Laffer Curve + Irish Implosion

To me an interesting article begins with an anecdote. So, Chris Farrell's piece on Arthur Laffer and his Curve, weaved with supply-side economic thinking as lead-ins to the current Irish economic crisis is, most certainly, an interesting article.

Basically, the point is that reduction of taxes a'la Ireland, is not a panacea to the challenges of managing an economy. But, then again, what policies are ever permanent? Of course, Farrell is dealing with the current set of economic challenges in the Western world - dealing with an era of tax cuts and deregulation - and witnessing the sheer and wanton abandon with which financial institutions failed to apply common sense and risk management principles.

Let me not get carried away.

I will just tease you with the opening lines of Farrell's piece. Then you can click on the "read more" to, well, read more:

It may be the most famous dinner in economic history. Arthur Laffer was a professor at the University of Chicago. In December 1974 he dined at the Two Continents Restaurant in Washington, D.C., with Donald Rumsfeld, chief of staff to President Ford; Dick Cheney, Rumsfeld's deputy; and Jude Wanniski, associate editor at The Wall Street Journal. According to Wanniski, Laffer grabbed a napkin and pen and sketched out the Laffer Curve, illustrating the trade-off between tax rates and tax revenues. In a few more years the tax-cut philosophy dubbed supply-side economics would dominate fiscal policy under President Ronald Reagan.

The global darling of supply-side economics was Ireland. The island nation was a European backwater for decades, a poor, depressed nation best known for its millions emigrating and for Guinness Stout. But in the 1980s and 1990s, Ireland started cutting taxes, and in the 1990s and 2000s it was growing at a phenomenal rate. The top marginal tax rate on personal income went from 65 percent in 1984 to 42 percent by 2000. More importantly, the corporate tax rate was cut in stages from 50 percent in 1986 to 12.5 percent by 2003. Ireland posted an average growth rate of more than 7 percent a year from 1997 to 2007, the quickest pace among the 30-plus members of the Organization for Economic Cooperation and Development. Ireland was the Celtic Tiger, the Irish Miracle.

When the current U.K. Chancellor of the Exchequer, George Osborne, was MP for Tatton and Shadow Chancellor, he penned an op-ed in the Times of London in 2006. Osborne called on Britain to learn how to run an economy from Ireland. "In Britain, the Left have us stuck debating a false choice," he wrote. "They suggest you have to choose between lower taxes and public services. Yet in Ireland they have doubled spending on public services in the past decade while reducing taxes and shrinking the State's share of national income." Two years later, supply-siders Arthur B. Laffer, Stephen Moore, and Peter J. Tanous wrote in their book, The End of Prosperity: How Higher Taxes Will Doom the Economy—If We Let It Happen: "The greatest supply-side economic success story of recent times (other than the Reagan Revolution) is the Irish Economic Miracle."

ON SECOND THOUGHT

Oops. By now, everyone in the global economy is aware that the Celtic Tiger has been declawed and the Irish Miracle a mirage. Ireland is an economic and financial disaster with a government budget deficit for 2010—including the cost of bailing out its banks—at 32 percent of gross domestic product. The nation's embattled government under Prime Minister Brian Cowen is negotiating the terms of a bailout from the European Union and the International Monetary Fund.

The significance of Ireland for public policy goes far beyond the tragedy of the nation. Ireland should signal the death knell of the lets-welcome-all-tax-cuts and the-market-will-take-care-of-the-rest recipe of supply-side economics that gained political prominence starting in the 1970s. Ireland is also a warning to those in Congress who believe cutting taxes and deregulating financial services is the path back to prosperity.

Yes, the logic behind supply-side economics is simple and persuasive. Lower tax rates give entrepreneurs, management, and workers an incentive to expand business, invest more, and log additional hours by raising the after-tax rate of return. In Ireland's case, the economy benefited from its close proximity to Europe and the U.K., which made it easy for the low corporate tax rate to attract foreign capital. "Everyone agrees that there are benefits to lower tax rates," says Daniel Shaviro, tax professor at New York University law school. Adds Varadarajan V. Chari, professor of economics at the University of Minnesota: "By offering very favorable tax treatment, it could attract a lot of capital relative to the size of the country."

But the gains didn't materialize just from becoming a supply-side tax haven. Ireland devoted large resources to turn its education system into a world-class one. Its intellectual property laws and research and development incentives encouraged technological innovation. Similarly, although supply-siders sing the economic praises of the Reagan tax cuts, the effect is exaggerated (and Reagan raised taxes in 1982, '83, and '84). Far more important was Paul Volcker and the tough monetary policy he initiated that set a three-decade cycle of disinflation in motion. So were Michael Milken, Henry Kravis, T. Boone Pickens, and other finance buccaneers of the era. Technological innovation flourished, too, especially with corporate America's embrace of the personal computer in the '80s and the Internet in the '90s.

TWO-EDGED SWORD

Problem is, incentives can also work against you. "Where they failed is also where the U.S. and the U.K. failed," says Jacob Funk Kirkegaard, a research fellow at the Peterson Institute for International Economics in Washington, D.C. "They believed the market would take care of itself, and that isn't true. The banks have been poorly regulated." Adds Chari: "The supply-siders are right to emphasize incentives, but I don't see why they don't see that incentives can work in socially perverse ways."

Certainly, that's what happened in Ireland. Regulators were nowhere to be found during the real estate-centered credit bubble. The Irish Central Bank did not have a history of independence from government and after joining the euro zone contented itself with gathering statistics and issuing currency, according to Morgan Kelly, economist at University College, Dublin. (Kelly's paper, "The Irish Credit Bubble," can be read here.) The banking industry also captured government. Kelly notes that politicians and financiers knew each other well in the small nation. The employment boom generated by bank lending—especially in the construction industry—generated a "natural alliance of interests among politicians, developers, and banks," he writes.

When it comes to generating economic growth, there's no simple blueprint (just ask the Obama Administration). Tax incentives matter. But supply-side economics has deteriorated into a mantra in which cuts are needed all the time to keep the economy growing. But there is no free lunch. Tax cuts coupled with a deregulated financial sector is a recipe for disaster. Ireland is paying the price. Let's hope Congress remembers Ireland as it debates fiscal policy.