This is part of a series ‘Economists Exchange’, featuring conversations between top FT commentators and leading economists
Few economists have a curve named after themselves. One of the exceptions, Arthur Laffer, is best known for the moment in 1974 when he drew a line on a napkin, highlighting the relationship between tax rates and revenues.
The Laffer curve is not itself controversial, highlighting merely that a zero tax rate will collect no revenue as will a 100 per cent tax rate because the taxed activity will cease.
Disputes about tax policy arise in practice over whether cutting tax rates energises entrepreneurial activity so much that economies improve and tax revenues go up. Most studies say this is rare. But it remains a core belief among many conservatives. Laffer, himself, is associated with such thinking, having advised Republican presidents including Richard Nixon, Ronald Reagan and Donald Trump.
Trump’s advisers this year named Laffer as one of the candidates in the running to be the next chair of the Federal Reserve when the position becomes vacant in 2026, should the former president re-enter the White House. Here he discusses inflation, the US deficit, tax policy and protectionism.
Chris Giles: Can I start off by talking about the US economy? We’ve just had a bout of inflation. How do you explain that?
Arthur Laffer: Well, I see this being the fault of the Fed, basically — the stimulus spending and the Fed increasing its balance sheet dramatically from 2007. The balance sheet increased from about $800bn to about $9tn. So you got this enormous expansion in the monetary base. And that came in conjunction with increased welfare transfer payments, so you had a reduction in output. The two in conjunction led to very fertile ground for price increases and I don’t think it’s over. It reminds me very much of 1972, in the Nixon administration.
The way I look at it, the answer would be to somehow do a Paul Volcker [Fed chair between 1979 and 1987]. If you’ll remember, he targeted spot commodity prices with monetary policy open-market operations and he controlled the balance sheet very tightly. We then had the tax cuts under President Ronald Reagan, which expanded output sharply and we were able to bring inflation down to 3.5 per cent. It happened because Volcker and Reagan combined the expansion of output and the contraction in the monetary base.
CG: This sounds like a lot of demand-side contraction, at least initially.
AL: No, it’s the monetary side. I don’t see that as contracting demand. I do see it very much on the inflation side. To me, lower inflation, lower interest rates, stable prices are really quite stimulative to demand and supply simultaneously.
CG: How much do you agree with the advice from the Bank for International Settlements, which says it is vital to move from a high-inflation world to a low-inflation world where people don’t have to think about prices?
AL: Yes, the whole reason for monetary policy is to have stable prices so that you and I can contract with each other for two years, five years, 10 years, 15 or 20 years in the currency and not be worried about, “Oh my god, it’s going to be triple the price or half the price.”
CG: Instead of the monetary base, the Fed thinks that the US economy has been through a whole bunch of supply shocks — there was Covid, then we had an oil price shock and Europe had a natural gas price shock — and these shocks primarily caused inflation. Have they got it wrong?
AL: Yes. I mean, they’re completely correct on the shocks. But they blame anything that’s happened to be nearby for their foul-ups. You know, these people at the Fed — nice people, and they are nice — are not well trained. They’re not Paul Volcker, they’re not McChesney Martin [chair between 1951 and 1970], they’re not Alan Greenspan [chair from 1987 to 2006].
The way I see it, chair Jay Powell’s a fine guy but he asks his staff, “What’s the right policy?” Volcker told his staff what the right policy was. This Fed thinks they control interest rates, and so they use interest rates to change policy. Volcker used interest rates to follow market rates not to lead them.
CG: That’s radical in today’s context because now markets are following and trying to think about what the Fed is going to do.
AL: We’ve got the whole thing reversed 180 degrees, which is the problem. How do you lead interest rates when the market doesn’t give you a clearing price? If the market gives you a clearing price, your balance sheet’s fine; if the market doesn’t give you a clearing price, you’ve got to absorb it on your balance sheet.
And that’s why the Fed went from $800bn to $9tn, because they were trying to keep interest rates low. And, of course, what you had to do was buy all the long bonds. Now there are almost no long bonds left in the US market, because they’ve absorbed them on to the Fed’s balance sheet. And that’s not the way to run monetary policy. I’ll make you a bet that balance sheet doesn’t shrink a hell of a lot in the next year. I’m just guessing.
