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Prosperity for All: An Interview with Arthur Laffer

Flickr. As Uncle Pennybags well knows, you can’t tax your way to prosperity.

Octavian Report: Do you think that any of the current GOP candidates have the will to produce actual change if elected?

Arthur Laffer: My view of this primary stuff is that politicians are united by one single characteristic not shared with most of the rest of the population. These people are united by the fact that they had bad mommies. These are people who did not have a value system instilled inside of them. Reagan probably spent three hours a day getting dressed. You’ve never seen a picture of Reagan with a hair out of place. Jack Kemp was an usher in my wedding. We would walk down Michigan Avenue in front of Marshall Field’s, past those big glass windows that you can see your own reflection in. He would flex in front of those and do his hair.

The neat thing about America is you can actually elect the president here. And candidacy is the perfect role for people with this characteristic because they become living, breathing, poll-taking machines. By the time the primary is over, my best guess is you’re going to get a candidate out of this process who is really fantastic and really reflects the mood of the electorate in a democratic sense of the word.

OR: Where do you think the mood of the country or the mood of the party is going to push whoever gets the nomination?

Laffer: I think we need far less compromise on basic principles of economics. You can’t tax an economy into prosperity. Forgive me for saying that, but you can’t. A poor person can’t spend himself or herself into wealth. Stimulus spending and taxation are the two biggest detractors of this economy. They are the reason why we’ve had the single worst recovery in history. We’ve got to reverse those and move towards the flat tax, sound money, free trade, spending restraint, and minimal regulations. The further we move in those directions, the better off the economy will be and the better off every single American will be. All any pandering does is cause everyone else suffering.

OR: Why does this agenda seem to be tied permanently together with isolationism and social ultraconservatism?

Laffer: I don’t know. Maybe it’s because there are only two parties, and you have to get 57,312 characteristics into each. When we came in in 1981, we had all of those elements in the Republican Party. We had the Pat Buchanans, we had the religious right, all of that stuff.

OR: You’ve long advocated the flat tax, a complete and radical overhaul of the tax code.

Laffer: Does the flat tax sound right-wing to you?

OR: It sounds very libertarian.

Laffer: Let me tell you who ran on it. In 1992, Jerry Brown ran on a complete flat tax. I worked with him on that campaign. We got rid of the personal income tax. We got rid of the corporate profits tax. We got rid of all payroll taxes. We got rid of the Medicare and Medicaid taxes — all of them. We got rid of all excise taxes. We got rid of all tariffs. And we went from eighth in the Democratic primary to second. We would have beaten Clinton had Brown not named Jesse Jackson as his running mate just before the New York primary.

There is a strong, strong feeling in this country towards the flat tax. Everyone thinks of it as being fair. You all pay the same rate. If you make 10 times as much as I do, you pay 10 times as much in taxes.

OR: Do you think that Obama is out of step with the general view of the country on that question?

Laffer: I don’t know about that, but he’s out of step with economics. He doesn’t understand word one. If you tax rich people and you give the money to poor people, you’re going to get lots and lots of poor people and no rich people. It’s straight, basic economics. If you reward behavior, you’re going to get more of it. If you punish behavior, you’ll get less of it. He is paying people not to work and he’s taxing people if they do work. It’s just outright stupid. Warren Buffett, remember, in 2010 paid $7 million in taxes. His income, conservatively estimated, was $12 to $13 billion. His effective tax was six one-hundredths of one percent. And he advocated raising tax rates on things that he hadn’t paid taxes on, for which he got the Presidential Medal of Freedom. That was his reward for being duplicitous — legally duplicitous, mind you, but duplicitous.

OR: There’s a lot of commentary now that supply-side economics, including your invention the Laffer Curve, has been discredited.

Laffer: I didn’t come up with the Laffer Curve. And you can’t discredit it. It’s been economics for a thousand years. The earliest explicit reference to it was in the Muqaddimah by Ibn Khaldun — which was written about 1,200 years ago. People like doing things they find attractive and don’t like doing things they find unattractive. Government policies can affect the attractiveness of specific activities. That’s why I say the last thing you want to do is raise taxes on work and increase payments for non-work, leisure, and unemployment. John Maynard Keynes has the most cool reference to this phenomenon I have ever seen. You can over-tax products to the point where you actually get less revenue.

