The Political Law of Diminishing Returns Jude Wanniski February 20, 1998

Supply-Side University Economics Lesson #6

Memo To: SSU Students
From: Jude Wanniski
Re: The Political Law of Diminishing Returns

There have been a great many questions raised about the communication of political wants and needs from the electorate to the ruling class. In our "Bulletin Board," which we now call the "TalkShop," we had a spirited discussion earlier this month about the Laffer Curve that involved the turning point on the curve, Point E, which I've said is the "optimum point" on the curve. We think of the law of diminishing returns as an ancient concept, one the philosophers of yore discussed as the "Golden Mean." If you get too much of a good thing you get sick. Everything should be in moderation. We know how this works when we sit down to eat, as there is always a Point E where more becomes less. Today's lesson will kick this idea around as it relates not only to tax policy, but to public policy in general. Eventually, we will even look at our policy toward Iraq along a Laffer Curve of diminishing returns.

First, though, I'd like to talk about the discussion we had on our Bulletin Board. One of the students, Falana, pointed out that former Federal Reserve Governor Lawrence Lindsey had written a paper on the Laffer Curve, criticizing me, for the Joint Economic Committee of Congress. The thrust of Lindsey's blast at Wanniski was that Point E was not the point at which the electorate desires to be taxed, because the electorate does not want to be taxed at a maximum rate. He argued that the optimal rate is below the maximum rate. Falana assumed that Lindsey had me cornered and that I should admit that 20 years after I had written about Point E, I should confess my error. Whereupon we wrestled around in heated debate about Point E.

My essential complaint about Lindsey is that he did not carefully read my book or the essay adapted for this book which we ran last fall in our SSU website. I never said Point E produced "maximum revenue." I said it produced the revenue desired by the electorate, which is what made it optimum. The only time the word "maximum" appears in my exposition is when I note that at Point E, "production plus revenue are maximized." The word PLUS does not mean AND. I do admit that plus means an addition, which in this case adds apples and oranges, the production of goods and services and the revenue available to the government to buy goods and services. But how else would I get politics and economics on one simple curve of the political economy? As there are no numbers on the curve, it cannot be that I inferred Point E was "maximum," when I plainly said it was "optimum." In the context of the curve producing diminishing returns after it hits Point E, the rest of my exposition makes it clear that if you want to err on one side or the other, it should be below point E. This is because any point above E means that both revenue and production are in decline.

This should make Lindsey happy, because he prefers lower revenues to higher revenues (unless he gets to say where to spend them), although I've not yet heard back from him.

This has to be clear before we proceed into the discussion of why I said it is the task of the political leader to find Point E, which is where the electorate desires to be taxed. So as not to be misunderstood by other libertarians in the class, let me say flat out that I believe a perfect system would produce very low tax rates at Point E. Which means, the public would be so satisfied with private allocation of goods and services that it would not have to call on government for public taxing and spending beyond minimal public requirements.

The Reagan tax cuts of 1981 were based on the Laffer Curve principle, that the 70% tax rate on income was on the upper reaches of the Curve, and that the electorate would be happier if the rate were lower, because production plus revenues would increase. We could tell the electorate was delighted because both the stock market and the bond market strengthened, even though the federal deficit increased. That is, the markets saw the tax cuts as a great investment, which over time would produce positive returns. The origins of the strong economy today are in the tax cuts of 1981. The Kennedy tax cuts of 1964 were also based on the principle of a law of diminishing returns, although Kennedy only verbalized the Curve. Kennedy and Reagan both had the experience of the 1920s, when Treasury Secretary Andrew Mellon not only argued that lower rates would produce greater revenue, he also argued that it was the responsibility of the political leaders to find the point of optimum taxation for public goods.

The best image Mellon presented was in testimony he gave before the House Ways&Means Committee, which I now cannot locate, but which I generally recall. He said that in the private sector, the prices of public goods and service are determined by competition. If Ford Motor Co. could sell 500 cars at $1 million each or a million cars at $500 each, clearly it would prefer the much easier way, and it would find 500 people willing to pay a million each. The reason they sell a million cars at $500 each is the fact that another car company or companies exist. They sell their cars cheaper than $1 million and Ford undercuts them, and at the end of the process the people enjoy the greatest number of cars at the lowest possible price.