CG: Do you think the Fed should tighten monetary policy more?
AL: I think that’s the wrong question. They shouldn’t do anything with domestic money except shrink the balance sheet. And then they should go back to following markets, not leading them. I think we’ll get back to that sooner or later. But Volcker was the best Fed chair. And I don’t say that because he was a good friend — I don’t think he liked me very much.
CG: If we could talk about fiscal policy. The US has been running a deficit of 6 per cent of gross domestic product for quite a long time now. What’s going on?
AL: It’s higher than it should be, but it’s nothing to make you go, “Oh my god, I’m jumping off a cliff.” When you look at public debt, the way I ask the question is, how much would you borrow if I would lend to you at 2 per cent and let you invest at 10 per cent risk free? Or how much would you borrow at 10 per cent, invest at 2 per cent? It depends on the spread and if your spread is positive, debt is great for the country, but if your spread is negative, it’s awful for the country.
Now, when we [the Reagan administration] came into office in 1981, we had seen a country that had been run into the ground by the four Stooges: Johnson, Nixon, Ford and Carter, the largest assemblage of bipartisan ignorance ever put on planet Earth. They had run it down, we scrambled through the rubble. We found this little plaque way down deep in the trash and polished off and it said “enterprise America” and we put it on the building and we borrowed like mad. And we used that to cut taxes because we felt the cost of borrowing was way less than the cost of using taxpayers’ money for tax cuts, etc. And then we sat back and prayed it worked. It sure as hell did.
CG: Do you think this is what the current Biden administration is doing with the Inflation Reduction Act — providing tax credits for green investment?
AL: No, they’re not. They’re not using a deficit to stimulate the economy, they’re using it to subsidise unemployment. They’re increasing transfer payments and transfer payments kill the economy. Please forgive me for all of this stuff, but let me go through the transfer theorem with you. And this is just a straight old theorem in economics. And it’s math. It’s not leftwing or rightwing, Republican or Democrat, liberal or conservative. Whenever you transfer resources, you always reduce output.
When we transfer by taking from those who have a little bit more, you reduce their incentives to produce and they will produce a little bit less. When you give to those who have a little bit less, you provide them with an alternative source of income other than working and they, too, will produce a little bit less. The theorem here is just plain simple math. Whenever you redistribute income, you always reduce total income, always — tall, short, old, young, liberal, Keynesian, it always does that.
Now, the dilemma from this theorem is delicious: the more you redistribute, the greater will be the decline and total output.
CG: The US is not known for a huge amount of redistribution compared with European countries, though, is it?
AL: No, but you’re talking about income redistribution. I’m talking about transfer payments in general. We do huge amounts of these and they’ve gone way, way up. And that’s why the US economy has been crap for a long time. I mean, we’ve had 20 years of weakness in this country ever since Bill Clinton left office. His was one of the best administrations.
Those transfer payments have led to the weakness of the US economy and to a very sharp decline in total US growth rates and it portends to be here as a permanent feature of the world economy.
CG: When you look at Donald Trump’s 2017 Tax Cuts and Jobs Act, how do you see the effects with hindsight? The Congressional Budget Office, for example, says they didn’t pay for themselves.
AL: If you look at the actual tax numbers, taxes went up in the two-year period from the initiation of the act. Total tax revenues, federal tax revenues, went up by more than they had in the prior two years. Not only were they larger, but they were increasing.
Now corporate taxes went way down — duh — but if you look at federal, state and local tax revenues combined, total taxes went way up so the CBO was just plain wrong. Everything they did on this they were incorrect. If you look at the economic results, you’re looking at improvements in the US poverty rate, the unemployment rates of the poor, minorities, Black people, the less educated. Phenomenal.
If you look at US growth rates, before that our growth rate and Europe’s were going along together and then all of a sudden, bam, US growth rates went up substantially higher. So I don’t know what all the brouhaha is about. These are the numbers.
