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Sketching the Laffer Curve
By Jude Wanniski
Jun 14, 2005, 19:32
Memo To: Website Fans, Browsers, Historians
From: Jude Wanniski
Re: How it Happened
One of the most important economic events of the last half-century was Arthur Laffer's drawing of his famous "Laffer Curve" on a cocktail napkin in 1974. All he did was depict the law of diminishing returns as it applied to tax policy, but it caused a sensation once I named it after Art and publicized it in my 1978 book, "The Way the World Works," as well as in newspapers and periodicals. The Curve simply showed that as tax rates rose, they would increase revenues to the government, but at a certain point the producers (suppliers) of goods and services would have so much of their output taken by the government that they could no longer remain in business… and the government would experience a decline in revenues. How did Art happen to draw the Curve? Here is what economist Stephen Moore wrote in Monday's Wall Street Journal editorial page:
As legend has it the famous Laffer Curve was first drawn by economist Arthur Laffer in 1974 on a cocktail napkin during a small dinner meeting at the Washington Hotel attended by the late Wall Street Journal editor Robert Bartley and such high-powered policy makers as Dick Cheney and Donald Rumsfeld. The Laffer Curve helped launch the Reaganomics Revolution here at home and a frenzy of tax rate cutting around the globe that continues to this day.I'm not surprised that Moore, who was still in knickers in 1974, got the details of the "legend" messed up, but the WSJ edit page editors should have known better. It wasn't a dinner meeting and neither Bob Bartley nor Don Rumsfeld was present at the late-afternoon get-together at the cocktail lounge of the Washington Hotel. Here's how it happened:
In May of 1974, when I first met Laffer's mentor, Robert Mundell, at a conference in Washington, he told me that unless taxes were cut by a substantial amount there would be a sharp decline in car sales when the new models came out and when calendar 1975 began there would be a recession, with unemployment topping 8% in January. Having been prepped by Laffer in the three previous years, it was clear to me that Mundell was right and conventional wisdom, which was that the economy was just fine, was wrong.
As an editorial-page writer for the Journal, I rushed home with the idea of expounding Mundell's warning only to find that the president of Dow Jones & Co. had already written an op-ed that Bartley had to run. It warned that unless there was a tax increase to close the deficit, inflation would get worse!!
All I could do was make private predictions to Bartley and my colleagues on what would happen unless income-tax rates were cut to offset the effect inflation had already had in pushing the work force into higher tax brackets.
In August, President Ford called an economic summit to discuss the state of the economy, with a variety of Nobel Prize winners attending, but without Mundell or Laffer. After two days of discussion, the summit recommended a 5% surtax on incomes, the worst possible prescription. The Dow Jones Industrial average fell below 600 and Congress delayed action on taxes while preparing for the off-year elections. My guess was that the Republicans would lose heavily in the elections, not because of Watergate causing the resignation of President Nixon several months earlier, but because the electorate would know a 5% Republican surtax would send the economy down further.
Two weeks before the election, I decided to make several appointments in Washington for the day after Election Day, expecting the GOP losses would make the Ford team open to new ideas. As expected, the GOP lost more than 40 seats and when I showed up at the White House and Treasury the officials were in a state of shock.
In the first meetings, with Treasury Secretary Bill Simon, CEA Chairman Alan Greenspan, and Bill Seidman, an aide to President Ford, I found them polite, but as I feared they were reluctant to face the fact that the tax hike they endorsed had caused the loss at the polls. I had better luck with White House Chief of Staff Rumsfeld, who had not joined the team until October and had not been part of the decision to raise taxes.
I'd known Rummy since 1967, when he was an Illinois congressman, but had not spoken to him for the years when he was Ambassador to NATO, living in Brussels. When I entered his office early in the afternoon, he was his same old self, brusque and to the point: "What do you have for me today?" he asked, after a bare nod of salutation. Just as quickly I told him why the GOP had lost 40-plus seats the day before and why the correct policy was to cut tax rates, not raise them.
"Who else believes this but you?" he said, taking quick notes on a yellow-legal pad. I told him there were only two people I knew of and I was afraid he probably never heard of either of them. But when I mentioned Mundell and Laffer, he looked up and said, "Laffer? Of course I know him. He's a genius," explaining that in 1970-71, when he, Rumsfeld, attended the morning staff meetings at the White House representing the Office of Economic Opportunity, Laffer was there as the budget bureau's chief economist. After I explained that Laffer was back teaching at the University of Chicago, Rumsfeld said, "Well, let's get him down here."
That took a month, but the meeting was finally scheduled in Rumsfeld's office the afternoon of December 4, just the three of us as far as I knew. But early in the afternoon Rumsfeld's secretary advised me that he had to cancel because the President wanted him at that hour, but that I should meet with his deputy, Dick Cheney.
I'd also known Cheney from his OEO days with Rumsfeld, and when I got him on the phone I suggested we meet at the Two Continents cocktail lounge in the Hotel Washington, just a block from the White House.
When we met there in a booth at 4 p.m., the only other person to join us was Grace-Marie Arnett, who had been press secretary to Sen. Pete Domenici and who Cheney later hired as deputy press secretary in Ford's 1976 presidential campaign. Oddly, both she and Cheney recall Laffer drawing the Curve, but he insists he has no recollection of having done so. It no doubt was routine to him, but not to the rest of us.
Really all I remember taking place was his drawing the Curve. This occurred with Laffer unable to get Cheney to see how two tax rates would produce the same revenue, one at a higher lever of production than the other. The paper-napkin sketch obviously impressed him because he called me a few weeks later at the Journal to tell me Rumsfeld had asked Treasury Secretary Simon to prepare a tax-cut proposal for presentation in January with the budget and the President's economic message.
Alas, the economists at Treasury were all Keynesians, which meant they were only thinking of putting money into people's pockets to boost aggregate demand, not of increasing incentives to producers to boost aggregate supply. I recall standing next to Bartley at the ticker in the editorial office when the news came in that Ford would propose a $50 tax rebate on income earned in 1974.
Horrified, I called Rumsfeld to tell him a rebate for income earned the previous year could have no incentive effect on future production. He was exasperated, but it was too late to do anything about it. President Ford, of course, went on to lose the 1976 race to Jimmy Carter.
[For a sketch of the Curve and an explanation of the theory, please link to this lesson at my Supply-Side University.]
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