POLICY PERSPECTIVES

tax notes
The Laffer Curve, Part 2
By Bruce Bartlett
Bruce Bartlett is a former Treasury deputy assistant secretary for economic policy. His latest book is The Benefit and the Burden: Tax Reform Why We Need It and What It Will Take (2012). Part 1 of this article examined the origins of the Laffer curve in the 1970s. Bruce Bartlett This part looks at the pre20th-century antecedents, examining both tax and trade policy debates regarding whether rate increases reduce revenue and rate cuts increase it.

Interestingly, there is a paper trail suggesting that Khaldun actually may have planted the seeds of supply-side economics. It begins with an article about him that appeared in the Journal of Political Economy in 1971, which cited his views on taxation.3 At the time the article was accepted, Robert Mundell, one of the founding fathers of supply-side economics and winner of the Nobel Memorial Prize in economics in 1999, was editor of the journal. I once asked Mundell whether the article was his introduction to Khaldun. He replied: I had become somewhat of a fan of Ibn Khaldun in my Chicago days, and I thought it prophetic that he was born exactly 600 years before I was! I vaguely recall accepting the Boulakia piece on Ibn Khaldun, and it would have to have been me because the lead time between acceptance and publication is usually from one to two years, but sometimes less or longer. It was not so much that I learned much about Ibn Khaldun from the article (although I probably did), but that I accepted this offbeat article because I thought others should learn about him.4 Mundell said he brought Khaldun to the attention of Wall Street Journal editorial writer Jude Wanniski. Wanniski was undoubtedly responsible for publishing a long excerpt from The Muqaddimah on The Wall Street Journal editorial page on September 29, 1978. Probably more people read Khaldun that day than in the previous six centuries.5 Among those who likely read that excerpt was Ronald Reagan, then a private citizen writing columns and doing radio commentary. While it is not known precisely when Reagan became acquainted with Khaldun, we do know that he mentioned him by

When the Laffer curve came on the scene in the 1970s, it seemed very new.1 But it quickly became apparent that it was not an original idea at all. Its antecedents date back hundreds of years. Ibn Khaldun Perhaps the oldest reference to something like the Laffer curve comes from a 14th-century Muslim philosopher named Ibn Khaldun. In his masterwork, The Muqaddimah, written in 1377, he wrote: It should be known that at the beginning of a dynasty, taxation yields a large revenue from small assessments. At the end of the dynasty, taxation yields a small revenue from large assessments. . . . When tax assessments and imposts upon the subjects are low, the latter have the energy and desire to do things. Cultural enterprises grow and increase, because the low taxes bring satisfaction. When cultural enterprises grow, the number of individual imposts and assessments mounts. In consequence, the tax revenue, which is the sum total of (the individual assessments), increases.2

Bruce Bartlett, The Laffer Curve, Part 1, Tax Notes, July 16, 2012, p. 299, Doc 2012-14599, or 2012 TNT 136-6. 2 Ibn Khaldun, The Muqaddimah, trans. Franz Rosenthal, abridged ed. (1967), at 230.

3 Jean David C. Boulakia, Ibn Khaldun: A FourteenthCentury Economist, Journal of Political Economy (Sept./Oct. 1971), at 1105. 4 Robert Mundell to Bruce Bartlett, June 2, 2002, via e-mail. 5 Khaldun was not totally unknown to economists before the Journal of Political Economy article. See Joseph Spengler, Economic Thought of Islam: Ibn Khaldun, Comparative Studies in Society and History (Apr. 1964), at 268; Suphan Andic, A Fourteenth Century Sociology of Public Finance, Public Finance (1965), at 22.

TAX NOTES, September 3, 2012

COMMENTARY / POLICY PERSPECTIVES

name on 10 different occasions as president and in his last major public statement before he succumbed to Alzheimers.6 Jonathan Swift Another early developer of the Laffer curve was the famous satirist Jonathan Swift. In 1728 he wrote an essay that explained how high tariff rates reduce revenue. Said Swift: I will tell you a secret, which I learned many years ago from the commissioners of the customs in London. They said, when any commodity appeared to be taxed above a moderate rate, the consequence was to lessen that branch of the revenue by one half; and one of those gentlemen pleasantly told me, that the mistake of Parliaments, on such occasions, was owing to an error of computing two and two to make four; whereas, in the business of laying heavy impositions, two and two never made more than one; which happens by lessening the import, and the strong temptation of running such goods as paid high duties.7 The significance of this passage was enormous. Adam Smith, David Hume, Jean-Baptiste Say, James Madison, and Alexander Hamilton are just a few of the important thinkers who cited this anecdote of Swifts to argue that high tax and tariff rates reduce revenue.8 As Smith put it: The high duties which have been imposed upon the importation of many different sorts of foreign goods, in order to discourage their consumption in Great Britain, have in many cases served only to encourage smuggling; and in all cases have reduced the revenue of the customs below what more moderate duties would have afforded. The saying of Dr. Swift, that in the arithmetic of the customs two and two, instead of making four, make sometimes only one, holds perfectly true with regard to such heavy duties, which never could have been imposed, had not the mercantile system

