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Pinnacle e-Letter Taxation's Impact on Economic Growth Dr. Laffer, prominent national economist and advisor to many national leaders, moved his economic research firm, to Nashville in 2006. His economic acumen and influence in triggering a world-wide tax-cutting movement in the 1980s have earned him the distinction of "The Father of Supply-Side Economics." He first became a valued Pinnacle client and more recently has accepted a role as a principal economic advisor to Pinnacle. The article below is based on Dr. Laffer's speech at the Pinnacle Forum earlier this month. As we enter another election year, it's important to step back, take a deep breath and take stock of where we stand. This paper is meant to provide an economic reckoning of our country's policy path to date and give some insights into how the policies that elected officials put in place impact you and the economy, for we stand at a critical juncture that could affect our nation's prosperity for many years. The Backdrop While there are many ways to view the world, from my vantage point you can break the world down into two groups: the redistributionists and the growthists. Redistributionists believe output is given and the primary role of the state is to redistribute that output. They take from those who have a lot and give to those who have little. They believe people work because there are jobs and save because their incomes are high. In short, they believe people work to pay taxes. Then there are the growthists, now often referred to as supply-siders. They don't believe that output is given or that people work because there are jobs. People work to get paid after tax. It's that very personal and very private incentive that motivates people to quit one job for another or trade leisure for work. Growthists believe it's the after-tax rate of return on savings that determines how much people save. In the growthist model, the primary role of the state is to enact policies that encourage people to increase investment, productivity and growth. Whereas redistributionists believe the size of the pie is fixed and government's job is to make the size of the slices more even, growthists believe the role of government is to make a larger pie. How government officials view the world is made evident through the economic policies they put in place. I believe the world of political economics is comprised of four all-inclusive grand partitions-fiscal policy, monetary policy, trade policy and incomes policies.
There's a lot of overlap and ambiguity when it comes to the details of which policy goes in which category, but the broad boundaries should be fairly understandable. As is only natural, the reason we concern ourselves with public economic policy is that we believe these policies not only matter, but matter a lot to the health and welfare of our nation. And they do! We really have come a long way over the past half century toward pro-growth policies, and this movement has improved the condition of our nation tremendously. History of Federal Taxation While policies in each of the four grand partitions of macroeconomics are incredibly important to the health of a nation's economy, taxation alone can be used as a proxy for how government views the world. The history of federal taxation is a fascinating tale. The personal progressive income tax was first introduced in the U.S. in 1913 with rates ranging from 1% up to 7%. With 20:20 hindsight, the debate preceding the 1913 enactment of the progressive income tax is almost humorous. Doubting Thomases in the U.S. Congress were convinced to vote in favor of the progressive income tax after being assured that the highest tax rate would never exceed 10%. Yet by 1918, the highest federal marginal income tax rate had risen to 77%; the excuse was the War to end all Wars. As history demonstrates, though, any excuse to raise tax rates-especially on high incomes-is appropriate to politicians. Immediately after the First World War, politicians would not cut tax rates back to their pre-war levels. In fact, it took a presidential election of monumental proportions to bring tax rates back to reasonable levels. In the election of 1920, candidates Warren G. Harding and Calvin Coolidge defeated their Democratic opponents James M. Cox and Franklin Delano Roosevelt by promoting a "return to normalcy," which meant in part bringing tax rates back to their pre-war levels. From the institution of the income tax all the way through the presidency of Jimmy Carter, the tax rate trend was up, up and away. The only times we ran against this proclivity to raise taxes were under President Warren G. Harding and President Calvin Coolidge, whose tax cuts ushered in the Roaring '20s, and President John F. Kennedy, whose tax cuts spurred the Go-Go '60s. Fortunately, following a long period of terrible policies, people began to take action. Proposition 13 in California received national and international attention, reflecting a sea change in U.S. politics. In 1978, California voters overwhelmingly chose to reduce property tax rates and make any future tax rate increases extremely difficult. President Ronald Reagan (1981-1989), riding on the crest of Proposition 13 and having promised tax cuts, won the 1980 election against incumbent President Jimmy Carter. The Reagan 1980s was an era of unprecedented tax rate cuts of virtually every variety. In August of 1981, Reagan signed into law the Economic Recovery Tax Act (ERTA, also known as Kemp-Roth). ERTA slashed marginal personal earned income tax rates by 25% across-the-board over a three-year period. The highest marginal tax rate on unearned personal income dropped from 70% to 50% immediately (the Broadhead Amendment) and the tax rate on capital gains also fell immediately from 28% to 20%. As a provision of ERTA, Reagan also saw to it that the income tax brackets were indexed for inflation beginning in 1985. And the rest is history! Currently, marginal income tax rates have only crept back up slightly, while the highest federal tax rates on the ownership of capital-dividends and capital gains-are the lowest in my lifetime. The Future In my life I've never seen an economy that comes even close to the current U.S. economy. I've never even read about an economy, modern or ancient, near or far, large or small that can hold a candle to today's America. While we aren't perfect, we are the closest thing this old planet has ever created. And there is no question in my mind that the pro-growth macroeconomic policies at the heart of supply-side economics are largely responsible for the economic performance of our nation. I know for many it's hard to get excited about how the economy is functioning, yet I can't overstate how important the choice of economic policies is. Just take a look at some of the staggering changes in the economy since the start of the supply-side revolution. The Misery Index (inflation plus unemployment) has fallen from a high of 21.9% in June of 1980 to today's level of right around 8%. From January, 1966 through July, 1982, the average annual inflation-adjusted compound rate of return of the Dow Jones Industrial Average was negative 7.9% versus positive 8.8% per year from July of 1982 until today. These are drastic changes brought about by the sea change in U.S. economic policies. Yet what policies giveth, policies can taketh away. America is prosperous because of pro-growth economic policies, including restrained government spending, low rate flat(ish) taxes, sound money, limited regulations, free trade and open borders. Reverse these policies and you will quickly experience the dark side of the supply side. With this in mind, the 2008 presidential election is shaping up to be the most significant election since at least 1980. It is hard to imagine reverting back to the high tax, high inflation, high unemployment America of the 1970s, but that is exactly what is at stake. Return to the October 2007 e-Letter
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