Arthur Laffer

Some Oklahoma politicians have trumpeted a report by economist Arthur Laffer to claim that eliminating the state income tax will fuel an economic boom. Laffer is best known for the Laffer Curve, which he famously sketched on a napkin while meeting with Dick Cheney in a hotel bar. It went on to form the basis of the Reagan administration’s trickle-down economics.

The Laffer Curve makes an obvious point: government revenues peak at a tax rate somewhere between zero and one-hundred percent. In the lower half of the curve, raising taxes will increase revenue, but go too high and the reduced economic activity due to excessive taxation will result in lower revenue.

The argument was not original to Laffer. It had been stated previously by thinkers ranging from 14th Century Arab philosopher Ibn Khaldun to John Maynard Keynes, the founder of modern macroeconomics. What made this idea influential in recent decades was not any special insight into economics, but its powerful appeal for politicians. Rather than explaining how tax cuts (popular) would be paid for by budget cuts or increases in other taxes (unpopular), they could simply claim that the tax cuts would pay for themselves.

However, whether a tax cut will result in higher or lower revenue depends on where you are on the curve. Estimates of the revenue-maximizing tax rate differ, but defenders of tax cuts have a much stronger claim when the top marginal rate is 70 percent, as it was at the beginning of the Reagan administration, than they do when the top rate is 35 percent, as it is today.

Laffer Curve with a maximum revenue point at about a 70% tax rate, based on "How Far Are We From The Slippery Slope? The Laffer Curve Revisited" by Mathias Trabandt and Harald Uhlig.

That doesn’t stop politicians from repeating to the point of absurdity the idea that all tax cuts lead to revenue growth. In Oklahoma, the top marginal rate is only 5.25 percent, and the average family pays an effective rate of less than 3 percent. No credible economist will argue that cuts from such a low starting point can pay for themselves.

To be fair, Laffer doesn’t say this either. His report argues that increases in other tax revenues will replace just one-half of what would be lost by eliminating the personal income tax. Even that much rests on rosy predictions for the economy and the highly questionable assumption that the state income tax is the most important variable for economic success.

Most people realize the picture is more complicated. Oklahoma’s economy is vastly more affected by oil and gas prices, as well as national and global economic trends, than it is by our modest state income tax. Tax cuts won’t put more oil in the ground or protect us from a European collapse.

Laffer also conveniently leaves out the obvious point that budget cuts have a cost. The economic benefit of a modest increase in individual income would be countered by cutbacks in what we can accomplish collectively, with fewer resources to ensure good schools, well-maintained roads, and a safe and healthy community. We have already slashed budgets for three consecutive years, and the result is larger class sizes, fewer officers on the streets, and longer waiting lists for treatment of children with disabilities, to name just a few.

It comes down to this: Arthur Laffer’s work leaves out more than it includes, because his goal is never to provide an accurate economic assessment. It is to tell politicians what they want to hear. As Jay Bookman put it, “It’s like telling someone with an obesity problem that the best way to lose weight is to always eat more ice cream — more times than not, their eagerness to believe overwhelms any skepticism.”

As a result, we keep going further down the tax cut rabbit hole. At least one lawmaker has already said that eliminating the income tax should be the first step towards… more tax cuts. Where does it end?

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This blog post was excerpted from remarks by Angela Glover Blackwell, founder and CEO of PolicyLink, during the opening session of PolicyLink’s 2011 Equity Summit in Detroit, Michigan.  The speech presented a new framework for creating an equitable economy.  Click here for a new report from PolicyLink looking at how demographic changes and deepening inequality demand an urgent re-imagining of our economy.

This is a critical moment.  The economy is in crisis.  The middle class is shrinking.  Inequality has come front and center in our conversation in America and we have rapidly changing demographics in which the racial and ethnic composition of the country is changing fast.  This economic crisis really represents a failed growth model, one that was based on a housing bubble; one that was allowed to present itself as opportunity when it was really only credit-fueled consumption that was improving the lifestyles of people [..]

We have a moment in time in which everyone is looking up and deciding that it’s okay to talk about inequality.  That we have to talk about inequality.  That as we struggle and work together as a nation to find our footing again in the global economy, as we try to reverse this crisis that we’re in, we need to make it clear that we cannot be nostalgic for a time that never was, while avoiding a future that is inevitable.  We cannot go back to what we had [..]

We are changing more rapidly than anybody expected that we would.  Already, 46.5 percent of all children under 18 in this country are children of color.  By the end of this decade, the majority of all children in this country will be children of color.  By 2030, the majority of young workers under 25 will be young workers of color and by 2040, the majority of people in this nation will be people of color.  This represents an incredible gift to America – an incredible gift [..]  But the sad, the troubling thing, is so many of those people that represent that gift are being left behind.