taught us, in many cases, to employ taxation as an instrument, not of revenue, but of monopoly.9 In The Federalist No. 21, Hamilton expressed his debt to Swift. As he wrote: It is a signal advantage of taxes on articles of consumption that they contain in their own nature a security against excess. They prescribe their own limit; which cannot be exceeded without defeating the end proposed that is, an extension of the revenue. When applied to this object, the saying is as just as it is witty, that, in political arithmetic, two and two do not always make four. If duties are too high, they lessen the consumption; the collection is eluded; and the product to the treasury is not so great as when they are confined within proper and moderate bounds. Nineteenth-Century Tariff History Throughout the 19th century, there were many occasions in which the Laffer curve was evident in the relationship between tariff rates and revenues. For example, in 1826 a drafting error accidentally reduced the duty on tobacco in Great Britain by one-fourth. Rather than reduce revenue, the diminution of smuggling caused revenues to increase.10 Laffer curve arguments were often invoked both as a justification for lowering tariffs and for increasing them. As early as 1842, Sen. John C. Calhoun of South Carolina, an ardent free trader, clearly articulated a version of the Laffer curve during debate on the tariff. Said Calhoun: On all articles on which duties can be imposed, there is a point in the rate of duties which may be called the maximum point of revenue that is, a point at which the greatest amount of revenue would be raised. If it be elevated above that, the importation of the article would fall off more rapidly than the duty would be raised; and if depressed below it, the reverse effect would follow: that is, the duty would decrease more rapidly than the importation would increase. If the duty be raised above that point, it is manifest that all the intermediate space between the maximum

Reagan cited Khaldun on Sept. 2 and Oct. 1, 1981; Apr. 25, 1985; May 14, 1986; and Jan. 20, Mar. 25, May 24, Nov. 14, Dec. 1, and Dec. 16, 1988. He also cited him in an op-ed, There They Go Again, The New York Times (Feb. 18, 1993). 7 Jonathan Swift, Irish Tracts, 1728-1733, ed. Herbert Davis (1964), at 21. 8 Bartlett, Jonathan Swift: Father of Supply-Side Economics? History of Political Economy (Fall 1992), at 745; Jean-Baptiste Say, A Treatise on Political Economy (1834), at 454; Gaillard Hunt, The Writings of James Madison (1901), vol. 2, at 306.

9 Adam Smith, The Wealth of Nations, ed. Edwin Cannan (1937), at 832. 10 Stephen Dowell, A History of Taxation and Taxes in England (1888), vol. 2, at 283.

TAX NOTES, September 3, 2012

COMMENTARY / POLICY PERSPECTIVES

point and that to which it may be raised would be purely protective, and not at all for revenue.11 In 1845 Treasury Secretary Robert J. Walker argued that protective tariffs, which by definition are not designed to maximize revenue but to minimize imports, were in fact unconstitutional. He said they violated the constitutional principle that Congress had a responsibility to collect revenue from customs duties, not merely to lay them. Hence, raising revenue was essential to the legitimacy of a rate of taxation or duty. Therefore, a tariff rate so high as to effectively be a prohibition on imports went beyond Congresss legitimate taxing power.12 In 1861 The New York Times reported that the Laffer curve regarding tariff revenues was the conventional wisdom in the nations capital. Said the newspapers Washington correspondent: It is a well-known principle in political economy that duties which are too high are as unproductive of revenue as those which are too low; and this is especially true of articles which are produced in considerable quantities in our own country. There is a rate neither high nor low, called the revenue standard, which will produce more revenue than one either higher or lower. As a general rule, twenty to twenty five percent upon the importations of an article will be found more productive than ten or fifteen on one side, or fifty, sixty or a hundred on the other.13 Although the Laffer curve effect was usually invoked by free traders to argue in favor of lower tariff rates that would simultaneously increase fed-

eral revenues, by the 1880s protectionists were also making a Laffer curve argument for their policies. Following the end of the Civil War, the federal government ran a continuous string of budget surpluses until 1894. Customs duties were far and away its dominant revenue source. By 1888 customs duties accounted for almost three-fifths of all federal revenue and were rising rapidly they were up 21 percent since just 1885. With the election of Republican Benjamin Harrison in 1888, replacing free trader Grover Cleveland, protectionists saw an opportunity to kill two birds with one stone: reduce budget surpluses that were becoming too large to manage and increase tariffs. They made the argument that higher rates would lose revenue and that this was a good thing because it meant that the tariff was truly having a protective effect by reducing imports. As historian Harold U. Faulkner explained the debate: In reply to the argument that if rates were not lowered the Treasury surplus would grow to unmanageable proportions, the exponents of protection ingeniously replied that if only duties were made high enough to discourage all foreign imports, there would be no revenue at all.14 In 1890 House Ways and Means Committee Chair William McKinley guided a tariff bill into law that largely increased duties but had a few cuts for products that did not compete with those made in America, such as sugar.15 Over the next two years, customs duties fell 23 percent. Part 3 of this series will examine the Laffer curve in the 20th century through the 1970s.

11 Congressional Globe Appendix, 27th Cong., 2d Sess. (1842), at 772. See also Phillip W. Magness, Constitutional Tariffs, Incidental Protection, and the Laffer Relationship in the Early United States, Constitutional Political Economy (2009), at 177. 12 Annual Report of the Secretary of the Treasury (1845), at 7. 13 Affairs at the Capital, The New York Times (July 20, 1861), at 5.

Harold U. Faulkner, Politics, Reform and Expansion (1959), at 107. See also Davis R. Dewey, Financial History of the United States (1931), at 438; Douglas A. Irwin, Higher Tariffs, Lower Revenues? Analyzing the Fiscal Aspects of The Great Tariff Debate of 1888, Journal of Economic History (Mar. 1998), at 59. 15 F.W. Taussig, The Tariff History of the United States (1931), at 256.

14

TAX NOTES, September 3, 2012