Mellon went on to tell the committee that because there is only one government, the price of public goods — the tax rates charged — can easily rise at the same time the revenues they produce are falling, thus being able to finance a smaller portion of public goods. This means that the competition must take place within the government monopoly, he said, with one candidate saying Elect me and I will lower tax rates or not raise them while the other says Elect me and I will raise them and spend them on things you want. The voters can make that decision accurately the same way they can produce a maximum number of cars at the lowest possible price. They do it most easily when presented with a bond issue, as we discussed in Lesson #3 on "The Political Market." There are times when they vote a tax increase when they reckon a positive return on investment in public goods and other times they will reject a similar proposal because of changing circumstance.

In my book, I quoted from Andrew Mellon's best student, President Calvin Coolidge, who clearly helped his pupil write his February 12, 1924 speech to the National Republican Club in New York City. It appeared in Mellon's book of the same year, Taxation, the People's Business, which is a terrific collection of essays on taxation that is still available in better libraries, but which appears to be out of print.

The proposed bill maintains the fixed policy of rates graduated in proportion to ability to pay. The policy has received almost universal sanction. It is sustained by sound arguments based on economic, social and moral grounds. But in taxation, like everything else, it is necessary to test a theory by practical results. The first object of taxation is to secure revenue. When the taxation of large incomes is approached with that in view, the problem is to find a rate which will produce the largest returns. Experience does not show that the higher rate produces the larger revenue. Experience is all in the other way. When the surtax on incomes of $300,000 and over was but 10 percent, the revenue was about the same as when it was at 65 percent. There is no escaping the fact that when the taxation of large incomes is excessive, they tend to disappear. In 1916 there were 206 incomes of $1,000,000 or more. Then the high rate went into effect. The next year there were only 141, and in 1918, but 67. In 1919, the number declined to 65. In 1920 it fell to 33, and in 1921 it was further reduced to 21.1 am not making argument with the man who believes that 55 percent ought to be taken away from the man with $1,000,000 income, or 68% from a $5,000,000 income; but when it is considered that in the effort to get these amounts we are rapidly approaching the point of getting nothing at all, it is necessary to look for a more practical method. That can be done only by a reduction of the high surtaxes when viewed solely as a revenue proposition, to about 25 percent.

I agree perfectly with those who wish to relieve the small taxpayer by getting the largest possible contribution from the people with large incomes. But if the rates on large incomes are so high that they disappear, the small taxpayer will be left to bear the entire burden. If, on the other hand, the rates are placed where they will get the most revenue from large incomes, then the small taxpayer will be relieved. The experience of the Treasury Department and the opinion of the best experts place the rate which will collect most from the people of great wealth, thus giving the largest relief to people of moderate wealth, at not over 25%.

When he ran for President in 1976, Ronald Reagan led in the polls in New Hampshire against the incumbent Republican, Gerald R. Ford. Reagan began his campaign with the promise of a $90 billion tax cut for the nation, which would be accompanied by a $90 billion federal spending cut. He did not have the benefit of the Laffer Curve; lacking that, he was forced into a dollar-for-dollar program. Still, it was popular, until the Ford campaign produced a list of the spending cuts that Reagan was contemplating. When the screams began that he would be hurting the poor, Reagan dropped the plan from his agenda and lost the New Hampshire primary. He lost the next three or four, until in North Carolina he delivered a half-hour televised speech that simply promised a tax cut and frugality in government. He won the primary and  many more, but lost the nomination by a handful of votes.