OR: What would Keynes be thinking about what’s been going on economically in recent years?

Laffer: Keynes would be right in line with me. He was writing about the Great Depression. He wasn’t talking about a standard behavior of government. The Keynesian model he meant to be a desperate, final attempt to pull a system out of a crushing and historically bad depression. He never agreed with liquidity traps for anything other than the most extreme cases. Once every thousand years you would do something like that: quantitative easing and Operation Twist. The IS and the LM curves are not natural states, according to Keynes. He understood this very well, as you can see if you go to any of his writings. He understood classical economics really, really well. He wrote this stuff to address a very unique, special situation in the world called the Great Depression.

OR: A number of thoughtful people feel that current monetary policy is a coordinated debasement of the currency. Do you think that we’re beyond the point of no return?

Laffer: No.

OR: How do we get out at this point?

Laffer: We went from $840 billion monetary base before QE1 to about $4 trillion monetary base now. If I know my numbers correctly, I think the currency in circulation was about $800 billion and bank reserves were about $45 billion before the beginning of QE1. Now currency in circulation is around $1.2 trillion and bank reserves are at $2.8 trillion. The Fed has also extended the duration of their balance sheet, so that the maturity of their assets is extraordinarily long.

There are two issues I see as really critical in the Fed’s balance sheet. One, by having such a long maturity, the mark-to-market value of the Fed’s balance sheet is highly sensitive to changes in interest rates. If the 10-year were to go up to six percent, the Fed would have an unfunded liability of about $800 billion — maybe even a little bit more. I find that extraordinarily worrisome. Though all of my colleagues do not worry about this: they say the Fed owes these liabilities to itself and that it can hold the assets to maturity. I don’t think that’s a good argument.

I’m very worried about the insolvency of the Fed. I’m very worried about the monetary base and that excess reserves are huge. Excess reserves are something like $2.7 trillion. I mean, it’s just an enormous number — which means that if inflation gets started there would be no way to stop it.

OR: Could you actually go into why you are concerned about the Fed being owed money by itself to itself?

Laffer: Because my model of how the Fed behaves has proven to be very incorrect. I had the classic textbook model à la Bernanke, à la every Fed person, à la Milton Friedman. This holds that open market operations increase the monetary base. The monetary base through the money multiplier increases the money supply, and the increase in the money supply matched by the quantity of goods is the inflation driver. Inflation is everywhere and at all times a monetary phenomenon. That has been my mantra for years and years. It’s proven out pretty well — until we got to 2008. It has proven to be a total loser since then. I’m still worried about it.

OR: Why do you think that is?

Laffer: I don’t know. I tend to want to go back to Fischer Black’s article on inflation, that it’s a metastable equilibrium situation. I really have a hard time in my heart believing that.

OR: Do you think the Fed will raise rates?

Laffer: I think probably they will. That’s what I’m worried about. If inflation starts there is no restraint on it coming from the monetary base. Excess reserves are about $2.5 or $2.6 or $2.7 trillion — and that worries me. If excess reserves were zero today, I would have very little fear of inflation.

Imagine as I outline what follows that I have support from both the House and the Senate, that the President loves me and gives me full support, and that I have total control of the Fed and the Treasury. What I would do is to take the Fed’s balance sheet and swap all assets of maturity two years or more with the Treasury for T-bills laddered between zero and two years. It would be a net-zero transaction. By doing that, even though the balance sheet of the Fed would still be the same, the risk, the sensitivity of the solvency of the Fed to interest rates, would be removed almost completely. Now, you could take the 10-year up to six percent or seven percent, and there’s virtually no change whatsoever in the mark-to-market value of the Fed’s assets.

After that, I’d take all the excess reserves at the Fed and distribute them pro rata to all the major banks in proportion to their excess-reserves holdings until I brought excess reserves down to zero. By doing that I would remove the risk. Other people don’t think it is a risk at all. I don’t think they’re being realistic.

