Dr. Arthur B. Laffer helped flatten the tax system during the Reagan and Thatcher administrations through large-scale tax cuts. The Liberty spoke with Dr. Laffer on the meaning of a flat tax.

Interviewer: Hanako Cho

Cho: You have been proposing a flat tax in which everyone pays taxes under the same tax rate. In 1984, your research paper titled “The Complete Flat Tax” proposed the elimination of all federal taxes including the income tax, social security payroll tax, corporate tax, capital gains tax, estate tax and gift tax. In exchange, you proposed a flat tax rate just below 12% on state corporate taxes and individual income taxes along with a minimum amount of tax deductions. This structure has been implemented during the Reagan administration’s 1986 tax cut.

Dr. Laffer: During the 1986 tax reform, we cut the number of tax brackets from 16 tax brackets to two tax brackets. We also cut the highest income tax rate from 50% to 28%, and the highest corporate tax rate from 46% to 34%. This is the movement towards a low and broad-based flat tax rate. We’ve had 40 years of pretty good prosperity.

A lot of countries have adopted parts of the flat tax idea, like the one in Russia.

Richard Vedder, a friend and an economist from Ohio, was an economic adviser of the Russian government at the time. Richard spoke to Putin about my flat tax idea. Putin implemented it in a flat 13% tax cut proposal.

Gov. Jerry Brown Proposed the Flat Tax and Ran for President

Dr. Laffer: There’s also a presidential nominee who advocated for flat tax and ran for the Democratic Party in 1992. That’s Jerry Brown, the former governor of California. I got to know Jerry with regard to Proposition 13.

In California in the ‘70s, the taxpayers’ dissatisfaction with heavy property taxes were exploding. A major tax reform was happening known as Proposition 13, with the aim of amending California’s Constitution. This Proposition 13 was passed by a referendum by a large margin, and immediately following the bill, I attended a joint press conference with Governor Jerry Brown.

Then, in 1991, he called me and said he’s running for president.

He said he’s done some very stupid things like not taking contributions over $100. There were eight candidates in the Democratic primary in 1992, and he said his poll numbers have him as eighth. “I need something from you,” he said.

Ever since Proposition 13, Jerry Brown felt the power of tax cuts on the state economy, which had rapidly grown. I invited him over to my house in San Diego and he spent the whole weekend at my home. I have all these pictures of him with my kids and I, and we sat there and worked out the flat tax.

I had written this paper in 1984 called “The Complete Flat Tax,” and that’s the one I started with. I used that paper for the reformation of the U.S. economy, and that is what he decided to do. That became the 13% flat tax that he proposed, 1% higher than my proposed 12%. He went from eighth in the race to second in the race, and we were just about to beat Bill Clinton when he announced Jesse Jackson as his running mate. We lost to Clinton, but we got the second highest number of votes. I mean, it was really impressive.

Cho: Was the flat tax policy popular at the time?

Dr. Laffer: Oh, it was. We would have won the Democratic primary with it. The Democrats supposedly hate the flat tax, but everyone loved it.

Reagan won the presidency on our version of the flat tax. In the ’86 Tax Act, we passed the Senate 97 to 3. Every Democrat voted for it except for three.

In 1996 and 2000, Forbes magazine publisher and one of my best friends, Steve Forbes, ran for president on the flat tax. He also got a lot of supporters at the time.

It’s not Republican or Democrat, left-wing or right-wing that matter. It’s good economics. That’s all it is. The flat tax is loved by everyone because it’s the right thing to do. Politicians don’t like it because they get their power from collecting taxes and doing things. That’s why you and I are so upset. Politicians don’t want to do the right thing.

Three Reasons for Implementing Flat Tax

Cho: It’s been said that you had the flat tax structure in mind before publishing your research paper in 1984. Why did you come up with this idea of a flat tax in the first place?

Dr. Laffer: First, you want to always cut the highest tax rate. The reason you want to do that is not because you love rich people and want to make them richer, although there’s nothing wrong with rich people.

The reason you cut the highest tax rate is because the incentive effect is much bigger at high tax rates than it is at low tax rates.

I’ve talked about this with you before with the example of John F. Kennedy (refer to Part 6 of Dr. Laffer’s interview series).

