Interview was conducted in February, 2025

The United States government has bloated and fattened up over the span of the last century. What will be the determining factor to succeed in achieving small government under the new administration?

Interviewer: Hanako Cho

 

Cho: Japan and the United States have become ‘big governments.’ Government spending as a share of GDP remains high at 44.55% in Japan, followed by 34.38% in the United States. When do you think the expansion of the state began in the United States, and what do you think caused it?

Dr. Laffer: Great question. U.S. federal government spending as a share of GDP was between 2.5% and 3-plus % in 1910. The role of the federal government was extremely limited back then and their major sources of revenues were tariffs and land sales.

The government made purchases of big lands like the Gadsden Purchase in 1854 when they bought land, now part of Arizona, from Mexico, or Seward’s Folly where they bought all of Alaska in 1867. The government bought all that land from foreign governments so it was government-owned land, and they sold the land to pioneers as they went across the country. Land sales were a very big source of revenue for the federal government, just for the record.

The last one that was really major and important as a revenue source was whiskey taxes or taxes on alcohol and tobacco.

 

1913: The Beginning of the Modern Era of Big Government

Dr. Laffer: But those were prior to 1913. Two things happened in 1913.

Number one is, the Federal Reserve was formed and the government started trying to monopolize money in the United States. It was a big move in the state to try to take over the money production. As you know, the dollar was defined as one-twentieth of an ounce of gold. It was also defined as one ounce of silver. Lastly, really the important function of government before 1913 was that they audited bank balance sheets to make sure that the banks’ accounting records and public statements were correct. The Fed took on this function as well.

Number two is, without taking a census of the population, President Taft proposed an amendment to the Constitution to allow an income tax in 1909. This was passed in 1913 as the 16th Amendment to the Constitution and it allowed a progressive income tax.

So, while the U.S. has been wanting an income tax for a long time, the Constitution prohibited it. The 16th Amendment allowed an income tax to come into play. It opened up the revenues. All of a sudden, there was an enormous revenue field to harvest. The highest marginal income tax rate in 1913 went from 0% to 7%, and there was a total of 358,000 people required to file an income tax, which was less than a half of 1% of the adult population. Almost no one had to file. That was it in 1913.

 

The Setback of ‘Small Government’ Advocates

Dr. Laffer: Then, in 1918, [the income tax rate] went way up to 77% and they expanded the number of people required to file a tax return from 358,000 people to 6.5 million people. There was a huge expansion of the income tax which provided the government with enormous revenues.

Now, initially, they used the World War I in 1914 and the 1918 [Spanish Flu] pandemic as their excuse for needing a lot of revenue. But they didn’t let the taxes go down afterwards. As you know, President Woodrow Wilson used those excuses to raise the highest rate to 77%. He eventually lowered the highest rate from 77% to 73% but that’s nothing. Once they got the revenues, they never let them go.

From then on, it was game on. Every year [the federal government] raised the rates and expanded the tax base.

This was pushed back by the victory of the Republican Party in the 1921 presidential election. Republican nominee Warren Harding beat Democratic nominee James Cox, who was chosen by Democratic President Woodrow Wilson. Harding, as well as President Calvin Coolidge who took over after Harding, both ran on a campaign of cutting tax rates. They cut the tax rates from 73% in 1923 down to 25% and we had the Roaring ‘20s. That was the Harding-Coolidge period of lower taxes. But they didn’t cut them all the way back to 7% where they were pre-World War I so they still had a much bigger tax base and a much higher tax rate.

In 1929, they had the Smoot-Hawley Tariff and the highest tax rate was raised under the Roosevelt administration, and that was just a crazy expansion [of government]. The new source of revenue was the next opportunity to expand government which caused a collapse in the stock market and the U.S. economy.

That’s the beginning of the modern era of big government.

There was the Roaring ‘20s, which they lowered taxes. That was the Harding-Coolidge period. But then in 1929, they had the Smoot-Hawley Tariff. Then they had the higher tax– and just was a crazy expansion. But really what caused the government spending was a new source of revenue that was readily available for government to take as it did. That’s what caused it. And that’s the beginning of the modern era of big government and that was a setback [for small government advocates].

For these politicians, who thought they could get revenues by the income tax, all they needed to do was to raise rates and they did. During World War II, the highest tax rate was raised up to 94% and stayed high after the war. We had a small reduction from 94% in 1945 down to 82%, but they it popped right back up to 91% just before the Korean War. The highest tax rate stayed at very high rates from then on until John F. Kennedy came in and cut it from 91% to 70%. Finally, Reagan cut it from 70% to 28%, but it came back up again under Presidents Johnson, Nixon, Ford and Carter.

