Dr. Arthur Laffer, one of the leaders of the supply side revolution of the 1980s in which marginal federal tax rates were slashed, criticizes a new Hillary Clinton proposal to almost double short-term capital gains taxes to 39.6 percent on those in the top tax bracket.
“She is absolutely out to lunch,” Laffer said for a recent article I did for the Sunday New York Post business section.
Laffer is the author of the Laffer Curve, which showed how high taxes can discourage thrift and actually reduce the amount of tax dollars the government receives. This happens, supply side advocates say, because sometimes there can be a motivation not to work when taxes are excessive.
These are assumptions that, I believe, make sense. Our nation for a few years after World War II actually had a 91-percent tax percent rate on the highest earners, which was ridiculous. Many of those approaching that rate late in the tax year would sit on their hands the rest of the tax year when they came up on 91 percent. That helped no one. That hurt our economy as excessive rates and senseless regulations almost always do.
I think it is reasonable to question why anyone would go to the effort of making an extra dollar, if one only were able to keep nine cents. That is a lesson that President Kennedy grasped in the early 1960s. He famously called for cutting taxes on everyone, including the rich, by saying “a rising tide lifts all boats.” But that is not the thinking of presidential candidate Hillary Clinton.
The Clinton proposal, supporters note, would only affect the top five percent of wage earners; those earning about $464,000 a year for married couples and $413,000 for singles. The Clinton rate would then go on a sliding scale, with the capital gains rate reduced to 24 percent over five years. After six years of holding a property before selling, the rate would be what it is today for the highest tax bracket—20 percent.
Higher capital gains are needed in the short term, she contends. They will promote more long-term growth and, ultimately, higher wages, according to Clinton.
“Corporate profits are at near-record highs, but they are not showing up in the wages of everyday Americans,” she wrote.
“That’s in part because too many pressures in our economy today are pushing businesses toward short-termism—a focus on the next earnings report or the short-term share price, rather than the sources of long-term growth and lasting value: workers and their skills, R&D, and physical capital,” Clinton wrote in a briefing paper.
Laffer argues that those in the highest tax rates are already paying taxes on most of their capital gains. The capital gains rate, Laffer says, should be zero because people would be encouraged to take more risks, start up more businesses and ultimately the government takes in more money as the economy booms.
The debate over raising investment taxes gave me a chance to revisit supply side tax policy with Laffer. I was not offered the opportunity to speak with Hillary Clinton, but relied on her position papers. Most of Laffer’s comments on the Clinton plan never made it into the Post as did some of the questions I raised about the controversies over supply side policies.
At the outset of our Q&A, I told Laffer that I think cutting taxes—whether on the rich, poor or middle class or everyone—and I favor the last option—is generally a good idea. Still, previously I have told him how I think the Reagan revolution went wrong: There never was a similar fervor for cutting spending as there was for cutting taxes.
For example, Reagan promised to close down useless federal departments (Which we have plenty of but try actually doing it! Special interest groups immediately start lining up and baying to every available media outlet that less government—or less of their favorite part of government—means the end of the world).
But, despite his tremendous popularity as president, Reagan never did commit much political capital to reducing what is now an out-of-control government. For generations now, our central government has endlessly taxed and regulated much the way the FDR administration did some four generations. (Said FDR’s close aide, Harry Hopkins, on what the administration was going to do, “We’re going to tax, tax, tax and spend, spend, spend.”).
Reagan was supposedly going to end generations of outrageous taxing and spending by, at the least, closing down two departments of government. Yet the U.S. Energy and Education departments were alive and well as well as better funded than ever when Reagan left office in 1989. And Reagan republicans such as George Will would later start bragging that republicans were doing a better job of running the welfare state than democrats.
That, of course, triggered this question: Whatever happened to the republicans’ opposition to the welfare state and their promises over the past 40 years to reduce it? What happened when republicans had their chances to run the government?
Republicans, in many ways, have behaved like Democrats, many of whom behave like Social Democrats, collectivists who never mention Marx but want the government to spend and tax more and more while taking over bigger parts of the economy. (The national chairwoman of the Democratic party was recently tongue tied when asked to explain the difference between the democrats and the socialists. Somewhere American Socialist leader Michael Harrington, the leader of Social Democrats USA who advocated that socialists join the left wing of the Democratic party, is smiling. By the way, in Britain, the first socialist minister was in the Liberal Asquith government of 1905).