OR: The conventional view holds that these massive excess reserves you’re talking about have already been sterilized, correct?

Laffer: Yes. They’ve allegedly been sterilized because interest is paid on them. Nonsense. It’s 25 bips. Give me a break. Take me through their process there. Look at an individual bank with $1 reserves and you’ll find that 25 bips is nothing, if there are any interest rates out in the market to be had from lending.

OR: Do you think that they’ll be able to raise rates in view of the dollar rising? Do they seem to be very worried about that now?

Laffer: Let me get it out of rate context. If they raise the TIPS yield, I’d be really happy because the TIPS is the expected real return on the unit of capital over the maturity of the TIP instrument. If they raise the nominal yield because of expected inflation, I’ve got a problem. It’s not just what happens to yields. It’s how those yields are construed. Now, I think cutting tax rates, going to a lower-rate broad-based flat tax, imposing spending restraints, creating sound money, pushing free trade, setting up minimal regulations, and then getting the government the hell out of the way would increase the expected real return on capital dramatically and rates would rise a lot — but not because of inflation. That, I think, would be wonderful.

OR: You don’t think that would pop a housing bubble or debt bubble?

Laffer: No. I don’t think there is any housing bubble. We’ve got the worst housing market since 2006 and it’s shown no signs of improving. None. New housing starts per 10,000 population is way below its historical trend and has been since 2006.

OR: Are you worried about the general credit market?

Laffer: Yeah. Sure. I’m of course worried about it. Basically because of the quixotic nature of government fiscal policy. The government can change the rules and make your firm insolvent in a split second — and they do this everyday. Like all these banks that took over failing banks and now are liable for the failing banks that they were required to take over by the Fed.

OR: Do you see the last 150 years in the U.S. as a constant movement forward in terms of the size of the government, increased regulation, and increased regulatory and tax complexity?

Laffer: No. When I was born in the early 1940s, the highest marginal income tax rate in the United States was 92.5 percent. Can you imagine the political world back then? Can you imagine the debate between liberals and conservatives? With the conservative saying, “Okay, okay, okay. Hey, I’ll go along with 92.5 percent. But 95 percent? That’s gouging!” and the liberal saying, “Yeah, yeah, yeah. But 87.5 percent — that’s a giveaway to the fat-cat rich!” Yet that’s the way it was back then. Kennedy cut it from 91 percent to 70 percent. Reagan cut it from 70 percent to 28 percent. We are winning the war completely. 

When we cut the corporate tax rate in 1986, we cut the highest marginal tax rate on corporations from 46 percent to 34 percent. At 34 percent, we were the lowest rate in all the OECD, maybe even in the world. Today, that rate is the highest rate — it’s back up to 35 percent. The world is with us. We’re winning everything. Plot union membership in the U.S. Plot right to work states. Plot states that have a death tax.

OR: Social Security and Medicare do not have realistic assumptions right now. Do you think it’s going to take some sort of crisis to have them actually address the issue in Washington?

Laffer: No. It takes a leader. And the single most important issue of the Republican primary is how we train the eventual nominee through the primary and on into the general election to become a great leader. So let me talk to you about Ronald Reagan for a little bit.

I worked with Reagan from the very beginning of my professional life. Reagan, before he became governor of California, was head of AFTRA and SAG. He was the first union president to call an industry-wide strike — and it was violent. He was an anti-business union leader. As governor of California in 1966, he, through his own legislation, raised the highest marginal income tax rate from 9.3 percent to 11.2 percent. He raised the capital gains tax rate from 9.3 to 11.2 percent. He raised the corporate tax rate from nine percent to 11 percent. He wasn’t pushed into this by Democrats. He did it on his own. Who would believe that that man would become the greatest president we’ve had in generations?

Ronald Reagan was like all of these politicians. He learned as he went along. If he had been elected in 1976, he would have been a very different president. The reason Reagan was so great was not because God granted him a gift from on high through a star above a manger. Reagan was great because he learned.

