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Undeterred by ‘Kansas Experiment,’ Laffer Presses Tax Cuts

Posted on August 9, 2017 by Jonathan Curry

In an interview with Tax Analysts, Arthur B Laffer, the “father of supply-side economics” and longtime champion of cutting taxes, defended the “Kansas experiment” outcome, challenged the conventional wisdom on economic growth potential, and dismissed the need for revenue-neutral tax reform.

In his role as a prominent conservative economist, Laffer advised Kansas Republicans on their effort to dramatically scale back taxes in the state. Kansas passed a series of major tax cuts in 2012 and 2013 — which included zeroing out the state income tax on passthrough entities — that Gov. Sam Brownback (R) promised would act “like a shot of adrenaline in the heart of the Kansas economy.” In subsequent years, however, the state faced multiple billion-dollar budget shortfalls and downgrades in its credit ratings, the Kansas Supreme Court ordered the state Legislature to reverse some of its education spending cuts that were used to offset the tax cuts, and the state’s economy grew sluggishly compared with the rest of the nation. On June 6, 2017, a two-thirds majority of the Republican-controlled Legislature voted to override Brownback’s veto of a bill to roll back most of the tax cuts, including the passthrough exemption.

“I thought Brownback’s proposal would be beneficial, and I still do,” but the tax bill that ultimately became law was not Brownback’s original proposal, Laffer told Tax Analysts in a July 26 interview. He acknowledged that Kansas has not experienced the economic growth he predicted, noting that Kansas is “not a prosperous state.” States “do have bad times, and taxes are not 100 percent of everything,” he said.

He also rejected the notion that there are any lessons from the Kansas experiment that should be applied to tax reform at the federal level, noting that there are 50 different states, each with its own set of economic conditions. “I don’t think there’s any one week’s episode that dominates the world,” he said.

And Laffer put a positive spin on the widely reported explosion in the number of passthrough entities that formed in Kansas after the tax cuts were enacted. “If that isn’t a supply-side response, I don’t know what is,” he said. Critics, however, have highlighted that response as evidence of widespread tax avoidance, famously exemplified by Kansas University’s basketball coach Bill Self, who changed from a salaried state employee to an LLC, presumably to benefit from the passthrough exemption.

Laffer acknowledged that completely exempting passthroughs from the state income tax “doesn’t raise you a lot of revenue,” and that at least some of those new passthroughs may have been from C corporations changing their business form or from individuals reclassifying wage income as passthrough income. “But there was a huge increase in overall number of businesses as well, which is exactly why they did it,” he said.

Laffer took a different approach on the issue in a subsequent interview August 3, reacting to a report by the conservative Kansas Policy Institute (KPI) suggesting the state government’s estimates incorrectly stated there were only 191,000 passthrough entities in 2012, when in fact there were around 330,000 after accounting for additional categories of passthrough income. The total number of filers reporting passthrough income increased by only 1.9 percent to 339,000 in 2014, according to KPI. That report undermines the arguments of critics that say the tax cuts spurred tax avoidance instead of economic growth, Laffer said.

A spokesperson for the Kansas Department of Revenue confirmed the accuracy of KPI's findings on the numbers of passthrough entities. But regardless of how the passthrough issue may or may not have contributed to Kansas's shortfall, critics would argue that the shortfall's existence is evidence of the failed overall experiment.

Joseph Henchman of the right-leaning Tax Foundation, which has long been critical of Brownback’s tax cuts and the passthrough tax exemption in particular, acknowledged KPI’s findings in a series of June 30 tweets, but said they “don’t boost any particular argument.” He noted that Kansas reported passthrough wage income increased by 11 percent over that time frame, and that the number of new business filings also grew by 11 percent in that time, but that the number of filers reporting passthrough income remained largely unchanged. "My guess is existing passthroughs found a way to shift more income from wages to passthrough income,” he surmised, although he said he would need more data to confirm the hypothesis.

Laffer said July 26 that the proposal to bring the passthrough income tax rate down to zero didn’t come from him, although he added, “It’s not a bad idea.” He said tax cuts should be dramatic if the goal is to spur business activity. “If you’re gonna go for growth, go for growth,” he said.

Laffer cited the example of Kansas City, which straddles the border between Missouri and Kansas, and said that while a small state income tax cut — 4.3 percent to 4.1 percent, for example — would have had little effect, the 0 percent passthrough tax rate created a “pretty attractive reason for moving” across the state boundary. He added, “The nicest form of flattery is when someone copies you, and Missouri did just that.”

Missouri enacted income tax cuts in 2014, although the rate reductions were more gradual than in Kansas and were contingent on revenue growth. However, because of slow revenue growth, the tax cuts are set to begin phasing in for only the first time in 2018.

