We spoke with Dr. Laffer who served for the U.S. across two generations as an economic advisor to the Reagan administration and Trump administration about the birth of supply-side economics.

 

 

(Interviewer: Hanako Cho)

 

—How did you become interested in economics?

When I finished my third year at Yale, I had been a math major at Yale University. I had not been a good student at Yale through the junior year. I performed very badly, so in my third year of college, I decided to study at the University of Munich in Germany.

When I registered as a student, I found that I had taken almost all of the math courses they offered. So I had to figure out some other classes to take. I took macroeconomics and microeconomics and I just loved them. That’s where my real change occurred.

Economics is really fun, isn’t it? You can solve real problems if you understand economics well, especially price theory in microeconomics. Microeconomics is nothing more than little tiny macroeconomics. It should be. Like quantum physics and classical physics it’s just so beautiful, so organized, so structured. The study of economics is very satisfying on an academic level, and it also works on a policy level.

In Germany, I was all of a sudden exposed to a very different world that I’d never had before. For example, I was in Berlin on August 13, 1961, the day the East Germans built the wall, which was terrifying. When I went by bus over to Berlin, I was the only American on the bus. We got into East Germany and they stopped the bus and inspected everyone’s passport.

They pulled me out of the bus because I was the only one with a foreign pass. So I had an American passport, and they grilled me in the police office for maybe an hour and a half. I was 19 years old and very scared. My mother and father were very far away and I had no protection. All of a sudden, I came to realize that this world is not easy and you have to do things on your own. The maturing process was extreme.

My roommate and I had no money at that time, so we took our books to the train station. In Germany, the train stations are very big buildings with dim lighting, but they’re warm. He and I would go there, order one beer each and sit at the tables for two or three hours studying, because it was warmer than our apartment.

We were poor students. It was a way to get the classes and do the work. It taught me respect for academics, respect for hard work and self-reliance. Germany was truly transformational on both personal and professional levels in every way, shape or form. I think it was 10 years ago that I got the alumni of the year called the Hans Mueller Award from the University of Munich.

When I came back to the U.S. in my senior year, I changed my major from mathematics to economics, and I did about as well as any student could do in all of my classes.

There’s a funny story. In one of my classes during senior year at Yale, one professor called me into his office. He accused me for cheating on an exam because of my past three-year record as a poorly performing student. He thought I cheated, but he couldn’t figure out how because my grade was so much higher than anyone else in the class.

Two of my classmates are Nobel laureates, and I was very proud of being a top student. I then went to Stanford University to get an MBA and all of this self-esteem kept pouring on. I think there were 225 of us in my business school class, and there was a competition to see who got the highest grades. You can guess who it was.

Stanford even gave me a scholarship of $10,000. Back then, $10,000 was serious money. My salary at the University of Chicago was $11,000 and it was taxable, while the $10,000 was tax-free. It really helped because I was a student married with two children.

 

Economics Is All About Incentives

—You went for your Ph.D. after receiving a MBA from Stanford. What are you major discoveries at Stanford?

There’s something I became very well aware of at Stanford. Economics is all about incentives.

I began to think that way after I took a class from one of the very few Marxist professors in the U.S. His name was Paul Baran and he was a Jewish from Europe. He believed that the government should own every company and all the means of production. He was a communist and a Marxist professor. I was in his class and I was his favorite student. I mean, I just loved the man. I loved understanding and working in economics because it’s so thrilling to see the different views of the world.

He was a very fine, educated man who developed his ideas honestly and forthrightly. To my way of thinking, a lot of what he said was good but he achieved it the wrong way. I was able to modify his economics through free markets and achieve the prosperity he wanted much more easily and better.

Prosperity in public policy is much better driven by free markets than government dictatorship in my view. I think the results of Japan and South Korea in the post-World War II era was just amazingly different than North Korea. You can also see the difference between Hong Kong and China.

We both have the same dreams, which is to achieve prosperity. I think his model didn’t work because he didn’t think about the individual.

There’s an old Marxist line that goes, “From each according to his ability, and to each according to his need.” It’s the idea of making everyone equal through communism.

To get to that world, you would have to tax 100% of the excess from everyone who made above the average income. You’d have to subsidize everyone below the average income up to the average income. Now if you actually did do that, there would be no incentive for people to work.

 

The Birth of an Economic Model

I continued trying to develop an economic model between 1970 and 1972 during my time as chief economist for the Office of Management and Budget.

I found a very funny statistical result. Government purchases goods and services increased GDP dollar per dollar in the first quarter. So if you increased government purchases of goods and services by $10, GDP will increase by $10. And then over the next three quarters, GDP will fall back down to where it had been before, which is very anti-Keynesian.

Then, I found one other result that shocked me. If government spends on transfer payments, unemployment benefits, welfare payments and all these other things, the GDP actually falls.

Today, it’s obvious why it falls, but it was not obvious to me back then. It took me a long time. That’s when I developed an economic model which is based upon individual incentives. This is published in a paper called the “A Formal Model of the Economy” in 1971. Here’s the quick summary of the paper: “If you tax people who work and pay people who don’t work, you’re going to get a lot of people not working.”

