Can Tax Cuts Really Pay for Themselves?

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.

Originally published at https://mytwocentsandcounting.substack.com.