Arthur Laffer has a powerful column today in the Wall Street Journal. He, of course, was the author of the “Laffer Curve” that led to supply side economics as the economic policy of Ronald Reagan.
People can change the volume, the location and the composition of their income, and they can do so in response to changes in government policies.
It shouldn’t surprise anyone that the nine states without an income tax are growing far faster and attracting more people than are the nine states with the highest income tax rates. People and businesses change the location of income based on incentives.
This is one effect that supply side economics, in its most basic form, should predict. Maryland passed a “Millionaire’s Tax” a couple of years ago and discovered that millionaires and their tax revenue disappeared.
But as the state comptroller’s office sifts through this year’s returns, it is finding that the number of Marylanders with more than $1 million in taxable income who filed by the end of April has fallen by one-third, to about 2,000. Taxes collected from those returns as of last month have declined by roughly $100 million.
That is supply side economics. The basic definition is narrow, that demand does not drive the economy but that economic activity is based on incentives for the producers. If you can make more money by producing widgets, you will do so. The principle difference from Keynesian economics is that the producers themselves, not government bureaucrats, make the decisions. This is Adam Smith’s Hidden Hand. Making more widgets will not necessarily cause consumers to buy them. It is up to the producer to recognize demand and fulfill it. Sometimes they will fail because they misread the market. That is their problem, not the government’s.
People can also change the timing of when they earn and receive their income in response to government policies. According to a 2004 U.S. Treasury report, “high income taxpayers accelerated the receipt of wages and year-end bonuses from 1993 to 1992—over $15 billion—in order to avoid the effects of the anticipated increase in the top rate from 31% to 39.6%. At the end of 1993, taxpayers shifted wages and bonuses yet again to avoid the increase in Medicare taxes that went into effect beginning 1994.”
Even Hillary CLinton recognized the incentive and had her law firm bonus moved up to December 1992.
We saw this in 1992 when there was a bulge in income realizations late in the year as people anticipated higher taxes after the election of Bill Clinton. Hillary Clinton’s law firm, for example, distributed bonuses in 1992 that otherwise would not have been paid until 1993. While the number of people who have this much flexibility in timing their income this way is small, the same principle applies to all income earners. In the aggregate, the impact can be large.
We have seen the same phenomenon with the “Cash for Clunkers” program and with the cash incentive for first time home buyers, which ended on April 30. In both cases, purchases were moved up to take advantage of the incentive but the sales after the incentive expired plunged. No net increase in economic activity resulted.
Laffer discusses the Reagan tax cut of 1981.
In 1981, Ronald Reagan—with bipartisan support—began the first phase in a series of tax cuts passed under the Economic Recovery Tax Act (ERTA), whereby the bulk of the tax cuts didn’t take effect until Jan. 1, 1983. Reagan’s delayed tax cuts were the mirror image of President Barack Obama’s delayed tax rate increases. For 1981 and 1982 people deferred so much economic activity that real GDP was basically flat (i.e., no growth), and the unemployment rate rose to well over 10%.
But at the tax boundary of Jan. 1, 1983 the economy took off like a rocket, with average real growth reaching 7.5% in 1983 and 5.5% in 1984. It has always amazed me how tax cuts don’t work until they take effect. Mr. Obama’s experience with deferred tax rate increases will be the reverse. The economy will collapse in 2011.
He doesn’t mention that the delay in implementation of the tax cuts was due to Bob Dole who, as Senate majority leader, rejected supply side economics and delayed the recovery. The result was a big loss for Republicans in the 1982 election. The election this fall is being compared to the 1982 election but there is a huge difference. The Reagan loss was due to the delay in tax cuts and economic recovery. This year, the loss will be due to anticipation of Obama’s policies that have not yet taken effect. Once they are in force, things will get worse, a lot worse.
Consider corporate profits as a share of GDP. Today, corporate profits as a share of GDP are way too high given the state of the U.S. economy. These high profits reflect the shift in income into 2010 from 2011. These profits will tumble in 2011, preceded most likely by the stock market.
In 2010, without any prepayment penalties, people can cash in their Individual Retirement Accounts (IRAs), Keough deferred income accounts and 401(k) deferred income accounts. After paying their taxes, these deferred income accounts can be rolled into Roth IRAs that provide after-tax income to their owners into the future. Given what’s going to happen to tax rates, this conversion seems like a no-brainer.
The result will be a crash in tax receipts once the surge is past. If you thought deficits and unemployment have been bad lately, you ain’t seen nothing yet.
This might be dismissed as partisan rhetoric except that Laffer predicted the 1981 to 83 effect of delaying tax cuts.
Next year will be a bad year for the US economy. I have read an investment letter since 1977. It is called The Dow Theory Letter and it has been written by Richard Russell since the 1950s. I wish I had taken all his advice but, fortunately, I have taken some. Twice, he has sent an unscheduled warning to subscribers. Each time, it was a warning of a major drop in the stock market. Once was in 1987, a month before the 25% market drop in one day. The second time was two weeks ago. He told his subscribers to sell all their stocks. He also said that, by the end of the year, the America we know would be changed beyond description. I think there may be a bit of hyperbole in that statement but I would sell all my stocks if I still had any.
We have not yet seen the Obama policies in effect. The economy has made some tentative moves in the direction of recovery. That will end once the Obama policies take effect. I have made adjustments in my life, including selling my house. I wonder how many others are doing the same thing ?
I generally like Arthur Laffer, I’ve seen him talk in person. However, he was on the wrong side of the 07-08 financial meltdown, so he doesn’t get everything right.
The tax cuts worked wonderfully, but there was no cut in spending. Now Obama has mashed the gas pedal to the floor, and his stooges are starting to swoon over the beauty of tax increases. We’re getting Bolshevism Lite.
I was critical of Reagan at the time for not vetoing a few spending bills. He had a Democrat Congress but he could have done more.
Dropping by to say hello. Hope everyone is happy and safe. Enjoy the summer.
peace
James
Hi James…
Hey doc did you see this
http://market-ticker.denninger.net/archives/2391-Stasi-Style-Doctors-On-The-Way.html
Cassandra, I have been aware of that and have even commented on it somewhere here. I can’t tell if the total dropout physician is affected. The trend is for physicians to drop Medicare, which I think this is aimed at, but there is also a trend to drop all insurance. I’ve written a couple of posts about it. The movement is gaining speed as Obamacare approaches. That has been the law in Canada with the exception that you are not barred from practice if you accept no insurance. It was controversial but is now a growing trend since the supreme court ruled last fall that “a health plan is not health care.” If Obama really tried to prosecute doctors for cash practice, it would really raise hell. I could see all medical facilities moving to Indian reservations.