So, eventually after taxes were cut under Reagan and the economy started to improve, we would start to hear the flawed economic analysis of a Dick Cheney. He famously said, “Reagan proved deficits don’t matter.” That’s a comment that probably would have pleased John Maynard Keynes. It made me think that, after years of power, some Republican Supplysiders seemed to have more in common with the Keynesians than they admitted.
Nevertheless, I believed in the 1980s and now that deficits do matter. They matter over the long term as the bad habits of governments overspending have become as much of a problem under Republicans as they have under Democrats.
Red ink even starts to change culture. Average Americans forget the lessons of their grandparents. They start to think that, if the government can live large and since the government will provide more and more services, then why should they save at all? Live large now.
And this Keynesian thinking—-Keynes demeaned savings and frowned on middle-class values—infests both major parties. Indeed, the Republicans, supposedly the party of fiscal conservatism and small government (Ahem!), have made massive red ink almost respectable in many quarters.
The Americans welfare-warfare state—-which people of my point of view, those who love liberty, want reduced if not sent to the ash heap of history—-has been growing by leaps and bounds for generations. Perhaps Robert Taft was the last major republican who actually wanted to reduce it. And he died in 1954.
Significantly enough, on his death bed, Taft was trying to reduce the military part of our leviathan by pleading with President Eisenhower not to send troops to Southeast Asia to bail out the collapsing French Empire (Ike listened. Unfortunately, successors Kennedy, Johnson and Nixon did not. For those who want more on that please see our series on America at War http://gregorybresiger.com/what-next-and-nexti-a-shorthand-history-of-modern-america-at-war).
I took up these Cheney forget about deficits comments and other issues with the energetic, brilliant and fun-to-talk to Laffer.
Gregory Bresiger: Do you agree with Cheney that “Reagan proved deficits don’t matter?” Is this how Dutch Reagan would want to be remembered?
Arthur Laffer: There are two ways in which deficits affect the economy. In one sense they don’t matter. And let me tell you what he was meaning there. What is the difference if I tax some more money from you or if I borrow some money from you that I never repay? In that sense they don’t matter.
Gregory Bresiger: But they do matter
Arthur Laffer: They do matter in the sense of timing and in the constellation of tax rates. They clearly matter there. They matter to you in a clearing out debate.
Gregory Bresiger: When too much government debt crowds out capital that otherwise could go into the private sector. But what about today?
Arthur Laffer: In the current context they do matter.
They change the timing. There aren’t as controlled. You clearly can’t say deficits don’t matter in Detroit or in Puerto Rico
Gregory Bresiger: So when you have a growing economy, you’re making the case deficits aren’t bad
Arthur Laffer: Because when you have growth, then the deficits can be paid off.
Gregory Bresiger: But you still have the cultural and institutional problem. Governments run bigger and bigger deficits, but the economy is growing. However, people start to think deficits can go on forever; it may even affect how they run their lives.
Arthur Laffer: I agree with that.
Gregory Bresiger: Why can’t you cut taxes—taxes across the board for every group—but at the same time cut spending to justify the tax cuts.
Arthur Laffer: Taxing is spending. Milton Friedman said this time and time again. Government spending is really important. But so are taxes. How you spend your money matters. How you collect your money matters and how you collect and spend matters.
Gregory Bresiger: But you can’t get a handle on taxes until you get a handle on spending. Otherwise, the debate over taxes is academic. Taxes are the result of spending. And if a government recklessly spends, then you have to find more taxes.
Arthur Laffer: I don’t disagree with you. But when you look at it, the relationship between taxes and spending amounts are very interrelated
Gregory Bresiger: So how do you balance spending with taxing?
Arthur Laffer: Let me just describe how the ideal world would be.
Gregory Bresiger: And so?
Arthur Laffer: You collect your money in the least damaging fashion.
Gregory Bresiger: Right. You don’t overwork the golden goose that is creating wealth for you.
Arthur Laffer: All taxes are bad. But some are worse than others. But what you want to do is collect money in the least damaging fashion.
Gregory Bresiger: Yes?
Arthur Laffer: Secondly, you want to spend your money in the most beneficial fashion. Then what you want to do is to stop spending and taxing at exactly that point where the damage is done by the last dollar collected is a little bit less than the damage done by the last dollar spent. Then you stop.
