Stimulating The Economic Growth Through Tax Reform

US economist and member of President Reagan’s Economic Policy Advisory Board, Arthur Laffer’s career has been marked by experience and success in business, in public policy, and as an academic economist and professor. He was a consultant to Secretary of the Treasury William Simon, Secretary of Defense Donald Rumsfeld, and Secretary of the Treasury George Shultz. Laffer’s economic acumen and influence in triggering a world-wide tax-cutting movement in the 1980s have earned him the distinction in many publications as “The Father of Supply-Side Economics.” On a visit to Australia, sponsored by the Australian Chamber of Commerce and Industry, Arthur Laffer addressed The Sydney Institute on Tuesday 17 March 2015. The paper, which follows, is an edited transcript of that address.

STIMULATING THE ECONOMIC GROWTH THROUGH TAX REFORM

ARTHUR LAFFER

It’s lovely being here, I just adore Australia. This is my fourth visit and every time it gets better and better. I just love it. Thank you for having me.

We have 50 states in the USA and, as you may know, constitutionally there can be no barriers amongst the states. Yet each state has its own economic policies – taxation, spending, wealth – all of that. So we have 75 years worth of data over 50 states and it’s an amazing cauldron of experimentation. I’d take you through some of that today.

If you have two locations, A and B, and you raise taxes in B and lower them in A, producers and manufacturers and people are going to move from B to A. That’s economics. I finished this year a book called is The Handbook on Tobacco Taxation: Theory and Practise. There’s no product on earth that’s been more taxed than tobacco. It’s a fascinating field for an economist, looking into how people respond to incentives. On a personal level, some of you may know I lived in California for many years. I was on the Governor Arnold Schwarzenegger’s Council of Economic Advisers, a part time position. When he turned to the dark side, I moved. I left and went to Nashville, Tennessee. Can any of you guess why I went to Nashville, Tennessee?

While I like the music, the real reason was that there’s no income tax in Nashville. Did I mention there’s no income tax? I paid for my house with my first year’s tax savings. I did miss California, especially Schwarzenegger; he’s a witty, interesting man. In fact, the first time I sat down with him at a breakfast, just before he become Governor, in his home in Los Angeles, I decided that my best defence was an aggressive offense. This was after having heard stories about his wit and his aggressive style in conversation.

Over breakfast, I told him how ecstatic I was to meet him and see him and be with him. When I heard his primary advisors were Wilson and Buffett, I was amazed, over the moon. To think, he had Wilson and Buffett as his advisors. When I found out it wasn’t Owen and Jimmy, but Pete and Warren, he laughed. A little bit later in the conversation he looked at me and said, “Milton Freidman, he can’t be more than 4 feet six inches tall. Little bitty, tiny man. You, Arthur, you remind me of Danny Devito. You know I starred with him in Twins.” I left California, went to Nashville, got my free house, and it was fun.

I want to talk to you today about mixing politics and economics. Politics is where the rubber hits the road. In the United States, politics is moving very much in the GOP direction. We had our elections in our November 2014. The pro-growth agenda won out – not always just with Republicans but also Democrats and others.

Economics is about incentives. Whether you’re tall, whether you’re short, whether your fat or skinny, incentives matter. If you tax people who work, and you pay people who don’t work, don’t be surprised if you find a lot of people not working. It’s all about incentives. If you tax rich people and give the money to poor people, you’re going to get lots and lots of poor people and not many rich people. People respond to incentives in the overall system.

Who ever heard of a poor man spending himself into wealth? It doesn’t make any sense. Who ever heard of an economy being taxed into prosperity? The Republicans now are the pro-growth party. They picked up nine seats in the Senate and now control the Senate which is a dramatic shift in events. The Republicans now have the largest number of Republicans in the House of Representatives since 1932. It’s an unassailable majority which they might well hold for the next 25 years.

The Republicans now have 31 governors in the United States. They picked up three net in 2014 – that is, they picked up four and lost one, Corbett in Pennsylvania. The Republicans control the legislatures in 30 states, Democrats control the legislatures in 8 states, and 12 are split. All the way across the nation, you’re seeing a political revolution in the US. From my standpoint, it’s a very exciting revolution. I’ve been to this barbeque before, and I can tell you what the outcome is going to be and you’re going to love it.

