Adam Smith: Yokel

by Don Boudreaux on December 23, 2005

in History, Prices

In today’s New York Times, Paul Krugman calls supply-side economics — by which Krugman means the idea that tax cuts can generate higher tax revenue for government– as "hokum for the yokels."

Krugman has long ridiculed the idea that for thirty years now in the U.S. has been known as "the Laffer curve."  Indeed, as his "hokum for the yokels" remark makes clear, Krugman sneers at the Laffer curve.

My first reaction, whenever I read Krugman’s (or anyone else’s) dismissal of the Laffer curve as illogical hooey, is to wonder if Krugman ever studied the concept of own-price elasticity of demand.

For the non-economists among you, this concept is taught in Economics 101, and explains that firms that raise their prices do not always earn higher sales revenue; their revenue can and often does fall.  (To see the point clearly: ask youself what would happen if, say, Starbucks raised the price it charges for a tall latte to $1,000.)  Likewise, firms can often increase their sales revenue by cutting their prices.

But Cafe Hayek’s Russ Roberts has a different thought: he knows that the Laffer-curve idea didn’t originate in the United States during the 1970s.  Russ knows that it expresses a truth so fundamental that thoughtful thinkers from even long ago understood it — thoughtful thinkers such as Adam Smith.

Here’s the great Scot writing in Book V, Chapter 2 of The Wealth of Nations:

The high duties which have been imposed upon the importation of many different sorts of foreign goods, in order to discourage their consumption in Great Britain, have in many cases served only to encourage smuggling, and in all cases have reduced the revenue of the customs below what more moderate duties would have afforded. The saying of Dr. Swift, that in the arithmetic of the customs two and two, instead of making four, make sometimes only one, holds perfectly true with regard to such heavy duties which never could have been imposed had not the mercantile system taught us, in many cases, to employ taxation as an instrument, not of revenue, but of monopoly.

Does the above sound like hokum for yokels — or hokum from a yokel?

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{ 21 comments }

NathanB December 23, 2005 at 4:47 pm

I can't tell if the New York Times Select subscription fee is supposed to keep the readers out or the dumb ideas in.

Randy December 23, 2005 at 5:24 pm

NathanB – good one :)

M. Strowbridge December 23, 2005 at 9:46 pm

Krugman doesn't dispute the Laffer curve. In fact, in article Prof. Boudreux links to, Krugman wrote:
The starting point of supply-side economics is an assertion that no economist would dispute: taxes reduce the incentive to work, save and invest. A businessman who knows that 70 cents of every extra dollar he makes will go to the I.R.S. is less willing to make the effort to earn that extra dollar than if he knows that the I.R.S. will take only 35 cents. So reducing tax rates will, other things being the same, spur the economy.

What Krugman disputes is the political proposition of "supply side economics" — the claim that we are beyond peak of the Laffer curve, and thus tax rates and tax revenues are *always* inversely related. Hard-core supply-siders predicted that Clinton's tax increases would cause economic disaster. They were encouraging their followers to divest from the stock market in the 90's, and didn't apologize for being badly wrong.

Krugman has attacked both right-wing supply-siders and left-wing protectionists. His attacks on the left are in his earlier Fortune articles, his Slate article "In Praise of Cheap Labor" http://web.mit.edu/krugman/www/smokey.html, and his book "The Age of Diminished Articles". Since he began writing for the New York Times, he has become a shrill, polemical, sometimes unfair, critic of the Bush Administration. However, Krugman's economic claims have been far more honest those of the Administration. Bush has claimed to support free trade while raising steel tarrifs and continuing massive agricultural subsidies. Bush has claimed that most of his tax cuts go to the middle class when this is not so. Bush has pretended to be fiscally conservative without vetoing a single spending bill. Krugman has correctly noted this.

So who is more dangerous? — An economist who likes free trade and capitalism generally, but who also supports single-payer health care (read socialized medicine); or a president who pretends to be a fiscally-conservative free-trader but actually inflates the deficit to sky-high levels by spending billions of dollars on agricultural subsidies, pension and airline bailouts, Medicare expansion, Homeland Security pork, Hurricane Katrina pork, Iraq War no-bid contracting, and highway bill pork. Democrats dispensed plenty of pork when they controlled Congress, but, as I recall from a WSJ article, there have been far more pork add-ons under Republican rule. Who is more reckless, Krugman or Bush?

M. Strowbridge December 23, 2005 at 9:51 pm

The Krugman quote I cited is from "Tax Cut Con" published in the New York Times on 9.14.03.

MrM December 23, 2005 at 10:00 pm

You got to give it to the Bush administration: it may be wrong, but it surely is consistent. Whether the economy is expanding or contracting, whether the government budget shows record surplus or record deficit, whether the country is at peace or at war, the recommendation neve waivers: "Cut the taxes!"

