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The #LafferCurve Doesn’t Work Like That!!

And A Misunderstanding Of Capitalism Too

Oh man. I really do not like Megan McArdle. Weasels like her and Ezra Klein are only just now sounding the alarm on ObamaCare after it is starting to really fall apart. But I really did not come here to talk about ObamaCare.

I was reading Megan McArdle’s article about Keynesianism, where she just mows it down like a freight train:

I find it interesting that an economic model with zero percent mindshare among professional macroeconomists has nearly 100 percent mindshare among public intellectuals and politicians.

Peach it sister! But then she attacks the Laffer Curve:

Consider the supply-siders. The thing is intuitively appealing; when we get more money from working, we ought to be willing to work more hours. And it is a mathematical truism that revenue must maximize at some point. Why couldn’t we be on the right-hand side of the Laffer Curve?

It was entirely possible that we were; unfortunately, it wasn’t true. And one of the reasons that supply-siders failed was that they were captivated by that one appealing intuition. In economics, it’s known as the “substitution effect” — as your wages go up, leisure becomes relatively more expensive relative to work, so you tend to do less of the former, more of the latter.

Unfortunately, the supply-siders missed another important effect, known as the “income effect”. Which is to say that as you get richer, you demand more of some goods, and less of others. And one of the goods you demand more of as you get richer — a class of goods known as “superior goods” — is leisure.

Of course, some people are so driven that they will simply work until they drop in the traces. But most people like leisure. So say you raise the average wage by 10%. Suddenly people are bringing home 10% more income every hour. Now, maybe this makes them all excited so they decide to work more. On the other hand, maybe they decide they were happy at their old income, and now they can enjoy their old income while working 9% fewer hours. Cutting taxes could actually reduce total output.

(We will not go into the question of how much most people can control their hours — on the one hand, most people can’t, very well, but on the other hand, those who can tend to be the high-earning types who pay most of your taxes.)

Which happens depends on which effect is stronger. In practice, apparently neither was strong enough to thoroughly dominate, at least not when combined with employers who still demanded 40 hour weeks. You do probably get a modest boost to GDP from tax cuts. But you also get falling tax revenue.

Oh Dear Lord in Heaven, where do I start? Ok, let us first go into what supply-side economics is all about:

[The] idea that greater tax cuts for investors and entrepreneurs provide incentives to save and invest, and produce economic benefits that trickle down into the overall economy. …

Like most economic theories, supply-side economics tries to explain both macroeconomic phenomena and – based on these explanations – offer policy prescriptions for stable economic growth. In general, supply-side theory has three pillars: tax policy, regulatory policy and monetary policy.

However, the single idea behind all three pillars is that production (i.e. the “supply” of goods and services) is most important in determining economic growth. The supply-side theory is typically held in stark contrast to Keynesian theory which, among other facets, includes the idea that demand can falter, so if lagging consumer demand drags the economy into recession, the government should intervene with fiscal and monetary stimuli.

This is the single big distinction: a pure Keynesian believes that consumers and their demand for goods and services are key economic drivers, while a supply-sider believes that producers and their willingness to create goods and services set the pace of economic growth.

There it is, the difference between Keynesianism and Supply-Side is the difference between consumer demand and production. A consumer based economy will need inflation to move it along, while inflation will kill a production based economy. Before we can do anything else however, we still have some definitions to clear up first.

Megan McArdle describes the “substitution effect” as “your wages go up, leisure becomes relatively more expensive relative to work, so you tend to do less of the former, more of the latter.” That is aboslute nonsense. The “substitution effect” is when one product or service’s demand is increased when the price of another “substitute” product or service increases. Conversely, the demand for a product or service is decreased when the price of another “substitute” product or service decreases. This has nothing to do with leisure or wages!*

Megan McArdle also describes the “income effect” which has something to also to do with leisure. This is also absolute nonsense. The “income effect” is baicly a change in consumption arising from the effect on real income of a change in the price of goods or services. A great example of this is when a neighborhood gets richer, the price of goods and serices in that neighborhood also go up. Again, this has nothing to do with leisure.**

Both concepts are neither good or bad, they just are observed effects. The problem with Megan McArdle, is that she does not understand capitalism. With her butchered explanation of the “substitution effect” she goes on to say when “your wages go up, leisure becomes relatively more expensive relative to work, so you tend to do less of the former, more of the latter.”

So she thinks that the more expensive your life style is, the less incline you are willing to work. That is so dumb, everyone is dumber for having to read it and I am sorry for reprinting it here. One of the things capitalism is based on, is if you are willing and able to work to pay for it. It is called “credit” and has been around since modern accounting, but the bill must be paid. You cannot have a high life style and not work to maintain it. If you yourself do not work, then you can also have either someone work for your high life style or earlier investments work for you (this is why we find the Capital Gains Tax so offensive).

Another thing about capitalism is also about moving up in the world, or moving down. One day you are poor, then find you are rich. Then poor again. In capitalism, there is no (or should not be) a permanent class. You do or you die. This will happen without government picking winners and losers. The left loves Darwinism, right up until they get into the economy.

In socialism and communism, in theory, since not everyone can not be rich, everyone has to be poor. In practice, there are the rich (the intellectual elite or leaders) or the poor (the worker). There is where you will find the permanent classes. Reread Nineteen Eighty Four and Animal Farm if you doubt me. Reread the history of the Soviet Union or China today, if you still doubt me!

Megan McArdle’s extreme misunderstanding of the Laffer Curve, just floors me. The Laffer Curve just explains the diminishing return of very low or very high marginal tax rates. You tax too high, then people will just not work. You tax too low, you will run government deficits. The problem (and it is only a small problem, in my opinion) is that the Laffer Curve only plots the 0% marginal tax rate and the rest is just theory. So we conservatives have choosen to just low ball taxes and then just cut the size of government.

Here’s a great video that really explains the Laffer Curve in better detail:

Again, the Laffer Curve just shows us lower tax rates “would be more than offset by a higher tax revenue base, due to greater employment and productivity.”

Remember that supply-side is more than just tax policy. It is also about regulatory policy and monetary policy. Government regulations and quantitative easing always works against production. If you just cut taxes, production will still be eaten up by regulations and inflation. We need to incentivize private sector production and that is what supply-side is all about.

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*Updated.

**I stand behind this explanation and example.

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