Argentina teaches the Laffer Curve lesson Washington refuses to learn

For decades, the Laffer Curve has been treated as a theoretical curiosity. The premise of the Laffer Curve is that taxpayers will not support excessive levels of taxation. As taxes consume higher shares of a person’s earnings, that person starts to either work less or to find ways to conceal their income to avoid taxation. In the aggregate, this means that at some point, raising tax rates begins to lead to a reduction in tax revenues because it causes the taxable base to shrink. Now, new research applying the Laffer Curve’s principles to Argentina offers both a path forward for Argentine tax reform and a lesson that the United States should learn.

Economist Arthur Laffer, for whom the idea is named, famously sketched a graph demonstrating this idea on a cocktail napkin in the 1970s. It later became the theoretical basis for the so-called “Reagan” tax cuts of 1981, which cut income taxes across all brackets and reduced the top rate from 70% down to 50%. Fifteen years later, Congress’s Joint Economic Committee evaluated the impact of these tax cuts and witnessed that the share of tax revenue received from the top 1% of income earners climbed substantially despite the lower rate, indicating these high earners were now willing to generate more taxable income. As the committee concluded, “reduction in high marginal tax rates can induce taxpayers to lessen their reliance on tax shelters and tax avoidance, and expose more of their income to taxation.” In other words, Laffer was right.

Argentina is the perfect case study of what happens when these principles are not applied. When President Javier Milei took office in December 2023, Argentina was a fiscal catastrophe by nearly any measure. Inflation exceeded 211% annually. At that rate, prices triple every year. The government was spending far beyond its means, and deficits were simply financed by printing money, which caused inflation.

The underreported part of this phenomenon is the role of taxes. Taxes in Argentina have become so high that they have pushed nearly half the country to the margins of society to avoid reporting income. According to Argentine census data, more than 44% of the employed workforce works on an unregistered basis because many firms and workers prefer to work outside the law so they can keep their income. The World Bank has consistently estimated that the effective corporate tax burden in Argentina exceeded 100% of average earnings. That means it’s not even possible to pay all the taxes. Only Comoros—a tiny island nation near Madagascar—has a higher effective tax rate.

As these high taxes pushed both firms and workers to engage in what the Congress’s Joint Economic Committee called “tax avoidance” by operating clandestinely, the tax base began to hollow out, and revenues could not keep pace with the increasing levels of entitlement spending ushered through by the governments of Néstor and Cristina Kirchner. That fiscal breach led to the more widely publicized inflation phenomenon.

This characterization of Argentina’s fiscal spiral now has empirical support. In research I conducted for Reason Foundation in partnership with Fundación Libertad y Progreso (an Argentine think tank), I examined how differing approaches to gross receipts taxation across the 23 provinces affect workers’ self-reported employment status in Argentine census data. All provinces assess a gross receipts tax on businesses, but each one does so at different rates for every industry, and these rates often change from year to year. Although this complexity and volatility aren’t great for tax policy, it does provide a rich dataset to measure the effect of taxation on individuals’ decisions to participate in the legal or so-called “informal” economy.

The results show Argentina’s tax rates are far beyond the revenue-maximizing level and that every increase in taxes leads to fewer revenues by pushing more people toward the street economy. The corollary is that tax cuts could help restore balance in Argentina. Milei, who worked quickly to balance the budget for the first time in decades after taking office, has received this message warmly and recently discussed some prospective tax reforms recommended in my research.

Ultimately, Milei’s approach to reducing both taxes and spending is poised to ignite a new era of prosperity for Argentina. Real income per capita is already growing again, and the proportion of Argentines living in poverty has fallen precipitously. Tax reform based on the Laffer Curve’s implications could be the next critical step to restore Argentina’s workforce and economy.

These trends hold new relevance for the Laffer Curve in the United States. The federal budget deficit has exploded from $440 billion in 2015 to $1.8 trillion last year. Congress actually began this century with a budget surplus of $130 billion. As a result of these rapidly accumulating deficits, the total debt now reaches $38.5 trillion—it has more than doubled in just the last decade. This is occurring alongside an aging of the population as birth rates have fallen below replacement level.

The upshot is that the cost of mounting debts and old-age entitlements for baby boomers will fall on a shrinking workforce, who will struggle to pay them. In short, this squeeze looks similar to the pressures that wreaked economic chaos in Argentina. It was not older, conservative voters who turned to Milei, but a rising generation of self-described libertarians who became fed up with economic turmoil and the tax burden they were asked to bear.

The United States may soon face a similar reckoning. Congress has clearly abandoned any commitment to fiscal discipline. Congress hasn’t even bothered to pass a budget on time since 1997, including periods of both Democratic and Republican control. Spending has also quickly outpaced revenues under presidents of both parties. Indeed, a commitment to fiscal recklessness might be the most bipartisan position in Washington.

But the underlying trends are clear. And Washington has been partially financing its deficits through monetary expansion for most of the 21st century, although that trend accelerated hugely in 2020-21 when the monetary base nearly doubled in a period of just 20 months.

It is tempting, particularly on the American right, to cast Milei and President Donald Trump as ideological twins. Both are political disruptors who ran against entrenched establishments. But on the substance of their policies, the comparison breaks down almost entirely. Milei’s program rests on the conviction that excessive government spending and taxation and limits on commerce, produce worse economic results for ordinary people. Trump’s approach often runs in the opposite direction. He has cheered active government intervention in markets, including through the direct purchase of private companies and the imposition of costly new taxes on trade. While Milei quickly slashed spending, spending has grown substantially throughout both Trump administrations.

It’s unclear if there will be an American Milei in the future. Still, it’s clear the federal government is creating the conditions that could lead to an insupportable level of frustration among the rising generation with the fiscal burden they’ve been asked to bear.

The post Argentina teaches the Laffer Curve lesson Washington refuses to learn appeared first on Reason Foundation.

Source: https://reason.org/commentary/argentina-teaches-the-laffer-curve-lesson-washington-refuses-to-learn/