Barry P. December 23, 2005 at 10:40 pm

So, Don, are we to the left or the right of the peak of the Laffer curve?

wt December 23, 2005 at 11:05 pm

the problem with supply-side economics is that the demand side effects are stronger than the supply-side and the supply-side effect take longer for them to kick in.

Keith G. Derrick December 23, 2005 at 11:41 pm

Since I'm not a subscriber of the New York Times, I can only read two sentences of the Krugman article. But these two sentences really say it all for Krugman:

"There is no longer any coherent justification for further tax cuts. Yet the cuts go on."

Hmm…maybe a "coherent justification" for a tax cut is that IT'S MY MONEY!

I didn't know there needed to be a justification to keep MY PROPERTY.

DS December 24, 2005 at 9:31 am

One of the fundamental tenents of supply-side economics is cutting spending. Unfortunately the fact that this was only done to a limited extent under Reagan (to be fair he had an extremely hostile congress to deal with) and has been completely discarded by both Bushes has allowed many on the left to deride supply-side economics as simple Keynsian deficit spending through tax cutting. This is far from the intellectual foundations of supply-side economics which abhor government deficits.

But every time tax RATES have been cut in the last half century revenues have increased. There is no magic here, the single most important component in tax reveues is growth in the economy: growth in the incomes of workers, investors, and businesses. Taxes retard economic growth, so when they are cut growth increases.

The same goes for tax increases. The only difference between the Bush Sr. tax increase and the Clinton tax increase is the point in the economic cycle. Bush sr. raised taxes on the way down and Clinton raised them onthe way up. But the budget was not "balanced" (although the national debt continued to increase) until the 1997 capital gains tax cut, after which tax revenues quite predictably went way up due the massive run-up in the stock market.

We are most certainly on the right side of the Laffer curve. To believe otherwise would imply that a marginal dollar taxed and spent by the government leads to more economic growth than a marginal dollar retained and spent in the private sector.

MrM December 24, 2005 at 9:54 am

DS:

Of course, there are cases when the government spends money more effectively than the private sector, for example, public goods like defense or national parks, or social programs like Medicare or Social Insurance or Unemployment Insurance.

Furthermore, tax dollars go not only towards government spending but also towards paying down the government debt, thus leaving higher share of savings available for private investments.

Could you please provide references to analyses showing the every tax rate decrease had resulted in tax revenue increase?

wt December 24, 2005 at 9:59 am

"But every time tax RATES have been cut in the last half century revenues have increased. There is no magic here, the single most important component in tax reveues is growth in the economy: growth in the incomes of workers, investors, and businesses."

The reason why tax revenues go up when tax rates are reduced are due to the demand side effects (Keynsian). Even a Keynsian would predict that tax revenues would go up when tax rates are reduced. Let's not be beat around the bush – supply side economics is hokum for yokels.

Mark December 24, 2005 at 10:39 am

"Could you please provide references to analyses showing the every tax rate decrease had resulted in tax revenue increase?"

The following are from
Flat Tax: A British case published by the Adams Smith Institute at http://www.adamsmith.org/economy/index.php/publications/details/flat_tax/

Over 5 years Calvin Coolidge cut the top tax rate from 73% to 25% and tax revenues increased from 1921 to 1929 by 61%.

JFK cut the tp rate of tax from 91% to 70% and from 1961 to 1969, revenues grew by 62%.

Ronald Reagan cut the top rate of tax from 70% to 28%, tax revenue increased 99.4% during the 1980s.

Magaret Thatcher cut the top rate of tax from 83% to 40%. The share of government revenue from the Inland Revenue (who then collected only corporations and income taxes) rose from 55.9% to 58.2%.

Moreover, in all cases the share of the tax burden paid by the richest increased (the numbers are available in a downloadable pdf).

Perhaps MrM could show anayses backing up his opinion that government social programmes are more effective than private spending or charitable efforts.

"We are most certainly on the right side of the Laffer curve. To believe otherwise would imply that a marginal dollar taxed and spent by the government leads to more economic growth than a marginal dollar retained and spent in the private sector."

Not true, the laffer curve says that is the case at every point. To be on the right side implies that higher taxes would lead to less revenue.

Finally, does the Laffer curve have to be applkied to the overall proprtion of government tax and spend? So, for instance, could the top rate of tax be to the right of the Laffer curve and the bottom rate of tax be to the left?

Randy December 24, 2005 at 11:56 am

Mark,

I like the idea of different curves for different rates. Sounds right.

Randy December 24, 2005 at 12:00 pm

MRM,

Defense – definitely true.
National Parks – I doubt it.
Social Security and Medicare – Only for those who receive welfare payments from them. Not for anyone else.

Keith G. Derrick December 24, 2005 at 12:06 pm

MrM.

