Bending the Laffer Curve

Arthur Laffer had a boldly titled op-ed in Monday’s Wall Street Journal, “Tax Hikes and the 2011 Economic Collapse.” This piece has been invoked at least once every ten minutes on each subsequent episode of The Kudlow Report.

US tax rates will rise in 2011, when the Bush tax cuts expire. Laffer argues that, to avoid these higher tax rates, Americans are shifting economic activity into 2010 that otherwise would have occurred in 2011. This shift is artificially beefing up the economy this year, but will detract from it next year.

Even commentators skeptical of Laffer’s call for a 2011 contraction have mostly accepted his logic. They just contend that the microeconomics of tax shifting are not large enough to put much of a dent in macroeconomic variables.

It strikes me that there is also a problem with Laffer’s underlying logic. (Others have already refuted his claims about how past tax changes allegedly influenced past economic performance.) His op-ed presents one piece of current data:

Consider corporate profits as a share of GDP. Today, corporate profits as a share of GDP are way too high given the state of the U.S. economy. These high profits reflect the shift in income into 2010 from 2011. These profits will tumble in 2011 . . .

Laffer’s conjecture is that corporations are choosing to book profits in 2010 as opposed to 2011. But why? The US corporate income tax rate is not scheduled to change in 2011 (or subsequent years).

Which tax rates will change?

. . . the highest federal personal income tax rate will go 39.6% from 35%, the highest federal dividend tax rate pops up to 39.6% from 15%, the capital gains tax rate to 20% from 15%, and the estate tax rate to 55% . . .

Corporations arguably have an incentive to concentrate bonus payments in 2010 rather than 2011, so that executives can collect their bonuses at this year’s lower personal income tax rates. However, compensation costs are deducted from profits. Shifting these costs from 2011 to 2010 would shift profits from 2010 to 2011, the opposite of Laffer’s conjecture.

Corporations may also be inclined to concentrate dividend payments in 2010, so that shareholders can avoid higher dividend taxes in 2011. But for the vast majority of corporations, dividends are only a fraction of total profits. Therefore, dividends could easily be shifted without shifting overall profits. (In practice, investor demand for steady dividend payments likely trumps tax-shifting opportunities anyway.)

In short, Laffer does not explain how upcoming increases in personal tax rates would prompt a shift in reported corporate profits.