OR: Do you think Hillary might learn?

Laffer: Yes. I think there’s a chance she would. For Bill Clinton’s first two years, he was a yahoo, but for the rest of his six years he was the best president we’ve had in ages. Clinton was as good as Reagan. He personally pushed NAFTA through Congress against his own party, against the unions. He got rid of the retirement tests on Social Security. He voted for welfare reform and signed it into law. What’s not to love about Clinton? Hillary might be good too.

OR: Do you think she’s going to be the next president?

Laffer: No, I don’t. But I’m still going to watch her.

OR: Do you think Obama has done a lot to exacerbate income inequality?

Laffer: Yes. Of course he has. Everyone knows you can’t get money from rich people. Rich people can change the timing of their income. They can change the location of their income. They can change the composition of their income. They can change the volume of their income. They have the means to hire the lawyers, the accountants, the deferred income specialists, the favor-grabbers, the congressmen, the senators. When you see a group of people hanging out with Obama, don’t think for a moment these are people trying to explain to him what it’s like being poor.

OR: Do you see continued reductions in military spending after the election?

Laffer: I don’t know. I would imagine military spending will be reevaluated quite strongly, not so much in volume but as in how it’s allocated and how it’s decided.

Look at sanctions. We’ve had sanctions on North Korea now for 65 years. Did they work out well? Did the North Koreans see the light and become a free-market, pro-growth, democratic, capitalist nation? No. They are the most hardened anti-American group in the world other than Cuba.

These stupid politicians don’t understand trade theory at all. All sanctions do is hostilize these people against us and hurt us besides. When we put sanctions on Libya, all that happened was that the American oil companies were forced to sell all their facilities there and the Italians, the French, and the Germans all bought them. They got a great bargain in the process. It didn’t change Gadhafi all. We should never put sanctions on enemies. We should always open up trade to make sure we get in there and get them relying on us as much as possible. Though I predict Hillary, if elected, would go crazy on sanctions.

In general, you have to get rid of the hostility in government policies. Rich people are not the enemy. China is not our enemy. China is our best friend. Without China there’s no Walmart and without Walmart there is no middle- or working-class prosperity. I have rich clients here at the firm. I don’t hate my customers for giving me checks. I love them, and yet the government hates rich taxpayers. They should be out there hugging every rich person who writes them a check, not flipping them off.

Voluntary compliance should be the governing concept in all tax structures. I know it won’t be 100 percent. But if rich people feel they’re paying tax rates that are fair, they’ll voluntarily comply and pay them. If you try to screw them, they’re going to try to screw you — and they’ll succeed.

OR: Do you think that the rhetoric around this issue is going to be toned down in the future?

Laffer: Let me bring you back to the 1986 Tax Act. If you go back in time and think about Dan Rostenkowski, Tip O’Neill, Jim Wright — these were not peaceful, loving, wonderful, cuddly people. These people were as bad as Pelosi, Reid, and Obama. They were terrifying.

But in the 1986 Tax Act we cut the highest marginal income tax rate in America down to 28 percent, just to make sure the fat cats got fatter, quicker. We then cut the highest corporate income tax rate from 46 percent to 34 percent, just in case we missed a couple with the income tax. To make sure we didn’t let our poor and disenfranchised off too easily, we raised the lowest tax rate from 12.5 percent to 15 percent. This was the first tax bill ever in U.S. history where the highest rates were lowered and the lowest rates were raised.

We got rid of all sorts of deductions, exemptions, and exclusions, to make it exactly revenue neutral. We went from 14 tax brackets to two tax brackets: 15 percent and 28 percent. Can you imagine that bill today in Congress? You wouldn’t get one vote on either side. Let me tell you what the vote was in the Senate: 97 to three in favor of that bill. 97 to three, and that was the whole bill I just described to you. There wasn’t anything else in there to sweeten it up.

