Ever since economist Arthur Laffer drew his namesake curve on a napkin for two officials in President Richard Nixon’s administration four decades ago, we have been told that cutting tax rates spurs jobs and higher pay, while hiking taxes does the opposite.
Now, thanks to recent tax cuts in Kansas and tax hikes in California, we have real-world tests of this idea. So far, the results do not support Laffer’s insistence that lower tax rates always result in more and better-paying jobs. In fact, Kansas’ tax cuts produced much slower job and wage growth than in California.
The empirical evidence that the Laffer curve is not what its promoter insists joins other real-world experience undermining the widely held belief that minimum wage increases reduce employment and income.
Laffer in Kansas
The Laffer curve refers to a theory of marginal effects of tax rates on tax revenues, which goes back hundreds of years, at least to a 15th century Muslim scholar named Ibn Khaldun.
Laffer’s model illustration looks like a bullet pointed to the right. It shows that the government collects no revenue when tax rates are at 0 or 100 percent. As tax rates rise, revenue does until reaching an unspecified rate that Laffer calls “prohibitive.” Above that level, as tax rates rise, government revenues fall off quickly.
Laffer qualifies many of his assertions about changes in tax rates, noting that tax cuts may result in less government revenue, for example. But on one issue from the Laffer curve, he is absolute:
Tax rate cuts will always lead to more growth, employment and income for citizens, which are desirable outcomes leading to greater prosperity and opportunity.
Is this absolute rule right? Let’s consider the tax law changes in Kansas and California that took effect at the start of last year.
When Sen. Sam Brownback ran for governor in 2010, he said he wanted to turn the state into a low-tax paradise and eventually to eliminate the state income tax — Kansas’ largest source of revenue, at about $2.7 billion. (Sales taxes, the state's second largest revenue source, brought in $2.25 billion.) The Brownback administration paid Laffer $75,000 for his advice on the tax cuts.
In 2012 Brownback signed his tax cuts into law. The bottom rate was cut from 3.5 percent to 3 percent. The top rate, which starts at $15,000 of taxable income for singles, was lowered from 6.25 percent to 4.9 percent.
The biggest impact was on 191,000 businesses. Their profits are now tax-free, though wages paid to owners remain taxable. This change prompted many owners of corporations to convert to partnerships and other forms of ownership that the law exempted from the income tax.
Beneficiaries of this change included Charles and David Koch, the billionaire brothers who are the richest people in Kansas. Much of their $82 billion of known wealth is in businesses that are now eligible to earn profits without owing Kansas state income taxes.
Moody’s Investors Service lowered the state’s credit rating after the $800 million of tax cuts took effect, a move Brownback dismissed as telling more about Moody’s policies than Kansas’ finances. Later Standard & Poor’s also downgraded Kansas bonds, citing “a structurally unbalanced budget,” in which taxes were cut more than spending.
The same month the Kansas tax rate cuts began, tax rates rose in California. For those making $500,000 or more, rates went up about 30 percent. Californians voted to raise the state sales tax by a quarter of a percentage point, to 7.5 percent, the nation’s highest rate.
So how did Kansas fare against California?
From January 2013 through September 2014, the latest data, California grew jobs at 3.4 times the rate of Kansas. Total nonfarm payroll jobs in Kansas increased 2.1 percent, in California 7.2 percent. The rate of cutting government jobs was also larger in California than in Kansas, Bureau of Labor Statistics data show.
Tax hikes did not hurt California job growth because the taxes were not on jobs but on high incomes.
Compensation in California also grew faster than in Kansas. California’s average weekly wage of $1,165 in the first quarter of this year was 13.4 percent higher than in mid-2012, while the Kansas average of $840 was up only 10.1 percent.
California’s credit rating improved. The Golden State can borrow at lower rates, while Kansas will have to pay more to compensate investors for the risk that the Sunflower State will lack the revenue to repay its debts.
Opponents of California’s tax-rate hike predicted that it would cause the rich, especially entrepreneurs, to flee the state. They did not. That’s because making big money typically requires living where one’s business is. A big Los Angeles car dealer would not sell nearly so many cars in Topeka.
Rich retirees can move, but they are a small slice of the high-income pie. Empirical research shows that most rich retirees stay put.
Tax hikes did not hurt California job growth because the taxes were not on jobs but on high incomes. A stiff state payroll tax that made each worker costlier would have dampened hiring because it would raise the overall cost of labor. But quitting California because the state takes $30,000 more out of each additional million dollars that top earners make would be penny wise and pound foolish: They can make more money staying in California
In Kansas job growth was weak because of economic conditions, including cuts in state spending that weakened the economy. The lowered tax rates were simply not attractive enough to draw entrepreneurs to a Plains state with the same level of government services available in neighboring states.
What about the effects of minimum-wage hikes? The dominant economic theory holds that raising the minimum wage should result in fewer jobs, though possibly more total income. Last January a Congressional Budget Office study estimated that gradually raising the $7.25 federal minimum wage to $9 by 2016 would result in 300,000 people being lifted out of poverty and $4 billion of additional income for people with income up to three times the official poverty level — about $24,000 for a family of four. But it also predicted fewer jobs. A $10.10 minimum wage would produce larger overall income benefits but cost jobs.
But real world data does not support the theory. Various studies have shown that employment and income may both rise with increases in the minimum wage.
The best data comes from counties that border one another but belong to different states, with one state raising its minimum wage and the other not.
A rigorously designed analysis of 504 such bordering counties by economists found “strong earnings effects” — meaning workers were paid significantly more in those counties which raised minimum wages — with “no detectable employment losses from the kind of minimum wage increases we have seen in the United States.”
We will get an excellent real world test of this once data become available breaking out the rest of California’s wealthy Santa Clara County from the county seat of San Jose, which raised its minimum wage $2 an hour, to $10 last year, and added 15 cents more this year.
It would make little sense for someone in San Jose to drive to Sunnyvale or Saratoga or Milpitas solely to save a few bucks on menu prices, because the cost of driving there would not be worth it. It would also not be worth the time spent avoiding higher prices, especially in Silicon Valley, where those with computer and related skills command high pay.
Facts over theory
Ultimately, real world results trump theory. Actual changes in the number of jobs and what they pay should be used to set policy, not ideology, assumptions and expectations.
Over a long time, the real world results from the tax cuts in Kansas and increases in California as well as the freezing of minimum wages in some jurisdictions while neighbors raise theirs may change.
My expectation, however, is that the gaps will widen, with higher tax California and higher minimum wage areas doing better over time than places like Kansas that cut taxes or that froze their minimum wage. Time will tell. The important thing is that policy should follow the facts, no matter where they go.
Laffer curve test results
The Laffer curve theory says tax rate cuts will always lead to more growth, employment and income for citizens. California raised taxes; Kansas cut them. Yet jobs grew twice as fast in California. Average wages also increased more in California.