—That led to the creation of the Laffer Curve?

Laffer Curve was a part of it. At the end of the day, they called it the Laffer Wedge as well, which is a wedge of taxes driven between wages paid and wages received. It’s all individual-based, not macro-based.

My professor Paul A. Baran thought in terms of helping people with no income, but he didn’t think in terms of individuals’ incentives.

 

Incentives in Our Daily Lives

You have billions of hamburgers produced, and every single one of those hamburgers goes into someone’s mouth. How is that possible?

It’s incentives. People like eating hamburgers, and therefore, they create businesses that make hamburgers for people to eat. The people who produce those hamburgers get paid, so they like producing hamburgers. It’s an incentive model.

In this case, the incentive is hunger, taste or whatever you want to call it, but it manifests through economics. You can see this in all sorts of activities outside of economics such as nature. I used to collect butterflies when I was very young. There was this one rare butterfly in New England. How does a little boy moth find a little girl moth, to have baby moths? It’s incentives.

There are also negative incentives on the other hand. When you beat a dog from going somewhere, you know where the dog won’t be. A positive incentive is that if you feed a dog, you know where the dog will be at feeding time.

Positive incentives tell you what to do and negative incentives tell you what not to do. If you look at economics system as being a profit-and-loss system, it’s the same. Losses tell you what not to do and profits tell you what to do.

It’s the same for taxes.

We tax speeders on the freeway, don’t we? It’s to get them to stop speeding. We tax smokers, don’t we? To get them to stop smoking.

Why then do we tax people who earn income? Why then do we tax people who employ other people? Why then do we tax companies that make wonderful products at low and cost and make lots of profits? No, we don’t tax them to get them to stop employing other people, to stop earning income and to stop making wonderful products at low cost. We do it to get revenues.

But don’t for a moment think that those same consequences don’t occur with the taxation of income, employment and profits. They do. You don’t want to create a system of incentives that creates the very problems you’re trying to cure.

This story I’m about to tell also explains the importance of incentives.

The Reagan administration pushed out tax cuts in phases, which meant that the tax cuts didn’t actually occur fully until Jan 1, 1983. When we passed the bill in August of 1981, President Reagan called me and asked what I thought of the bill.

He was very happy we got it passed, but I guess I wasn’t as enthusiastic as he had thought I should be. So he said, “What’s the matter, Arthur?” I said, “Well, you phased in the tax cuts.” And he said, “Oh, you academics are all the same. You’re all this theoretical, esoteric, ivory tower stuff. The only way we can get the bill passed was by telling people there wouldn’t be a deficit right away.”

I said, “I understand the politics of it, sir, very well, but let me ask you a question. Sir, how much would you shop at a store a week before that store has its big discount sale?” And he stopped and said, “Oh, my gosh. How bad is it going to be?” And I said, “It’s going to be a barn burner.”

As the example of the discount shows, businesses deferred all the income they could until the following year when the tax rates are lower. So 1981 and 1982 were very bad years for the economy.

Like I said, economics is all about incentives. The real world all obey the simple edict that every one of us is driven by incentives. If the government changes incentives, people will change their behavior in a very predictable, clear and efficient way.

The academic world should be about that, although it’s not. Academics is going to drift.

 

You Can’t Tax an Economy Into Prosperity

There’s a debate that’s still going on today. Have you ever heard of an economy taxed into prosperity?

They say that if you give a person money, that person will spend a portion of that money. The claim goes that it will create jobs to put in employment, and those employees will spend it. People claim that there’ll be this cascading effect of government spending that will create a multiplier.

The truth of the matter is if the government spends the money, they have to take it from someone else. With the money they take from the other person, won’t that person spend less that create a cascading effect in the opposite direction that the two effects end up being zero? The technical term for this is the income effects of a price change or a spending change or a tax rate change. The income effect always sum to zero. The income affects always sum to zero.

Furthermore, taxation will unbalance the economy and reduce production. The substitution effect become negative. The effect of government intervention on the economy using the Slutsky equation is the sum of an income effect and substitution effect, so if you understand the Slutsky equation, you know that taxation creates negative effects on the economy as a whole.

These guys don’t understand the Slutsky equation. They’re just basically not trained in economics.

—How can politicians act with incentives to better the well-beings of their citizens?

I would put all government officials, elected and otherwise, on commission. If the GDP growth rate is three percent, they deserve their salaries. But if the growth rate is four percent, double their salaries. If the growth is two percent, no salaries at all. If the growth is one percent, they owe you money.

Government employees don’t care because their incentives are not aligned with the prosperity of our country. That has to change.

 

Academic Advancement Came From Compassion

I became very appreciate of prosperity while working towards my Ph.D. I was working at the University of Chicago at the time, living in the south side of Chicago. I lived in a neighborhood that was almost entirely black. Not all of it was poor, but it was mostly poor.

When you wake up every morning and you see the circumstances all of your neighbors are living in, you see the poverty, the despair, the lack of hope and opportunity, it makes your heart cry. It makes your heart cry. That’s when you sit there and say, “What can I do as an economist do to make their lives better?”