Let me tell you some of the ones who voted for it: Alan Cranston from California, Mr. Lefty-Wefty. My neighbor and dear friend here, Al Gore, loved it; he told me six months ago it was the best bill he ever voted for. Howard Metzenbaum, Mr. Death Tax himself from Ohio, voted for it. Mr. Tall and Pink, Bill Bradley, voted for it. That guy from Delaware, Joe Biden, voted for it. Chris Dodd voted for it. Teddy Kennedy voted for it. Barbara Boxer voted for it. Harry Reid voted for it. Dick Durbin voted for it. Charlie Rangel voted for it. Chuck Schumer voted for it.

Why did these guys vote for it? Because they knew it was right. That’s the whole reason why.

OR: Do you think that economics is the main issue in the current political landscape?

Laffer: It’s the only issue. You can’t have a strong defense in a weak economy. What the hell is the meaning of gay rights in the soup kitchen? Of equal rights in an unemployment line? It’s dumb. When you have a full-employment economy, racists are so busy making money they can’t afford to be racists. Kids in the inner city will get jobs. The best form of welfare is still a good, high-paying job. No American was ever made better off by pulling a fellow American down. We’re all made better off whenever any one of us is made better off.

OR: Are you bullish now on the U.S. economy?

Laffer: I’m bullish about what it’s going to become in 2018. It’s a long way off, but we’ve turned the corner. I’ve been to this barbecue before and I’ve seen how it plays out. You are going to be thrilled by how this plays out.

OR: You say that Reagan only became Reagan when he became president. Is that true as well on foreign policy?

Laffer: I don’t know. That’s not my turf. But I used to love talking to Reagan about foreign policy because it gave me goosebumps. I’ll tell you one story. Right after the fall of Grenada, he and Mrs. Reagan came back out to California. They went up to Rancho del Cielo and then he came down to the Century Plaza. He and my godparents would go to Chasen’s for dinner; I came along and I asked him how he made his decision to invade Grenada. His comment to me was: “Well, Art, I just asked myself what would John Wayne have done.” It’s exactly the right answer. He didn’t sit there and say, “What? I don’t know. Let me get my pollsters in here.” If I wore the white hat, what would the scriptwriters write for me? What’s the right thing to do? I love that stuff.

That decisiveness is what we’re missing now on the economic side. You know how to make this economy great? You have a low-rate, broad-based flat tax and get rid of all the other taxes. You provide people with the fewest incentives to evade, avoid, or otherwise not report taxable income and the fewest places in which they can stick their income to avoid paying taxes. Spending restraint: you and I know that government spending is taxation, pure and simple. The Tooth Fairy doesn’t work at the Treasury and governments don’t create resources. They redistribute them.

Sound money is critical. You can bring an economy to its knees with unsound money. Free trade: there are some things we do better than foreigners and there are some things foreigners do better than we do. We and they would be foolishly extreme if we didn’t sell them those things we make better than they do in exchange for those things they make better than we do. Lastly, regulations. Everyone knows we need regulations. But what we want to make sure is we don’t go beyond the specific purpose at hand and create a lot of collateral damage.

Low-rate, broad-based flat tax, spending restraints, sound money, free trade, minimal regulations, then get the hell out of the way and let the economy soar. We’re pretty close to that period. Once that process starts, you can’t believe how it becomes a contagion. Look at the way it was in 1986. Everyone was a tax cutter back then. Everyone was a spending controller. The economy was roaring. It’s amazing how brilliant people are in bull markets.

OR: What do you think changed it?

Laffer: Once rich people get very rich, they feel guilty and they start going the other way. Once they start going the other way, they keep going until the country becomes Greece or Puerto Rico, until the city looks like Detroit or Chicago. Once you get far enough down, all of a sudden there are no options left — and you have to go grow. We’re pretty close to that. We’re really very close. Remember, trying to tax your way to prosperity by soaking the rich is like playing dodgeball. These guys think of the world in dodgeball terms, where the person whom you’re throwing the ball at doesn’t move. The problem is they do move. If you raise taxes, people don’t keep the same income constellation. They change their behavior. Whenever we’ve cut tax rates on the rich, the revenues have increased from the rich. Whenever we’ve raised tax rates on the rich, except in 1913, we’ve collected less money.

OR: That’s fantastic. Thank you.