Magazine | May 3, 2010, Issue

The Joy of Supply-Side

Return to Prosperity: How America Can Regain Its Economic Superpower Status, by Arthur B. Laffer and Stephen Moore (Threshold, 336 pp., $27)

When I worked for Vice President Dick Cheney during the first Bush term, the ever-ebullient Arthur B. Laffer was a regular visitor to our office. He and Cheney had been classmates at Yale, and had worked together in the Nixon and Ford White Houses; in fact, it was during a 1974 dinner with Cheney that Laffer sketched on a napkin his famous curve illustrating the trade-off between tax rates and tax revenues. When Cheney became vice president, he regularly called on Laffer for his insights on the economy.

During one of his trips to Washington, Art had me set up a meeting with another Ford alumnus: Don Rumsfeld, the former White House chief of staff, who was making his second tour of duty as Defense Secretary. Art insisted that I accompany him to the Pentagon: “C’mon guy. It’ll be fun hanging out with Don in the Secretary’s office.” As we drove into the Pentagon complex, Laffer instructed our driver to drop us off at the Pentagon’s river entrance overlooking the Potomac and Washington, D.C. “Isn’t the view just awesome!” he exclaimed, joyously grinning from ear to ear. “You can see the entire city. Neat, isn’t it?”

Art Laffer’s boyish enthusiasm, can-do optimism, and reverence for the power of free-market capitalism to make people’s lives better shines through in Return to Prosperity, co-written with Wall Street Journal senior economics writer Stephen Moore. Despite high unemployment, a housing-default crisis, and exploding public debt, Laffer sees “a more prosperous future” — but only if Washington corrects recent, as well as long-standing, economic-policy mistakes.

Laffer and Moore pick up where they left off in The End of Prosperity (2008) by explaining how “panic-based” fiscal, monetary, and income-policy decisions made by both Republicans and Democrats caused America’s financial and economic meltdown in 2008. On the Bush-Paulson financial rescue plan, now commonly referred to as TARP, Laffer writes: “When Secretary Paulson went to Congress with a one-page piece of legislation allocating to him and him alone $700 billion, to spend as he chose, without any hearings, without any oversight whatsoever, I knew the government had lost its senses.” (I’m in the camp of conservatives who supported the initial TARP program as necessary to unlock frozen credit markets, but agree with Laffer that it has morphed into a costly taxpayer-funded slush fund to bail out failing industries.) Of President Obama’s $787 billion fiscal-stimulus package, he says: “It’s dumb. Government bonds are not net wealth and there is no stimulus from increasing net debt, period. That doesn’t happen no matter how much you want to believe in the tooth fairy, Father Christmas, or free lunches.” Laffer correctly calls for all unspent stimulus and bailout funds to be immediately canceled. He also warns that the Obama administration is rapidly worsening the regulatory landscape with the cap-and-trade energy plan, the “card check” plan to end the secret ballot for labor unions, and the newly enacted health-care-reform law.

What really scares Laffer is the explosion in government spending and public debt: “The Bush administration and the Obama administration, along with Congress, have gone crazy, and I mean crazy, on government spending and on transfer payments.” According to the Congressional Budget Office, the federal budget deficit for fiscal 2009 was $1.4 trillion; the federal net national debt was 53.0 percent of GDP in 2009 and is estimated to be 63.2 percent in 2010. According to Laffer, the total unfunded liabilities of Fannie Mae, Freddie Mac, AIG, and all other government transfers puts the total federal net debt closer to 100 percent of GDP today. And get this: The total unfunded promises for future payments to individuals from entitlement programs was $65.1 trillion in 2008. This is genuinely frightening.

#page#How can policymakers solve these seemingly insurmountable economic problems? A consistent theme in Return to Prosperity — and a fundamental tenet of good economics, according to Laffer — is that people respond to incentives, and that pro-growth policies must be consistent with basic human behavior: “It is as basic as it is right that if government taxes people who work and pays people who don’t work there will be fewer people working and more people out of work as a consequence. Similarly, if government taxes rich people and gives the money to poor people, society will end up with lots of poor people and few rich people. People respond to incentives. It’s a simple fact of life, neither good nor bad, but simply what is.”

Laffer and Moore’s prescription is wide-ranging — including proposals to put government on a low-fat diet, reinstate a sound monetary policy, expand free trade, and repeal ill-conceived regulations — but unsurprisingly, the bulk of their recommendations focus heavily on supply-side tax policies. “During tough times after-tax earnings are depressed naturally,” they write, “which is why unemployment rates are so high.” Therefore, increasing taxes, as President Obama does in his new health-reform law to the tune of $500 billion, will only worsen the problem of slow growth and high unemployment. Laffer, of course, calls for a rejection of all tax increases during an economic slowdown (a no-no under Keynesian economics, too) and making the Bush tax cuts permanent.

