I.O.U.S.A. (57 page)

It ’ s a lose/lose situation. There is no argument I can think to ever oppose cutting the capital gains tax rate if you number one, collected more revenues and, number two, made people who invest better off. That ’ s a win/win for everyone.

But even if the cut in the tax rate did not increase capital gains tax receipts, you still might make it a no - brainer, a win/win for everyone. For example, with lower capital gains tax rates, you ’ re going to get more investment, more output, more employment, more production. You ’ ll have more sales taxes, more income taxes, more payroll taxes — all sorts of other taxes will increase.

Even if you don ’ t collect more revenues from the capital gains tax itself, you may, in fact, collect more revenues for the federal government in total.

But even if you collect fewer total revenues in the federal government from a cut in the capital gains tax rate, you still might make it a no - brainer. For example, a lot of government spending is predicated on needs tests, means tests, and income tests.

You have unemployment benefi ts, you have food stamps, and you have supplemental security income. But if you cut the capital gains tax rate and increase output employment and production, that should lead to a reduction in government spending. So even if the shortfall in revenues is there, you might have an induced reduction in spending that would more than offset the shortfall in revenues, and you would actually have a reduction in total debt. That would still be a no - brainer for cutting the capital gains tax rate.

Even if the federal government debt increases, there are state and local governments that will benefi t by the federal capital gains tax rate reduction. They ’ ll collect more taxes. They ’ ll spend less. If the total amount of debt, federal, state, and local, is reduced, I see no argument on God ’ s earth as to why you wouldn ’ t want to cut the capital gains tax rate.

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Even if that ’ s not true, even if all debt goes up, you still want to look at the time pattern of this debt. Let ’ s imagine, for a moment, that I build a factory based upon a presumed tax rate of 10 percent on corporate profi ts. The day I fi nish that factory, the tax rate goes up, from 10 percent to 90 percent. Do I tear the factory down? Of course not. I don ’ t tear it down, but when things wear out, I don ’ t replace them. It takes a long time to create a capital stock, and it takes a long time to destroy a capital stock. Supply and demand elasticities are very much greater after a long period of time than they are immediately. Even if the immediate impact of lowering the capital gains tax rate is to increase federal, state, and local debt over time, when those elasticities become greater and greater, that debt will fall, and, in fact, you might even get surpluses.

When you look at the overall picture, you want to consider the discounted present value of all future debt. That is the essence of the Laffer curve [the relationship between tax rates and tax revenue collected by governments]. The Laffer curve is not the end - all and be - all for cutting tax rates. You really want the government to benefi t society. If you create more output, employment, and production, you may still want to even have larger defi cits because it ’ s great for society.

You should not use the Laffer curve as your tax criteria. The last thing you ever want to do is maximize tax receipts in a society.

You want your tax rates way below that point. It ’ s not simple, or not easy. You ’ ve got to think it through very, very carefully. In certain areas, where you have the capital gains tax rate and higher taxes on personal income, there are very strong feedback effects.

On other taxes, you don ’ t have those same strong feedback effects.

The political issue today is what to do with the highest marginal tax rates, such as inheritance, capital gains, and dividends. I would argue that those are the exact areas in which you get the most feedback effects and in which you ’ re most likely to be into the prohibitive range of the overall Laffer curve. If people try to raise the highest marginal tax rates on the rich and lower them on the poor, believe me when I tell you they ’ re going to destroy the economy and they ’ re going to create huge defi cits.

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Q:
Can you talk about it in a personal way?

Arthur Laffer:
If you ’ re talking about the time value of debt, that ’ s a little complex and arcane. The point I ’ m making is that you never can tax an economy into prosperity. If you want to create growth, people have to have incentives to grow. You can create growth to get yourself out of a defi cit problem.

In the 1980s, we saw the country overrun by Fabian socialists.

