to the economic environment. In the current environment, those who can will move as much income and other taxable activities from the high-tax year (2011) to the low-tax year (2010). Those with the most income will also likely have the most and best tax accountants, who will do a good job in maximizing these transfers. Thus, the largest producers in the economy will adjust the volume, timing, composition, and location of their income to minimize their tax exposure--they would be foolish not to.

At the macro level, Laffer estimated that this could shift 3 to 4 percent of U.S. GDP from 2011 to 2010. If Laffer's right about the magnitude--I'm confident he's right about the direction--then the current GDP growth (3.9 percent in the 1st quarter of 2010 and 4.9 percent in the 2nd quarter) is anemic without the economic activity displaced from 2011. This also means a drop of 6 to 8 percent when the economy goes over the cliff.

I guess the message is to hold on tight. The new year could be a rough ride.

Further Reading
Arthur Laffer, "Return to Prosperity: How America Can Regain Its Economic Superpower Status," video, lecture at the Heritage Foundation
Arthur Laffer, "Tax Hikes and the 2011 Economic Collapse," Wall Street Journal
Arthur Laffer, "The Laffer Curve: Past, Present, and Future," Heritage Foundation
"Six Months to Go Until The Largest Tax Hikes in History," American's for Tax Reform

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