Gregory Bresiger: But there can be a problem. Once you start raising taxes, it is often difficult for governments to stop, to get out of the habit of taking more and more. Even Reagan, along with House Speak Thomas “Tip” O’Neill, raised some taxes.
Arthur Laffer: You’re right. It’s very hard to stop once you get going on raising taxes. And I think we’re just about at that time right now where we’re about to stop it.
Gregory Bresiger: Well, maybe. But let’s look at the proposal before us. Presidential candidate Hillary Clinton wants to virtually double the short term capital gains rate on those in the top rates. She says she’s trying to stop speculation and short termism.
Arthur Laffer: Oh, that’s just ridiculous.
Gregory Bresiger: And so?
Arthur Laffer: Let’s go through it. Number one, the value of an asset is the discounted present value of the after tax flows.
Gregory Bresiger: After I’ve paid all the bills, what I get to put in my pocket.
Arthur Laffer: Yes. The change in the value of an asset, capital gains, which reflects the change in the after tax flow to the person’s pocket. That after tax flow has already included in it; future returns on the asset. So therefore you’re double taxing; capital gains is a double taxation of the cash flows. And therefore the correct capital gains rate should be zero.
Gregory Bresiger: But there is another aspect…
Arthur Laffer: And there is another capital gains that you find here, one you find in the textbook. This is how people can change the receipt of income by changing the composition of that income.
Gregory Bresiger: How people take their gains?
Arthur Laffer: For example, Warren Buffett, by owning Berkshire-Hathaway stock, he can pay himself a dividend, he can pay himself an income or he can see an increase in unrealized capital gains. This set of capital gains is fungible with income. This is especially true of privately held companies and publicly held companies as well
Gregory Bresiger: It is your point that there are differences among capital gains and it can be difficult for the tax authorities to distinguish among them?
Arthur Laffer: The one capital gains is the discounted value of income flows. Someone owns a stock in the market and sells it. Bang. That is the capital gains there.
Gregory Bresiger: And the other one?
Arthur Laffer: The other is fungible with income. Those two are very different and very different in how they should be treated in the tax code.
Gregory Bresiger: But there’s a problem here…
Arthur Laffer: It is impossible to treat which is which.
Gregory Bresiger: And so…
Arthur Laffer: Why I say the proper capital gains rate is zero, that is when I am referring to the first. When I am referring to the second, the proper rate should be based on the income tax rate; whatever their income rate is.
Gregory Bresiger: Now let’s get to the point at which you say that the Clinton plan would have “a devastating effect on capital formation.”
Arthur Laffer: What she does is not only raises the rate, but she has the rate going down the longer one holds the asset.
Gregory Bresiger: There’s a sliding tax rate the longer one holds the asset
Arthur Laffer: This a devastating thing because it locks in the asset. And does not make the asset fungible and liquid to shift to the most economic usage.
Gregory Bresiger: People hold on to assets even though, without the threat of excessive short-term taxes, they might sell.
Arthur Laffer: Yes, Senator Russell Long (former head of the U.S. Senate Finance Committee and longtime political leader in Louisiana) told me there was a huge property in the middle of a city in his state owned by a man who was old. But he couldn’t sell the land because that would trigger a capital gains tax. And he was going to wait until he died and avoid the capital gains tax. And it was locked in and the property was put to a very inferior use because of the capital gains tax.
Gregory Bresiger: It sounds like rent control laws in which people never leave apartments so there is very little apartment turnover, which locks out the people not lucky enough to have rent controlled apartments.
Arthur Laffer: Yes, that’s exactly it. This locked in effect on high capital gains is the same as rent controls; it leads to very inefficient use of capital for the overall economy.
Gregory Bresiger: And you argue this would be a bad deal for the government…
Arthur Laffer: Yes, there’s a tax revenue effect. And this is why Hillary is out to lunch on this. There is no tax that we have in this society that is more prone to losing revenues than is the capital gains tax
Gregory Bresiger: You would make the argument that President Clinton cut the capital gains rate. President George W. Bush cut the capital gains rates. And the government took in more money.
Arthur Laffer: Yes. Now it is not only that they took in more money from capital gains taxation, but they also took in more money because there was more jobs and growth in the economy as there were more sales and state and other kinds of increased tax revenue.
Gregory Bresiger: Mr. Laffer, thanks for your time
Arthur Laffer: You’re welcome