Can Tax Cuts Really Pay for Themselves?
The short answer is "almost certaintly not"
Sometimes you hear the claim “These tax cuts will pay for themselves.” The idea behind is that taxes suppress economic activity, which is in general true. So if you cut taxes and economic activity increases by a LOT, you can in principle have tax revenue go up: the tax rate is lower, but the amount being taxed is so much higher that the tax revenue, which is the product of the two, is higher too.
Is this possible? Yes, in theory. There’s an idea called the “Laffer curve”, named after Arthur Laffer, who first described it. Suppose the tax rate is 0%. Total tax revenue is of course 0. Now suppose the tax rate is 100%. Revenue will also be zero – no one will do something where EVERYTHING they make gets taxed away by the government.
If the tax rate is initially zero, then increasing it will of course also increase tax revenue. But because a 100% tax also has zero revenue, there must be a tax rate beyond which tax revenue starts going back down as the tax rate increases. Clearly, we never want to be on the downward sloping side of the Laffer curve in a typical market because then you’re just reducing economic activity and not even getting a higher tax revenue as a result. The clear solution in that case would be to lower the tax rate: both economic activity and the tax revenue will increase.
The next question is, are we actually on the wrong side of the Laffer curve? Here, things get more complicated because this is an empirical and not a theoretical question. But the short answer is, there’s no evidence that the US is anywhere near the wrong side of the curve. There’s some evidence that Europe is near the peak of the Laffer curve—where tax revenue is maximized—but still on the side where cutting taxes decreases revenue. So tax cuts will not pay for themselves – if the US or Europe lower the tax rate, tax revenue will decrease.
This doesn’t mean it’s always a bad idea to cut taxes. Tax cuts will increase economic activity to some extent, just not enough to pay for themselves. But the government also needs tax revenue to pay for things that private markets are bad at providing, so some taxation is necessary. Unfortunately, there’s still no such thing as a free lunch.
Thanks for your commentary, with which I largely agree. In his 1997 edition of his textbook “Principles of Economics” Harvard professor of Economics Greg Mankiw used the phrase as “charlatans and cranks” (1) to describe the advisors of President Reagan who promoted the falsehood that broad based income tax cuts would pay for themselves. Yet, the discredited idea has persisted, promoted by politicians (mostly Republican) and economists such as Stephen Moore, whose relationship with the truth could, in my opinion, be described as estranged.
Tax cuts paying for themselves may be popular because tax payers don’t like taxes. And those of us old enough to remember the 1970s stagflation and gas lines, are also old enough to remember the economic recovery of the 1980s, which is too often attributed to Reagan’s tax cuts. Two other factors were arguably much more important to the 1980s recovery: falling energy prices, (2) and falling interest rates. Oil prices started falling within a month of Reagan taking office and remained low for his two terms. Reagan claimed it as due to his deregulation, but he only expedited by a few months a deregulation plan that President Carter had initiated. Oil prices fell due to increased production and moderation of demand by conservation measures. Interest rates fell because inflation had been reduced thanks to the action of the FED headed by Paul Volcker, who had been appointed by Carter.
During the 1980 Republican primary campaign, Reagan claimed his economic plan would eliminate the fiscal deficit. Candidate George H.W. Bush called it “Voodoo Economics” because the numbers did not add up. We now know that Bush was correct, but Reagan won the election and became very popular politician. Subsequent politicians advocating for “Reaganomics” (aka “Voodoo Economics”) have failed to produce 1980s economic recoveries probably because of the flawed math and conditions have changed. Bruce Bartlett was on Reagan’s team and in 2023 gave Congressional testimony (3) about his view of changing conditions, including the view that the Bush and Trump tax cuts provided little economic stimulus. From a different perspective, Oren Cass also doubts the stimulus effect of the Trump tax cut. (4)
Sources:
1) https://gregmankiw.blogspot.com/2007/07/on-charlatons-and-cranks.html
2) https://washingtonmonthly.com/2012/05/29/like-president-reagan-obama-or-romney-could-benefit-from-falling-energy-prices/
3) https://www.budget.senate.gov/imo/media/doc/Mr. Bruce Bartlett - Testimony - Senate Budget Committee1.pdf
4) https://www.understandingamerica.co/p/tax-cuts-as-tragedy-then-farce