I’m looking at from 2017 December to December 2019, so that two-year period before the huge stimulus spending. I mean, this is about facts, not opinion. And the numbers are explicitly that federal tax revenues went up in real terms. Bingo.
CG: What about if we look forward. What does the US need to do to have more sustainable public finances?
AL: Now, on tax policy, my view is to have the lowest possible tax rate on the broadest possible tax base. So you provide people with the least incentives to evade, avoid or otherwise not report taxable income, and you give them the least number of places where they can stick their income to avoid paying taxes.
The ideal is a low-rate, broad-based flat tax, that lowers the highest rates, gets rid of the loopholes, raises the lowest rate, so you bring in a flat tax and all of that is the ideal direction. We’re moving in exactly the opposite of that.
We all know we need government spending — for libraries, tax collectors, the judiciary, highways, schools. Everyone knows that. And these are very important aspects of our economy and are very productive. An optimum level of government is really needed, but anything beyond that is too much.
CG: What about the other core function of government — regulation?
AL: We all know we need regulations. When the Brit comes over to the US, you can’t have him driving on the left-hand side of the road. You need regulation in industry. But you want to make sure these regulations don’t go beyond the specific purpose and create a lot of collateral damage. We’ve got all sorts of interferences in the marketplace and we’re moving in the wrong direction. You know, Reagan’s phrase when we hit crisis in 1987: “Don’t just stand there, undo something”, not do something.
Trump was really good at deregulating. So we had low-rate, broad-based flat tax, spending restraints, sound money, minimal regulations.
CG: What about trade? Trump introduced protectionist measures. How do you feel about that?
AL: Now, whenever you use sanctions or restrictions on trade, they never work. I mean, look, we put in sanctions against Cuba in 1958. You know, that was 65 years ago. So have they now seen the light, and become pro-free market democracy saying, “Oh, thank God, America, for showing us the right deal”? No — we’ve created permanent enemies. Free trade is a way not only of having good economic relations and prosperity. It’s also the way of solving global crises.
It’s terrifying today. We need free trade, especially with Russia, especially with China, especially with Iran, especially with North Korea. Now, not in weapons and stuff — but so we can talk things over. But no, no, no.
CG: You must be very disappointed. There are no free-trade Republicans out there now — not many in the Democratic party either.
AL: Trump called me, said, “I’m, you know, I’m a free trader.” I said, “Yes, I always assumed you’re a free trader,” and I said also, “Sir, anyone who imports two foreign wives has to be a free trader.” He did not think that was funny, but I thought it was a riot. I mean, any businessman who runs an international company has to be pro-free trade.
He said, “Let me tell you what my position is.” I said, “Fine.” And he said, “How do you get other countries to come to the table to negotiate free trade agreements? I’ll tell you how. The only thing they care about is access to our markets. So what I’m doing is I’m threatening tariffs to bring them to the table, to negotiate a free trade agreement.”
I know you think he’s a protectionist. But look at what he does — not at what he says. I’m just telling you, this is a negotiation strategy with him. I’m perfectly in sync with this negotiation strategy. I’m a free trader.
CG: When Trump left office, the US had higher tariffs than when he came in, so that does not work . . .
AL: Major trade agreements too. Oh, yeah. What he was trying to do was move in that direction. And I don’t know how to criticise him on that. I love Nafta [the North American Free Trade Agreement], as you know. And then it was passed by Clinton. Thank God. I love Clinton for this. Big fan of Clinton. You know, I voted for him and campaigned for Clinton because Clinton did cut taxes. And that’s the way I see Trump on this.
CG: One thing the Trump team has said is that you are a candidate to be Fed chair in 2026. What do you think?
AL: I’m 83. Unfortunately, George Shultz talked me into being his right-hand person in 1970 in the Nixon administration’s Office of Management and Budget. I was in the most anti-free market administration on Earth. I found out what I don’t do well. So I made a vow that I would never, ever work for a government again. Ever. And I’m going to stick to that.
With Reagan, I never took a position with him and yet I was more influential than all the rest of them combined. I never took a job with Trump, and I was offered very big jobs with Trump. So I said, no, thank you, sir.
The above transcript has been edited for brevity and clarity
Source: Economy - ft.com
