During US election season, Simply put examines the dream scenario of many politicians – that lowering taxes can catalyse growth and generate more robust tax returns. President Reagan unsuccessfully put this theory into practice in the early 1980s, but could today’s markedly different economic circumstances lead to a more promising outcome and how should investors prepare their portfolios?
The Laffer Curve strikes back
Amid another US presidential election, certain campaign issues are strikingly familiar, notably the clash between advocates of increased public spending and proponents of tax reduction. Even more reminiscent is the Republican narrative suggesting that lower tax rates could maintain budget deficits unchanged.
This notion can be traced back to Ronald Reagan's election in the early 1980s, championed by a notable economist Arthur Laffer. His theory, famously sketched on a restaurant napkin, posited that identical tax revenues could be achieved through two distinct tax rates: one high and growth-inhibiting, the other substantially lower yet fostering robust economic activity and, consequently, greater tax revenues.
While 21st-century economists have largely dismissed this approach, as such theoretical maximum rates were never likely to be achieved, the concept's intuitive appeal endures, influencing both so-called Reaganomics and Trumponomics.
So, what relevance does the Laffer effect hold in 2024?
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The tax paradox
Classical and liberal economists have developed theoretical frameworks demonstrating the adverse effects of excessive taxation on economic activity, resulting in two prominent theories: the Ricardo-Barro effect and the Laffer effect. The former suggests that the impact of a temporary increase in public spending is diminished by taxpayers anticipating the future tax increases needed to fund it – rendering fiscal spending growth neutral. The latter postulates the existence of an unproductive taxation threshold. In a now-legendary meeting, Laffer illustrated this concept to former US vice president Dick Cheney with a bell curve depicting the relationship between tax rates and revenue. Although Laffer professes no memory of this drawing, his elegant proposition endures: two tax rates could yield equivalent revenue – one high, stifling economic initiative, the other lower, catalysing growth and generating robust tax returns.
The choice between these scenarios appears self-evident: prudent fiscal policy should embrace moderation, particularly when such restraint proves fiscally neutral due to enhanced growth stimulating unexpected revenue streams. Yet this compelling intuition warrants careful scrutiny.
Academic consensus has largely diverged from this theory, primarily due to historical evidence. Analysis of US Treasury data plotting tax revenues against both household and corporate tax rates (Figure 1) reveals telling patterns across five-year intervals from 1945 to 2024. Corporate tax rates, fluctuating between 20% and 50%, consistently showed increased collections with higher rates – contradicting the Laffer effect.
Regarding income tax, the Laffer effects only become apparent in the case of the highest brackets of revenues, with marginal tax rates reaching between 85% and 90% – far from today's approximate 40% threshold. Despite this empirical challenge to the Laffer effect, Republican rhetoric continues to embrace its intuitive appeal, regardless of contradictory data. The Reagan administration's economic programme stands as a crucial case study in this regard.
FIG 1. Tax revenue-to-GDP ratio versus corporate tax rates and US household top marginal income tax rates1
Read also: How could US fiscal slippage impact markets?
Reaganomics = Trumponomics
If political economics teaches us one undeniable truth, it's that while history may not repeat itself, it composes remarkably similar verses. In 1980, the Reagan administration fell under the spell of Arthur Laffer's seductive proposition: reduce taxation to enhance tax collection. The Economic Recovery Tax Act (ERTA) of 1981 encompassed a comprehensive suite of cyclical measures designed to reinvigorate an economy substantially weakened by the Federal Reserve's aggressive interest rate hikes – a strategy implemented by the formidable Paul Volcker to combat unexpectedly persistent inflation. At ERTA's core lay an ambitious overall tax reduction, exceeding 5%, that was theoretically positioned to rejuvenate the American economy and, consequently, generate enhanced tax revenues.
Figure 2 chronicles the aftermath of this economic programme's implementation, mapping the trajectory of tax revenues, deficit evolution, debt accumulation and real interest rates. For contemporary observers, the narrative should strike an uncomfortably familiar chord: Treasury revenues contracted by 2% of GDP, the public deficit persisted at 5% of GDP for half a decade, national debt swelled by approximately 20% of GDP, while real rates surged by 8% – all while the Federal Reserve maintained its anti-inflationary stance, counteracting the fiscal stimulus's inflationary pressures.
Does this historical parallel perfectly mirror our current circumstances? Not entirely. Volcker's policies undeniably precipitated a double recession that became emblematic of 1980s economic history – a severity absent from our present situation. Today's inflation, while concerning, pales in comparison to that era's challenges and, unlike the 1980s, no oil shock preceded our recent inflationary surge. Instead, our current predicament stems primarily from demand-side pressures, fuelled by expansionary public spending.
Nevertheless, we must recognise a crucial lesson: Laffer-style supply-side policies fundamentally function as demand stimuli, inevitably leading to sustained debt accumulation. Tax reductions, while politically appealing, prove notoriously difficult to reverse – a costly lesson for the Reagan administration. Perhaps most ominously, the resulting elevation in real rates stands as the most pernicious consequence, with recent surges in long-term rates serving as a distant yet disquieting echo of that era.
FIG 2. Trends in tax revenues, public deficit, government debt and real interest rates: 1980-19902
What this means for All Roads
Our All Roads strategies have seen their allocation to hedging assets increase in importance since the summer, including the bond allocation shifting from underweight to neutral3. Since then, given turbulent trends, volatile market sentiment and a continuing normalisation in bond volatility, our duration exposures have ceased to increase. While bond risk remains present, it does not match the levels observed in 2022. The approaching US elections call for robust diversification and a form of neutrality that aligns with our current allocation strategy.
Simply put, tax cuts deepen the deficit and increase debt – a trend that has concerned markets recently.
To learn more about our All Roads multi-asset strategy, click here.
Macro/nowcasting corner
The most recent evolution of our proprietary nowcasting indicators for global growth, global inflation surprises and global monetary policy surprises are designed to track the recent progression of macroeconomic factors driving the markets.
Our nowcasting indicators currently show:
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Our growth signals, which had shown renewed vigour since September, appear to be marginally retreating. For now, growth continues to show signs of improvement
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Inflationary pressures continue to increase as we approach the year-end, particularly in the US
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According to our signals, the global pivot in monetary policy should continue. The European Central Bank’s pivot appears most at risk given the recent increase in inflationary pressures in the eurozone
World growth nowcaster: long-term (left) and recent evolution (right)
World inflation nowcaster: long-term (left) and recent evolution (right)
World monetary policy nowcaster: long-term (left) and recent evolution (right)
Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).