In 1980, Reagan had the benefit of the Laffer Curve, which told him he did not have to pay for tax cuts, but could promise to replicate the Kennedy cuts of 1964. I'd written The Way the World Works in 1977 and it was published in April 1978. One of Reagan's former staff aides, a 32-year-old conservative intellectual named Jeff Bell, came to New Jersey where he had lived as a boy, and with life savings of $6,000 decided to run for the U.S. Senate in 1978, based on the Laffer Curve idea. He had to win the OOP primary from a liberal Republican named Clifford Case, who had served five terms and was a fixture in state politics. Bell promised that if elected he would push for a 30% tax cut of the kind then being promoted by Rep. Jack Kemp in an early version of the Kemp-Roth legislation that Reagan had passed in 1981. Sen. Case pooh-poohed the idea and Bell won the race with a breathtaking closing finish.

We then observed the difference between a bond issue and a race between candidates who represent a varied package of policy issues. In the general election, Bell faced a former professional basketball player who had never run for office, Bill Bradley. Bradley had won his primary by running as a no-holds-barred liberal. For the general election, he decided he could not compete with Bell on taxes. He suddenly emerged with his own tax-cut plan, his own plan for increased defense spending, and an attack on Bell's social conservatism. Bell, the intellectual, chose to fight Bradley on the social issues and went into the November elections identified as the tax-cutter who wants a constitutional amendment to ban abortions and one to put prayer back into the schools. The voters chose Bradley, but not by much, and post-election polling showed they favored Bell's position on taxes by 3-to-l while they favored Bradley on the social and cultural issues.

All was not lost, because Reagan's campaign manager, John Sears, saw the post-election poll and persuaded Reagan to run as a Jack Kemp-style tax-cutter, with a specific promise to replicate the Kennedy tax cuts, and with only vague promises of balancing the budget through economic growth. Sears asked Bell to write a dozen 30-second tv spots for Reagan along those lines. Wherever the spots ran, Reagan won in the primaries. Where the campaign could not afford to run them as they had run into spending limits, George Bush won. In the general election, with fresh money, Reagan still fell behind the incumbent Jimmy Carter, until he agreed to debate him, the tax issue included, and ran closing tv spots that featured tax cuts as a supply-side spur to economic expansion. Reagan's landslide election and re-election in 1984 carried in a OOP Senate, but the voters withheld the House of Representatives, afraid of the return of Herbert Hoover and needing the insurance of a Democratic House. In 1986, the GOP lost the Senate as well, as the budget balancers came back to control the election themes that fall, after the GOP blunder of allowing the capital gains tax to be hiked to 28% from 20% in the 1986 tax bill.

In 1988, George Bush won the presidency by pledging, in no uncertain terms, to not raise taxes and to cut the capital gains tax to 15% from 28%. A silver-spoon baby himself, the President surrounded himself with men of inherited wealth, who had practically decided before his inauguration that they would figure out a way to get him to raise taxes. They succeeded in the 1990 tax bill, which ended any chance of Bush  winning re-election. It did not matter that he swore up and down that he made a mistake in raising taxes, and if re-elected he would cut rates. All the voters needed to know was that Bill Clinton was not Jimmy Carter and would not make matters any worse. It was significant that with the entry of Ross Perot, Clinton won two elections without a majority of votes cast. The electorate did not have many good choices, given the inefficiencies of the political mechanisms we have and the small pool of potential leaders capable of mounting a race for the presidency, but it did the best it could.

The nation's primary leader, the president, has a lot more to do than find point E on the Laffer Curve. Indeed, it is more likely that the 535 members of Congress, acting in the dissonant concert of the legislative process, will find Point E more easily than the President. More than anything else, we expect the President to deal with the nation's relationships with the rest of the world — especially because the United States is the primary leader in the unipolar world. The President has two primary tools by which to deal with the rest of the world. One is diplomacy; the other force. They go hand in hand, or in peacetime, iron hand in velvet glove.

