The Laffer Curve works

Posted: Sep 26, 2003 12:00 AM

In a recent column, I defended supply-side economics from an attack by Princeton economist Paul Krugman in the New York Times Magazine. One of the rare civil criticisms I got came from my friends at TAPPED, the web log of the liberal American Prospect magazine. Their point is that Krugman was justified in his attack because supply-siders have no academic allies, despite a large number of conservative economics professors. "Supply-side ideas simply won't stand up under scrutiny," TAPPED wrote.

As it happens, around the time I was reading this blog entry, I had on my desk a recent paper from the International Monetary Fund, "An Analysis of the Underground Economy and Its Macroeconomic Consequences." Right on page one it has this to say: "Our model simulations show that in the absence of budgetary flexibility to adjust expenditures, raising tax rates too high drives firms into the underground economy, thereby reducing the tax base."

In other words, the Laffer Curve works -- and this from an organization hardly known as a hotbed of supply-side economics. Nor is this the only instance in which the IMF has acknowledged fundamental truths about supply-side economics.

-- As long ago as 1987, it published an entire book titled, "Supply-Side Tax Policy: Its Relevance to Developing Countries."

-- In 1997, it published a paper on Social Security reform in France that contained this finding: "The simulation results ... point to the presence of 'self-financing,' whereby reductions in various tax rates lead to lower budget deficits in the long run, as the result of an expanding tax base and lower unemployment insurance outlays."

-- In 1999, it held a seminar on trade policy that came to this conclusion: "A number of countries maintain tariff rates that exceed revenue maximizing levels. These countries could liberalize, at least initially, without significant adverse consequences for revenues from trade taxes."

The IMF is not alone in its acknowledgement of supply-side truths. Across the street, the World Bank has done similar studies. In 1993, one of them came to this conclusion: "Above a certain level of the official tariff rate, further increases in the official rate produces no increase (and there is some evidence of a decrease) in the collected rate."

Even though supply-siders often criticize Bank and Fund policies, the fact is that they are more receptive to their ideas than universities because they have to operate in the real world. Every day, they see the consequences of excessive tax rates in operation in countries that need revenue a lot more than feel-good redistributionist policies. They can't afford to overtax the rich, or they will just move or bribe the tax officials to leave them alone. Either way, the government doesn't get any tax revenue to spend on pressing social needs.

Furthermore, Bank and Fund officials have seen with their own eyes the impact of low marginal tax rates in places like Russia, where implementation of a 13 percent flat tax in 2001 led to a significant increase in government revenue. Although rates were much higher under the old system, evasion was so pervasive that little revenue was actually collected. Under the new system, it was no longer worth as much to risk punishment for evasion, leading to increased compliance and higher revenues.

OK, my friends at TAPPED might say, but what about academia? Isn't supply-side economics still ignored there? The answer is no. A good example is Nobel Prize-winning economist Robert Lucas of the University of Chicago. After many years of dismissing supply-side economics in much the same way TAPPED does, he finally took a serious look at it. In a 1990 article in the Oxford Economic Papers, he admitted that he had been wrong, that reducing taxes on capital could in fact deliver a huge economic windfall, just as the supply-siders had argued.

Said Lucas, "The supply-side economists, if that is the right term for those whose research I have been discussing, have delivered the largest genuinely free lunch I have seen in 25 years in this business, and I believe we would have a better society if we followed their advice."

Earlier this year, Lucas reiterated support for supply-side policies in his presidential address to the American Economic Association. He compared supply-side economics with Keynesian stabilization policies and found the former far superior to the latter. "The potential gains from improved stabilization policies are on the order of hundredths of a percent of consumption, perhaps two orders of magnitude smaller than the potential benefits of available 'supply-side' fiscal reforms," he concluded.

Space prohibits the presentation of further evidence, of which there is ample. Suffice it to say that supply-side economics is far from the academic outcast its enemies wish it was.