 

‘Government Spending Is Taxation’

Cho: You’ve explained the correlation between government spending and economic growth using the case of Japan, that is, when government spending goes up and the government expands, the economy moves in the opposite way and declines. I may already know your answer, but would you explain the negative impact on economic growth of higher government spending?

Dr. Laffer: As you know, government spending is taxation. I’ll explain it again just so you have it on the record.

Good economics is scalable, which means that good economics works for a country the size of the United States or China and it also works for small countries like Luxembourg. The nice thing to know about the theorem that [economics] is scalable is that it’s scalable in both directions. Good economics applies to little economies and big economies the same.

It’s really hard to understand the role of government spending in a great, big economy. But in a little economy, you can see it. Imagine we have a little economy of two people, farmer A and farmer B. That’s it. There’s nothing else except those two people, farmer A and farmer B. If farmer B gets unemployment benefits, who do you think pays for those benefits?

Cho: Farmer A.

Dr. Laffer: Yes. Farmer A pays for the benefits. Farmer B gets the benefits. Government spending, or the benefits, are the liability and the tax on the other person.

Government spending is taxation and that what you see happening with Japan all of a sudden, coming in about 1989, is this huge surge in government spending. Japanese growth stopped and Japan became one of the slowest-growing countries in the world with one of the largest bureaucracies.

The cutting of welfare programs, the cutting of social spending and the huge reduction in government spending as a share of GDP would have increased Japanese growth dramatically. Japan lacks animal spirits, enthusiasm. Japan’s growth is tragic and I worry about their growth.

 

A Limit on Government Spending: 10% of GDP

Cho: As Adam Smith said, I feel that the primary function of government should be limited to national defense and maintaining a system of justice including a police force. What are your thoughts on this?

Dr. Laffer: What is the role of government? When you look at the role of government, I go back to Teddy Roosevelt. The role of government is to make sure that the playing field is level and fair. It’s to make sure that every person has a right to achieve what he or she is able to achieve with his or her own efforts and abilities. That is the only role of government. The government’s role in society is not to redistribute income so that everyone comes out equal.

That role includes a judiciary, a defense and some huge capital advancement like control of pollution of waterways. For instance, major highways in the United States that go horizontally or vertically need huge nationwide planning.

I would do the public education in the way of vouchers or providing them with the income so they can go to schools and pay for the schools. It makes sense for those people who are sufficiently poor, that they can’t provide their children with schools, and that maybe the proper role for government there is to provide that specific group with schools. It should not be to provide everyone with education, but the government should provide opportunity for those who need it to get public education.

All of that having been said, I would say the level of government activity should not be all that much larger than it was prior to 1913. I would put some limit, maybe a 10% of GDP. That’s the rule of thumb that I use. That gives government plenty of room for doing things they shouldn’t do but really want to do.

Government should not be used as a way of buying boats. Government should be a way of making sure that improper actions are not taken against the citizenry, that the gangs are not allowed to rob people in stores, that neighborhoods are kept safe, that our country is kept safe from foreigners.

All of that makes perfect sense that the laws need to be applied equally. The judiciary needs to be independent and applied to all people, not just rich people, not just poor people. But it needs to apply to everyone. There should be equality under law. It should not be an instrument or weaponization in a political process. Unfortunately, when the money gets there, people in government have an insatiable appetite for spending that money as long as it’s there for the taking. That’s what you see have happened.

For example, Trump revoked security details for Mike Pompeo, who was Secretary of State during his first term, and for all these other people. Let me just say that I was in government and I’ve been involved in government issues for a long time. It makes me a much more attractive speaker at conferences. Pompeo makes a lot of money because he was Secretary of State and so do all of these other people who make a lot of money at speaking rounds. Do they really deserve security?

Now, I was attacked back in the day in 1987 for being involved with the Reagan administration. I don’t know who the attackers were. They attacked my home. They killed all my animals at my home. I had lots of letters and threats of my life. I have had that all my life. They almost always start at, “You dirty Jew,” and I try to explain to them I’m not Jewish. Now, Reagan was very lovely in sending me a security detail to assess the risk to my children. In the end, I didn’t get security clearance. I paid for it myself. All I’m saying is that when you get involved in government, whether you’re Donald Trump or Arthur Laffer or Mike Pompeo or someone else, you take on a risk. There is no reason why the government should be liable for that risk forever.

