Politics & Policy

Will the Real Fiscal Stimulus Please Stand Up?

Arthur Laffer warns of the folly of a demand-side stimulus package.

Last week was one of those times when things aren’t what they seem to be.

Since I’m a heavy investor in foreign markets, I experienced my own “black Monday” when non-U.S. stocks plunged in value. The following day I anticipated at least a 500-point opening decline in the Dow, since there’s a historical relationship between U.S and foreign markets. The big decline happened, and it continued into Wednesday before the Dow rocketed back. Unfortunately, by then the knee-jerk responses were just about said and done. The Fed responded with an emergency three-quarter-point cut to the fed funds rate. The House of Representatives then rushed through a fiscal-stimulus package, a “bipartisan” agreement that had the full support of President Bush.

While all this was going on the media attributed the outsized market volatility to fears of a U.S. recession. That was my thinking at the time, too, and this assuredly played a part.

But on Thursday morning it was revealed that a French bank’s rogue trader had run up a $7 billion liability in trading baskets of common stock, the discovery of which forced the bank to begin liquidating its portfolio. That’s what sparked the global sell-off. Unfortunately, neither the Fed nor Bush nor Nancy Pelosi got the news in time, so they rushed to judgment on stimulating the economy.

The elixir of a lower Fed interest rate did help stem the emotional upheaval of markets last week, and it may indeed help homeowners refinance. (The boom appears to have already begun.) But there may be an equally painful offset in lower income for savers who hold money-market funds and Treasury securities as safe havens. Just check on the relationship between interest rates and GDP in Japan to see the lack of any causation.

Then there’s the latest Keynesian demand stimulator: a tax-rebate plan that “puts money in people’s pockets.” George Bush’s first tax cut did just that, and it turned out to be a temporary palliative that kept the economy and financial markets in never-never land until the real Bush tax cuts landed in 2003.

Alternative fiscal-stimulus plans being offered by businessman Mitt Romney and ex-New York City Mayor Rudy Giuliani seem to make a lot more sense. Their tax programs would stimulate economic activity by encouraging entrepreneurs to be productive, resulting in increased output and lower prices.

But where’s the beef when it comes to fiscal policy today?

In an editorial for the Wall Street Journal last Friday, Arthur Laffer, the renowned supply-side economist, warned of the folly of implementing a demand-side fiscal-stimulus package. Whenever economists mention supply-side solutions such as those offered by Laffer, the counter-argument is that such tax plans favor the rich and are unfair. But Laffer provides important statistics to support his argument that cutting tax rates on the rich provides higher, not lower, tax revenues over time. Laffer begins,

Since 1980, statutory marginal tax rates have fallen dramatically. The highest marginal income tax rate in 1980 was 70%.

Today the top rate is 35 percent, an apparent tax-break windfall for the rich. However, Laffer goes on:

In the year Ronald Reagan took office (1981) the top 1% of income earners paid 17.58% of all federal income taxes. Twenty five years later, in 2005, the top 1% of income earners paid 39.38% of all (federal) income taxes.

For the bean counters who like to whip out their inflation slide rules, Laffer provides statistics on a real (inflation-adjusted) basis:

In 1981, the total taxes paid in 2005 dollars by the top 1% of income earners was $94.84 billion. In 2005 it was $368.13 billion.

Now consider those middle- and lower-income folk who, Democrats say, have suffered during the Republican tax-cutting years. Here’s Laffer’s response:

From 1981 through 2005, the share of all income taxes paid by the bottom 75% of all income earners (as reported on the individual income tax returns) declined to 14.01% from 27.71% … the bottom 75% of all taxpayers today pay less than 35% of all the taxes paid by the top 1% of all income earners.

The data that Laffer provides refute the notion that supply-side tax-rate cuts favor the rich and hurt the poor. Yet the proposed economic platforms of the Democratic contenders for president commit to higher tax rates and the expiration of the stimulative Bush tax cuts. Laffer’s conclusion that cutting tax rates on the rich actually increases government revenue over time — while reducing tax rates on middle- and lower-income earners actually lowers government revenue — should serve as a warning to those who would do the opposite. Writes Laffer:

Mark my words: If the Democrats succeed in implementing their plan to tax the rich and cut taxes on the middle and lower income earners, this country will experience a fiscal crisis of serious proportions that will last for years and years until a new Harding, Kennedy or Reagan comes along.

Art Laffer has had the uncanny ability to recognize good economic policy and the impact of such policy on the economy. Given the accuracy of his past forecasts and his dire warnings about prospective tax increases, Americans should think twice before voting for populists who promise a free-lunch supplied by the entrepreneurs of this country.


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