Hate the Laffer Curve? Try Woodhill's

Story Stream
recent articles

Liberals don't like the Laffer Curve. If you have any doubts, Google "‘Laffer Curve' +discredited" and peruse the 13,400 hits you get. Well, if Liberals hate the Laffer Curve (and they do), they are really going to hate the Woodhill Curve.

Professor Laffer originally stated his principle as follows: "For any tax, there are always two tax rates (a high one and a low one) that will produce the same revenue." The example he cited was that tax rates of zero and 100% would both bring in the same amount of revenue-namely, zero.

The Woodhill Curve extends the concept of the Laffer Curve in two ways: 1) It takes into account the element of time-the fact that the future matters; and, 2) It focuses on the impact of tax changes on total Federal revenues rather than on the revenue generated by an individual tax.

The principle behind the Woodhill Curve can be stated as follows: "There are an infinite number of combinations of "tax take" (Federal revenues as a percent of GDP) and average annual real economic growth rate that will yield the same present value (PV) of future Federal revenues." While the shape of the Laffer Curve is a matter for speculation, it is possible to quantify the shape of the Woodhill Curve. As it happens, the results of the calculations are very bad news for liberal tax hikers, but very good news for supply-side tax cutters.

Financially, it is the PV of Federal revenues that really matters, not just tax revenues in the current year. This is why the Social Security Trustees use PV as their ultimate measure of the long-term financial condition of Social Security. Also, when an organization borrows, it borrows against the PV of its future cash flow. The markets are happy to finance investments that increase the PV of future cash flows by more than the amount of the loan. However, lenders get very concerned when they believe that the PV of an organization's future cash flow is falling (e.g., Greece).

The recently released Social Security Trustees' Report assumes that U.S. GDP will grow at a real long-term average rate of 2.11% and that the U.S. government will pay a real interest rate of 2.9% on its debt. Based upon these assumptions, the "present value to the infinite horizon" (PVIH) of U.S. real GDP is $2009.4 trillion. Assuming a tax take of 19.3% [from the CBO's "Alternate Fiscal Scenario" (AFS) in their June 30, 2010 "Long Term Budget Outlook" (LTBO)], the PVIH of Federal revenues is $387.8 trillion. So, one point on the Woodhill Curve is located at a GDP growth rate of 2.11% and a tax take of 19.3%. This combination of tax take and growth rate yields a PVIH of Federal revenues of $387.8 trillion.

Liberals (although probably not Professor Laffer himself) would argue that, in terms of the Laffer Curve, a tax cut only "pays for itself" if the revenues produced by that tax stay constant or rise in the first year. Very few tax cuts can meet this test, and it would never be possible to eliminate any tax completely if this were the criterion.

Under the Woodhill Curve, a tax cut "pays for itself" if the calculated PVIH of Federal revenues after the tax cut is $387.8 trillion or higher. Completely repealing a tax is justified if doing so stimulates enough extra economic growth to compensate for the reduced tax take. As a corollary, tax increases are financially useless if they do not increase the PVIH of Federal revenues.

Liberals want a permanently larger government, and want to raise taxes to pay for it. So, let's look at the point on the Woodhill Curve where the tax take is 22.3%, or 3.0 percentage points higher than the CBO's AFS. The corresponding GDP growth rate for that point is 1.99%. In other words, if this enormous tax increase (by far the largest in U.S. history) reduced long term GDP growth by just 0.12 percentage points, it would leave the government financially no better off (and the rest of the country considerably worse off).

The Woodhill Curve points the way out of the Federal government's current fiscal woes: cut taxes to spur growth. The rate of economic growth is most sensitive to the taxes that impact capital investment, so these are the logical taxes to cut.

In their LTBO, the CBO expects the corporate income tax, the capital gains tax, and the death/gift tax to bring in a total of 3.0% of GDP. Eliminating all of these taxes would cut the Federal tax take to 16.3%. At this point on the Woodhill Curve, the corresponding GDP growth rate is 2.23%. In other words, it would take only an additional 0.12 percentage points of economic growth to pay for the complete repeal of these three taxes. Anyone who believes that repealing the corporate income tax, the capital gains tax, and the death/gift tax would not increase economic growth by at least 0.12 percentage points needs to consult a psychiatrist, not an economist.

The Federal debt held by the public is currently $8.9 trillion, or 2.3% of the PVIH of Federal revenues. This debt load is manageable, although running trillion-dollar annual deficits while the economy is stagnant would eventually bankrupt the government. However, the (approximately) $100 trillion of "unfunded obligations" of Social Security and Medicare that were estimated in the 2009 Trustees' Reports (the 2010 Medicare report is Obamacare fantasy) represent almost 26% of the PVIH of Federal revenues. This is not manageable.

Funding $100 trillion of unfunded obligations would require increasing the PVIH of Federal Revenues by $100 trillion. In a "static analysis" case, this could be accomplished by increasing the tax take by five percentage points (e.g., from 19.3% to 24.3%). In the real world, a tax increase of this magnitude would crush the economy and reduce, rather than increase, the PVIH of Federal revenues.

Woodhill Curve calculations show that all that would be required to generate the needed additional $100 trillion (PVIH) of Federal revenues would be another 0.14 percentage points of real economic growth. So, if eliminating the corporate income tax, the capital gains tax, and the death/gift tax increased economic growth by at least 0.26 percentage points (i.e., to 2.37%), it would not only pay for the tax cuts, but also for the unfunded obligations of our major entitlement programs.

The Woodhill Curve methodology reveals that the most important financial goal for the Federal government is to get America's GDP growth rate above 2.9%, which is the real interest rate on government debt. At growth rates of 2.9% and above, the PVIH of GDP goes to infinity, and the PVIH of Federal revenues also goes to infinity (at any non-zero "tax take"). This means that it is in the Federal government's financial interest to cut taxes by whatever amount is required to push America's real economic growth rate above 2.9%. For example, cutting the tax take by 48% (to 10.0% of GDP) would pay for itself if economic growth increased by just 0.39 percentage points (to 2.50%).

Obviously, shoring up Federal finances is not our only important economic objective. We have 34.5 million unemployed and underemployed citizens who need jobs, and many more who need a pay raise. Prosperity is possible, but to get to prosperity from here we need a "growth spurt" -a sustained period of very high GDP growth. Eliminating the corporate income tax, the capital gains tax, and the death/gift tax should produce the economic boom that we need. It is likely that these tax cuts would support a real annual growth rate in excess of 5% for many years.

Let's get rid of the taxes that are holding our economy down. Don't worry about the Federal budget. The Woodhill Curve shows that the tax cuts will pay for themselves, and then some.


Louis Woodhill (louis@woodhill.com), an engineer and software entrepreneur, and a RealClearMarkets contributor.  


Show commentsHide Comments

Related Articles