In 1972, I wrote an article about enterprise zones, which was a very simple draft in the beginning. Number one, any person whose principal residence is in the enterprise zones should pay no payroll tax. Number two, there will be no income tax up to $50,000 a year.

Let’s say that the tax bracket in Philadelphia indicates that if you earn $56,000 every year, your income will be reduced by $27,000 due to tax. You’ll choose not to work over $29,000 from the start. People essentially lose the will to work hard.

Number three, thoroughly review all building codes, regulations, restrictions and requirements to make sure they’re not anti-economic growth. When you use building codes and lawyers and accounts to exploit these people, it’s just not fair. And then number four, I proposed getting rid of the minimum wage for young people in the enterprise zone.

These kids have not been educated and highly educated families. They haven’t gone to fine prep schools like I did. They’re street people, they live in these neighborhoods that are very uneducated neighborhoods. They can’t work for jobs worth $15 an hour, these kids. They need training. No one will hire them at the minimum wage. After being unemployed for two or three years, they become unemployable. And after being unemployable for two or three years, they become hostile.

What you’re seeing in the United States today is an exact example of that, George Floyd killed by a white police. It’s just a tragedy waiting to happen.

If you create the enterprise zones, you can bring the inner-city people out and get them to be prosperous to have good high paying jobs and create prosperity in slums by using tax codes and regulations to be able to bring them back into the mainstream of American prosperity.

When I was a little kid, I was raised at home by a black nanny. This lady was the most wonderful person in the world who actually raised me. It’s a part of society that we need to focus on correctly. Black people are no different than white people except for their skin color. That’s it. Now the backgrounds and circumstances of many are very different, and these have led to intense poverty.

We need to remove the barriers, what’s called the poverty trap, to create a society that can lift itself up through self-esteem. This can be done by actual work and being rewarded for their work, not through the government handing them money.

Benjamin Hooks, a civil rights leader and an executive director of the National Association for the Advancement of Colored People (NAACP), have said that blacks are “last hired, first fired.” During uncertain economic times, black people are affected negatively the most. A strong economy can save poor people living in slums.

The issues of poverty arose during the Johnson administration in 1963, and it seemed like they were well on their way of being resolved during the Reagan administration. These issues carried over, unfortunately, to the George W. Bush and Obama administrations.

Trump actively sought to solve these tough problems, and unemployment rates fell for black and Hispanic teens as a result. That’s not all. Black employment rates shot up, dependency on government aid went down and the number of people on food stamps fell. This happened because these people obtained work and earned income.

That’s when the coronavirus interfered. It’s nothing but a spiteful turn of events.

I don’t know how to say this without sounding silly. But to be empathetic with the place of other people is very important in driving you to want to find the right answer. Once I empathized with those less privileged, it became clear that prosperity is compassion.

 

Dr. Laffer’s Mission

I have been raised in a very privileged environment. As a person of privilege, my father was CEO and chairman of one of the largest companies in America called Clevite Corporation, which was probably the 90th largest company in America. My parents were both successful and my family was very wealthy. That’s how I got to go to a fine prep school and attend Yale University like my other family members.

There’s nothing wrong with privilege. There’s nothing wrong with it as long as everyone can earn that privilege. But instead of taking away privileges, you should expand privileges. You want to balance up, not down. Instead of hurting the rich, you want to make the poor richer.

There are all these people today in this world who want to hurt the rich by taxing them and more, but that’s not the dream. The dream is to provide opportunities for the poor to become richer.

This is what I’ve tried to do all my life with Proposition 13, tax cut policies for Ronald Reagan and Donald Trump, suggesting enterprise zones, Chile’s Pinochet administration and working with Margaret Thatcher. Everything I’ve done were to bring prosperity to our society.

The people in Japan are wonderful and they deserve a chance at prosperity. I’m speaking with you because I love Japan and how can we not want to make Japan prosperous? It’s my mission in life to make this a better world, a more prosperous world where we all share.

You’re also working for Liberty Magazine to bring prosperity to Japan. What you’re doing is Lord’s work. Our work is Lord’s work. And you know, if you can’t help a child or a poor person, or a person in distress, what good are you on this Earth?

 

Finding Talented Economists Through Debates

I’ve been doing many debates. The other day, the Spanish press asked Piketty from France to do a debate with me in Europe. His answer was no because he was afraid.

In the 80s, I had a debate with a Keynesian socialist named Jacques Attali. It was Reagan’s economist versus Mitterrand’s economist. He didn’t have a chance. They don’t do these debates anymore because they don’t want their ignorance exposed.

There was also a debate in the 80s with a liberal economist named Walter Heller, but it didn’t work out well for him because he didn’t know his economics.

I’ve had several debates with Jared Bernstein who was Biden’s chief economist, and he didn’t understand economics either. Last week, I had a debate with Austan Goolsbee who was the Chairman of the Council of Economic Advisors under Obama. All he did was talk about the coronavirus. He didn’t even mention economics.