Faced with the self-conflicting demand for better health coverage without significant tax hikes, Maine legislators earlier this year considered a fifty cent cigarette tax increase as a way to modestly expand its health program. Broad, progressive, and sustainable tax increases were still out of the question given the political climate in the state, but legislators realized they may be able to raise a smaller and less important tax. Despite being starkly regressive, cigarette taxes have become an extremely popular revenue source among states since they tend to be less controversial than hikes in income, property, or general sales taxes. But having already doubled its cigarette tax in 2005, Maine policymakers soon had to back down from this idea.

The legislature, to its credit, didn’t give up completely in its effort to find funding with which to expand health care coverage. The debate then turned toward another relatively minor tax – alcohol and soda taxes. The argument was made that these products should be taxed more heavily because of their link to higher health care costs, but the more salient reason for the proposal was undoubtedly its perceived political feasibility. Rather than making the hard decision to raise taxes broadly in order to meet the goal it set for itself five years ago, the legislature tried to take the easy way out.

But in Maine, apparently any tax increase isn’t so easy. In response to the tax hike, the “Fed Up With Taxes” coalition was formed, consisting largely of restaurant owners and other related business interests. The coalition is already collecting signatures at restaurants across the state in hopes of getting a repeal of the tax on the ballot.

Despite proceeding so cautiously in search of a revenue source that wouldn’t get them into too much trouble with the voters, the end result of this legislative session may ultimately be a failure to find any way to secure additional funding for the uninsured.

This sudden challenge to the beverage tax suggests that the blame for the lack of funding for the Dirigo health plan should not be placed on legislators – but that the root cause of this embarrassment is instead a refusal on the part of voters to take responsibility for paying for programs they believe to be worthwhile. Across the country the clear preference has been for lower taxes and better government services. These two demands cannot be reconciled, and their interaction has helped contribute to both the national debt and to the avalanche of fiscal problems at the state level.

Too often, voters unwilling to accept higher taxes point to cutting “wasteful spending” as the source of revenues from which favored programs should be enacted or expanded. While wasteful spending certainly does occur, it’s likely not of the magnitude most believe it to be, and identifying it accurately is not a simple, uncontroversial, or inexpensive process. It’s easy to blame whatever one believes to be “wasteful spending” when revenues start to fall short, but the reality is that there’s no easy solution to funding more government services.

Taxpayers either need to learn to expect less from their government, or they need to take responsibility for chipping in to pay for government services. A failure to do these things is what led to the current situation in Maine where a heated battle appears imminent over a tax hike that in the grand scheme of things is too small to substantially improve upon the health care situation in the state. If voters ever decide that they are willing to pay what is needed for government services, the result will be a climate of debate in which sensible reform of the tax system can be enacted. That situation would certainly be preferable to the current one where minor, disjointed, and often regressive tax increases at the margin have the best chance of gaining approval.

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Enter John McCain. According to Senator McCain,

“tax cuts, starting with Kennedy, as we all know, increase
revenues”.

If true, the Senator from Arizona has found a way around one of the most dreaded problems facing our lawmakers. No longer must we weigh the pros and cons of higher taxes vs. better services. No, in McCain’s world, lower taxes and better services are a natural pair. In fact, according to McCain, the tradeoff between taxes and services that policymakers have wrestled with for centuries is not only unnecessary, but also nonexistent:

“historically, when you raise people’s taxes, guess what, revenue goes down”. – Senator John McCain

Lower taxes aren’t just the easy way to get more revenue – they’re actually the only way!

The Laffer Hypothesis: Show Me The Money?

If only it were that easy. What McCain is referring to is the infamous “Laffer Curve”, or “Laffer Hypothesis”. Under this hypothesis, it is asserted that U.S. tax rates are so high that investment and overall economic activity has been greatly stifled. So stifled, in fact, that since individuals and businesses are paying so much of what they earn to the government, the incentives to take risks and work hard have been effectively removed from the economy – as a result, markedly less taxable economic activity is being than would otherwise be the case. With less taxable activity, there is less tax revenue. Under these extreme circumstances, lowering tax rates should actually boost economic activity to the degree that tax revenues will increase.

Unfortunately for McCain, the evidence against the Laffer Hypothesis is staggering, and few if any serious economists believe the hypothesis to be applicable to the U.S. tax code in its current state. The Department of the Treasury authoritatively showed this to be the case in this 2006 report. That report shows that in each of the four years following the 1981 and 2001 tax cuts, revenue markedly declined. In contrast, following the 1993 tax increases, revenue increased. Simple as that. It seems that the tradeoff does in fact exist: if you want more money to go to funding government services, you’re going to have to pay more in taxes. This really shouldn’t be all that surprising.

Not Just No Revenue … No Growth, Either!

