Following in Reagan's misstep.

Photographer: TNS via Getty Images

Republicans Keep Repeating the Same Tax Mistake

Megan McArdle is a Bloomberg View columnist. She wrote for the Daily Beast, Newsweek, the Atlantic and the Economist and founded the blog Asymmetrical Information. She is the author of "“The Up Side of Down: Why Failing Well Is the Key to Success.”
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It looks as if Governor Sam Brownback may be leaving Kansas to take up a job at the United Nations. Brownback’s critics, of which there are many, charge that having led his state into a fiscal crisis, he’s bailing out on the wagon train while the rest of his party staggers onward over the cliff. “Brownback would be fleeing a political and economic crisis,” writes Alan Pyke of ThinkProgress, “leaving about 3 million Kansans behind in a budgetary inferno of his own devising.”

You can certainly see why Brownback would want to get out. After Republicans pushed through aggressive tax cuts in 2012 and 2013, the state keeps coming up with deep budget holes that have to be patched in an annual scramble. This year’s drama is still being played out after the governor vetoed a plan to raise taxes, and the state Senate responded by crushing Brownback’s proposed alternative.

For budget wonks, the saga of the Kansas budget will be reminiscent of the Reagan years, when supply-side tax cuts resulted in big deficits. The administration had hoped that the tax cuts could be paid for by a combination of faster economic growth unleashed by lower marginal rates, and the infamous “magic asterisk” (in which unidentified spending cuts were promised, details to come later).

Such rosy hopes are never sustained for long; the cruel arithmetic of inflow and outflow cannot long be dammed, or hidden. Reagan was forced to do another tax reform a few years later, hiding the fact that he was increasing taxes by cutting marginal rates but doing away with the generous exemptions that had dramatically lessened what people actually paid. Nonetheless, it took two more tax hikes -- under Bush the First, and Clinton -- to get the budget into some semblance of structural balance.

History does not repeat itself, but it often stutters. Which raises an interesting question: Why has this happened more than once? Was the example set under Reagan not clear enough?

The answer is, I think, that a lot of Republicans have a view of how taxes affect labor markets that is simple, intuitive, and wrong. (Not necessarily any less wrong than what Democrats think, mind you. But differently wrong, and in a way that matters here).

The basic intuition driving a lot of Republican conversation on taxes is simple: Taxes discourage work. After all, if your taxes go up from 30 percent of your income to 40 percent, you’ve essentially taken a 15 percent pay cut. In general, if the reward for doing something goes down, you will do less of it. Ergo, the higher the taxes, the lower the work effort.

We can take this further with a simple observation: If the tax rate on your efforts is 100 percent -- that is to say, if you are allowed to keep none of the fruits of your own labor, not so much as a pen filched from the office supplies -- then you will not work, because what’s the point? Then the government will get no revenue from its 100 percent rate. If the tax rate is zero percent, you will also not generate any revenue for the government. Somewhere in between those points, there is a rate at which the maximum amount of tax revenue will be raised; any tax rate higher than that will cause revenue to start declining again.

Many of you will recognize that I am describing the famous Laffer curve. And the Laffer curve is absolutely right -- for some effective tax rates. It has not, however, turned out to be correct for the tax rates actually prevailing in the United States during the later postwar era. Relatively modest decreases from modest tax levels do not increase economic growth enough to offset the losses from the lower tax rate, at least not in the short or medium term. In fact, they may not increase economic growth at all.

How can I say that? How can I call myself a libertarian? Don’t I understand Econ 101?

Well, yes. But here’s another concept from Econ 101 that is crucial to understanding why tax cuts have not worked out as some Republicans hoped: elasticity.

Elasticity tells us how strongly people respond to price changes. We say that goods are price inelastic when demand doesn’t change much no matter how high the price goes (think of drinking water in the desert). A very elastic good, on the other hand, is one where the price matters a great deal. Think of, say, those little paper umbrellas they put in drinks. Many of us would probably be willing to pay a penny to give our drinks a pretty little shade from the sun. Many of us would refuse to pay a dollar. Almost no one would splurge as much as $5 for such a superfluous decoration.

People who expected great things from tax cuts were essentially hoping that labor supply was very elastic; if you changed the price people got for working, they’d respond by working a lot more. It turned out to not be not nearly as responsive as hoped, in part because this mental model of how markets worked was incomplete.

You see, people had been thinking of labor supply as being a pretty simple matter of substitution effects. What do I mean by that? Well, work involves a trade-off between leisure, and consumption of everything else. High income tax rates essentially worsen the exchange rate between leisure and “everything else,” so that people tend to consume more leisure than they would in a world without the taxes. Thus, everyone ends up materially poorer, though richer in free time. Cutting those tax rates, it was theorized, would make work more attractive.  We’d get a lot more “everything else,” some of which could be skimmed off the top by the government to make up for the tax revenue they’d lost by cutting rates.

Unfortunately, they’d forgotten about income effects: Our demand for goods changes as our income does. If you only have $5 to spend for one day’s worth of food, a loaf of bread and a jar of generic peanut butter probably sounds like a pretty decent way to allocate your cash. As you get a little more money, you might buy brand-name peanut butter, maybe some jelly. By the time your food budget reaches $1,000 for the day, you’re probably not eating peanut butter at all.

This is as true of leisure as it is of everything else. Yes, as your hourly wage rises, each additional hour of leisure is more costly in terms of other stuff you could buy. On the other hand, it’s also more enjoyable. If all you can afford to do with your leisure time is sit on your stoop and talk to your neighbor about her cat’s angina, you’re not really giving up much by going to work. If you have a yacht and can afford to cruise around the world staying in fine resorts, each hour of leisure lost is more painful.

I haven’t even gotten into complex effects, like the fact that many high-income, high-status people like working. I mean, they also like paying lower taxes, because who doesn’t like more money? But that doesn’t mean that if you lower their tax rates, you’ll actually get substantially more effort out of them. They may already be working about as hard as they can without dropping dead.

These are empirical questions, mind you: Whether the substitution effects of lower taxes outweigh the income effects depends on many factors, including how high the existing tax rate is, what sort of value your culture places on work and leisure, how much flexibility you have to decide how many hours you work, and how enjoyable the work available is. But it’s safe to say that in America, in the late 20th and early 21st century, they didn’t outweigh the income effects, and the other various factors keeping work rates relatively constant, enough to pay for themselves, or even come close. Nor did they dramatically goose the growth rate. As long as tax rates are kept within a reasonable range, most of what happens in the economy will end up being determined by other factors, such as regulation, technological change, demographics, and the individual decisions made by millions of people about what they want to do with their lives.

And yet, this simple view of how taxes affect labor supply remains common currency among Republican voters, and Republican politicians. What happened in Kansas is a reminder of the costs of betting too hard on what we know that ain’t so.

(Corrects change to tax rate in ninth paragraph.)

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