You said:

"Of course, there are cases when the government spends money more effectively than the private sector, for example, public goods like defense or national parks, or social programs like Medicare or Social Insurance or Unemployment Insurance."

The government NEVER spends money more effectively than the private sector. Your above list is proof. Aren't all of the above items in need of some serious reform? Social Security – is this really an effective program? Medicare? Unemployment Insurance? Aren't these all examples of government failures? Not to mention unconstitutional.

Even the national defense has seriously failed. And the idea that national defense is a public good has some serious flaws. Check out The Myth of National Defense by Hans-Hermann Hoppe.

Supreme Court Justice Oliver Wendell Holmes once said, "Taxation is the price we pay for civilization." But isn't the opposite really the case?

"TAXATION IS THE PRICE WE PAY FOR FAILING TO BUILD A CIVILIZED SOCIETY. The higher the tax level, the greater the failure. A centrally planned totalitarian state represents a complete defeat for the civilized world, while a totally voluntary society represents its ultimate success. Thus, legislators, ostensibly concerned about poverty and low wages, pass a minimum wage law and establish a welfare state as their way to abolish poverty. Yet poverty persists, not for want of money, but for want of skills, capital, education, and the desire to succeed."
– Mark Skousen

Patrick R. Sullivan December 24, 2005 at 12:24 pm

As Jim Glass points out, one of the yokels–Robert Lucas–has a Nobel Prize in economics:

http://www.scrivener.net/

DS December 25, 2005 at 9:10 am

"Not true, the laffer curve says that is the case at every point. To be on the right side implies that higher taxes would lead to less revenue."

Wouldn't it be called the Laffer line then? On the right side of the curve higher rates lead to less revenue, lower rates lead to more revenue. I have seen credible estimates that the apex of the curve is located somewhere around 10% of GDP, or less.

There is a point where basic rule of law and national defense, if eliminated, would lead to less economic growth and tax revenues. But no government in the developed world (certainly not America) operates in the left side of the curve.

"Finally, does the Laffer curve have to be applkied to the overall proprtion of government tax and spend? So, for instance, could the top rate of tax be to the right of the Laffer curve and the bottom rate of tax be to the left?"

Could be. I think this is what happened during the late 90's where even though tax rates on capital gains were reduced they produced so much revenue that overall government revenues increased to their highest percentage of GDP ever. Essentially more of the GDP of the country was being taxed at the higher rates because more people were getting rich in the stock market.

A Keynsian analysis would say that this tax increase (brought about by decreasing rates) and the resulting budget surplus (which did not come about because of any fiscal responsibility by Democrats or Republicans) retarded growth and was what caused the recession of 2000. This was the justification for the original Bush tax cuts, but they were shifted so far into the future that they had little effect until 2003 when the dividend and capital gains cuts were passed. Then the economy "miraculously" recovered strongly. Miraculously if you don't understand the Laffer curve that is.

I have always looked at the Laffer curve as a symbolic contruct not a mathematical predictive function. Boiled down all it really says is that economic growth = increased tax base = more govenment revenue. All things being equal increased tax rates retard economic growth, thus government revenues. There are exceptions, but you can't make sound government policy based arond exceptions to economic reality.

Mark December 25, 2005 at 4:33 pm

"Wouldn't it be called the Laffer line then? On the right side of the curve higher rates lead to less revenue, lower rates lead to more revenue. I have seen credible estimates that the apex of the curve is located somewhere around 10% of GDP, or less."

Every line on a graph in economics is called a curve whether it's a straight line or a curve. The Laffer curve does not measure the overall size of the economy against tax rates, it measures total revenues against tax rates. The principle is that increasing tax rates reduces the size of the economy, wherever you are on the curve. The apex is the point where the reduction in the size of the economy outweighs the effect of the higher rate.

I am not saying that we are to the right of the curve and 10% does not sound unreasonable to me.

GumboFilé December 27, 2005 at 11:41 am

Taxes need to be cut to the point that the Laffer Curve is no longer a consideration. Taxes AND government revenue both need to be drastically cut.

David Hays
Grand Coteau, Louisiana

nmg December 27, 2005 at 12:39 pm

Who cares about the Laffer Curve? I'm always amused when progressives attack the Laffer Curve, as if there is no question that the government should try to maximize revenue and if it can be shown that low tax rates do not maximize revenue, well then any thinking person could then see that higher taxes are better.

If lower tax rates were to generate less revenue for governmet, that would be yet another point in favor of low tax rates.

nmg

Maxim December 28, 2005 at 11:31 pm

Interestingly, the notion that high taxes can reduce tax revenue was noticed way back the 14th century, by the Islamic scholar Ibn Khaldun. The idea is mostly common sense — it seems like the only debate should be about which side of the Laffer curve we are on.

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