We have over a third of black and Latino children who are overweight or obese.  One third of all black teenage girls are obese.  Serious problems in terms of what that represents.  We know that our educational system is leaving millions and millions of children that are Latino and African-American behind.  They’re behind when they begin school, they’re behind by 4^th grade, they’re dropping out before they finish high school.  They’re entering a work system that has no place for a worker that has at least a high school diploma.  While we look at this gift, we know that it will not be viewed as an asset if we don’t deal with these issues.

The United States has invested in equity before.  Right after World War II, California looked at its population and what it saw was a population that was very poor, with a quarter of the people there living below the official poverty level.  Only half of the adults had a high school diploma.  This state looked at its population – that was white – and viewed it as an asset.  Under Republican Governor, Earl Warren, and Democratic governor, Pat Brown, California rolled up its sleeves and it built the best educational system in the country.  It built the best healthcare system.  It built the best system of roads and parks and infrastructure. By 1960, California had a 25 percent advantage in terms of growth and salaries over the rest of the nation.

That is a story about what happens when government and the private sector look at the population that it has, views that population as an asset, and steps up.  We’ve got to step up as a nation [..]  For all of the years that I’ve been working on equity I have felt that it was the right thing to do.  The moral thing to do.  That there was something immoral about a nation that systematically leaves people behind [..] It continues to be the right and moral thing to do, but it has now become an economic imperative.

This nation has no future worth mentioning [..] if it doesn’t figure out how to be competitive in the global economy, how to unleash the creativity and the entrepreneurial spirit that is here [..] That agenda, that equity agenda, has become an imperative for the nation.  Equity no longer stands out there as the thing to do because it’s the right thing to do – begging and pleading for people to find a heart, find a conscience, do the right thing.  Equity is the only way forward.  Equity is the superior growth model for the nation.  [..]

This is not a poor country.  We have more wealthy people than anyone could ever think would be possible.  We have more infrastructure – crumbling as it is – than most places ever dream of [..]  We have the ability; we have the money to do what we need to do [..]  We have a crisis, but it’s not a crisis that comes of not having any resources to address it.  How should we use all that money that we do have?  We need to use it to invest in the nation’s infrastructure because it’s win, win, win [..]  We target the places that need it – rural communities without broadband, urban communities where people are isolated from opportunity because of the absence of transportation.  We invest in the places, we invest the projects, and ultimately we invest in the people.

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View other clips from OKPolicy’s “Watch This’ video series:

Making Ends Meet: The Medicare Generation

A tale of two (Oklahoma) cities

Living Through the Oklahoma Dust Bowl

Reducing Infant Mortality

What is Sharia Law?

Panic Nation

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The unemployment rate as calculated by the Bureau of Labor Statistics (BLS) is an imperfect measure of unemployment, especially in the aftermath of a protracted economic downturn.  The widely reported unemployment rate only counts people who “made specific efforts to find employment” in the last month.  If you are unemployed but don’t meet that criteria, you are not considered part of the labor force.  This method discounts unemployed Oklahomans who had no specific leads on a job, didn’t make any effort to find a job, or have given up looking for work indefinitely.  The BLS describes the distinction this way:

Persons who are neither employed nor unemployed are not in the labor force. This category includes retired persons, students, those taking care of children or other family members, and others who are neither working nor seeking work.

This post considers two alternative statistical measures of state unemployment:

• The employment to population ratio, a comprehensive figure that better captures all of the state’s unemployed, including discouraged and unsuccessful job seekers.
• The duration of unemployment, a particularly helpful statistic to consider as the economy recovers from one of the worst recessions in American history.

These indicators reveal that long-term joblessness is a persistent problem in Oklahoma, even as the state’s unemployment rate falls.

The employment to population ratio (EPOP) measures the proportion of the working-age population that is employed.  While a decline in the unemployment rate may be attributable to people dropping out of the labor force, rather than finding jobs, a decline in this indicator over time means a shrinking working population.  This graph compares the employment to population ratio in Oklahoma to the national ratio over a thirty-year period:

The percent of the state’s population that is employed has lagged behind the national ratio consistently since the mid 1980s.  Oklahoma’s employment to population ratio has dropped every year since the recession, hitting a thirty-year low of 58.2 percent in 2010; the national EPOP reached a 34-year low last month.

The duration of unemployment is another crucial indicator.  The longer a worker is jobless, the greater the likelihood that they will drop out of the labor force.  Long-term unemployment is so widespread and systemic that the BLS recently changed the way they collect data from the unemployed to more accurately reflect economic trends:

There was an unprecedented rise in the number of persons with very long durations of unemployment during the recent labor market downturn. Nearly 11 percent of unemployed persons had been looking for work for about 2 years or more in the fourth quarter of 2010.  Because of this increase, BLS and the Census Bureau updated the CPS instrument to accept reported unemployment durations of up to 5 years.

