Thursday, November 20, 2008

Arthur Laffer at the NDA

I arrived at the Bellagio for the Nevada Development Authority’s annual luncheon not knowing exactly where the event was being held. After wandering around the lobby for a few minutes looking for a sign I noticed a man in a suit and a woman in a dress who appeared to know where they were going. I followed them and, lo and behold, ended up in the right place. The featured speaker was economist Dr. Arthur Laffer, an adviser to Ronald Reagan also known as the father of supply-side economics. He offered his thoughts on taxes, the economy and the current financial crisis.

Laffer proffered his theory that the origin of the current crisis had its roots in a blunder in monetary policy. The demand for money is based upon two factors: the level of transactions (people hold higher or lower levels of cash based upon their expected future purchases) and interest rates. He explained that real income peaked in 2003. From ’03-’07 the demand for money collapsed. The Federal Reserve reduced the rate of growth in the money supply (the “best thing” they could have done, according to Laffer) and interest rates increased during this period.

But, in mid-’07, the situation changed. The transaction demand for money expanded rapidly but the Fed continued to fight inflation. The Fed committed “an enormous mistake” by not allowing the supply of money to increase to meet demand. This caused a panic, which resulted in a collapse of the credit markets.

He listed a series of government responses to and revenue effects of the crisis that total to nearly $3 trillion – among them the $170B stimulus; $75B now as much as $150B for AIG; $300B additions to housing and farm bills; $200B for Fannie Mae and Freddie Mac; $700B financial system bailout; $300B proposed additional stimulus; and $300B revenue shortfall. Although its proponents are well-intentioned, government stimulus is folly, he explained, because “the income effects always net to zero of any government policy.” Worse, the overall effect is a net loss because of transaction costs, or “the toll for the troll”, as he described it. In other words, a package that provides $100B in stimulus actually costs $130B. His prescription for what government should do to mend our current economic woes: “do nothing.”

Laffer is most famous, and most controversial, for his views on tax policy. He invented the Laffer curve, which shows that at a certain (undefined) level increased tax rates result in decreased tax revenues.

He explained that in 1981 when the highest marginal income tax rate was 70% the top 1% of earners supplied 17.5% of the income tax revenue (or 1.5% of GDP). In 2007, with the highest rate at 36%, this same group accounted for 40% of income tax revenue (3.2% of GDP). One reason he submitted for this phenomenon is that those at the highest income levels can change the “timing, location and volume of their income.” He offered himself as one example. For what he does to generate income (lectures, TV appearances, writing) he can not only choose to work as much or as little as he desires, he can also live anywhere he wants. He chooses to live in a state, Tennessee, with no income tax, thus avoiding the income tax collectors of his boyhood home of California.

Laffer is a very controversial economist. Whatever one thinks of his work, however, he is a highly intelligent and talented person and a very entertaining speaker.

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