Art Laffer and the Founding of Supply-Side Economics.

In light of supply-side economics hero Arthur Laffer’s Wednesday endorsement of Newt Gingrich’s economic plan, it’s worth recalling Laffer's history remaking American politics and world economics.

Art Laffer rose to national fame in the early 1970s. As 30-year-old chief economist at the Office of Management and Budget, he became a source for political reporter Jude Wanniski of the now-defunct National Observer. When Wanniski was tapped to analyze President Nixon’s August 1971 decision to end the dollar’s international convertibility to gold, Laffer, who opposed the gold move, helped Wanniski to understand the magnitude of Nixon’s action, which severed the dollar’s 150-year gold link and led to a precipitous drop in the dollar. He also recommended Wanniski speak with Canadian Robert Mundell.

By 1971, Mundell was a towering figure in academic economics, a major figure at the University of Chicago (editor of The Journal of Political Economy), and Laffer had been his colleague. When Wanniski met Laffer, the nascent supply-side revolution had already been cooking in top academic circles and needed only conveyance out of that fishbowl into politics and the public mind should conditions warrant it – and by the 1970s, did they ever.

As a result of his tutelage under Laffer and Mundell, Wanniski, by then at The Wall Street Journal editorial page under Robert Bartley, was far ahead of the curve in analyzing rising inflation and the soaring oil price: “Because of Laffer's occasional visits to New York and the success of his private forecasts, which I kept reminding the others on the [WSJ] staff were highly accurate, we were not taken in by the fourfold increase in the price of oil in 1973. The rest of the economic universe thought the Arabs could do this because the world was running out of oil. Laffer pointed out that Mundell... had predicted that in January 1972 the price would soon rise dramatically and be followed by price increases in all other commodities – this, because of the rise in the gold price.”

In 1974, Mundell and Laffer foresaw recession alongside rising monetary inflation – an impossible combination under the era’s reining Keynesian dogma – and began to argue for a US tax cut. Wanniski reported Mundell and Laffer’s view in The WSJ, “It’s Time to Cut Taxes.”
Around the same time, at Wanniski’s invitation, Laffer famously lunched with Ford Administration officials Don Rumsfeld and Dick Cheney to discuss ideas to boost the economy. While it is disputed whether Laffer drew his soon-to-be-famous curve on a napkin at that meeting, his argument was arresting: high marginal tax rates could reduce economic output and thereby reduce tax revenues. At a certain point on the curve, a lower tax rate would produce equal or even greater government revenue.

Wanniski summarized the insight:

In studying public finance, there is nothing more important than an appreciation of the Laffer Curve. Nothing. Empires have been built on the wisdom of a few men who understood the law of diminishing returns as it applies to tax policy. Caesar Augustus understood. Napoleon understood. The architects of the Byzantine Empire understood. So did the Founding Fathers of the United States. The temporary, but sharp decline of the U.S. economy in the 1970s was the result of the failure of our political leaders to realize the law of diminishing returns was eroding the economy in a new and different way. The tax rates themselves were constant, but because of the inflation that began to take hold in 1967 when the U.S. commitment to a dollar/gold standard began to waver, real rates of taxation were rising and had passed the point of diminishing returns. We were inflating our way up the progressive tax schedules of the income-tax code.

Moreover, Laffer explained this idea was not original to him, having been expressed throughout history in various formulations. For example, Ibn Khaldun, the 14th century Muslim philosopher, wrote in his work The Muqaddimah: "It should be known that at the beginning of the dynasty, taxation yields a large revenue from small assessments. At the end of the dynasty, taxation yields a small revenue from large assessments."

In 1975 in Irving Kristol’s The Public Interest, Wanniski produced the first long-form enunciation of the tax rate cut/sound money formula, “The Mundell-Laffer Hypothesis,” later rechristened supply-side economics by Wanniski after Nixon economist Herb Stein’s scoffing dismissal of “supply-side fiscalists.” With the US moving deeper into stagflation and conventional economics seemingly unable to respond effectively, the article struck a nerve. It circulated widely among Republican intellectuals and contributed to the conversions of US Rep. Jack Kemp (R-NY) and eventually staff close to former California Governor Ronald Reagan. Wanniski continued to expound Laffer’s views at The Wall Street Journal, and in 1978 delved deeper into “Taxes, Revenues, and the ‘Laffer Curve’” in The Public Interest.

Laffer’s role was evident in two seminal tax policy debates that same year. With Laffer’s endorsement, California voters passed Proposition 13 to reduce property tax rates and restrict the state assembly’s ability to raise future taxes. Also in 1978, US Rep. William Steiger (R-WI) proposed cutting the capital gains tax rate down to 25% for individuals and corporations. Steiger’s argument came straight from Laffer – that increased economic growth would offset the lower tax rates, and the measure passed under a Democratic Congress. Steiger’s revenue predictions were confirmed as capital gains revenues remained higher after the rate cut than before, even through the deep recession of 1981-82.

In 1978, Kemp met with Reagan to discuss economics and succeeded in a day of conversation in convincing Reagan, who grasped the economics immediately, to focus on lower tax rates and growth rather than balanced budgets. Laffer was a key Reagan advisor during the 1980 campaign, and Reagan ran on the Kemp-Roth plan to cut income tax rates across the board by 30%
The rest is history. Combined with Reagan’s commitment to a stable dollar, Kemp’s tax cuts – phased in from 1981-83 with bipartisan support – helped launch one of the great US economic booms, arguably lasting from 1982-2007. The top tax rate was lowered from 70% to 50%, and then down to 28% in 1986, again with bipartisan support. Twenty million new jobs were created, the Dow Jones Industrial Average soared, interest rates plummeted and the inflation rate dropped from double digits to below 3%.

Since the 1980s, the top income tax rate has been raised twice and cut once, settling at 35% for the last decade. Income tax rate increases have been offset by cuts in the capital gains tax rate, now at 15%. More than 30 nations have adopted flat tax systems, including, ironically, most of the former Soviet bloc nations, and several other countries are considering them today. Recent discussions of lowering the US corporate tax rate have included bipartisan recognition that lower rates could bring in similar levels of revenue. While in the 1970s many developed nations had top tax rates well above 70%, today, most nations keep tax rates below 50%.

In short, Art Laffer is a world historical figure who has helped lead the restoration of classical economics’ focus on production incentives. That his arguments about tax rates’ incentive effects have been accepted in broad terms today among economists of all political stripes is testimony to his tremendous skill as an economist and advocate.