Taxes Have Curves

The July economic statistics are out and “everything in the American garden is lovely. So, why the long face buddy?” asked Gerard Baker in The Times of London.

U.S. employers created 207,000 jobs in July, while the unemployment rate held steady at 5 percent. "Once skittish businesses are turning into confident businesses that are willing and able to hire," said Mark Zandi, chief economist at Economy.com.

So far this year, the economy is adding an average of 191,000 jobs a month, better than the average of 183,000 a month registered last year. The payroll numbers are based on a survey of employers while a separate survey of households determines the jobless rate. That survey showed employment rose by 438,000 last month, about the same as the number of people entering the job market.

As the labor market gained traction, workers' wages are also going up. “Strong gains in efficiency have buoyed real incomes and restrained inflation,” Fed Chairman Alan Greenspan said in July 20 testimony before Congress. Real compensation--wages plus benefits-- grew at a 3.9% rate in the first quarter of this year, the latest period for which such data are available, compared to a 2.8% rate when Bush took office.

The US economy continues its amazing growth. Last year the economy grew at a rate of 4.2%, the fastest in five years. The last quarter the economy grew at a 3.4% pace and it was the ninth straight quarter in which the economy has grown at an annual rate of more than 3%. By miserable contrast, Germany has not had nine quarters in the last 50 in which its economy expanded at that pace. Over the last 23 years the US has had only two years of moderate downturn, separated by ten and a half years of brisk expansion.

Bill Clinton left George Bush a weakening economy following the dot-com bubble burst. This was followed by the 9/11/01 terror attacks, a string of corporate scandals, a European recession and oil at $60+ a barrel. Not the best of hands.

But Bush played it very well indeed by instituting a smart tax-cutting program that reduced everyone’s taxes and stimulated business investment. More important, he established an optimistic tone that combined with pro-business actions (eg. class-action and bankruptcy law reform) to provide further encouragement to a level of risk-taking and entrepreneurial activity that is the envy of the world.

It is important to note that the reduction in tax rates has been accompanied by an increase in government revenues. The theory behind this seeming paradox is really one of the simplest concepts in economics, yet its logic continues to elude the class-warfare lobby among the Democrats.

The idea is that lowering the tax rate on production, work, investment and risk-taking will spur more of these activities and thereby lead to more tax revenue collections for the government rather than less. This is the essence of the famous Laffer Curve, first drawn by economist Arthur Laffer in 1974, and credited with launching the Reaganomics Revolution here at home and a frenzy of tax-rate cutting around the globe (with the exception of continental Europe) that continues to this day.













As the figure shows there is an optimum tax rate that maximizes government revenue. When tax rates are too high (past the peak) a rate reduction will move the point on the curve upward toward the peak yielding more revenue.

The Congressional Budget Office just released its latest report showing that Federal tax revenues surged in the first eight months of this fiscal year by $187 billion, a 15.4% rise in federal tax receipts over 2004. Individual and corporate income tax receipts are up 30% in the two years since the Bush tax cuts. Once again, tax rate cuts have created a virtuous chain reaction of higher economic growth, more jobs, higher corporate profits, and finally more tax receipts.

This Laffer effect has also created a revenue windfall for states and cities. As the economic expansion has plowed forward state tax receipts have climbed 7.5% this year already.

Returning now to Gerard Baker, when it comes to economics, all but America’s most fervent critics can still only marvel. So why are we so gloomy?

The real problem, I suspect, lies in the paradox of the efficient modern globalised economy that the US has become. The factors behind America’s impressive performance are the very same factors that make Americans uncertain and nervous about their future. Since the late 1980s, its flexibility and dynamism has made the US both the main driver and the main beneficiary of the economic forces at work in the world: technological change; deregulation and competition; globalisation. These have combined to raise productivity, lift living standards and quell the inflation that bedevilled the industrialised world for decades. But even as they sharpened US competitiveness, these forces pierced Americans’ own economic security. There are global lessons in the discomfiting success of the US economy. Creative destruction not only produces winners and losers; it makes even the winners nervous.

So, buck up!, America, the world is your oyster.