Pray we are to the right of T-RMAX

Remember the Laffer Curve?

The Laffer Curve is based on a sound principle regarding the elasticity of tax rate vs tax revenue.  On the curve above, the Y axis represents tax revenue (R) and the X axis is the tax rate (T).

We can all agree that if the tax rate is zero, tax revenue will be zero.  What may not be immediately obvious is that if the tax rate is 100 percent, tax revenue will also be zero.  After all, who would earn income just to turn it all over to the government? No one.  Thus the curve.

In the example above, T-RMAX represents the tax rate in which the maximum amount of tax revenue (R-MAX) will be collected.  If you either raise or lower the tax rate from that point, tax revenue will fall.  This is really common sense.

Here is where it gets interesting.  If the tax rate is anywhere to the right of T-RMAX and you lower the tax rate, tax revenues will actually increase.  You read that right: Lowering taxes, in this circumstance, would increase tax revenues… at least until you arrive back at T-RMAX

The thing is, it is a very complicated problem to discover the actual shape of the laffer curve or where current tax rates place you. If it looks like the blue line below, for example, we don’t have much chance of increasing revenues by decreasing rates.

Team Trump says the current tax rate is definitely to the right of T-RMAX and his tax reductions will “pay for themselves” in the form of increases in tax revenues.

Unfortunately, virtually every independent economist disagrees, however, and says that the US is currently to the left of T-RMAX and a decrease in tax rates will result in a decrease in tax revenue.

A decrease in tax revenue is a problem since the US is already running a budget deficit and a huge national debt. With fewer tax revenues and Trump’s plans for increased spending, the government would need to take on even more debt in the form of capital investment to pay the bills.

This would require foreign investments in T-Bills and similar instruments increasing the capital account surplus. As we have discussed elsewhere, an increase in the capital account surplus will absolutely, positively increase trade deficits.

Trump has indicated, however, that he is willing to fight trade deficits with trade protectionism. This, then, represents contradictory policy in which desperately needed foreign investment is curtailed even as debts increase. The result of this sad situation is 100 percent predictable… It will result in increased interest rates, increased inflation, a shortage of investable funds and increased unemployment. In other words, stagflation.

If taxes are to be radically cut, we should all hope and pray that Trump, and not economists, is correct and we currently live to right of T-RMAX. Otherwise, we are really asking for trouble.