Taxes Have Consequences: An Interview with Arthur B. Laffer and Brian Domitrovic

In this month’s interview, contributing editor Kelly Hanlon, along with Gustavo Alcantar, interviews economists Arthur B. Laffer and Brian Domitrovic about their book, Taxes Have Consequences: An Income Tax History of the United States. The interview transcript has been lightly edited for clarity and length.

Kelly Hanlon: Thank you for joining us today. This interview turned out to be particularly timely as congressional leaders have again narrowly averted a shutdown of the federal government due to reaching the debt ceiling limit. We seem to be in a cultural moment in which both the Left and the Right are advocating the expansion of the administrative state through newly created, or greatly expanded, federal programs that would be paid for by rising taxes—now, or in the future.

Dr. Laffer and Dr. Domitrovic, together you make the argument that taxes have consequences and there is a natural level of tax revenue that we can expect to raise regardless of which political party is in control. For our readers who aren’t familiar with your book, could you briefly describe the argument you make about tax revenue?

Brian Domitrovic: We have found that according to, say, Hauser’s Laws, tax revenues as a share of GDP are often static, maybe just around 20 percent of GDP. It doesn’t matter what the tax rates are. If tax rates are high, the GDP will be lower and then the tax revenues will be proportionally lower. And if tax rates are low, GDP will be higher and the same proportion holds: about 20 percent of GDP will be collected as tax revenue. 

So we were interested in that relationship ever since the beginning of the income tax in 1913, because we’ve had incredible variation in tax rates as low as 7 percent and as high as 94 percent at the top. That’s an enormous difference. We wanted to test some of these ideas and, sure enough, found out that the economy falters particularly when you raise the top rate of the income tax. And, the economy does really well, including with tax revenues, when you lower the top rate of the income tax.

Arthur B. Laffer: Now, let me come back to you about the new administrative state being paid for by the higher taxes, etc. That’s the minor portion of the payment. The real portion of the payment is the destruction of output where everyone suffers enormously. This is called the transfer theorem. It has nothing to do with your political leanings, whether you’re left-wing or right-wing, Republican or Democrat, liberal or conservative. It does have to do with math and theorems: a transfer occurs when you take from someone and you give it to someone else. 

Normally, we think of taking from someone who has a little bit more and giving to someone who has a little bit less. That’s the usual way we think. But it does not have to be that way. It can be taking from those who have a little bit less and giving to those who have a little bit more, or it can be taking from tall people to short people, old people to young people. It’s whenever you have a transfer, and I’m going to use the example of taking from someone who has a little bit more to someone who has a little bit less to prove the theorem to you verbally. 

Whenever you take from someone who has a little bit more, you reduce that person’s incentives to produce and that person will produce a little bit less. Whenever you give to someone who has a little bit less, you provide that person with an alternative source of income (other than income produced by working) and that person, too, will produce a little bit less. 

The theorem is simple. Whenever you transfer resources you always reduce total production in the system. Always. You take from those who have a little bit more, reduce their incentives to produce, and they’ll produce less. You give to those who have a little bit less, provide them with an alternative source of income, and they, too, will produce a little bit less. Whenever you redistribute income you always reduce total income, period. Think of it intuitively: if you tax people who work and you pay people who don’t work, do I need to say the next sentence to you? Don’t be surprised if a lot of people end up not working.

Now, let me do the lemma from this theorem: the more you redistribute, the greater the reduction in total income, total production. If you were able to redistribute all income so that everyone came out the same, there would be no income whatsoever. Let me prove it to you. 

In order to get everyone to come out the same, you would have to tax everyone above the average income 100 percent of the excess and you have to subsidize everyone below the average income. You would have to subsidize everyone below the average income up to the average income. Only in this way can you ensure everyone comes out the same. Now if you actually did that, if you actually taxed everyone above the average income, 100 percent of the excess, and if you actually subsidized everyone below the average income up to the average income, I will stipulate that everyone will come out equal at zero. 

What I’m going to say to you here is really important historically in every sense, and please, please understand this theorem because it dominates our lives: whenever you redistribute income, you never actually redistribute income. You destroy total income completely. Every revolution on planet Earth has been fought in order to change the distribution of income.

Not one of those revolutions has ever succeeded in redistributing income, but all of them have succeeded in destroying the entire quality and quantity of total income. And it is implicit and explicit in our book, every single step of the way. All of these attempts at high tax rates have been attempts to redistribute income, taking from the rich and giving to the poor. Robin Hood. And none of them have succeeded. But what they have succeeded in doing is destroying total income and the quality of life in our country. 

Everywhere you look in political economy today, this theorem is true, in Russia, in China, in Europe, in Chile, in Africa. I don’t care where you are: all of these policies are aimed at transfers and the redistribution of income. And they all are failing miserably and all you’re doing is destroying everyone’s prosperity.

KH: It seems so obvious and so elegant and so simple. Why is it so hard for the broader public or for the policymakers to understand?

