Art Laffer and the Welfare State

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Art Laffer, of late, has been saying something that is really profound.  I have heard him say it three times on three different outlets.  It goes like this.  When you take money away from a person who earned it and give it to a person who didn't, you disincentivize the producer by decreasing his reward for producing, but you also disincentivize the recipient who now does not need to produce as much to acquire the same purchasing power.  This, very succinctly, explains why socialism, or more precisely, welfare states have lower GDP/capita and thus lower standards of living.

As we can see by the above chart, the U.S. has had higher GDP per capita (PPP) than the EU for the reported time period.  However, the gap has been increasing.  Without a doubt, some of this is the result of adding low GDP nations in Eastern Europe to the EU.  However, the discrepancy exists with Western European nations, albeit at a lower percentage, as well.  The question is, why would this be?  The reason is almost surely that EU countries spend 45.8% of GDP on government and the U.S. spends only about 37.8%.  When we look at the details, the EU spends 1.9% of GDP less on defense than the U.S. but substantially more on social welfare programs, national health care being the major component.

Art Laffer, despite not inventing it, is generally considered to be the father of the Laffer Curve and, as such, one of the primary proponents of Reagan's Supply Side Economics.  While it was often referred to as 'trickle down economics' or 'voodoo economics', it is, actually, solid Economic theory and a major component of the Reagan revolution.

Basically, the Laffer Curve notes that lower taxes generally stimulates economic growth and higher taxes leads not only to lower growth but also increased tax avoidance.  His claim was that at very low tax rates, while economic growth is high and tax avoidance is low, the lower tax rates result in lower tax revenues.  As tax rates increase, economic growth is less and tax avoidance is greater, but the increase in tax rates in an increase in total tax revenues.  At some point, the depression of economic growth and increase in tax avoidance will swamp the increased revenue from increased tax rates and total tax revenue will fall.

This is good Economics and really not very controversial.  However, Laffer went on to claim that the tax rates at the time Reagan took office were to the right of the mode of the curve and by lowering tax rates, tax revenues would actually increase.  That was very controversial, but despite that, tax rates were lowered, the economic growth rate did increase and tax revenue also increased.  While the Laffer Curve is solid, there really is no good way to determine on which side of the mode a country is at present.

Over time, Art Laffer will undoubtedly be recognized as one of the most influential Economists of the late 20th and early 21st Centuries.  However, he will not win the Nobel or other major awards for Economists because he argues for lower taxes and supply side economic policies in an era of high taxes and demand side economics.  In essence, he argued for an effective decrease of total transfer payments and in the political environment of the time, this was anathema.  However, his arguments are powerful and they did (and still do) diffuse into the collective intellectual consciousness and modify policy to some degree.

As to the divide between Supply Side and Demand Side Economics, it is a politically driven false dichotomy or what Greg Gutfeld calls 'The Prison of Two Ideas'.  Clearly, economic growth requires producers to produce more (Supply Side) or there is nothing more to buy.  However, consumers need to have more purchasing power (Demand Side) or they will not be able to afford additional consumption.  Rather than arguing that one is better than the other, a rational argument is that the two must be in balance.  In other words, while fiscal and monetary policy stimulate greater supply, it must also stimulate greater demand in the same measure.

In other words, I am divorcing myself from Dr. Laffer's political argument while I simultaneously recognize the contribution he has made to our understanding of the relationship between economic growth and social welfare policies.  I am also not arguing that because increasing social welfare expenditures lowers economic growth, society should lower social welfare spending - at least not directly.  There are both economic and philosophical arguments that militate for social welfare expenditures.

GDP and GDP per capita are convenient and important measures of economic well being.  However, they are not the only ones.  While the Pareto distribution assures that income and wealth equality are not possible without creating disastrous economic problems, excessive inequality is politically destabilizing and can result in excessive poverty rates.  Also, because high income people generally save more than low income people, changing income distribution can change the relationship between demand and supply, either causing inflation or slowing economic growth.  A potential result can be depressing purchasing power among consumers while increasing the value of securities without increasing their intrinsic value.

However, one can also argue for reduced income inequality as a necessary consequence of Social Contract theory.  In other words, by agreeing to the Social Contract, a citizen can reasonably expect that a full faith effort in productivity should result in sufficient income to enjoy a modest, but dignified lifestyle.  To a degree, I make this argument in 'An Information Age Income Model'.

It is not unreasonable to suppose that a wealthy society may want to guarantee some subset of Maslow's two lowest levels.  A reasonable set would be food, shelter and health and one that is embraced by most of Europe.  However, considering the disincentives discussed above, it is almost surely unwise to provide them free of charge to everyone rather than only to those who are truly in need of assistance in order to procure them.  To assure these without creating too much of Dr. Laffer's disincentives is not a simple task.  One could argue, as I do, that no nation is doing it well.