1 The Laffer Curve and the Failure of Stimulus Spending Lecture delivered to the Institute of Economic Affairs 27th June 2012 IEA Current Controversies Paper No. 38 by Dr. Arthur Laffer November 2012 The Institute of Economic Affairs, 2 Lord North Street, London, SW1P 3LB; Tel 020 7799 8900; email [email protected] 2 About the author Dr. Arthur B. Laffer is founder and chairman of Laffer Associates and was a member of President Reagan’s Economic Policy Advisory Board for both of his two terms. Dr. Laffer also advised Prime Minister Margaret Thatcher on fiscal policy in the U.K. during the 1980s. He has been a faculty member at the University of Chicago, University of Southern California and Pepperdine University. Dr. Laffer received a B.A. in economics from Yale University in 1963. He received a MBA and a Ph.D. in economics from Stanford University in 1965 and 1972 respectively. 3 Contents Executive Summary 4 Lecture 5 Raising tax rates and reducing revenues 7 “Stimulus” spending 11 Questions and discussion from the floor 14 4 Executive Summary • If there is a Republican administration after the November presidential elections, we can expect a significant change of policy on tax, spending and stimulus. • There is a rich variety of data from the USA that demonstrates that raising tax rates often reduces revenues and vice versa. This is especially so when raising taxes from the high rates that we currently have. • There are many examples over the last century when tax rates were reduced, economic growth increased and the proportion of the tax take from rich people increased. • So-called fiscal stimulus policy does not work. A stimulus has to be financed and the income effects on those benefiting from the stimulus are cancelled by the “destimulus” from those financing it. • To make matters worse, a fiscal stimulus will normally raise taxes – at least in the long term – and may well be used to provide benefits to those not paying taxes. This reduces work incentives, gives better off people incentives to hide income by avoidance and evasion and reduces economic growth. The better off are particular adept at finding ways not to pay taxes. • During George W. Bush’s last two years in office the USA had the biggest ever increase in federal government spending in peacetime – from around 21 per cent of GDP to 27.5 per cent of GDP. The Great Recession began in that period. 5 Lecture We have an election coming up in November, and, obviously, it’s President Barack Obama versus former Governor Mitt Romney, the presumptive Republican nominee, and it’s a very different time today than it was four years ago. Four years ago, it was hard to tell the players without a play-card. Both Barack Obama and John McCain took a day off so that they could go back to Washington and vote for TARP. TARP was the ‘Toxic Asset Relief Programme’. Most of the Republicans voted for TARP, most of the Democrats voted for TARP. If you look at the issues back in 2008, you really couldn’t tell a Republican from a Democrat. If you look at what George W. Bush did - we had a stimulus package in 2007 - add-ons to a housing bill and a farm bill to “stimulate the economy”: deficit-financed stimulus spending. And then, of course, in March 2008 we had the Larry Summers’ famous $600 per capita tax rebate. They called it a tax rebate but, of course, it wasn’t really a tax rebate, because if you paid too much in taxes, they didn’t give it to you but, on the other hand, you didn’t have to pay any taxes for them to give it to you. You just received a cheque. Then we had the bailout of AIG. That was about $170 billion. Forgive me for rounding errors on some of these things. Then we had some asset swaps with Bear Stearns. Do you even remember that one? And then, of course, we had TARP. The bill Paulson gave to Congress that he insisted had to be passed in one day granted him total control over $700 billion to spend as he saw fit to save the US economy. It was a four-page bill, but those are Congressional pages. Congressional pages have really wide margins, big print and large spaces between lines. It’s about 100, 150 words per page max on a Congressional bill. So, it was maybe a 400-600-word bill that gave him $700 billion with no hearings or any other oversight. We then nationalised Fannie Mae and Freddie Mac followed by Barack Obama with his own plans. He had an $862 billion stimulus package; Obamacare; and the Dodd-Frank Bill. So, we had all this stimulus. At first, it was during the Bush years: there was no distinction between him and the Democrats. However, while you couldn’t tell the players apart in 2008, this year, in 2012, the lines are drawn precisely and very sharply. I’m going to go through a couple of them with you because they’re really fun issues. Today, there is not one Republican who would vote for additional stimulus spending. In fact, there’s 6 not one Republican who would ever admit that he or she ever voted for TARP. Republics are, to a person, against any additional stimulus spending. The Democrats, to a person, are for additional stimulus spending. The divide has been really made very sharp and very clear. The divide is not just on stimulus spending but it is also on tax rates on the rich. This election is probably the single most important election in my lifetime; maybe the 1980 election was right at the same level - but this one will be a huge determinant of future policy. If the Republicans win, you will see something along the lines of Simpson-Bowles, where the tax base is going to be broadened substantially. We are going to have a much lower rate flat tax. You will see spending restraint: something along the lines of the Ryan Budget or ‘Cut, Cap and Balance’. You are going to see monetary policy change dramatically, much more towards a sound monetary policy. And you are going to see trade move to a free trade type of model. I think you’ll see all that and I think you are going to see regulation reform in the US as well. We don’t want regulations going beyond the specific purpose at hand and thereby doing a lot of collateral damage to the overall system. So, what I think you’re going to see in the US is a lower rate flatter tax, spending restraint, sound money, free trade and minimal regulations going forward. But let me take further two of the issues that I think are really important: tax rates on the rich and stimulus spending. Those two issues have really, crystallised. If you look at the tax rates on the rich, President Obama has been arguing that we should raise them to fund programmes etc. These people have plenty of money, they can afford to pay a little bit more, it’s only just and fair and we need the money badly, it is argued. 7 Raising tax rates and reducing revenues Let me take you through the Republican view of this. Rich people don’t like to pay taxes. That may in fact be why they’re rich. We have had a long experience in the US on tax rates and the rich. We put in the progressive income tax in the United States in 1913. When we put in the progressive income tax in 1913, the highest marginal tax rate was seven per cent. Seven per cent was the tax rate on the rich. I want to stipulate today, just so no-one has any ambiguities in relation to my views, that, by raising the highest rate from zero per cent to seven per cent, tax revenues on the rich went up. Now, let me take you through what happened after that. By 1919, Washington had raised the highest tax rate on the rich to 77 per cent. After the War, Woodrow Wilson picked his candidate to run for president. He was the governor of Ohio, a man named James Cox. Cox picked his best friend to be his running mate, New York Governor Franklin Delano Roosevelt (FDR). So, the race of 1920 was James Cox and FDR versus Warren Harding and Calvin Coolidge. The issue was exactly the same issue we face today: tax rates. Calvin Coolidge and Warren Harding ran on a slogan of “a return to normalcy,” which meant cutting tax rates back to their pre-World War I level. Harding and Coolidge beat Cox and Roosevelt by the largest percentage ever in US history. It was a landslide victory. Let me now tell you what they did once in office. They cut the highest income tax rate in America from 77 per cent to 25 per cent. We have magnificent data on taxes including data on tax revenues from the top one per cent of income earners. Now, as you know, in the US, as opposed to the rest of the world, we had a boom during the Harding-Coolidge period. It was called the ‘Roaring Twenties,’ a huge economic expansion. If you look at the tax revenues from the top one per cent of income earners, as a share of GDP - not just in dollars but as a share of GDP - tax revenues from the top one per cent of income earners went through the ceiling during the Roaring Twenties.