This trend represents a sobering challenge to the recovery of the job market because the rate at which the long-term unemployed find jobs compared to their newly jobless counterparts drops steadily from week to week.  In 2010, 89 percent of the nation’s unemployed who found a job had been out of work for less than a year.  In Oklahoma, the percentage of unemployed who were out of work for more than 15 weeks is an increasingly larger share of the state’s jobless population:

These auxiliary data reveal that it’s still too early to claim victory on the economic front.  With more and more media and political attention focusing on the debt ceiling and deficit reduction, red flags in the labor market are fading into the background.  Detailed monthly jobs reports issued by the Center for Economic Analysis (CEPR) document a litany of mounting statistical evidence on a painfully slow and slight economic recovery.  This is a critical time for state and national leaders and lawmakers to be developing new strategies for creating jobs and sparking economic growth.  A falling unemployment rate is welcome news, but we should keep a watchful eye on alternative indicators that alert us to underlying problems in the labor market that have the potential to weigh down the economy in the coming years.

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But inadequate revenues is not the only problem. It’s just as important that the cost of supporting government is fairly distributed and does not privilege some businesses or individuals over others without good justification.

As we explain in an issue brief released today, Oklahoma’s sales tax has fallen victim to both of these problems. The economy has evolved so that services and online goods which are not covered by the sales tax make up a larger proportion of purchases. In addition, the legislature has granted a growing number of exemptions, many with questionable economic rationale. One report found that just 35.7 percent of all purchases in Oklahoma were covered by the sales tax in 2003, compared to 52.0 percent in1990. Trends in the economy make it likely that the situation has only gotten worse since then.

Why does it matter? For one, the sales tax is the single largest revenue source for state and local governments in Oklahoma. In FY ’08 the sales tax comprised more than 1/4th of all state tax dollars and almost 2/5ths of local tax dollars. Cities, which cannot assess property or income taxes, are especially dependent on the sales tax.

Even apart from its importance to revenues, arbitrary sales tax exemptions distort the economy, reduce efficiency, and harm Oklahoma businesses and consumers. To understand why, consider an example: We pay sales tax when buying carpet cleaning supplies, but not when we pay a carpet cleaning service. This creates an artificial incentive to purchase untaxed services rather than taxed goods and unfairly advantages the service providers over retail stores.

In addition, since many services are purchased primarily by affluent households, the tax burden is shifted to middle- and lower-income Oklahomans. We see frequent battles over whether to exempt groceries from the sales tax, but little to no discussion of why services like horse boarding, pool cleaning, and investment counseling are already exempt.

Another aspect to this problem is that the state can’t require tax to be collected on many Internet sales when the seller has no physical presence within the state. That means purely online retailers like Amazon can avoid charging sales tax, while Main Street businesses that directly employ Oklahomans cannot. Oklahoma is among 21 states that does not charge sales tax for online downloads, which unfairly benefits retailers like iTunes over local merchants. That also advantages wealthier Oklahomans at the expense of those who do not have access to a computer, high-speed internet, and a credit card.

For all of these reasons, expanding the base of the sales tax would be beneficial, even if done in a revenue-neutral way. For example, we could extend the sales tax to cover more purchases while simultaneously reducing the overall rate. We will continue to debate what overall level of taxation is needed to maintain core public services, but even those who favor lower taxes should realize that sales tax loopholes are unfair, inefficient, and bad for Oklahoma business.

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The possibility of reform raises many troubling questions. Will there be new taxes? Will current employer-provided benefits be taxed? Will government control health care decisions? Will private insurers be run out of the business? Will the federal deficit get even worse?

Whenever we consider significant public policy changes, it is reasonable to ask “What happens if we do nothing?” The Council of Economic Advisers, a White House agency charged with offering objective economic advice to the President, suggests that may be the worst alternative of all. Their new report forecasts the economic effects of health care reform and gives us some insight into the “do nothing” alternative. The Council finds that:

• Letting costs grow at the present rate stunts economic growth. By 2030, gross domestic product would be eight percent below levels we could expect if we achieve minor–1.5 percent per year–cost controls.
• Translated into personal terms, a family of four would see about $10,000 less income in 2030 under the current health care system than under one that controls cost growth.
• Uncontrolled health care costs reduce employment by about 500,000 per year.
• The current system is inefficient. There is no relationship between cost and health outcomes, and it costs society more to leave people uninsured than it would to insure them. Employer-provided insurance keeps people in jobs when they might have better opportunities elsewhere, and makes it difficult for small businesses to compete with larger ones.

The Council concludes:

The CEA report makes clear that the total benefits of health care reform could be very large if the reform includes a substantial reduction in the growth rate of health care costs. This level of reduction will require hard choices and the cooperation of policymakers, providers, insurers, and the public. While there is no guarantee that the policy process will generate this degree of change, the benefits of achieving successful reform would be substantial to American households, businesses, and the economy as a whole.

Keep in mind that the Council works for a pro-reform president. The report, however, is well-documented and does not advocate any particular reform.

As we learn more about specific reform proposals, most of us will see something we don’t like. Many will vocally and arduously oppose most of the proposals that are offered. As we weigh new options, however, we should never lose track of the risks of leaving the current system alone.

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