The most exciting issues are about how to tax the rich – what to do and how they should tax the rich. And the other one which I want to emphasise is stimulus spending. Stimulus spending is popular with Keynesian economists and classical economics. But it never had a chance to flourish and grab the soul of people until George W Bush came along with the housing bill. In 2007, we had the agricultural bill with huge increases in spending to stimulate the economy. Then we had the stimulus package of 2008. Henry Paulson, who was Secretary to the Treasury, proposed a stimulus bill for $700 billion. $700 billion. If you were to stack it up in one dollar bills it would go back and forth to the moon three times. It’s a lot of money.

This bill, which would have granted Paulson control of the $700 billion was four pages long. It granted him total control over $700 billion do. He had to have it immediately; he was like a five year old in a scary movie, “Eek, you’ve got to give it to me now or we’re about to go over the ledge of the cliff.” There were no hearings on it, it was not debated, just a vote or otherwise it’s the end of the earth.

I’ve been around a lot of politics and government. I was in the White House from 1970 to 1972 as George Schultz’s right hand person. I was the first one to go to China in 1970. I’ve been involved in politics for a long time. Whenever politicians make decisions, when they are panicked, the consequences are rarely attractive. So,after of course the George W Bush huge stimulus spending, Obama came in and did his own $864 billion. I’ll discuss the theory and what has actually happened.

But first, tax the rich. This seems to be the topic du jour. We’re all worried about inequality but let’s look at the facts and pull back and explain those facts. In the United States, we did not put in a progressive income tax until 1913 when we introduced the progressive income tax. The highest rate was 7 per cent. Having moved from 0 per cent to 7 per cent on the rich, tax revenues from the top 1 per cent of income earners went up. I will cede that point. But in only four years, by 1919, we’d raised the highest marginal income tax rate in the United States from 7 per cent to 77 per cent.

Governments love to keep records of taxes. Any economist can look at this data at any time. After World War I, the big battle was on at the election of 1920 as to how we should deal with the high tax rates. The rest of the world kept their high tax rates, but the US had a battle, which was fun. President Woodrow Wilson did not recontest and the Democrat candidate was the Governor of Ohio, James Cox. He chose his best friend as his running mate, a man named Franklin Delano Roosevelt. Cox and Roosevelt wanted to keep those tax rates high to pay off the war-time debt.

Warren G Harding was the Republican nominee, and Calvin Coolidge was his running mate. They wanted to cut tax rates back to the pre World War I levels, and that was the battle. The Republicans won by the largest percentage ever in US presidential elections. They cut the highest marginal income tax rate – from 77 per cent to 25 per cent. The tax rate on the rich was cut to less than a third of what it had been before. Tax revenues from the top 1 per cent of income earners, as a share of GDP, went up. This period has been labelled the Roaring 20’s, mostly because tax revenues went up dramatically during this time, in spite of the rate being less than one third of what it had been before.

Then, of course, we came to the 1930s where we had the biggest tax increases on traded products. This was known as the Smoot–Hawley Tariff, signed into law by Herbert Hoover in 1930. The economy went into a tailspin. On 1 January 1932, Hoover raised the highest marginal income tax rate from 25 per cent to 63 per cent. This was an attempt to raise tax revenue. Unsurprisingly, the US went into the depths of the Depression. 1932 was only the first trough of the Great Depression. Hoover was thrown out of office in a landslide by Roosevelt who went even further down the tax and stimulus route.

Roosevelt had all sorts of problems with the economy. On 1 January 1936, Roosevelt raised the highest marginal income tax rate on the rich from 63 per cent to 79 per cent from which it wandered on up to 83 per cent. It didn’t stop. Is it any wonder it was the longest, deepest depression. There was another big trough at the end of 1937. Tax revenues for the top 1 per cent of income earners, went from 25 per cent to 83 per cent, and tax revenues for the top 1 per cent of income earners fell as a share of GDP. The economy tanked for 10 years. There is an echo today of this.

As President, John F. Kennedy cut the highest marginal income tax rate from 91 per cent to 70 per cent. He also introduced the investment tax credit, accelerated depreciation for write offs, and the Kennedy Round tariff negotiation which lowered tariffs and trade barriers. Kennedy also cut the corporate tax rate from 52 per cent to 48 per cent. He tried to cut it to 46 per cent, but Republicans Barry Goldwater (in the Senate) and Bob Dole (in the House of Representatives) prevented that. The Republicans were the tax increasers back then. If you look at the Kennedy period, guess what happened to the tax revenues from the top 1 per cent of income earners? They went up as a share of GDP.