Tax rates were out of control, infl ation was out of control. When we took offi ce, the prime interest rate was 21.5 percent. Can you imagine that? Tax on what they called unearned income was 70

percent. In 1978, Steiger - Hansen had cut the capital gains tax rate but, before that, it was at 35 percent on nominal capital gains, not real capital gains. The effective tax rate on real capital gains prior to 1978 was probably well over 100 percent for many, many years.

These were seriously bad taxes and structures.

We tried to cut tax rates and put in a sound monetary policy.

That was Paul Volcker all the way, and he did a great job. Ronnie Reagan did a great job on fi scal policy, on regulatory policy, and on trade policy — we had tariff cuts. It was great. We grew the economy like mad and we grew our way out of the fi scal crisis.

And that ’ s exactly what you ’ re supposed to do. It was Reagan and Clinton who really created the surpluses at the end of the Clinton era.

Clinton did a great job when he was president. He pushed NAFTA through Congress against his own party and against the unions. He put in welfare reform, the idea that you actually have to look for a job before you get welfare. He cut government spending as a share of GDP, by three and a half percentage points, more than any other president ever had done. He signed into law the biggest capital gains tax rate reduction in our nation ’ s history, exempted owner - occupied homes from any capital gains taxes. That ’ s amazing. He got rid of the retirement test on Social Security. He reappointed Reagan ’ s Fed chairman twice. Yes. In his fi rst two years, he made a huge mistake on the personal income tax and he pushed through a bill that cost c17.indd 228

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him the House, the Senate, the governorships, and the state legislators. He then switched and became more Reagan than Reagan and was a great president for the last six years of his term in offi ce. I ’ m a huge fan of Clinton.

Q:
Can you tell us about the crisis you inherited when you went
into offi ce?

Arthur Laffer:
I told my mom, “ Mom, you can ’ t believe it. I just wrote a speech for Nixon and he used every single word. Well, he did make two little changes. Everywhere I had ‘ is, ’ he put ‘ is not ’

and everywhere I had ‘ is not ’ he put ‘ is, ’ but other than that, Mom, it ’ s exactly my speech. ” Nixon did all sorts of things wrong: the import surcharge, the wage and price controls, the huge increase in social spending, the doubling of the capital gains tax rate.

But, to my way of thinking, Nixon ’ s biggest problem was going off gold. I am a strong advocate of sound money. I believe that it ’ s basically the Fed ’ s responsibility to guarantee the value of the dollar; to make sure we don ’ t have infl ation. Nixon wanted us to go off the gold, which led to the high interest rates and hyper infl ation of the ’ 70s and very early ’ 80s. In fact, it really was a global phenomenon.

There was one person whose side I was on. Paul Volcker and I worked on going off gold — that was our task — but both of us shared a view that we needed to keep on the gold standard to provide discipline to the monetary authorities. And, unfortunately, we lost the battle. They went off gold and you can see the consequences: the devaluation of the dollar back in the early 1970s. But when Volcker came back in later as Fed chairman, it was just spectacular what he did. He and Ronald Reagan were the two instruments of the prosperity of the ’ 80s.

Q:
Could you characterize the environment that led to Nixon
wanting to devalue the dollar?

Arthur Laffer:
In the 1970s, we had all sorts of economic problems. Infl ation was rising. We had a weakening of the dollar through Johnson and Nixon. Even before Johnson, we had a weakening with Kennedy. There were all sorts of restrictions on c17.indd 229

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trade. You may remember that Kennedy had a problem with France on the dollar and then, when Johnson came in, he, too, had them.

We had the Buy America program, the interest equalization tax, the voluntary foreign credit restraint program, all of these things aimed at improving the trade balance, the capital balance of the U.S. And, throughout this whole period, we had reduced our reserves of gold and we really had not used gold as the discipline that it should have been. That ’ s with the Bretton Woods agreement.

When we came into the 1970s with Richard Nixon, I was very involved — as you may know, I was the fi rst chief economist at the OMB when it was formed. In fact, I joined the government in October 1970. I was George Schultz ’ s right - hand person back then, his economist. My fi rst job was a trip to China. I was in charge of mainland China for the White House, which, for a kid my age back then, was pretty cool.

