Lower Tax Rates = Higher Revenue? Gingrich May Be On to Something

When Newt Gingrich threw his hat in the ring for the Republican presidential nomination, he tossed Arthur Laffer in there too. Laffer is the economist who popularized an idea that became one of the theoretical underpinnings of Reaganomics and apparently will be one of the founding principles of Newtonomics.

Laffer's argument was that when tax rates exceed a certain level, revenue begins to decline because the disincentive to work reduces taxable income by more than can be offset by extra takings from the higher rates. He illustrated this notion with the Laffer curve, which plots the tax rate on the horizontal axis and revenue on the vertical axis.

Tax rates of 0 percent and 100 percent would raise no revenue, Laffer explained, because there would be no tax owed in the first place and no incentive to work in the second. As for where the peak in the curve should be, well, it's impossible to tell, but the assumption of President Reagan and his economic advisors is that it was somewhere to the left of rates in effect at the time. That led to various moves during Reagan's presidency that slashed the top tax rate by more than half.

More From Less
Did it work? Yes. Tax revenues increased during the Reagan years. It was no fluke, either; revenues also increased in the 1920s after tax rates were cut drastically.

The success of the Reagan-era tax rate cuts is obscured, however, by the continual increases in government spending that accompanied them. Spending rose at a faster clip than tax receipts, forcing the Treasury to borrow more and raising the fiscal deficit.

Gingrich is not the only politician urging Congress to give sharp tax cuts another go. There has been solid bipartisan support for reducing corporate tax rates, although policy experts are skeptical that action will be taken before the 2012 election.

Even if it is, it's likely to come with strings attached. Perhaps mindful of the expanding deficit in the 1980s - as well as the ballooning borrowing and spending of the last three years as Washington has tried with limited success to buy the country out of recession - many who call for lower corporate rates also recommend closing myriad loopholes in the tax code.

Cutting corporate rates is a good idea because the United States has the highest rates in the developed world except for Japan. That limits the ability of American businesses to compete with foreign rivals.

A Modest Proposal
Whether reducing personal tax rates makes as much sense is less clear. Rates are much lower now than in the 1980s, and the deficit is much higher.

How about this? Combine lower corporate tax rates with a reduction in payroll taxes. Perhaps the two-percentage-point cut in the employee's share for 2011 could be extended and a similar cut granted for the employer's share.

That mix might alleviate corporate America's persistent reluctance to hire. Then as payrolls expanded, revenue to the Treasury would get a boost as the newly employed got off the dole and started sending money back the other way. It's a long shot, at least this year, but whichever party is seen to be implementing a tax overhaul that helps the little guy might have the last laff on Election Day.