If we analyze the crisis we now face in Iraq, we can get at least a good feel for it by thinking of the law of diminishing returns and Point E on the Laffer Curve as it applies to diplomacy and force. The United States is trying to get Iraq to do something. Iraq does not want to do it. The President says it had better do it, or we will use force. The Republicans say the force the President threatens is insufficient. The President rattles his sabers with more vigor. The Republicans outbid him by insisting he solve the problem once and for all by "getting Saddam." The President prepares a bombing campaign. The GOP warriors insist it will take ground troops. All the while Saddam Hussein is asking why the United States will not sit down with his representatives and discuss the matter in dispute. He indicates a belief that even if he does what Clinton demands, he will not see the seven-year sanctions lifted. Saddam says there is no diplomacy being attempted. Only demands for unilateral action. Diplomacy means negotiation and compromise. The Republicans insist there can be no negotiation or compromise, but that diplomacy must be tried. The President, not wishing to appear weaker than the Republicans, agrees that Saddam can make no demands at all, but must submit to diplomacy, which means the United States will essentially take over Iraq and install a puppet regime as we did in Vietnam. Otherwise the bombing starts any day now.

As I have spun out this scenario, you can readily see the United States creeping up the Laffer Curve in is threat of force — a higher tax rate unless Saddam does what we demand. We have passed Point E, the optimum mix of diplomacy and force, and are climbing steadily toward massive air attacks on a nation that is currently threatening nobody, but is simply asking to sit down with the United States and negotiate an end to the sanctions. This is what led Jack Kemp to assert on CNN's Evans&Novak last weekend that the debate now is "between bombs and bigger bombs." President Clinton, weakened by the sex scandal, cannot appear to be weak, so he yells louder, stretches the truth on where we stand with Baghdad in order to demonize Iraq to rationalize his policy. The Republican leaders, not wishing to seem weaker than Clinton, climb up his back and demand quicker action and bigger bombs. Read Paul Gigot's column in today's Wall Street Journal for an example of a normally intelligent political columnist run amok with the war fever in his political party and among his Cold Warrior intellectual buddies.

There comes a point on the Laffer Curve where the diminishing returns you get from the use offeree mean that you will have greater problems as a result of that higher "tax." From his view of the United States marching up the Laffer Curve, Russia's Boris Yeltsin warns of "World War III," which is certainly possible if there is nothing to interrupt the march up the Curve. At the top of the Curve is total force and zero diplomacy. That's total war. In Columbus, Ohio on Wednesday, the administration attempted to rally the electorate toward higher tax rates on Iraq. The response of the students of Ohio State, however, was an attempt to pull Clinton back down the Laffer Curve. Former President Jimmy Carter spoke out as well, warning it would be a mistake to bomb. Unfortunately, none of these voices carry any specific diplomatic program. They simply warn of force, while the President and the GOP Cold Warriors insist the "peace-niks" (as Paul Gigot sneeringly calls them) are only a loud minority, and that the American people will rally behind the government once the bombing begins. The only possible way to head off the bombing is through the genuine diplomatic initiative of Jack Kemp — in a sense, a deep tax cut in foreign policy. Because all Saddam Hussein is hearing is Force, he cannot give up the one bargaining chip he has — which is to allow the UN inspectors to look anywhere they want to look. Kemp says if Saddam Hussein would let them look anywhere, for a limited number of inspections in a limited time frame — six months, perhaps — the UN should agree to lift the sanctions. The fact that Kemp is a major Republican party leader, with the best chance at this early stage of winning the GOP presidential nomination in 2000, means that his initiative has to be taken seriously. If it is not, and a bombing campaign produces a reaction from the Islamic world that causes horrific acts of terrorism against Israel and the United States, nobody will be able to say that there was no serious alternative on the table. Indeed, the Iraq Ambassador to the UN, Nizar Hamdoon, left for Baghdad on Thursday morning with UN General Secretary Kofi Annan. Prior to his departure, he e-mailed me a note saying he was going to discuss the Kemp proposal with his government. We may see the bombing headed off yet and a compromise found that satisfies everyone but the Bombers.

So we have an interesting experiment in political theory underway right under our noses. This week's lesson has been hastily assembled, because I've been involved in a dozen other projects that have demanded my time. But I hope the discussion of the law on diminishing returns in the area of tax policy and foreign policy gives you at least a footing for thinking things through on your own.

* * * * *