I had to have 24-hour security for a year. I had police guards with guns at my house. But they came and they killed all my animals. They put them on the doorsteps. I was at risk there. I didn’t get security clearance. I had to pay for this myself.

 

The Key to Success is ‘Incentives’

Cho: So, you think the government spending should be less than 10% of GDP, right?

Dr. Laffer: That’s the rule of thumb that I use. That’s not a scientific number, but that makes sense in that you stop [spending] when the benefits done by the last dollar of money are a little bit higher than the damage done by the last dollar of taxes collected. In other words, the government is doing what it’s supposed to do when the benefits (profit) that come out of their spend is higher than the damage they incur via taxes collected. When the damage outweighs the benefit, the government is too big. They should not be collecting more taxes.

There’s a way of preventing the government from expanding, which is by putting government people on incentives.

Not only do you want to make government efficient, but you also want to reduce the size of the efficient government. You need both efficiency gains and volume gains.

Now, I was the chief economist in the Office of Management and Budget (OMB) from 1970 to 1972. I know this stuff really well. [The Department of Government Efficiency, or DOGE] will not be successful, ultimately, unless they can change the incentive structure inside government so that the government itself will want to become more efficient and want to become more parsimonious. They need to make it so that productivity gains inside government are rewarded with bonuses and that waste is responded to by punishment, by firings. If they are able to instill an incentive structure inside government, they can affect the future of America by a huge amount. If they just go through each department and each agency and cut off fat here, there and elsewhere, it’ll come right back.

If you really want to control government, you need to restructure the incentives within government to make it efficient. You want it to do what it’s supposed to do efficiently, and then you want it not to do what it’s not supposed to do. That’s what you want from government. The only way you can make sure that happens is if the people in those areas which should not exist are rewarded for getting rid of that government spending. And those people in the areas where government should exist are rewarded for doing it efficiently. DOGE must really focus not on misallocation of resources, but on instilling incentives so that the structure corrects itself.

 

Award Bonuses to High-Performing Government Employees!

Dr. Laffer: Let me give you an example. I gave you an example long ago of Billy Weld, who was the governor of Massachusetts. He had an employee who saved the state something like $8 million and he gave her a bonus of $10,000 but it was removed because it was illegal for him to do that. What’s wrong with giving a bonus to someone who did a really great job? You should be able to bonus people. Teachers who teach well should be paid more than teachers who don’t teach well. The government should be run like a company where the administrator can determine which ones get the bonus, which ones don’t, which ones are fired, which ones are hired. The CEO and board of directors are all paid on a commission by stock options, and they, in turn, determine who gets the bonuses below them. So, it should be a filtering down. Every bonus should not be determined by voters, but ultimately voters should be responsible to instill the incentives on the politicians.

 

How to Reduce Unemployment Benefits: Don’t Pay People Not to Work

Dr. Laffer: Let me talk to you about the importance of incentives using an example of unemployment benefits.

You want work requirements for unemployed people. If you’re going to give unemployment benefits, make sure that they are fully funded by the employment tax and based upon the incidence of receiving unemployment. Unemployment benefits should be very short-lived and be used only to allow people who are unemployed for reasons not their own to find another job and get the executive training to take that job 10, 12, 13 weeks. That would make perfect sense.

But unemployment for 99 weeks doesn’t make sense. The unemployment benefits should be only enough to really make it through so you don’t have to suffer enormously. It shouldn’t be allowed so much that you take vacations in Las Vegas and go gambling, take trips around the world, that type of stuff. It should be enforced carefully.

When I was a professor, I knew that a lot of my students were on unemployment benefits and using that time to study. Well, of course they did. They took advantage of it. The unemployment benefits should be very tightly controlled so it’s not misused. That’s all I’m saying on that. It’s very hard to have a program like that where you don’t have a lot of abuse. The incentives are just way too strong there.

But let me give you a success story.

What we did in North Carolina under Pat McCrory is that we cut unemployment benefits from $550 a week to $350 a week. We reduced the unemployment benefit period from 99 weeks to 17 weeks. There were riots in the Capitol and all of this but within short order, the unemployment rate dropped dramatically while North Carolina’s growth rate increased dramatically. The unemployment fund, which was huge deficit, became in surplus. We got rid of the inheritance tax. We got rid of the highest tax rate there and the corporate tax. We got rid of the death tax, the gift and estate tax. And North Carolina became one of the fastest-growing states. This was called the ‘Laffer Plan’ in North Carolina.

