Wednesday, October 25, 2006

Tax Reform versus Tax Cuts

David Altig today provides a nice summary of some recent discussions of the Laffer curve, prompted by the recent claims by some that the federal budget deficit is falling thanks to the Bush tax cuts. He also gives a qualified defense of, if not the actual Laffer curve, then at least some "Laffer-type effects". The example he points to is this:
Several years back, I was part of a team that simulated the effects of the HR flat tax, and similar forms of fundamental tax reform. We found that in the most straightforward version of this type of tax reform, the shift from something like our present income-based tax system to an HR-like consumption-based system would require a tax rate on labor-income of 21.4 percent in order to keep revenues from falling. Over time, as the growth effects of removing capital taxation took hold in our experiments, the tax rate required to maintain revenue neutrality fell by 2 percentage points.
The study he cites is a fascinating one, which I had forgotten about (so thanks for the reminder, David!). But I would disagree considerably with David about how to characterize the simulation result that he mentions, however.

I think that the results he alludes to are not at all of the Laffer variety. The idea of the Laffer curve is that cuts in tax rates lead to increased tax revenues. Yet what David is describing is something quite different, it seems to me: revenue-neutral tax reform. In other words, rather than the simulations showing that tax cuts cause tax revenues to go up, they show that certain types of tax reform (e.g. shifting taxes away from capital and onto consumption or labor) may cause revenues to go up.

I don't think that most economists would disagree with the notion that tax reform, if done properly, could be greatly efficiency-enhancing (though I'm not personally convinced that capital formation is that sensitive to the rate of taxation of capital). And as a result, most economists would agree that if one changed the ways taxes are collected, one might be able to collect the same amount of tax revenue at lower marginal rates. And that seems to be what the Altig, et al. study illustrated. But that seems to be something quite different from Art Laffer's notion that simply cutting the marginal rates of the taxes we have today will lead revenue to rise.

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