Ajivaka Wallacian ஆசிவக வாலேசன்: My favorite economist

Saturday 17 May 2014

My favorite economist - Arthur Laffer

Do you have a favorite actor? Poet? Politician? Singer? Flower? Author? Cricket player? Food? Color? Almost certainly. In India we often have several; we even have favorite Gods and Goddesses, saints, swamis, parks, temples.. Favorite Scientist? Probably, but only for about a small percentage of the public. How about economist? Few people have a favorite economist. It’s like having a favorite bureaucrat, or train driver, or janitor. These people are usually anonymous. We are much more likely to have a favorite barber, gardener, or grocer. But some economists have had and continue to have far more effect on most lives than any of these people.

Karl Marx is probably the most popular and most famous economist in history, even though Marxism is perhaps the worst economics, which most countries have tried with terrible consequences. Academics journalists and intellectuals, people who have the least understanding of economics love Marx the most. Adam Smith, Milton Friedman, and Friedrich von Hayek are some popular economists of the free market. Most Indians know of and admire Chanakya for his Arthashastra, even if their knowledge of his principles is negligible.

My favorite economist is perhaps Arthur Laffer, whom most of the world has not heard of. I think he has had more impact on the world, on the positive side, than any other economist in the twentieth century. I am probably in an extremely small group, less than ten thousand worldwide, who thinks so. Laffer is not well known outside economics, but is held in great contempt among his fellow professionals, especially in the USA, especially the majority who are Keynesians.

Have you heard of the Laffer curve? It had (and has) more impact on your life than Newton’s third law of motion.

Here is the simple graph called the Laffer curve. The horizontal X axis is the rate of tax, the vertical Y axis is the actual amount of tax the government is likely to receive. It is a simplification, but during the insane 1960s and 1970s most ministers, bureaucrats, legislators, and even economists didn’t understand it. Most still don’t, especially in socialist countries.

Laffer curve on a napkin

The Laffer curve demonstrates a simple principle – the difference between Arithmetic and Economics. Arithmetic tells you that a higher percentage of anything yields a higher amount. But that is not true in Economics, especially not with taxes. This is a similar to another well known phenomenon, the Law of Diminishing Returns. But let me explain the Laffer curve. Think about income tax. You pay a percentage of your income to the government. What is the right percentage? There is no such thing, it is whatever the government decides to charge you. That is why income tax varies substantially from country to country, from time to time, and between income groups. But after the end of the Second World War, when socialist thinking dominated the world, not just in Asia, Africa and South America, but also in most of Europe and even the USA, lost connection with sanity. They went up to 70% for the highest income earners. In India, maximum rate was 97% at one point. I wonder why the remaining three percent was left alone. Entrepreneurship plunged, the number of existing businesses severely tightened their belts, their profits dwindled, new investments or expansions dried up, unemployment soared, inflation worsened, and tax revenues of governments began to suffer. The only reason there wasn’t global recession was that technology was the engine that kept things going, expanding the economy wherever it was allowed, even though it was like driving with both accelerator and brake pressed simultaneously.

Even now most people still believe that the rich people should pay more than poor or middle class, as a percentage of their incomes. Most economists agreed, especially the ones advising Prime Ministers and Presidents. But some like Arthur Laffer were vocal in their opposition and demanded lower taxes for the rich. They were vilified both in public and in academic circles. Very few vilifiers ever wondered if Laffer was right and they were wrong : because by obvious arithmetic, a higher tax on high incomes yielded higher revenue for government. Two such people in US Government, at that time, set aside their superior knowledge, and asked Laffer if he could explain why he was right. They stepped into a restaurant, he drew this graph on a napkin.

Suppose there is a 0% (zero percent) tax rate. How much tax does the government get? Zero. Suppose there is a 100%. How much tax does the government get? The Arithmetic answer is 100% of your income, but the Economics answer is Zero. Why? If the government took every dollar, rupee, dinar, yuan you earned, would you even bother to work? This is what the Laffer curve shows – the difference between Arithmetic and Economics. At any rate between 0% and 100% people will work, and pay tax on their income. Therefore, argued Laffer, the government’s revenue from taxes increases from 0% upto a particular tax rate, after which it starts diminishing.