So those incentives really work.

If you look at the percentage of people unemployed, if you look one week, two weeks, three weeks, four weeks or five weeks, all of a sudden you see it just goes right down. The number of people unemployed stayed stable until the 17th week when the unemployment benefits ran out. People go and find a job right away. So, there is a huge disincentive effect from these programs, and this is what I would hope DOGE would look to, and look at the incentive effects.

 

The Incentive Isn’t to Control Other People’s Lives

Dr. Laffer: We’re all humans. With the correct incentive structure, very inferior people can create wonderful things with the correct incentive structure. Very superior people with bad incentive structures will ruin the economy and ruin everything. It’s far more important that you set the structure of incentives correctly, than you get the correct people. If you set the structure correctly, people will do the job for you. If you set it incorrectly, the smartest people in the world will do it badly.

What you do with your students and your children is try to set a set of structures, of incentive structures, so that when your kids do a good job, you want them to feel good on their own.

One of your kids does something and you say, “No,” or you whack them on the hand and say, “No.” What you want to do is instill in them that when they go to that activity, they remember the no, they remember the whack and they don’t want to do it. What you also want to do and instill in them when they do something good. You helped your sister, you helped your brother, you were nice, and here’s a candy; you want them to feel good when they do something good, and you want them to feel bad when they contemplate doing something.

That’s what you try to do as a parent, as a teacher, as a friend. You’ve got to instill in people those incentive structures. But you can’t control their lives. You’ve got to set the instruction. That’s why I’m a supply-side economist.

Price change what you do. If you see something and it costs more, you’re going to buy less of it. If you see something and it costs less, you’re going to do more of it. If you’re selling something and the price goes up, you’re going to produce more of it. If you see something and the price goes down, you’re going to produce less of it.

That’s what economics is all about. It’s about changing the incentive structure so that you respond in a mature and constructive and positive way on earth so that we can all be better off, so that all poverty is eliminated, so prosperity creates. That’s the dream.

 

The Recipe for Cutting Welfare Spending

Cho: Elon Musk-led DOGE proposed not making cuts whatsoever on mandatory social spending like the Social Security program, food stamp and all of that. Some people argue that this will prevent DOGE from taking drastic measures to cut spending.

Dr. Laffer: Look, you and I know very well that all spending should be considered as part of making the country efficient. However, even this administration has political considerations. It’s very hard to take away Social Security spending to the people who voted for you. They’re retirees. “I voted for you, and now you’re going to cut my Social Security check.” They’re 83 years old, 84 years old like I am and they don’t have an alternative source. They’ll be very upset and I can understand. If I were to advise the president on this issue, I would make the same suggestion they do, “Do not touch Social Security, do not touch food stamps for the current recipients.”

Just like I advised Reagan before, I will advise Trump to extend the age of retirement. Today, 50-year-old people are working and paying Social Security taxes. If we move the age of retirement from 67 to 71 years old, the Social Security system is fully funded. Once it’s fully funded, which would just take a minute to do, then you could quickly privatize those accounts. You could easily do that because there’s no unfunded liability anymore. You could do that with the earlier accounts, all right?

As of now, the government is saying that they won’t cut Social Security or food stamps. I think they should go back and plan on what should be done for Social Security seven or 10 years from now and plan on it, get the system there so it’s phased in and comes in correctly. People retire based upon their expectations of what they’re going to receive.

 

The End of U.S. Senescence

Cho: If DOGE succeed in this project and American wealth has been put to good use, do you think the United States will be able to grow more rapidly and stop the senescence?

Dr. Laffer: The answer is “Yes, yes, yes, yes, yes!” This is exactly what is needed.

What Donald Trump is proposing, if I may say, is on a much bigger scale than Ronald Reagan ever did.

I am now coming to the view that not only was he the best first-term president in U.S. history, which he was on economics, but I think he might be the best second-term president ever too. I think he might pass Ronald Reagan on that. And Ronald Reagan did an amazing job with cutting the highest tax rate from 70% to 28%, deregulation, by monetary policy to soften inflation with Paul Volcker. He did a phenomenal job. But still Trump might pass him.

Right now [the Democrats] are on the bad side of history. We are on the right side of history. I’m working with countries like Britain, Brazil and Argentina to establish a growth-oriented economy. We are not going to lose.