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Tax History: A Laffer Curve for Tariff Rates

Posted on June 17, 2019

On June 19 President Trump will bestow the Presidential Medal of Freedom on Arthur Laffer, the patron saint of supply-side economics and pivotal figure in 20th-century U.S. tax politics. As it turns out, Laffer might have been pivotal in the 19th century, too, had he been alive — his ideas were certainly in play.

Laffer’s claim to fame rests on a truism: In some circumstances, lower tax rates can produce higher revenues. According to legend, Laffer depicted this observation in a famous pen-on-napkin masterpiece, now enshrined at the Smithsonian Institution. (According to The New York Times, however, the napkin is something of a fraud.)

Laffer’s basic point is obviously true. “As a pedagogical device, no one has ever disputed the curve’s essential truth that tax or tariff rates can be too high to maximize revenue,” observed Bruce Bartlett in a 2012 article for Tax Notes:

The curve shows that there are two tax rates that collect no revenue: 0 percent and 100 percent. Somewhere in between is a rate that maximizes revenue collection. Below that rate, tax rate increases will raise revenue; above it, they will lose revenue. Conversely, on the low end of the Laffer curve, tax rate reductions will lose revenue, and rate reductions for those on the upper end will raise revenue. [Prior analysis: Tax Notes, July 16, 2012, p. 299.]

The central problem with Laffer’s curve is its indeterminacy. The revenue-maximizing tax rate falls somewhere between 0 and 100 percent, but Laffer’s curve says nothing about precisely where it might fall on this continuum. That omission limits the usefulness of the curve as a guide to formulating wise tax policy. Over the decades, that vagueness has also helped to justify a lot of distinctly unwise policy.

“The observation at the core of the Laffer Curve often gets distorted as supporting the idea that tax cuts pay for themselves,” notes the American Enterprise Institute’s James Pethokoukis. “Like that should be the baseline assumption or something.”  Laffer himself has sometimes encouraged that sort of loose talk.

Still, as Americans enter an election cycle in which many Democratic candidates are calling for higher tax rates on the rich, Laffer’s point, however obvious, is worth keeping in mind. It doesn’t mean those candidates are wrong. According to many economists, the revenue-maximizing rate for personal income taxes is probably well above current levels. But when it comes to tax rates and revenue, the sky is definitely not the limit.

(Of course, revenue may not be the only — or even the best — reason to raise rates. “Their root justification is not about collecting revenue,” asserted Berkeley economists Emmanuel Saez and Gabriel Zucman in a January op-ed for The New York Times. “It is about regulating inequality and the market economy. It is also about safeguarding democracy against oligarchy.”)

Tariffs, Too

Laffer’s curve has figured prominently in tax debates since the 1970s, thanks chiefly to Ronald Reagan’s enthusiasm for the famous graph. But Laffer’s core idea is much older than Laffer, or even Reagan. In another of his outstanding Laffer curve expositions, Bartlett has identified proto-Laffer ideas dating as far back as the 14th century. (Prior analysis: Tax Notes, Sept. 3, 2012, p. 1207.)

More to the point, Laffer-style reasoning was important to 19th-century American politics, pervading the decades-long debate over tariff duties. Broadly speaking, federal revenue was tariff revenue for the first 70 years of America’s history as a nation. During the Civil War, import duties had to share the stage with income and other internal taxes. But by the 1870s, the tariff had regained its place atop the revenue pyramid, eclipsing every other source of federal revenue. Tariff duties would remain dominant until the start of World War I, after which they declined sharply as a share of total revenue (Andrew Reamer, A Centennial History of the United States International Trade Commission, ch. 2 (2017)). (Prior analysis: Tax Notes, July 2, 2018, p. 12.)

Throughout most of the 19th century, tariffs did a good job of raising revenue — sometimes too good. In the two decades after the Civil War, protectionist tariff duties were yielding large annual surpluses; in the 1880s, according to the tariff historian Douglas Irwin, the federal government took in $1.40 in revenue for every $1 in spending. The resulting surpluses threatened the liquidity of the U.S. financial system. “At one point, nearly a third of the nation’s circulating money stock was sitting dormant in the vaults of the Treasury Department,” Irwin writes in his magisterial history of U.S. trade policy, Clashing Over Commerce.

