Art Laffer and the Triumph of Politics

Presentation is everything.

An excellent idea, poorly presented, is a failure.  A simple concept may sizzle, even if there are flaws.

Take the Laffer Curve.  Famously drawn on a napkin, Laffer suggested that a tax rate of zero raised no revenue, a tax rate of 100% raised no revenue, and there must be something in between that was ideal and appropriate.  This simple concept became the foundation for a series of books and articles and the idea of supply-side economics.

There was a real-life experiment for this theory during the Reagan Administration.  This was a time when we thought we could have low taxes, high defense spending, and make up the difference by  cutting waste, fraud, and abuse out of the Federal budget.

Why should we care about this?

If you want to understand about deficits, taxation, and spending, you need to know history.


Don’t Confuse Your Politics with Your Investments

The Current Issue

The debate about supply-side economics could be left to history but for the current implications.  Seizing upon recent stock market weakness, Laffer launched a political assault.  In a Wall Street Journal op-ed he argues that the market is already starting to reflect the end of the Bush tax cuts.  Larry Kudlow highlights the Laffer piece in a confrontation between Laffer and James Altucher.  Regular readers of “A Dash” know that we are long-time fans of the Kudlow program, mostly because the host brought together differing viewpoints and brought out their best through impartial questioning.

This seems to be at an end.  The show is becoming overtly political, which makes it less valuable for thinking investors.  In the Laffer/Altucher matchup, one of the participants has a napkin and the other provides a quiet review of data — earnings, interest rates, and other factors that are different from 1981.  If you watch this as a debate, and I urge you to do so, it is pretty one-sided.   Laffer does not respond to the specific Altucher points.  Despite this, Kudlow awards his “prize” to Laffer.  Take a look for yourself.

Altucher also cites an argument that nearly everyone misses — the importance of the slack demand for labor.  This helps to contain inflation, but it also helps new businesses which can draw upon these inexpensive resources.  This is the natural way economies grow, and it is something that most observers miss.

An Avalanche of Criticism

The Laffer initiative generated a well-deserved response.  Here are some of the highlights.

Barry Ritholtz, one of our featured sources, has a first-rate analysis of the Laffer WSJ piece.  Here is a key quotation:

In his OpEd, Mr. Laffer confuses causation with correlation, ignores market history, makes spurious argument, and simply make up crap as he goes along.

Readers would be disappointed if Ritholtz pulled any punches.  I urge you to read the entire, point-by-point analysis.

Another data-rich commentary from Asha Bangalore at Northern Trust may be summarized as follows:

It is not clear yet if the Bush tax cuts will expire in 2010.  Given the fragile state of the economy, it is entirely possible that the tax cuts will be extended into 2011.  Assuming the tax cuts are allowed to expire, the forces that may prevent strong economic growth in 2011 are entirely different from tax increases.  The headwinds from the financial sector, by way of a severe credit crunch, lackluster job growth, and housing market challenges are factors that will influence the near term path of the economy.  The evidence presented here suggests that Mr. Laffer’s story is selective and incomplete.  Many factors will play a role in how the U.S. economy performs in the next few years in addition to taxes.

Read the entire article and enjoy the great charts.

And also check out Brian Wesbury’s video.  He talks about several concerns including debt levels and the comparisons to Greece, the end of government stimulus, and the Laffer article.  Wesbury sees a continuing strong recovery for stocks, but thoughtful readers will want to watch the entire video.  Like other critics of Laffer cited here, Wesbury uses data.  He looks at the actual interest rates as an indicator of risk.  He also suggests that people look at the assets held by the federal government.  Yosemite anyone?

The Real Story

If you really want to understand the Laffer theory and the Reagan implementation, go to the source.  David Stockman was the Budget Director in the Reagan Administration.  He provided an interview that was pretty frank, and was “taken to the woodshed” by the president.  I taught about this stuff back in the 80’s, often to a skeptical audience.  Eventually I was able to use Stockman’s book, Triumph of Politcs:  Why the Reagon Revolution Failed, as a piece of evidence.  The book is now added to our recommended readings for serious students.  Stockman argued that the supply-side test failed, but was not fair.  Judge for yourself.

Investment Conclusion

With the mid-term elections a few months away, we are entering the season of intense political debate.  There is no question that the decisions we make as voters will affect our nation’s future and our economy.

I intend to exercise my voting rights.  I expect that readers will do the same.

Now how about making money from our investments?

As usual, I recommend paying attention to the prospects for corporate earnings and cash flow.  Look at specific stocks.  There are many choices that are very cheap.

If you cannot see them, perhaps those with a political agenda are blinding your vision.  Get ready for several more months of the same.

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  • Lee Gibson June 11, 2010  

    Shorter Art Laffer: Reagan. Reagan, Reagan, Reagan. Reagan. Also, Reagan.

  • Jack Reacher June 11, 2010  

    To say that Reagan’s policies did not work is wrong. For the government to take half of what I make and give it to people sitting on their duffs is wrong. It’s all as simple as the “Teach a man to fish” analogy.
    To tax me to death so that some public employee unionist can retire with a mathmatically unsound actuarial pension is wrong.
    I plan to vote, too.

  • Mike June 12, 2010  

    Raising taxes is not the solution to our problems. Assume that taxes are raised… then they will simply spend more and the cycle repeats itself. The problem is not on the tax side, it is on the spending side. There are currently no curbs on spending. Let people spend their income on what they want and the economy will improve.

  • George M June 13, 2010  

    “Laffer suggested that a tax rate of zero raised no revenue, a tax rate of 100% raised no revenue, and there must be something in between that was ideal and appropriate.” Did he or anyone else propose a particular percentage or range that could be tested. I seem to have missed that one.
    Re: Bush tax cuts. The market completely ignored them: Kudlow was sharing a show with Cramer and he asked why high-dividend stocks had not reacted and Cramer replied that investors preferred “growth.” If they didn’t respond then, why would they now?

  • Jeff Miller June 14, 2010  

    George M — You have highlighted the key point. We do not have enough different natural experiments at different tax rates to draw any firm inferences.
    Don’t expect that to stop anyone from trying!