"Missing Elements" of Mr. Laffer's Incomplete StoryJune 7, 2010
by Asha Bangalore
by Asha Bangalore
Stepping forward from Laffer's utopic economic era, why did the economy post noticeable growth after tax increases were implemented in 1993? The recession ended in March 1991 and the banking system was beset with issues, which delayed the robust recovery until later. A revival of bank lending led to the self-sustained growth witnessed despite the tax increases instituted in 1993 by the Clinton administration. If Laffer's thesis about tax cuts is valid, why did the U.S. economy record the weakest period of economic expansion following the Bush tax cuts of 2001 and 2003? The evidence from tax cuts is essentially not as strong as Mr. Laffer's leads the reader to believe.
The best method to compare the performance of the economy across these three business cycles is by using an index chart. The index chart (see chart 2) sets the level of real GDP in each trough at 100 and plots the corresponding growth of the economy. An index reading of 108 in this chart stands for 8% increase in real GDP growth from the trough. Real GDP's outstanding performance in the 1982-1990 expansion exceeds the imprints of the next two business expansions without doubt. As shown in the chart, real GDP of the U.S. economy had risen 25% by the end of the expansion which stretched from March 1991 to March 2001, while the U.S. economy recorded a growth of 18% between the trough and peak of the expansion during November 2001 and December 2007. In other words, economic growth registered during the Bush-II period is roughly 72% of the GDP gain recorded after the Clinton tax increases.
An important aspect to note is that the federal budget deficit has recorded a surplus only during 1998-2001 (see chart 3) when considering the different tax regimes since the early 1980s. The budget deficits after the Bush tax cuts were exacerbated by war-related expenditures and support programs to stabilize economic conditions after the financial crisis unfolded in August 2007.
It is not clear yet if the Bush tax cuts will expire in 2010. Given the fragile state of the economy, it is entirely possible that the tax cuts will be extended into 2011. Assuming the tax cuts are allowed to expire, the forces that may prevent strong economic growth in 2011 are entirely different from tax increases. The headwinds from the financial sector, by way of a severe credit crunch, lackluster job growth, and housing market challenges are factors that will influence the near term path of the economy. The evidence presented here suggests that Mr. Laffer's story is selective and incomplete. Many factors will play a role in how the U.S. economy performs in the next few years in addition to taxes.