BD: I don’t know that we can come up with an empirical answer to that question. But we can certainly identify narrow reasons why the government would want high tax rates that might be destructive of total income. We spend a large portion of the book talking about tax sheltering. When there are very high tax rates, the rich do a great deal to hide their income legally from the ample opportunities that Congress (via the tax code) gives higher earners in exemptions and deductions, exclusions, and so forth. The higher the tax rate, the more valuable a deduction to that tax rate. It is Congress that manufactures and passes out those deductions. The relevance of Congress and its relationship with the highest earners goes up the higher the tax rate because the more valuable the deductions become.

There is an unfortunate incentive that Washington has in raising the tax rate so that people will beg for exemptions from it, take them out to dinner, lobby them, and give them campaign donations so that Congress provides a tax break. That’s a problem because when you lower tax rates, all of a sudden, the rich become less interested in what Washington has to offer. 

AL: Russell Long put it this way: “Don’t tax you, don’t tax me, tax the man behind the tree.” 

Gustavo Alcantar: When I was reading your book, I was reminded of what happened in the UK where they froze corporate taxes, borrowed large sums of money, and cut income taxes modestly, but then the pound collapsed. The pension funds were endangered. What is the relationship between having a balanced budget and the ability to lower taxes effectively without jeopardizing the overall economy? 

AL: You’re talking about Liz Truss and Kwarteng Kwasi in the UK. They never cut taxes. They were thrown out of office in three weeks, so there was no policy involved that would warrant looking at the data.  The weakness of the pound was just a political weakness of the government.  

We do know what happened when Gordon Brown raised the highest tax rate from 40 percent to 50 percent: the economy collapsed in Britain and revenues went down. We do know what happened when the prime minister reduced that tax rate from 50 percent to 45 percent: the economy rose again and revenues increased. Brian, do you want to add anything?

BD: Reducing the top rate from 50 percent to 45 over the last twelve years was one of the most successful policies that Britain has undertaken since Margaret Thatcher. If Kwasi Kwarteng and Liz Truss had been able to put forth their plan, it’s highly unlikely that the pound would’ve encountered trouble. But the policy never got out of the blocks whatsoever and both of these people were kind of thrown out of office or ushered out of office. There was no opportunity to test the plan.

AL: Now, let me give you the example here that Brian mentioned: we got to a tax rate of 40 percent under Lady Thatcher when she was Prime Minister. She reduced the highest marginal tax rate in Britain. Now, I know these are fuzzy funny numbers because they’re high ones from ninety-eight to 40 percent. Now that 98 percent was a freaky rate on one little thing there, but it was very, very, very high. She lowered it to 40 percent and you had the biggest economic boom in British history. Gordon Brown reversed that. 

BD: Labour has now indicated that it does not believe that the top tax rate can be increased any more. There seems to be a growing consensus that they were a little too tough on Liz Truss and Kwasi Kwarteng.

GA: One takeaway is that it would’ve worked if they had been allowed to implement it and not been kicked out of office so quickly. Regarding your earlier points about transfer payments, do you think those should be reduced even when you have greater revenues under lower income taxes and more production? Should the government have a balanced budget to maintain confidence in the currency, in paying off a nation’s debts? How important are balanced budgets to tax policy or are they just of secondary concern?

AL: I think they’re of secondary concern, to be honest. What you really want to do is have the optimal tax structure you can, a low rate, a broad-based, flat tax. What you want to do is have the government do what it does really well (and it does do a lot of stuff really well). And what you want is the optimally sized government so that the damage done by the last dollar of taxes collected is less than the benefit done by the last dollar of money spent. That’s the proper size of government. That’s where it should be. Any government larger than that is too big. Any government smaller than that is too small. But three things in government are critical. Number one is how you collect your taxes. Number two is how much you collect and spend, the total volume, and how you spend the money.

And if you collect your taxes by taxing the productive people and if you spend the money by paying the unproductive people, you’re going to get a really lousy economy. 

KH: How do you unwind it? Where do we go from here?

AL: Just change it. The faster it’s done, the better it’s done. Now you’re going to ask me a political question and I’m going to tell you, and, forgive me, it’s just economics, you elect Trump. He did medical transparency. He did the Tax Cuts and Jobs Act. He deregulated a lot of the economy. He did Warp Speed. I could go on and on. In economics I have never seen a president in such a short period of time do so much good in my life. Now, I am separating that from all the other stuff and all the noise. And you can hate him or you can like him.  But, when you have a brain surgeon operating on your loved one, you don’t really care to like the guy. You want him or her to be the best surgeon in the world irrespective of color, age, gender, and Trump is like that.

There are times I’m shocked by some of the stuff he says too but bottom line, if you want it done right, get it done right. Look at Joe Biden. He’s a really nice guy, but absolutely incompetent. I don’t think it’s because of his age. I think it’s because of his behavior. 

KH: Let’s talk a little more about a specific policy. We have a lot of socially conservative readers who are very much in favor of child tax credits and things to encourage family formation. But in the book, we read that child tax credits are basically welfare programs by another name. Can you talk a little bit about that part of the Tax Cut and Jobs Act?

