A recent Star Tribune commentary argued that the federal government shouldn’t raise income tax rates because ultimately no new public revenue would be generated since high-income households will choose to work less in response to the higher marginal tax rate.
This is a variation of the old “Laffer economics” (dubbed “laugher economics” by critics) popularized during the Reagan administration. During the Reagan years, it was argued that the federal government would increase revenue by cutting tax rates because people would choose to work more; thus, even though tax rates were lower, the government would generate more revenue due to the increase in economic activity.
Sound too good to be true? Well, it was. The general consensus is that the reduction in federal tax rates during the Reagan years resulted in less federal revenue and higher deficits. According to Time business and economics columnist Justin Fox, “If there’s one thing that Republican politicians agree on, it’s that slashing taxes brings the government more money … If there’s one thing that economists agree on, it’s that these claims are false.”
In 1999 and 2000, Minnesota cut income tax rates, including the rate on the top tier. Did the cut in state tax rates result in higher state revenue? It is difficult to answer this question definitively because income tax collections are dependent not just on tax rates, but on the overall economic activity. However, since the income tax rate cuts of a decade ago took effect, per capita state income tax collections have generally failed to keep pace with inflation. It appears likely that the income tax rate cuts of 1999 and 2000 have contributed to Minnesota’s recurring budget deficits.
There is no indication that Minnesota’s income tax cuts stimulated any sort of economic boom in the state. Since the rate cuts of 1999 and 2000 took effect, Minnesota GDP and job growth have both lagged about 3 percent behind the national average.
The argument made in the Strib commentary is the flip side of the argument made back in Reagan era. Just as lower tax rates were to produce more revenue, higher tax rates are supposed to generate less revenue. As with the original premise, the corollary is counter-intuitive and probably not true in the majority of instances. My recommendation is to be cautious before drinking Laffer Kool-Aid. In general, tax rate increases will generate more public revenue and tax rate cuts will generate less.
Postscript: In fairness, it should be noted that the fundamental premise of Laffer economics-that at a 100 percent tax rate no tax revenue will be generated because no one will have any incentive to work-is sound. Also sound is the assertion that as tax rates get exorbitantly high, tax revenue can diminish. However, what is dubious is the assertion that any reduction in tax rates will necessarily lead to more public revenue and that any increase in tax rates will necessarily lead to less.