Tuesday, July 31, 2012

Laffer on Judgement versus Data

Marketplace, a public radio program, has been covering Wealth and Poverty issues on its programs for several months. On July 26th, a segment titled "Arthur Laffer on income inequality, raising taxes" was broadcast. The audio can be downloaded from this link. Following is an excerpt from the transcript:

Horwich: Many economists will say the data is extremely inconclusive in practice as to how marginal tax changes actually affect personal and business activity. What makes you so sure?

Laffer: Because basically, these economists you talk about never worked in the real world. They're just looking at the econometrics and the data there. If you ever go and look at what's being recommended from the CPA firms, from financial planners. If you actually look at how they go through, do their tax returns -- believe me, they are more focused on their taxes than you and I are on their taxes.

Horwich: But am I right that I just heard you criticize economists for actually looking at the data and making their decisions based on that?

Laffer: No, no, not looking at the data. I think it's wonderful to look at the data. But I think it's really silly to look at this accurate data and not make any judgments beyond those aggregate data

I was especially struck by this last statement about judgement versus data. It sounded to me that Laffer has made the judgement to ignore the data! The whole point of carefully measuring the data is to test your judgements. I agree that taxes likely have an effect on individual behavior, prompting less effort at working and more effort at avoidance/evasion. However, who is to say how large these effects are and whether there are any counter effects? In this post on my blog , I quote page 115 of the book "The Coming Generational Storm", co-written by economist Laurence Kotlikoff which states:

...For tax cuts to raise revenues, pretax labor earnings have to rise by a larger percentage than the tax rate falls.

There are two competing forces at play in determining whether pretax earning rise, stay the same, or fall. On the one hand, workers may say to themselves, "Boy, now that taxes are lower, I can work less and still receive the same after tax pay. I'm going to cut back my workweek." On the other hand, they may say, "Boy, now's a good time to work more and earn more because taxes are lower on every extra dollar I earn". Economists call the first of these reactions the income effect. They call the second reaction, the substitution or incentive effect.

Some of the best labor economists in the country have spent their lifetimes measuring the income and substitution effects. The broad consensus of these experts is that the two effects are roughly offsetting. This means that if wage tax rates are cut by, say 15 percent, tax revenues will fall by 15 percent.

Only by looking carefully at all of the data, can one test one's judgements and make sure that one is not misjudging an effect or missing counter effects. I did that to the best of my ability in this analysis on my web site. For years, I've asked supply-siders to tell me any specific numbers or conclusions in my analysis that they disagree with. Alternately, I've asked them to post a link to one serious economic study that purports to show evidence of any income tax cut that has ever paid for itself. None have. So, until someone can provide me with a study or arguments that counter this analysis, I'll just have to stick with the data.

Note: There is a discussion of this post at this link.

About Me

I became interested in U.S. budget and economic matters back in 1992, the first time that I remember the debt becoming a major issue in a presidential election. Along with this blog, I have a website on the subject at http://www.econdataus.com/budget.html. I have blogged further about my motivations for creating this blog and website at this link. Recently, I've been working on replicating studies such as the analysis at this link.

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