When you lower the highest tax rate and compare the additional cost on the government to the benefit of a higher incentive for the taxpayer, the benefit-cost ratio becomes higher than if you were to cut the lowest tax rate. The higher tax rates are, the greater the benefits per dollar of tax cut. Therefore, you always want to cut the worst taxes, the highest taxes, the most.

Now second, this is a subtle argument but it’s true. Let me tell you about the progressive tax system in America. Your first $10,000 you pay it at a 10% [marginal] tax rate, and the next $30,000, you pay it at 12%. As your income goes up, the tax rate keeps going up until you reach the highest tax rate at 37%.

But we all know that economics only works on the margin. The important point is that all tax rates lower than the highest tax rate are what we call inframarginal, and they don’t affect behavior right now.

Everyone pays the lowest tax rates, but almost no one pays those tax rates on the margin. The percentage of people on the margin at the lowest tax rate is about 2%. Everyone who pays the highest tax rate pays on the margin because that’s the highest marginal tax rates. Therefore, the percentage of people on the margin in the highest tax bracket equals 100%.

You want to the cut the marginal tax rate, and by cutting the highest tax rate, you affect everyone on the margin. Everyone in that bracket is incentivized to produce more and shelter less.

That’s exactly what Prime Minister Obuchi did in Japan in 1998. He cut the highest rates without cutting the lowest rates, which was amazing.

That was the second thing, that when you cut the highest rate, everyone is on the margin and susceptible to those incentives. When you cut the lowest tax rate, almost no one is on the margin, and there’s almost no marginal impact.

You want to cut the top rates down for incentive reasons, and you want to raise the lower rates up for incentive reasons.

And if you keep doing that analysis, what you want is to have two low rate flat taxes, or the tax rate is the same on the first dollar you earn to the last dollar you earn.

The last thing you want to understand is that the highest taxpayers have the highest earnings and tend to be the richest people.

The richest people have more money than poor people. But rich people also have all sorts of tax shelters. They can change the location of their income. They can change the timing of their income. They can change the volume of their income, and they can change the composition of their income.

And they have the money to hire lawyers, accountants, deferred income specialists, favor grabbers, politicians. They can buy these things. Poor people cannot. So therefore, these people are much more able to not report their income than are the lowest income earners. The lowest income earners, they don’t have the money to hire lawyers or accountants or deferred income specialists or politicians or favor grabbers or all this. They’re not rich.

The rich have the ability to hire all these specialists to reduce their tax bill by legal or illegal means, and they do it. Therefore, their sensitivity to tax rates is much greater than the poor people’s sensitivity to tax rates.

It has nothing to do with liking rich people or anything like that. You want to have the rich people pay their taxes fair and square without using lawyers, accounts and deferred income specialists. To do that, you want to make the tax rates low enough.

The three principles I just described to you are why we should have a flat tax. You want to collect your tax revenues that you need for government with the least damage to the economy.

Problems Arise as You Save the Poor With Tax Deductions

Dr. Laffer: If there are some people who do suffer inordinately, even with the flat tax, that’s when you use government spending to step in and give them a helping hand. No one wants people starving on the streets or old people living in poverty and shivering in the winters. No one wants that. That’s where the government spending programs should come into play to help those who can’t help themselves.

But what you don’t want is provide an excuse for those people who can help themselves to not work. You don’t want to make it so attractive to not work that they decide they’d rather take welfare.

In this aspect, you would be wrong if you think you’re helping poor people and disadvantaged people, the less fortunate, by giving deductions, exemptions and exclusions.

You want to collect your taxes in the most efficient way possible, so if you want to help certain groups in society, which I think is fine, use spending to do it. Write them a check. Don’t give them a tax credit because that’s a very inefficient way of helping the poor. In other words, your taxes should be a low rate, broad-based flat tax with no exemptions, deductions, exclusions and credits. You should never put a spending plan inside a tax plan.

Do you remember the story I told you about a single lady in Philadelphia? In Philadelphia, a person with an income of $56,000 is deducted $27,000 for tax, so they choose not to work over $29,000 from the start.

In a tax credit, once the poor start making some money, they lose all their tax credits. They lose all their tax deductions, and then they’ll quit working because the tax effect of losing all their welfare puts them into a bracket over 100%.

All taxes are bad, but some are worse than others. You don’t want the tax system to do excessive damage.