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Monday, May 08, 2006

Debunking One of the Worst Ideas in Economics

In this column, I'm focusing on bad economics. In fact, I'm going to write about what I consider to be the two worst economic ideas -- or at least ideas that pass as economics, though both have been thoroughly repudiated by nearly all credible thinkers.

When I say worst, I don't mean the most outlandish (e.g. stock prices are controlled by aliens) because those ideas usually collapse of their own weight. Rather, the most pernicious bad ideas in economics are those that have a ring of truth. They're hard to debunk because they have a certain intuitive appeal. As a result, they stick around, providing bogus intellectual cover for bad policy, year after year, decade after decade.

For the sake of political balance, I'll skewer a favorite of the right in this column, and then a favorite of the left in my next piece.

The Laffer Curve

Economist Arthur Laffer made a very interesting supposition: If tax rates are high enough, then cutting taxes might actually generate more revenue for the government, or at least pay for themselves. (In one of life's great coincidences, he first sketched a graph of this idea on Dick Cheney's cocktail napkin.) If the government cuts taxes, then Uncle Sam gets a smaller cut of all economic activity -- but reducing taxes also generates new economic activity. Laffer reasoned that, under some circumstances, a tax cut would stimulate so much new economic activity that the government would end up with more in its coffers -- by taking a smaller slice of a much larger pie.

In fairness to Mr. Laffer, there's nothing wrong with this theory. It's almost certainly true at very high rates of taxation. If you consider the extreme, say a 99 percent marginal tax rate, then the government will probably not be collecting a lot of revenue. To begin with, citizens are going to hide as much income as possible. (The more honest ones will turn to barter and avoid the tax system entirely.) And no one is going to rush out and take a second job or build a factory if they get to keep only $1 of every $100 that they earn.

So it's entirely plausible that slashing tax rates from 99 percent to 30 percent could increase government tax revenues. It would deflate the black market and provide a huge new incentive to work and invest.
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