The next period in US history was what I like to refer to as the Four Stooges – Lyndon Johnson, Richard Nixon, Gerald Ford and Jimmy Carter. What I refer to as largest assemblage of bi-partisan ignorance ever put on planet earth. Every one of them raised taxes. From the wage and price controls tax surcharge with Johnson, it just doesn’t stop. Tax revenues from the top 1 per cent of income earners were flat to down during that whole period.

Then the skies opened, the sun shone forth onto the planet, the fields turned green, the animals flourished in the fields, the trees bore fruit, the children danced in the streets and Ronald Reagan was nominated as a presidential candidate for the Republicans. After his election we cut taxes. We cut the highest marginal income tax rate in the United States from 70 per cent to 28 per cent. We cut the corporate tax from 46 per cent to 34 per cent – and always with the support of the Democrats. In fact, we didn’t have majorities at that time and they all voted with us. We kept going with tax cuts. Anything that swam, we cut its taxes. If it flew, we cut its taxes, if it sat there, we cut its taxes. If it crawled, we cut taxes.

Personal income tax revenue from the top 1 per cent of income earners as a share of GDP in the US was 1.5 per cent in 1980. In 2006, after a binge of tax cuts, from Clinton all the way through, tax revenues from the top 1 per cent of income earners had gone to 3.2 per cent of GDP.

For all other groups, when you cut their taxes they pay less. When you raise their taxes, they pay more. But not the top 1 per cent. And why is that? The top 1 per cent are different from the rest. They’re rich. They can hire lawyers, accountants, deferred income specialists, congressmen, senators. You see these people hanging with Barack Obama. Don’t think for a moment these people are street people, trying to explain to the President what it’s like being poor. They’re not. They’re people in their asking for favours, and they usually get them. They’re all just trading. That’s all they do. Rich people can change the location of their income. I moved from California to Tennessee for tax reasons alone. Poor people don’t do that, I do that.

Rich people can change the timing of their income. Rich people can change the composition of their income. And they do. When you change tax rates of rich people they respond. The debate about raising taxes on the rich is fatuous in my mind and this is the battleground for the 2016 presidential race. The debate is what type of taxes do you raise or cut.

The other topic is stimulus spending, that is not just regular government spending, but spending above and beyond what the government normally would have spent to stimulate the economy. This is not paying for police, fire and all that, this is just “Woo Hoo, have a party guys!”

In the Obama period, stimulus spending has added up to about $3.75 trillion. Total federal taxes during this period were a little less than $2.5 trillion. So stimulus spending in this period, from 2007 to around 2010, would have been about one and three quarter years worth of total tax revenues.

Larry Summers, Director of the National Economic Council, is a Keynesian economist. A little short, but other than that not too bad. The logic is, if you give a guy $600, that guy will have $600 more than he otherwise would have had and he’ll spend part of that. That, in turn, will create jobs or output employment from the people he is now hiring, who otherwise would not have been hired had you not given him the $600. Those people who are now hired who would not have otherwise been hired have income that they would otherwise not have had, had this guy not been given $600. Then, with that higher income, they spent more than they would have spent had they not had the job and not had the income, and that in turn will create more jobs, more output, more employment, and there will be a cascading effect through the economy as the economy sort of lifts itself up from the bootstraps. If you want to follow it, this is Larry Summer’s lecture in London.

Now, as far as Larry Summers goes, he’s correct. It is true, if you give someone $600 that the person will spend more than he or she would have otherwise spent. That will in turn create more jobs, more output, more employment, higher incomes – that’s all true. But it’s not the whole truth. It’s the partial truth. It’s the first chapter in a three chapter book.

It is very true that the people who receive the stimulus spending are stimulated; they spend more than they otherwise would and that creates a chain of income, demand output and employment. That’s all true. But, unfortunately, the tooth fairy no longer works at the US Treasury. We live in a double entry accounting world. The government doesn’t create resources, the government redistributes resources. So every time the government uses funds to bail someone out of trouble, they also put everyone else into trouble. There is the transfer recipient, and the transfer payer or the taxpayer.

The transfer recipient is stimulated but the person from whom the resources are taken to give to the others, those people now have $600 less than they otherwise had. These people, in turn, spend less than they otherwise would have spent. That, in turn, un-employs people who had hereto been employed. They no longer have jobs because the people who lost the money are no longer buying goods from them. With their incomes down they spend less and there’s a cascading effect on the other side of the transaction that exactly offsets the first figure.

This insight came to us in economics through a French economist named Leon Walrus, a great economist. He came into the English language with Lord Hicks, in his book Value and Capital. What you learn from Walrus is that they went back to the Slutsky’s equation which shows that whenever you change a price, the income effects in a closed, total system, are always sum to zero. While the transfer recipients have a positive income effect, the transfer payers have a negative one, and those two effects are always sum to zero.

The example Walrus used is if the price of apples. If this rises, it is very true that apple growers will have higher incomes , they’ll be wealthier and they will spend more. But it’s equally as true that if the price of apples rises, consumers will be poorer, they’ll have lower incomes and they’ll spend less. These two effects offset each other by the hour, by the day, by the week, by the month, by the year to the 5360th decimal place.

There is no stimulus in stimulus spending. While the transfer recipients are stimulated, the transfer payers are de-stimulated and those two effects offset each other. In an economy of 100 apples produced, if the government takes ten of those apples and gives them to people based upon some characteristic other than work effort, the people who had 100 apples now only have 90 apples, and those income effects are there.

Now let me take you to the bad chapter, the chapter you’re not going to like. You’re not going to like it if you’re human. While the income effects of the Slutsky’s equation in an economy is always sum to zero, the substitution effects are not. The substitution effects aggregate across. Let me give you the Walrus example. If the price of apples rises, while those who grow apples are richer and have higher incomes and those who consume apples are poorer and have lower incomes, for every individual the higher price of apples will reduce their marginal incentive to consume apples, for rich and poor alike. For everyone who produces apples, the higher price of apples will incentivise them to produce more. The substitution effects work to a greater production of apples, and to lower consumption of apples to bring you back in equilibrium.

The same thing is true with regard to transfers. Substitution effects all work against higher output, employment and production. They all work to destroy the economy. I had the worst time with Senator Nelson from Wisconsin. It was around 1974 and Gerry Ford had just done his “Whip Inflation Now” which included a tax rebate. I was in Congressional testimony with Paul McCracken and Gardner Ackley. They were all, of course, fans of this tax rebate. I, of course, was not.

I was trying to explain substitution effects to Senator Nelson and I became frustrated. It was hard and I didn’t know how to do it. Finally, I said to him, “Senator, if those three other economists are wrong and this $600 stimulus is going to help us, what is wrong with you and those people in Congress? Don’t you love our country? If you love our country why stop at 600? Lets have a boom! Don’t just do $600, do $60,000, do a million, have a 100 per cent of GDP. Let’s do a stimulus package for 100 per cent GDP. So everyone who works and produces receives nothing and all those who don’t work and don’t produce get everything.”

Then I asked the Senator what did he honestly think would happen to output if this happened? Of course production would go to zero. You can’t trade something out of nothing.

Let me take that to today’s world. In today’s world, we had stimulus spending in the US of $3 trillion and $750 billion. The reason it is the great recession is because of our stimulus spending, not in spite of it. It is the government’s response that caused the great recession to exist, just like it did in the Great Depression. I took you through the tax rates in the Great Depression, I’ve taken you through stimulus spending here. In all honesty, stimulus spending and quantitative easing show how American economists don’t know their double entry accounting facts. They don’t understand that you cannot get something for nothing. There is no free lunch, as my colleague Milton Friedman put it. And, as Milton Friedman put it every single time, government spending is taxation pure and simple.

These are two of the key issues in the debates in US politics today. I don’t know whether these are important here in Australia but I guess they might be. This is the battleground. This is where the whole political nexus is coming together.

I’m going to leave you with a little fun. I’ve been to this BBQ before. The first time I was at it in the late 1970s when I was at it with the real president. I had no idea what it was. It smelt great, but I had no idea what it was. Now I know what it is. I used to tease the real president, and say:

Sir, you know it is my professional judgement as an academic, as a professor, as a Ph D economist, and in my personal judgement sir, that you truly are a certifiable genius. But some of my colleagues at the university don’t concur in my assessment of your intellectual acumen, sir. Some of my colleagues actually don’t think you’re very bright at all. But the one thing my colleagues and I do agree upon, is that your one unique characteristic is your uncanny ability to select your four predecessors. Anyone following Johnson, Nixon, Ford and Carter just can’t look bad.

I was with Reagan in 1976, and if he had been elected in 1976, as president, you would have not seen the same president that you saw. In all truth, it took Jimmy Carter to create Ronald Reagan. It really did. And in the same breath that it took Jimmy Carter to create Ronald Reagan, you will not believe how great the president who is going to follow Barack Obama will be.