Taxes are a contentious issue, the debate over which often generates more heat than light.
Disagreements over taxes cause people on both sides of the political divide pitch to make snide remarks. Most of the debate over taxes among economists is, fortunately, relatively civil and productive. There is a good reason for relative civility: Economists have arrived at some generally accepted propositions about the effects of taxes on economic conditions. That is to say, the field of public finance in economics has progressed to a point where economists generally agree about basic propositions regarding the effects of taxes, and disagree over small or precise details.
Economists think that tax hikes will at some point cause revenue to decline. (This position is often referred to as “supply side” economics.) And why do economists generally agree on this? They agree because it is generally — and correctly — accepted that tax increases discourage productive trading. Of course, simple revenue maximization is not a legitimate goal, and the true tax-rate/revenue relation is difficult to estimate. Government officials should collect only as much tax as is necessary to fund true examples of “public goods”— and this fact makes taxation questionable. Yet public debate cannot even get past the more basic point about the limits of governmental powers to increase revenue.
Public debate over taxes remains acrimonious largely because the public has not learned the lessons of economics. For example, New York Times columnist Paul Krugman refers to those who accept these down-sides of taxation as “ignorant.” Krugman asserts that this “supply side” economics is “snake-oil,” a virus which “however often it may be eradicated from the settled areas, is always out there in the bush, waiting for new victims.”
But the economist Krugman seems to disagree with the columnist Krugman. According even economist Krugman, supply side economics works better than columnist Krugman thinks. The Krugman-Wells economics text explains how supply-side economics works.
[A] tax increase affects revenue in two ways. On one side the tax increase means that the government raises more revenue for each unit of a good sold. On the other side, the tax increase reduces the total quantity sold.
The Krugman-Wells Text explains that supply-side economics does work:
[S]o is there a Laffer Curve? Yes-as a theoretical proposition its’ definitely possible that tax rates could be so high that cutting tax rates would increase revenue… its’ rare to find an existing tax rate so high that reducing it leads to an increase in tax revenue.1
High tax rates do reduce revenues, so politicians usually avoid raising taxes “too far”:
[T]he marginal tax rates paid by high earners ere very high indeed. However, these have moderated over time as concerns arose about the severe incentive effects of progressive taxes.2
This holds for tariffs too:
As the tariff rate is increased, however, the costs begin to grow more rapidly than the benefits and the curve relating national welfare to the tariff rate turns down.3
Krugman the Economist has some doubts about the Reagan tax cuts, but the most recent edition of the Krugman-Wells text notes that the 75% income tax in France went too far.
A 1997 change to French tax law significantly raised taxes on wealthy French citizens. As a result, by one estimate, by 2013, 200 to 250 billion euros in assets-around $275 to $350 billion- had been moved out of France by those who had left France to escape the higher tax rates. 4
Krugman suggests that the American tax rate of 70% was not enough to have a negative supply-side effect, concluding that “American tax rates simply were not high enough to provide a significant deterrent to economic activity. Krugman and Wells.”5
Krugman and Wells think Europe may be in a slightly different situation than the USA. However, Krugman and Wells still insist that , yes, higher taxes do tend to reduce revenue and economic activity.
The relationship between the level of taxes and the amount of revenue collected may not even be positive: in some cases raising the tax rate actually reduces the amount of revenue the government collects. [Emphasis in original.]6
Thus, Krugman the economist is forced to conclude that cutting taxes can indeed raise economic activity — and thus, revenue — concluding that [t]he possibility that a higher tax rate can reduce tax revenue, and the corresponding possibility that cutting taxes can increase tax revenue, is a basic principle of taxation that policy makers must take into account… a well-informed policy maker wont impose a tax so high that a tax cut would increase revenue.”7
The only disagreement among most economists appears to be at what point tax increases actually decrease revenue. Moreover, the statistical data itself does not provide an answer. Greg Mankiw describes the issue at hand.
Tax rates were so high, [Laffer] argued, that reducing them would actually increase revenue. Most economists were skeptical of Laffer’s suggestion… The idea that a cut in tax rates could increase tax revenue was correct as a matter of economic theory… When Reagan ran for President in 1980, he made cutting taxes part of his platform… Many believe that subsequent history refuted Laffer’s conjecture that lower tax rates would raise revenue… other economists view the events of the 1980’s as more favorable to the supply siders. To evaluate Laffer’s hypothesis definitively, we would need to rerun history without the Reagan tax cuts and see if taxes were higher or lower. Unfortunately that experiment is impossible… Laffer’s experiment may be more compelling when considering countries with much higher tax rates. In Sweden in the early 1980’s, for instance, the typical worker faced a marginal tax rate of about 80%. Such a high tax rate provides a substantial disincentive to work. Studies have suggested that Sweden would indeed have raised more revenue if it had lowered its tax rates. 8
There are real potential benefits to educating the public about the effects of heavy taxation. The part of the general public that denies the logic of sound economics wastes time on pointless political diatribes. And yet, high tax rates are counterproductive even if we have the goal of maximizing total tax revenue. Worse still, tax dollars are mostly spent for the benefit of special interest groups, not for “the public”. Given the current tax burden, the American public would benefit more from reducing wasteful spending and taxes.
Economics teaches everyone important lessons to be learned about the effects of taxation. Politicians are neither omnipotent nor omniscient. Politicians cannot simply expect people to maintain their productivity and effort in the face of rising taxes. Politicians cannot outthink taxpayers when they try to avoid taxes. Politicians will have difficulty in trying to estimate the tax rate that maximizes total government revenues. Politicians are also not benevolent. Ordinary people should not expect politicians to spend our money more wisely, or even with the intention of making us all better off. Unfortunately, there is a broad divide between those who understand the true nature of taxation (as proven by economist), and those in the median and the public who believe that government officials can and will use tax dollars in “the public interest.”
The divide between Krugman the economist and Krugman the columnist illustrates the difference between economists and the (leftish) public generally. Can the differences between Krugman and Krugman be reconciled? Yes, they are not worlds apart. Krugman the economist has personal biases, but also an incentive to maintain book sales and a professional reputation. Krugman the economist tries to downplay the true costs of taxation, but he knows that this theory is correct. Krugman the columnist caters to the New York Timesreadership. It does seem like Krugman the columnist knows something about the writings of Krugman the economist, he does choose his opponents and words carefully. Krugman the columnist attacks Republican politicians and their calls to “stimulate the economy” with tax cuts. Krugman the columnist recognizes that Republican politicians exaggerate supply-side effects of tax cuts. Of course, Democrat politicians are no strangers to hyperbole, yet for some reason Krugman finds less fault with their incessant demands for tax increases. Krugman and Krugman should discuss these matters over lunch sometime. Conveniently enough they both live in New York.