The upshot of surpluses was a determined drive to cut revenue, increase spending, or both. Predictably, given the highly partisan cast of 19th-century tariff debates, Democrats and Republicans fought bitterly over the best way to save the nation from black ink.

Democrats offered the most obvious, intuitive answer: cut tariff rates. Conveniently, this remedy was consistent with their party’s long-running preference for low tariffs. Republicans, on the other hand, suggested that an increase in federal spending might help. The party championed, in particular, a series of very generous pension measures for Civil War veterans. So generous, according to Irwin, that by the 1890s, Civil War pensions accounted for 40 percent of total federal spending.

(Generous spending programs can have a lingering effect on federal spending. As of 2018, according to the Department of Veterans Affairs, there was still one American receiving a Civil War pension. Various news reports have identified her as Irene Triplett, whose veteran father was 83 when she was born in 1930. At last report, Triplett was still collecting $73.13 each month, thanks to her father’s service with the Union Army.)

Besides higher spending, Republicans had another idea to reduce budget surpluses. Higher tariff rates, they suggested, would curtail imports, producing a decrease in revenue collections. This was a Laffer-style argument, although an unusual one by 20th-century standards. Although modern Laffer adherents want to raise revenue by cutting rates, their 19th-century predecessors wanted to cut revenue by raising rates.

This argument over tariff rates played out repeatedly in the later decades of the 19th century, but it came to a head in the Great Tariff Debate of 1888. This debate was so great, in fact, that even Donald Trump has taken note of it:

It was the Great Tariff Debate of 1888. And the debate was: We didn’t know what to do with all the money we were making. We were so rich. And [William] McKinley, prior to being president, he was very strong on protecting our assets, protecting our country. And he made the statements that “Others cannot come into our country and not defend our country. We can’t do that. We can’t ever allow that to happen.”

McKinley doesn’t seem to have actually said anything like this, as Matthew Yglesias has pointed out for Vox.com. But Trump is still right about the broad outlines of the 1888 argument.

In the short run, Republicans won that debate from 131 years ago. GOP candidate Benjamin Harrison lost the popular vote in the 1888 presidential election but won a comfortable majority in the Electoral College. Once in office, he signed a new tariff law that raised many import duties — and cut total revenue.

As Yglesias pointed out, however, the new tariff law didn’t directly vindicate the GOP argument about raising rates to cut revenue. The McKinley tariff of 1890, in addition to raising numerous rates, also cut the import duty on sugar — the single most important levy in terms of revenue. It was that single rate cut, rather than the law’s numerous rate increases, that accounted for its revenue loss.

The revenue result of the 1890 tariff law was consistent with the conclusion that Irwin reached when he tried to evaluate who was right during the Great Tariff Debate of 1888. In a 1997 article, Irwin concluded that given the price elasticity of U.S. import demand, a general increase in tariff rates would have probably increased revenue, not reduced it. In other words, Democrats had the right idea when it came to decreasing the surplus: cut rates.

The genius of the McKinley tariff, however, was the way it squared the circle for Republicans. As Irwin noted, the law sidestepped arguments over the revenue effect of higher rates. By increasing rates on many items but lowering them on a few key ones, like sugar, Republicans were able to advance the party’s protectionist agenda without further increasing those pesky surpluses.

Still, the 1888 tariff debate is a good reminder that the Laffer curve was hard at work long before Arthur Laffer made his appearance on the world historical stage. Political leaders of the 19th century understood the concept of a revenue-maximizing tariff rate. But they were operating in a world where revenue maximization was a bug, not a feature, of the tariff schedule.

The 1888 debate is also a useful reminder that the Laffer curve doesn’t provide easy answers to complex problems. How a rate change will affect revenue depends on a host of factors, including (in the case of tariffs) the price elasticity of U.S. import demand. Some rate cuts will raise revenue, and others will reduce it.

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