Economic Scene: Tax Cuts, Sold as Fuel for Growth, Widen Gap Between Rich and Poor

Nonetheless, tax policy today is still being driven by his decades-old argument, devised in an economy that looks nothing like today’s.

Today, 1 percent of the population is taking in more than 20 percent of the nation’s income, twice as much as when the fateful dinner took place. Today’s top marginal tax rate, 39.6 percent, is a little over half what it was then.

Critically, how the pie is sliced has become as important as how to raise productivity further. Indeed, the questions are intertwined. Compelling new economic research suggests that in the economy in which we live, cutting taxes on the rich further won’t just fail to foster growth, it could even make the economic pie smaller.

The direct case against lower taxes on the rich was made most clearly a few years ago by the French economist Thomas Piketty — noted for his analysis of inequality trends over the centuries — and colleagues from the University of California, Berkeley, and Harvard University.

Looking at a set of industrialized countries from the 1970s until the years preceding the financial crisis, the economists found no meaningful correlation between cuts in top tax rates and economic growth. Big tax cutters like the United States did not grow faster than countries like Denmark, which kept taxes high. What did respond to lower taxes was inequality: The income share of the top 1 percent grew much more sharply among big tax cutters like the United States than in countries like France or Germany, where top tax rates changed little.

Cutting Taxes

The top marginal income tax rate has been cut sharply since the 1960s.

Highest marginal income tax rate

Highest marginal income tax rate

The findings contradicted the basic proposition on Mr. Laffer’s napkin. Indeed, they suggested an entirely different dynamic: Lower taxes did encourage executives and other top earners to raise their incomes, but not in ways that benefited the entire economy, like working and investing more. Instead, they were encouraged to manipulate the system in ways that, in fact, reduced the pie for everybody else, putting every decision at the service of increasing their pay.

Think about tax avoidance or outright evasion — which simply hides money from the Treasury, reducing the government’s ability to fund often critical programs, at no gain to the economy. But executives have been known to use other tricks — say, options backdating or earnings manipulation, or simply lobbying the compensation committee of their company’s board, or putting corporate strategy at the service of the current quarter’s earnings to give the share price a bump.

Taking into account all the ways top earners respond to taxation, Mr. Piketty and colleagues suggested that the optimal top tax rate on the Americans with the highest incomes — the rate raising the most money for the government — could exceed 80 percent with no harm to growth. Loopholes would have to be closed to prevent avoidance, but only the mega-rich would lose out. From an economic perspective, soaking the rich would, in fact, do good.

The argument that inequality matters little and redistribution mars economic success has always been suspect. In more unequal societies, the disadvantaged will have less access to many of the things that improve productivity, like education, health and the internet. Rising inequality can hamper consumption by weighing on the income of the middle class.

Douglas W. Elmendorf, former head of the Congressional Budget Office and now dean of the Kennedy School of Government at Harvard, once said that to assess the macroeconomic impact of cutting taxes and spending, it is indispensable to assess which taxes are cut and what spending is affected. “Major changes to benefits for lower-income people could have notable effects on the economy by altering labor supply, and those effects could be an important criterion in evaluating such changes,” he argued.

In more unequal societies, the rich have more power to distort policy making to channel more of the fruits of growth in their direction by, say, cutting taxes and government spending that might improve productivity and growth. Politics becomes more polarized. And it becomes more difficult to recover from economic shocks: Citizens in unequal societies are less likely to buy government promises that sacrifice today will lead to gains tomorrow.

“We have not paid enough attention to macro distributional linkages,” said Jonathan D. Ostry, deputy head of research at the International Monetary Fund, who has published groundbreaking research linking inequality and growth. “Even if you are only interested in the aggregate gains, you are forced to think about equity, because equity matters for the aggregate. The distribution might come back to bite you.”

Mr. Laffer may still be calling to cut tax rates, to provide an incentive for executives to earn even more. But tax policy today calls for a new napkin, one with a place for equity.

Correction: October 3, 2017

An earlier version of this column rendered one word incorrectly in a quotation from Jonathan D. Ostry of the International Monetary Fund. He said insufficient attention had been paid to “macro distributional linkages,” not “macro distributional influences.”

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