The major reason most people don’t understand this (or don’t want to), is that they are not in the highest tax bracket. Or frequently, don’t even have enough income to pay tax. Or, they are exempt from income tax.

The two people listening to Laffer in that restaurant were Donald Rumsfeld and Dick Cheney. They are now notorious for launching the war against Iraq in 2003 under President George W Bush, Cheney being his Vice President, Rumsfeld his Defence Secretary. But at that time Rumsfeld was Chief of Staff to President Gerald Ford, after having served earlier in Nixon’s cabinet. And this lesson did not change the tax policy of either President Ford or his successor, Jimmy Carter. The Laffer curve was only put into policy by a person who experienced the effects of high income taxes first hand – Ronald Reagan. When Reagan was working as an actor in Hollywood movies, he often stopped acting in films after August, he said, because most of the money he made after that, went to taxes. A similar movement was initiated in the United Kingdom, which also had high taxes. An economist called Keith Joseph, going against post WW2 conventional wisdom, went on a nationwide tour espousing the cause of entrepreneurs. As a member of the Conservative Party, he tried to run for office, but was hounded everywhere including his house, by activists and professional intimidators. One of his friends in the Conservative Party, listened to him, and decided to contest for the Prime Ministership herself – Margaret Thatcher.

Laffer didn’t invent this idea of reasonable tax rates yielding better revenue of course, he only came up with this simple graph that explains it so well. The idea is almost as old as taxes, and has references in Adam Smith, ibn Khaldun and Manu Smriti. Here is one link to an article Manu Smriti and Kautilya’s Arthashastra with the Laffer curve.

And this is the sloka from Manu Smriti on tax rates :

पञ्चाशद्भाग आदेयो राज्ञा पशुहिरण्ययोः ।
धान्यानामष्टमो भागः षष्ठो द्वादश एव वा ॥ १३० ॥

pañcāśadbhāga ādeyo rājñā paśuhiraṇyayoḥ |
dhānyānāmaṣṭamo bhāgaḥ ṣaṣṭho dvādaśa eva vā || 130 ||

In the case of cattle and gold the fiftieth part shall be taken by the King; and in the case of grains, the eighth, sixth or twelfth part.—(130)

There is even a beautiful Purananooru poem by Pisiranthaiyar that also advocates low taxes. Here is the poem and its translation, which came to my attention via Twitter.

காய் நெல் அறுத்துக் கவளம் கொளினே,
மா நிறைவு இல்லதும், பல் நாட்கு ஆகும்;
நூறு செறு ஆயினும், தமித்துப் புக்கு உணினே,
வாய் புகுவதனினும் கால் பெரிது கெடுக்கும்;
அறிவுடை வேந்தன் நெறி அறிந்து கொளினே,
கோடி யாத்து, நாடு பெரிது நந்தும்;
மெல்லியன் கிழவன் ஆகி, வைகலும்
வரிசை அறியாக் கல்லென் சுற்றமொடு,
பரிவு தப எடுக்கும் பிண்டம் நச்சின்,
யானை புக்க புலம் போல,
தானும் உண்ணான், உலகமும் கெடுமே

English translation

If rice is harvested carefully and consumed, yield of a Ma (1 Ma = roughly 1/3 of an acre) will last for many days. But yield of even a 100 Sei (1 Sei = roughly 1 3/4 of an acre) will be wasted if an elephant enters it, because it tramples much more with its legs than what it eats. Similarly, if a ruler collects taxes as per rule, his country will yield a lot to him and it will prosper too. However, if he becomes weak and on the advice of fawning relatives he collects taxes without any mercy on the populace, his country will become like an elephant entered field

Swaminathan S Aiyar, the economics journalist of the Times of India writes that top tax rates plunged from 56% in 1991 to 30% in 1997. Equally crucial was the abolition of wealth tax. Communist countries like China and USSR did not have this problem, because no one was allowed to be wealthy in the first place. As Tom Friedman, an opinion columnist of the New York Times, and author of the book The Lexus and the Olive Tree succintly stated, “Communism achieves equality by making every one equally poor.” See Venezuela or Cuba today for this effect (neither of which gets much screen time on TV).

