A Conversation with Dr. Arthur Laffer

After-Tax Income as Incentive

I recently had the pleasure of meeting Dr. Arthur Laffer after a talk he gave in Beaver Creek, CO, hosted by the Steamboat Institute.  Over 90 minutes, Dr. Laffer shared stories from his fifty years in public policy as the preeminent supply side economist.

Dr. Laffer gave excerpts from his upcoming book, Taxes Have Consequences an Income Tax History of the United States.  (to be released Sep 27, 2022).

It is understandable how anyone alive today would assume that income taxes are normal and natural and something we have always had.  Not so.  Until 1913 a tax on income was deemed unconstitutional.  The 16th amendment changed all that and progressive Democrat President Woodrow Wilson introduced the income tax in 1913.

The highest tax rate in 1913 was just 7%.  With a national population of 62 million, the income tax only fell on 385,000 people.  When the tax was first introduced it really only applied to the top, top earners – the wealthiest in the country.

Since they were first imposed, the income tax rates have been high, and low, and high again.  They have fallen on many and fallen on few.  Taxes are supposed to raise revenue for the government but they are equally a political weapon, positioned to punish and incentivize.  It’s the mechanism of incentives that lead to Dr. Laffer’s breakthrough with Supply Side Economics.  

Dr. Laffer said that people don’t work to pay taxes.  They work to get what they can after taxes.  It is that personal and private incentive that motivates someone to quit one job and go somewhere else.  It is the after-tax incentive that is critical to human behavior.

For example, with no taxes at all a fellow earns $100.  His incentive for working is the $100 he receives.  If you introduce a 1% tax, his incentive is $99.  That’s still good.  If you make the tax 99% then his incentive is what’s left – just $1.  That’s not so good.

It is this simple alignment of tax rates reflected in individual behavior that Dr. Laffer famously drew on a cocktail napkin – soon to be known as the Laffer Curve.  A simple, but profound idea.  There is an optimal level of taxation that will provide government the revenue it needs without removing the incentive to work, which would then reduce government revenue.

President John F. Kennedy signed a breakthrough tax bill.  Prior to his bill, the highest marginal income tax rate was 91%.  His bill dropped the highest rate to just (!) 70%.   He also dropped the lowest tax rate from 20% to 14%.  All the rates in the middle also dropped.  But let’s just focus on the top and the bottom rate.

The top rate was reduced from 91% to 70%, a reduction of 21%.  That is a reduction of about 23% of the tax rate (21 divided by 91).  However, look at it from a perspective of incentive.  With the higher rate, the taxpayer would get to keep 9% of their earnings.  Under the new, lower tax rate, the taxpayer would get to keep 30% of their earnings.  The incentive to work went from 9 cents of every marginal dollar up to 30 cents!  That s 233% increase in the incentive to work.

The difference between the increase in incentive (233%) to the cost (23% rate reduction) is 10:1.  A ten-to-one “benefit cost” ratio.

Now, let’s look at the lowest bracket.  The tax rate dropped from 20% to 14%.  That’s an arithmetic reduction of 6%, or 30% of the taxes (6 divided by 20).  Before the tax cut his incentive was to keep 80 cents of each marginal dollar.  After the tax cut he gets to keep 86 cents of each dollar.  That’s a 7.5% increase in his incentive.  What is his Benefit Cost ratio?  The increase in incentive (7.5%) divided by the rate reduction (30%).  Benefit Cost ratio is 1:4.

This is the foundation of Supply Side Economics – looking at what you get to keep as opposed to what the government takes from you.  In the interest of generating revenue for the country, you want to incentivize behavior of the people with money.

Every time it’s been done, government revenue has increased and the burden on the middle and lower classes has been relieved.  Dr. Laffer summarized what the data clearly show, “When you raise tax rates, the economy goes in the doldrums when you lower tax rates, it booms. And lastly, when you raise tax rates on the rich, the burden of taxation on the poor increases dramatically. And when you lower tax rates on the rich, the burden of taxation on the poor goes down.”

The talk concluded with a lively Q&A from a good audience, all looking for some light at the end of the current inflationary tunnel.  Dr. Laffer is hopeful, but due to the complete vacuum of competence or economic leadership in the executive, he foresees a long dark period before the pendulum will swing back.

View the entire video of the event below: