An interview with Arthur B. Laffer, noted American economist

Arthur Betz Laffer is an American economist who postulated the famous “Laffer Curve”, which forms the basis of supply-side economics. Laffer curve suggests that when the tax level is too high, lower tax rates will boost government revenue through higher economic growth. The theory formed the basis of the economic growth in mid-80s, popularly dubbed “Reaganomics”, which saw low levels of inflation, steep rise in private investment, and rising incomes. Between 1982 – 1990, the theoretical foundations of Laffer Curve enabled the second longest peacetime economic expansion in U.S. history.

Arthur Laffer was a member of President Reagan’s Economic Policy Advisory Board during 1981-89. During the 1980s, he also advised Prime Minister Margaret Thatcher on fiscal policy in the UK. Laffer also served as an economic advisor to Donald Trump’s 2016 presidential campaign. In June 2019, he was awarded the Presidential Medal of Freedom for his contributions in the field of economics.

Earlier this month, Laffer visited Pakistan on the invitation of PRIME Institute, a public policy think tank that advocates market-based economy in the country. During his visit, Laffer also met with Prime Minister Imran Khan and other members of federal cabinet, and advocated broad-based, low-rate, flat taxation.

BR Research also sat down with Arthur B. Laffer during this short visit to capture the gist of his message for our readers. Below are the edited excerpts:

BR Research: the US economy is once again witnessing rising inflation, just as in late 1970s before Reagan took office. How was the policy response different at that time?

Arthur B. Laffer (ABL): The stagflation during the 1970s was a result of 16 years of disastrous economic policies championed by ‘largest assemblage of bipartisan ignorance’ in US history. These marked the presidencies of Johnson, Nixon, Ford, and Carter. The fiscal policy during that period was marred by high and rising inflation; and high and marginal tax rate of 70 percent.

This period of stagflation taught policymakers in the United States a fundamental economic lesson the hard way: you cannot tax your way out of a recession. In order to counter inflation, economies must increase the supply of goods, and reduce the quantity of money. Inflation can only be countered if economy is rooted in sound money. This marked the great shift from demand-side economic policies to supply-side policies across the western world, but more particularly in the United States.

In 1976, Reagan ran in Republican Party primaries on tax cuts, but argued that he will pay for those tax cuts through lowering waste, abuse, and fraud. He was not a believer back then and thus lost that race. By 1980s, Reagan ran on a genuine supply-side reform agenda, and won the presidency. With Paul Volcker at the Federal Reserve, US conducted the greatest experiment in low-rate flat taxes, and sound money; and the result was there for the world to see: inflation dropped, production of goods and services soared, and the economy took-off.

BRR: But evidence from across developed economies has established that low tax rates contribute to income and wealth inequality, which is possibly the greatest challenge currently facing global economies”

ABL: This is exactly the question I have addressed in my upcoming book: “Taxes Have Consequences”. The book is in-part directly aimed at champions of ‘wealth inequality’, namely Thomas Piketty, Emmanuel Saez, and Gabriel Zucman. What they do is they look at pre-tax reported income of the top 1-percenters, and analyse it as a share of total income.

Naturally, it seemingly appears that inequality was high before 1913 when income tax was first introduced in the US. By 1918, marginal tax rate was increased up to 77 percent, and as a result, income inequality dropped, or is so claimed. Similarly, during the roaring 1920s, inequality increased dramatically. In 1930s, equality came back and continued till late 1950s. These economists also like to point out that income inequality increased during the Reagan administration during 1980s.

But this is a patently wrong conclusion drawn from accurate data. Beginning 1943, IRS data is available on average income of top 1 percenters; while Saez and Piketty have reconstructed income data going back to 1913. I use their data for analysis in my book and find that whenever taxes are increased on the rich, invariably, the rich report a lot less income. This is due to reasons. One, when tax rate rises, rich earn less. Two, whatever they do earn, they shelter a lot more of it in tax havens and tax-exempt foundations. The reported earnings of the rich always follow this trend precisely.

But remember, reported income is not true income. Remember also the second point, that whenever tax rate is raised on the rich, they shelter a lot more of their income. As a result, when tax rates are raised for the rich, historic data shows that the economy always falters. From 1913 to 1918, the US economy did very poorly when the marginal tax rate on the rich was raised from 7 percent to 77 percent. From 1918 onwards, tax rate was cut down to 25 percent, and the US witnessed the roaring 1920s.

When taxes are raised on the rich, not only do they report a lot less income, the average tax rate does not change much. That’s because they report a lot less income, while the poor do even more badly. This is because rich are able to shelter their income, so tax revenues also fall sharply. By corollary, every time tax rates are cut, tax revenues – collected from the rich - increase sharply. And this has remained true throughout 1913 to the present day.

BRR: Fiscal and monetary expansion by governments – in response to the pandemic – is now being held responsible for rising inflation across the world. Do you agree?

ABL: What we see today is enormous amounts of government spending taking place to stimulate the economy. US government’s debt to GDP has gone from 82 percent to 105 percent and is forecast to go up to 125 percent next year. What does economic theory posit?

Let’s imagine that the US government deposited $1 billion in the checking account of each citizen. What will happen? Those working minimum wage or earning $20 per hour in dismal jobs would simply pull out of work. The labour participation rate in the US has dropped from 66 percent under Clinton to 61 percent today. These low productivity workers who have now left the workforce will also lose their skills over time.

Meanwhile, if the unemployed person were previously going to put their quarter million-dollar worth house for sale, they would no longer do so as they have a $1 billion in their account. So, this house disappears from the real estate market, lowering supply of houses. On the other hand, since every adult has$1 billion liquidity, the demand for housing will have increased.

This is effectively what has happened today. The workforce participation rate has dropped dramatically, while demand has increased rapidly due to transfer payments. That’s why the world is witnessing rising inflation in almost every country.

BRR: So, should the governments reduce transfer payments?

ABL: This is what transfer payments do. They lead to huge increase in demand, reduce supply, lower economic growth rate, create commodity price spiral across all categories, choke supply lines at ports due to low labour availability, lower workforce participation rate. That’s the income effect of large transfer payments.

Then there is also the substitution effect. Transfer payments take from those who have more and give it to those who have less. In the process, those who previously had more have a lower incentive to produce. Meanwhile, those who receive transfer payments now have an alternative source of income other than ‘work’. As a result, their incentive to work and produce also falls.

Whenever governments increase the size of transfer payments, total income falls. In fact, the theorem posits that if governments raised transfer payments such that every person ended up with some income, there would no income at all!

BRR: What is your policy prescription for developing countries like Pakistan, which suffer from narrow tax base, and very high indirect taxes?

ABL: Pakistan’s policymakers must take radical actions to reform economy by following five pillars of prosperity.

First, they must remember that while all taxes are bad, some are worse than others. Thus, pillar one is that governments must impose “lowest possible, flat tax rate, on the broadest possible tax base”. So, people have least possible incentive to evade, avoid, or otherwise under report taxable income.

Second, they must never mix government spending with taxation. Taxes are a negative incentive. Spending is a positive incentive. Positive incentives tell you what to do. For example, if you feed a dog at the same time every day, you can predict where the dog will be at feeding time tomorrow or day after. If you beat the dog at the same place every day, you can predict that tomorrow the dog won’t be found in that one place where it received the beating.

Just the same way, taxes are a negative incentive. They tell people what not to do i.e., not to report (or under report/how not to report) taxable income. That may be achieved through evasion, avoidance, moving to underground or informal economy, or moving to a different tax jurisdiction altogether.

Thus, policymakers must never mix a positive incentive with a negative incentive. The tax code must exclusively exist to raise revenues only. There should not be any tax credits, deductions, exemptions, or exclusions. It should be the lowest possible rate on a broadest possible tax base.

Moreover, government is elected so spend public money in the most beneficial fashion. Also remember, the first pillar of prosperity, which posits that all taxes are bad, but some are worse than others.

Thus, governments must stop spending when the damage done by the last dollar of tax collected is equal to the benefit caused by the last dollar of tax revenue spent. That’s the right size of the government. Any government smaller than that size needs to expand; any government larger than that size needs to be cut down in size. Thus, the second pillar of prosperity is spending restraint, and right size of government.

Third pillar of prosperity is sound money. There is nothing that can bring down an economy to its knees faster than weak money. When Reagan took office in 1981, prime interest rate in US stood at 21.5 percent. Mortgage rates were in the vicinity of 18 – 19 percent. No economy can function when inflation rates are so high, and currency is fast losing its value.

Fourth pillar is minimum regulations, as regulations must never go beyond the specific objective at hand. Over regulation kills the economy, by assuming that the private sector cannot handle itself. And lastly, free trade. Policy makers must always remember that there is something their economy does better than foreigners; and other things that foreigners can do better than them. The theory of comparative advantage is thousands of years old, and dates back to medieval Muslim philosopher Ibn-e-Khaldun. Policymakers must never allow the hubris of self-sufficiency and isolationism takes themselves over, and always allow free trade to flourish so that consumers everywhere can benefit.

BRR: Developing countries such as Pakistan also suffer from scrouge of corruption, where whatever little tax revenues are collected are lost to public sector inefficiencies.

ABL: Politicians everywhere behave in a similar fashion, and are prone to indulging in corruption. But let’s first take example of two companies: A and B. The top management in Company A has high salary, owns no stock, nor stock options. Management of Company B has low salary, owns lots of stocks, and also has stock options. Invariably, investors will always choose Company B over Company A for investment. Why? Because the incentives of management performance are completely aligned with performance of the company/stock in the second case.

The problem with politicians is similar. That is, they have no incentive to make efficient choices. They spend other people’s money, and spending other people’s money is always fun. Whether the economy does well or whether does poorly, the salary of politicians, congressmen, and parliamentarians never change. Politicians simply do not have the incentive to do the right thing.

And that logic applies to every country in the world: whether it is USA, Pakistan, or Venezuela. Nowhere in the world do Presidents or congressmen die poor.

And same principle applies to economists who take positions in the government as advisors. Once you take a pay-check from the government, you become its subordinate, and then your job becomes to make the politician’s performance look good, even when you know the government is performing poorly.