But even today, if you search for most articles on the Laffer curve, you will notice only negative comments about it. The most popular criticism is that Laffer curve is simplistic. Of course it is. So is evaporation.

The opposite of Simple or Simplistic is usually bureaucratic. When you need an extremely complex tax structure, it employs millions of accountants, bureaucrats and academic economists. Most of the government’s cost goes towards maintaing this bureaucracy, not for improving the lives of the public. We see this in state government budgets in India nowadays, where nearly half the government’s income goes to salaries and pensions.

The Wikipedia article on Laffer Curve is so unabashedly prejudiced that it pretends that recent lowering of tax rates in Kansas didn’t work, conveniently ignoring that it worked pretty spectacularly first the USA, and then Europe, then finally after the Berlin wall fell, in most of the world. Even Narasimha Rao, the great liberalizer of the Indian economy, didn’t reduce tax rates that much. He took the simpler and far more effective route, of de-licensing industry first. It was under Deve Gowda that taxes fell to 30%.

The other criticism, regularly voiced by wily economists like Paul Krugman on the New York Times, is that government spending actually increased massively under Reagan, because of wasteful military programs like Star Wars. This is a standard red herring. The argument of lower tax rates is about how income much tax payers get to keep, not how much of government is allowed to spend. Government can only spend money it gets from tax payers.

I recently read the book "The End of Prosperity" by Arthur Laffer. Who else could link American Presidents Coolidge, Kennedy and Reagan on simple economics and tax policy?

The US has an interesting history of income tax. When it became independent, in the 1780s, there was no real income tax, as the USA was designed to be a very Federal Republic, with most of the power residing in individuals and in state governments. (Slavery, counting blacks (or Negros) as three-fifths of a legitimate person, women having no property rights and having several Red Indian reservations, flavor that history). The first National income tax was levied by Lincoln, to recover money for the Civil War. In 1895 the US Supreme Court declared income tax unconstitutional.

In 1913 the US Constitution was amended to enable the first income tax law, after extensive promises that it will never go high. The top rate was 7% (perhaps they read the Arthashastra or Purananooru). Very quickly the rates zoomed up over 70% during WW1, and it went up to 90% when Calvin Coolidge was elected President. Coolidge reduced income tax from 90% to 24%, the largest reduction in American history. The American economy experienced a rapid growth – the decade was called the Roaring Twenties. Taxes went back up to an insane 74% under the hero of the socialists, Franklin D Roosevelt, worsening a decade long recession. Taxes went to 90% under Eisenhower! John F Kennedy brought them down to 70%. In 1982, Ronald Reagan brought them down even further.

Arthur Laffer and Ronald Reagan

All tax cuts were followed immediately by economic booms. Between 1980 and 2005, under Reagan, GHW Bush, Bill Clinton and GW Bush, the USA saw the largest economic boom in its history. Bill Clinton, the only Democrat that Laffer admires after Kennedy, understood economics. Laffer calls the four Presidents betweem Kennedy and Reagan the Four Stooges – Lyndon B Johnson, Richard Nixon, Gerald Ford and Jimmy Carter.

As Swaminathan Aiyar observers “The lesson is clear. Extortionate taxes hit honesty, not riches.”

Lower taxes are not the only driver of economies. Technology and innovation have been the primary drivers. But high taxes can devastate the positive effect of technology.

August 14 is Arthur Laffer’s birthday. Thank you, Professor Laffer and may you live a long long life.

I will write about more from his book in a later blog.

On the Laffer curve

The Four Stooges

Manu Smriti and Arthashastra on tax rates

Arthashastra and Arthur Laffer

Purananoonuru on low taxes by Pisiranthayar

Ronald Reagan quoting ibn Khaldun

Record Taxes in India by Swaminathan Aiyar

History of US income tax law