AL: I guess I’m not a conservative, I’m not a liberal, I’m not an optimist, I’m not a pessimist. I’m an economist. If you want good results, you have a low-rate, broad-based, flat tax with a minimal number of deductions, exemptions, exclusions, credits, and omissions. Tax credits for kids are not worthwhile. There’s no sense in that. What you really need is a straightforward way of creating the maximal output you can, given society’s potential.

BD: I might be so bold as to turn the tables to suggest that it is the child tax credit itself that has caused the demographic problem and the economic growth problem. The child tax credit was the centerpiece of George W. Bush’s non-marginal tax cut of 2001. That is the exact juncture at which the United States stopped growing at its historic rates. We’ve grown less than 2 percent per year in GDP since that time. The prior two decades we’d grown at 3.5 to 4 percent per year with a tremendous demographic increase. So it was ensuring that we have high marginal tax rates, taxing people who create jobs and create the possibility of mass livelihoods, large families, and so forth, that was embodied in the original child tax credit that put us on this road. We’ve got to eliminate all that stuff, get down to low tax rates, and we’re going to have great results.

KH: I studied economics in graduate school. I did not finish my Ph.D., but I know enough to be dangerous. I became known as the socialist in my economics department because I was quoting Aristotle and others in some of my papers as I was trying to make cases for particular things. But we didn’t study supply-side economics even in graduate school. And so I have these few moments with you and I wanted to ask for the non-specialist, for the average Americans that feel the impacts of these policies: what’s the best case that you can give for supply-side economic policies?

AL: You were taught Keynesian economics, I assume.

KH: Of course.

AL: You were taught about stimulus spending.

KH: Yes.

AL: The multiplier.

KH: Yes, my focus was on the Great Depression. 

AL: Oh, wonderful, wonderful, wonderful. It focuses on the Great Depression and spending policies, not how high marginal tax rates really caused it.

Just to be dangerous, let me give you your traditional, introductory macro course on Keynesian economics and let me then bring supply-side economics into it. 

I was in London and I was reading the Financial Times and here’s how Larry Summers described the need for stimulus spending in the U.S. He started off by saying, if you give a person $600 that that person would not have had, that person will spend more than he or she otherwise would’ve spent as a result of the additional $600. That spending out of the additional $600 will create jobs for the people who are there to produce the additional goods and services demanded from the person who received the $600. Then, they’ll have higher incomes that, in turn, will create more demand and there’ll be this cascading effect through the system. 

This infinite series that we can sum is 600 times the multiplier, which is one over one minus the marginal propensity to consume and there you have the increase in output. The economy has lifted itself up by the bootstrap. 

Summers is right: If you give someone $600 that person otherwise would not have had, that person will spend more than he otherwise would’ve had he not had the $600. That will, in turn, create more jobs, more output, and more employment to meet the demands of that person and there will be this whole cascading effect for the transfer recipient. Totally true—but, that’s only part of the truth. Unfortunately, the government does not create resources. The government redistributes resources. So if you give someone $600 that that person otherwise would not have had, you have to take that $600 from someone else who had the $600. The transfer payer will have lost $600. That, in turn, means they will reduce their demand for goods and services by the amount of $600 times the multiplier. That, in turn, will disemploy people who’ve been producing goods for that person, who otherwise would’ve produced it but now are not producing because their demand is lower. And there’ll be a cascading effect in the exact opposite direction that precisely offsets the stimulant effect of the transfer recipient to the de-stimulative effect of the transfer payer. 

In the Slutsky equation, if you take all the income effects of a closed system, the summation always adds up to zero. For every stimulus, there’s a de-stimulus. 

It’s a double-entry accounting system. For every stimulus, there is a de-stimulus effect and the sums of those income effects will always come to zero. 

The third part is the coolest part of the Slutsky equation. While the income effects sum to zero, the substitution effects do not sum to zero. Higher prices mean everyone produces more and it means that everyone consumes less. Now, when you take these substitution effects across the board of the transfer payment, the sum of the incentives will reduce incentives and everyone will produce less. That’s the transfer theory I went through. 

I was testifying before the Senate Finance Committee with Otto Eckstein, Paul McCracken, and Gardner Ackley. The four of us were testifying and, of course, they loved the Jerry Ford tax rebate. They thought it was great. And, of course, I thought it was stupid, and I did the transfer theorem there and went through all this stuff and all the substitution effects. So I tried to figure out a way of explaining it correctly and I said, “Well, Senator, if these other economists are correct, what’s the matter with you? Don’t you like our country? Why don’t you do $6,000, $60,000, $6,000,000? Why don’t you do 100 percent of GDP so that everyone who works and produces receives nothing, and all those who don’t work and don’t produce receive everything? Senator, what do you think would happen to the economy?” And he leaned back, he said, “Well, it would go to zero, Dr. Laffer.”  

Taxes have consequences and we have every single tax return in the U.S. We know which tax return was the bottom of the top 1 percent and the top of the bottom 99 percent. This is about facts, not how you feel.