The tax cuts, Laffer said, "in my view were, if anything, positive, but they were positive like a hose in an ocean storm. They were not hugely material in the outcome in Kansas, but everyone made it so.” Rather, he blamed the state’s current problems on a nationwide drop in oil and crop prices, budget forecasting mistakes by the state, and a pension funding crisis that was a long time in the making.

He later expounded on that point, saying that sometimes tax cuts work out and sometimes they don’t, but that “the preponderance of results is very clear” in favor of reducing taxes. “That doesn’t mean there’s no variation; of course there’s variation,” he continued, before concluding that he doesn't think Kansas “was a very significant test” of supply-side economics.

Getting to 3 Percent

The Trump administration insists it can boost annual GDP growth from around 2 percent to 3 percent through its economic agenda, which consists of tax, trade, and regulatory reform.

However, some economists have suggested that 2 percent increases in GDP are the “new norm,” and that boosting economic growth to 3 percent of GDP is wishful thinking at best. Former Council of Economic Advisers Chair Jason Furman, who served under the Obama administration, and former Congressional Budget Office Director Douglas Holtz-Eakin, appointed by President George W. Bush, have argued that demographic factors like peaking labor force participation rates by women, the aging baby boomer population, and slipping immigration rates limit the growth potential the administration hopes to gain through its domestic agenda, even under the best of circumstances.

Laffer is not one of those economists. “I think it’s just plain nonsense to talk about demographic facets as if they’re locked in steel,” he said. Most of the issues cited by critics as largely unchangeable are actually “very tax-driven responses,” he asserted. Better healthcare and increasing life expectancy enables individuals to work and put off retirement longer than they would have in the past, and lowering marginal individual tax rates would reduce the disincentive to have a second earner in the family, boosting female labor participation rates, he said. Economic growth and greater job opportunities resulting from tax cuts would also then reduce the number of taxpayers on welfare and get more individuals back into the economy, he said.

“I think the majority of the academic literature shows that the two [tax cuts] that really do juice the system are the corporate tax cut and [cutting] the highest marginal income tax rate. Both of them are the biggest drivers of economic growth . . . and then, once the growth starts occurring, it feeds on itself. It has this huge sort of dynamic impact,” Laffer said, referring to potential secondary and tertiary effects, like reduced incentives for tax evasion and increased state and local tax revenues.

“What I’m saying is really mainstream economics; it’s not kooky right wing," he said. “I mean, who ever heard of taxing an economy into prosperity?”

Achieving that growth would have the added benefit of boosting President Trump’s lagging favorability ratings, said Laffer, who compared Trump’s current situation to President Reagan’s in the early 1980s. The economy was in a downturn and Reagan’s 1981 tax cuts were phased in slowly, preventing the growth effect from fully taking effect until 1983, according to Laffer. But when real GDP growth topped 8 percent in 1984, Reagan went from being a president who was unpopular with both Republicans and Democrats to seeing his favorability ratings surge, he said. “All of a sudden the skies opened and we had clear sailing. And that’s what I’d love to see happen this time, and I think it will happen,” Laffer said.

Other conservative economists, like James Pethokoukis of the American Enterprise Institute, have credited a large part of the economic boom of the mid-1980s to a change in monetary policy, in addition to Reagan’s tax cuts and other economic factors.

‘They Don’t Know Their Economics’

In an April 19 op-ed in The New York Times, Laffer, along with fellow conservative economists Lawrence Kudlow and Stephen Moore, made the case that, rather than tackling comprehensive tax reform all at once, lawmakers should instead quickly push through deep business tax cuts and save the challenges of reforming the individual tax code for later.

That op-ed appeared to elicit an indirect response from House Speaker Paul D. Ryan, R-Wis., who a week later made public a letter from the Joint Committee on Taxation indicating that even a two- or three-year corporate tax cut would increase the deficit outside of the 10-year budget window and, if not offset, would run afoul of the Senate’s Byrd Rule if a budget reconciliation process were used as planned.

As for whether tax reform should be revenue neutral: “Stupidest thing I’ve ever heard!” Laffer said. And while Republican leaders in the White House and Congress have suggested that tax cuts would be revenue neutral using dynamic scoring models as opposed to static models, Laffer suggested that the JCT’s dynamic model still doesn’t sufficiently account for macroeconomic growth.

“In the real world that we operate in, there’s one thing that causes more revenues, and that’s growth. Period. Cutting the corporate tax rate will create growth, and it will reduce the deficit dramatically, right away,” Laffer said. “Does that sound like any scoring model that you’ve seen? No. Because they don’t know their economics. . . . You can try as you might — looking at tax rates and revenues, you find no correlation at all . . . but growth you do. The tax base — you find a huge change there.”