Q:
How old were you?

Arthur Laffer:
I was 29, maybe 30. At that time, we wanted to devalue the dollar and the French did not. John Connolly was our union representative and he was discussing this with Giscard d ’ Estaing, and Giscard d ’ Estaing was trying to explain to Connolly why they really could not allow the U.S. to devalue the dollar. This was just before the Smithsonian Accord. He said, “ Mr. Connolly, I don ’ t know if you understand the program from the standpoint of France, but you see, sir, we hold the dollars in reserves and, therefore, if we allow you to devalue the dollar against the French franc, we will suffer the capital loss on the reserves in France. That is what will happen. ”

And with that, Connolly takes his unlit cigar, swirls it in his mouth, puts his foot up on the table with boots on, points that cigar at Giscard, and says, “ Well, hell, Giscard, we have more dollars than you do. ” And, of course, everyone bursts out laughing.

But going off gold and devaluing the dollar was a very big mistake.

It caused a decade of hyperinfl ation, high interest rates, and the collapse of the world economy. We raised tax rates dramatically under Nixon and we devalued the dollar. We caused this c17.indd 230

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hyperinfl ation. It was a double whammy, and it led to one of the worst 15 - or 16 - year time periods in the U.S.

After the Kennedy go - go 1960s, the Dow Jones Industrial Average peaked in February 1966 at just about 1,000. Sixteen and a half years later, in August 1982, the Dow Jones Industrial Average was about 800. Ouch. In 16½ years, the nominal value of America ’ s stock market fell by 20 percent, and that doesn ’ t count the trebling of the price level during that period. The average annual real rate of return from February 1966 to August ‘ 82 on the Dow Jones Industrial Average was minus 8 percent per annum compounded annually. That bear market was caused by Nixon ’ s devaluation of the dollar and by high taxes and by restrictions on trade.

In the ‘ 80s, we reversed those policies. Paul Volcker brought us back to sound money. Ronald Reagan gave us tax rate reductions and we had a prosperity that had not been seen on planet Earth for a long, long time. We cut tax rates, we had sound money, we had free trade, and we had minimal regulations. All the four grand kingdoms of macroeconomics were put in the right place. The Dow Jones Industrial Average in August 1982 was at 800. Today it ’ s at 13,500. That is a bull market. In the ’80s, we would have given our right arms to have an unemployment rate as low as 6

percent. We ’ ve had the long bond yield fall to 4.5 percent. When the long bond is at 4.5 percent, the gods truly love you. We ’ ve had a tremendous prosperity. I ’ m going to say it here and I say it seriously: If they reverse those policies, if these tax increasers try to raise taxes on the rich and have unbridled monetary expansion, or if they try to restrict imports or stop illegal immigration or try to reregulate the economy, believe me that the fi lm will play backwards. You ’ re going to get a mini 1960s/ ’ 70s period again.

It ’ s a catastrophe that they ’ re proposing.

Q:
What was it like be a part of the administration as you argued
successfully for the tax cuts? At the same time, can you talk
about how Paul Volcker restored sound money?

Arthur Laffer:
I watched the world go to hell in a handbasket under Richard Nixon. I liked the people there, but for everything c17.indd 231

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I believed in, everything I thought was sound economics, the opposite was done. Under Nixon, we had the import surcharge, we had the doubling of the capital tax gains tax, we had the unhinging of the paper currency, and we had Social Security and tobacco. We had all of this stuff happening under Nixon. That was part and parcel of one of the worst periods in U.S. history.

Before Reagan, I had done a lot of work with Bill Steiger on the capital gains tax rate reduction. I was very involved with Proposition 13 in California in 1978. Then you got Paul Volcker in 1979, and Ronald Reagan in 1980, with all of the policies of the tax cuts, sound money by Volcker, free trade, and deregulation. It was just a beautiful era. Paul Volcker clearly knew what he was doing on monetary policy and was spectacular.