While the Treasury report just cited is more than enough to refute the Laffer Hypothesis on its own, there is also a wealth of literature examining the hypothesis’ premises. Specifically, that literature looks at the merits of what is known as “supply-side economics”, or the school of thought that cutting taxes for businesses and wealthy investors (the “suppliers”, as opposed to the “consumers” in the economy) will markedly improve economic growth. In the American political landscape, this rationale for tax cuts has been equally if not more important than the issue of what will happen to government revenues.

Unfortunately, however, this rationale has been proven to have little if any merit. Ironically, not only have so-called “pro-growth” and “pro-investment” tax cuts been demonstrated to be incapable of raising revenues, they have also been shown (at least in their most recent manifestations) to be incapable of promoting growth or investment. The Center for American Progress (CAP) and the Economic Policy Institute (EPI) recently teamed up to add to the body of literature on this point with their report, “Take a Walk on the Supply Side: Tax Cuts on Profits, Savings, and the Wealthy Fail to Spur Economic Growth“.

In their report, CAP and EPI find that investment growth, as well as overall economic growth, were much stronger in the years following the 1993 federal tax hike, than in the years following the 1981 and 2001 tax cuts. Numerous other indicators suggest a similar finding: median household income, wages, employment growth, and of course, the federal budget, were all in much better shape following the 1993 tax hike than during either of the periods that followed “pro-growth” tax cuts.

Of course, tax policy isn’t the only determinant of economic performance. But if the supply-side argument has any merit, we shouldn’t have seen the economy surge so dramatically following “anti-growth” tax hikes, and fizzle in an equally dramatic fashion in the wake of “pro-growth” tax cuts. At the very least, we would have expected these opposing sets of tax policies to have brought these three periods closer into line with each other. Simply put, when the supply-siders got their chance in 1981 and 2001, they failed to produce results, and dug the nation deep into debt.

Backed by the Politicians, Refuted by the Experts

But aside from all the empirical evidence regarding the Laffer Hypothesis (the CAP/EPI report, as well as another EPI Report from Harvard Economist Jeffrey Frankel already cover that ground more than adequately), the other important point for today’s debate is what to make of various politicians’ inexplicable belief in this thoroughly disproved hypothesis. The allure of putting more money into the taxpayer’s pocket (via tax cuts) while at the same time putting more money into the government’s coffers (through increased economic activity and the associated higher tax revenues) is apparently irresistible, as evidenced by the following quotes taken from Frankel’s paper:

“The increase in revenues should be financed not by new and higher taxes, but by lower tax rates that would produce more money for the government by stimulating higher earnings by corporations and workers”
- President Ronald Reagan

“Some in Washington say we had to choose between cutting taxes and cutting the deficit. That was a false choice. The economic growth fueled by tax relief has helped send our tax revenues soaring. That’s what’s happened”
- President George W. Bush

“The deficit would have been bigger without the [2001] tax relief package”
- President George W. Bush

“It’s time for everyone to admit that sensible tax cuts increase economic growth, and add to the federal treasury”
- Vice President Cheney

More quotes of a similar vein can be found in Frankel’s paper. Also contained in that piece are valuable quotes directly from each of these administrations’ chairmen of the President’s Council of Economic Advisers. The statements of these highly trained economists reflect a remarkably different opinion on the Laffer Hypothesis:

“The height of supply-side hyperbole was the ‘Laffer curve’ proposition that the tax cut would actually increase tax revenue because it would unleash an enormously depressed supply of effort . [this has been] proven to be wrong”
- Martin Feldstein, chairman of the Council of Economic Advisers under President Reagan

“Although the economy grows in response to tax reductions, it is unlikely to grow so much that lost tax revenue is completely recovered by the higher level of economic activity”
- Glenn Hubbard, chairman of the Council of Economic Advisers under President George W. Bush

“Subsequent history failed to confirm Laffer’s conjecture that lower tax rates would raise more tax revenue. When Reagan cut taxes after he was elected, the result was less tax revenue, not more”
- Greg Manikew, chairman of the Council of Economic Advisers under President George W. Bush

The conflict between these two sets of quotes reflects deep divisions between the politicians and the experts with which they surround themselves. John McCain fits this pattern perfectly. Since McCain is not President (at least not yet), he does not have his own Council of Economic Advisers to refute his wild claims regarding tax cuts. He does, however, have Douglas Holtz-Eakin as his Senior Policy Adviser. Holtz-Eakin is a Princeton-trained economist and former head of the Congressional Budget Office. He also is on record as explicitly rejecting the Laffer Hypothesis.

But McCain isn’t taking Holtz-Eakin’s word for it. Aside from the quotes from John McCain cited earlier, further deference to the Laffer Hypothesis from the McCain camp has been evidenced by the candidate’s choice of Arthur Laffer, the chief proponent of the Laffer Hypothesis, as one of the campaign’s special economic advisers.

This whole asinine situation brings to mind McCain’s previous admission that “the issue of economics is something that I’ve never really understood as well as I should”. Perhaps, given his inadequacies in the subject area, he would be better off deferring to those who do understand it. More “pro-growth” tax cuts targeted to the most fortunate members of society, like McCain’s, are the exact opposite of what is needed.

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