A lengthy chapter details what Laffer and Moore call “The Complete Flat Tax,” which would replace the personal income tax, the corporate tax, the payroll tax, and the estate tax with two flat taxes of equal rates: a flat-rate personal income tax with no deductions, and a flat-rate business value-added tax. Laffer and Moore believe a flat tax would dramatically improve incentives to work, save, and invest; eliminate economic distortions; and unleash economic growth, thereby creating a “more stable revenue source” for the government. And, of course, it would; but it’s hard to see how pure flat-tax plans can overcome the political challenge of ending popular tax deductions for mortgage interest and state and local taxes.

Laffer and Moore add one additional wrinkle to the flat tax that might surprise conservatives: a carbon-emissions tax. While Laffer admits that he is “not an environmental scientist,” he notes that the scientific consensus is that global warming is happening and that there’s “a risk that man-made global warming is real.” This direct tax on carbon emissions would be an improvement over Obama’s cap-and-trade regulatory policy (which attempts top-down bureaucratic quantity control of carbon emissions): It would be more efficient and less economically damaging, especially if the added revenue were used to reduce marginal tax rates.

Both a value-added tax and a carbon tax — as part of a flat tax — make economic sense. But the evidence from around the world suggests that the value-added tax and other consumption taxes are never used to replace the income tax but rather to increase the size of government. Nonetheless, with federal debts and deficits rising, policymakers cannot enact pro-growth tax reforms without raising revenue elsewhere, through base broadening or other measures (such as a national tax-amnesty program, which Laffer recommends). After all, reducing tax rates that are on the wrong side of the Laffer Curve will lose tax revenue.

#page#Laffer’s diagnosis of the central role monetary policy played in the financial collapse differs from the conventional view that the Federal Reserve kept interest rates too low for too long in the early 2000s, which caused the housing bubble in the mid-2000s and the subsequent financial meltdown in 2008. Instead, Laffer argues that the Fed “did a good job” of controlling inflation by ensuring that the supply of money did not exceed the demand for money. In early 2007, the demand for money began to increase, but the Fed kept the money supply too tight, which caused a liquidity crisis of “world-class proportions,” triggering the housing and sub-prime-mortgages debacle. The Fed, says Laffer, waited too long to increase the money supply in 2008, and then overdid the increase, which will produce future inflation. He thinks the Fed should immediately tighten the money supply, which he admits could slow the economy. But the danger of letting the inflation genie out of the bottle is too great. Laffer wants to end the Fed’s “erratic and panicked” monetary policy by replacing its current discretionary and ad hoc practices, which have produced swings between inflation and deflation, with an explicit price rule — one in which forward-looking, inflation-sensitive indicators such as commodity prices, the price of gold, the dollar exchange rate, and long-term interest rates would guide monetary policy.

Laffer and Moore’s prescriptions fall woefully short on how to control government spending. After warning of the debt explosion and the looming entitlement-spending crisis, the authors offer three ideas to change Washington’s spending culture: require Congress and all government employees to live by the laws applied to other citizens, ban congressional earmarks, and grant the president the line-item-veto power. All of these reforms are necessary, but even if we put them all into place today, they would not affect the automatic growth of entitlements. Laffer and Moore should have spent as much time detailing how to reform and modernize the Big Three entitlements — Medicare, Medicaid, and Social Security — as they did on the flat tax. Their recommendations about how to address the government’s massive unfunded liabilities would have had more depth and seriousness if they had called for, e.g., raising the retirement age, changing the calculation for initial Social Security benefits from wages to prices, block-granting Medicaid, and voucherizing Medicare.

Nonetheless, Return to Prosperity provides insightful, timely, and updated supply-side prescriptions for today’s economic crisis. As an adviser to presidents, Art Laffer has seen their biggest policy blunders, such as Nixon’s disastrous wage-and-price controls and Ford’s “Whip Inflation Now” tax surcharges, and played an indispensable role in crafting their biggest success, namely President Reagan’s 1981 tax-rate cuts, which were emulated by more than 40 countries. Laffer’s worldview, the basis of his contribution to national and global prosperity, can be summed up as follows: “In a low-tax environment, people work more and harder, more people work, people devote less energy to sheltering income, people get more educated, and the people’s entrepreneurial spirit is exceptionally strong. The dream in America has been to make the poor rich, not to make the rich poor.” Amen. The next Republican president should award Arthur B. Laffer, Ph.D., the Medal of Freedom.

–Mr. Conda, formerly assistant for domestic policy to Vice President Cheney, is a founding principal of Navigators Global, a Washington, D.C.–based public-affairs firm.

Cesar Conda, a former Bush-Cheney White House domestic-policy adviser and senior aide to three Republican U.S. senators, is founding principal of Navigators Global.

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