Laffer v. Keynes: Ultimate Economy Championship

Sometimes – in economics and politics – labels and theories get in the way of common sense.

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Don't expect this to be an exhaustive study of 20th Century economic theory. But I got to thinking (while in the shower, as usual) that two economists have been portrayed like pro wrestling hero and villain – supply side versus demand side, "cut taxes" versus "spend more", "stop choking investment!" versus "step on the gas!"

Economist Arthur Laffer is a prominent supply-side advocate who drew the Laffer Curve to illustrate the relationship between government revenue and tax rates. Laffer and other supply-side economists suggested that tax rates in the United States in the 1970s were so high as to create a disincentive to work and – by lowering tax rates – government could simultaneously encourage growth and increase tax revenue. However as Laffer postulated the relationship, continually reducing the tax rate would – at some point – reduce government revenue without a sufficient offsetting revenue kick from growth.

Economist John Maynard Keynes advocated government involvement to encourage economic activity. Especially influential during the Great Depression of the 1930s, Keynes argued that aggregate demand in the economy determined the overall level of economic activity, and that inadequate aggregate demand could lead to prolonged periods of high unemployment. Ultimately Keynesian or demand-side economists insist that a mixed economy – mostly private sector but with a significant government role – is best placed to dampen economic cycles and encourage growth.

From my point of view the political emphasis of "my economist can beat up your economist" is misplaced, monotone, and unproductive. One party justifies tax cuts in good times because "it's the people's money" and in bad times because "taxes stifle growth". The other party wants to spend money in good times because tax revenue is flowing freely and in bad times because increased government spending counteracts curtailed individual spending.

Every theory can be taken to extreme and become disconnected from reality. Here's my take on applying these ideas to the mechanics of government finance.

• Tax rates have to be steady for two reasons:  constancy sets long-term expectations and it allows tax revenue to rise or fall with economic fortune.  When revenue is high, you retire debt; when revenue is low, you take on debt.  Set 'em and forget 'em.

• Government spending has to be countercyclical for two reasons:  in a weak economy, it supplants reduced individual spending and it's cheaper to finance government debt when interest rates are low.  Conversely in a strong economy, government spending needs to be throttled back because the extra stimulus promotes a feast-or-famine business cycle and it's important to retire debt when interest rates are high.  (By the way, the U.S. Government currently has $15 trillion in debt.)

The idea here is not to try to regulate or influence the overall economy by changing tax schemes or spending your way to prosperity. Rather, it's for government to maintain taxpayer expectations and take advantage of economic conditions to get the best value for each tax dollar. Any macroeconomic influence of this practical approach is a bonus.

There's an old adage that one man's trouble is another man's opportunity. In this case, government needs to borrow when costs are low and pay off debt when money flows.