Editor's note: Called the "Father of Supply Side Economics" by supporters, Arthur Laffer is encouraged by the re-election of President Bush and the outlook for the U.S. economy. Laffer came to national prominence more than 20 years ago for his service in the Reagan Administration and his inventing of the "Laffer Curve" for tax policy.

He now heads two firms in California, one doing economic research and consulting and the other managing client investments. At the same time, he is on Gov. Schwarzeneger's Advisory Council and remains active in national Republican economic and policy issues.

ac: I'd like to start with election results, which I am sure you were pleased about. There still is lots of talk going on about the campaign, about leadership, terror, Iraq, and values, but surprisingly little about the economy and taxes. What do you think was most important in what the voters were saying?

AL: You know that I have written on this, Al, which is the Seven Wonders of Political Power, which really traces the Presidency, the Senate, the House, the State Governors, the State Legislatures, the Supreme Court and the Federal Reserve Board. Looking at those seven positions, it seems very clear that there are two issues that dominate almost all elections — strong pro-growth economics and defense of the United States. Those two were the key determinants in my mind from 30,000 feet and that all this stuff before the election about the polls and whether he answered a question correctly or not are not really material. It is pro-growth economic policies and defense of the country. That is the way it was with Kennedy in 1960 when the Democrats controlled all seven positions of political power and now the Republicans control all seven positions of political power purely and simply based on the issues.

ac: So that gives President Bush a stronger mandate. What do you think the priorities should be?

AL: I think the priorities should be exactly what he promised. That means a strong defense and economic growth policy. That is accomplished by making permanent the tax cuts; accelerating and making permanent the inheritance tax elimination; he should do tort reform; he should do lifetime savings accounts; he should do some portion of the privatization of social security; he should do the second stage of the capital tax cut getting rid of the 15% percent dividend tax cut and the elimination of the capital gains tax. Those are the ones he should do and follow through, and I think the President is going to do it. In the second part of the second term I think he is going to go for a flat tax.

ac: What do you see as the most serious risk?

AL: For this Administration the war in Iraq and the terrorist threat are the most serious risks. But with his political mandate, I just don't see what risk he really has. He has the politics locked down pretty well. The Republicans have 55 Senators; he has control of the House. In the next election, Al, in 2006 there more Democrats are up for election in the Senate then there are Republicans. The Democrats are even at higher risk in 2006. My guess is that on the economy he has the wind at his back. The economy looks very good for the incumbents and the President. In 2006, I think he will be a very strong contender to pick up more seats in the Congress.

ac: You are praised by many and scorned by many others for your thinking about taxes and supply side economics. I will get into specifics about that, but before I do, could you give, for those who don't know much about your work, a brief explanation about supply side economics and what the Laffer Curve says?

AL: Sure, supply side economics is really very basic, Al. People respond to incentives. People like doing things they find attractive and are repelled by things they find unattractive and Government policies can affect the attractiveness of activities. Let me use taxes as an example. If you tax an activity, you make that activity less attractive and people will do less of it. If you subsidize an activity it makes that activity more attractive and people will do more of it.

What we have been finding ourselves doing in this country probably since the 1913 income tax law, we have been taxing work, output and employment and subsidizing non-work, leisure and unemployment. It should come as no surprise why we have gotten so much non-work, leisure and unemployment and why we have so little work, output and employment. Just look at other countries, France, Germany, these countries are doing an even worse job than we do.

The Laffer Curve (below) is part of supply side economics and says that there are two effects tax rates have on total Government revenue. The most obvious is the static one. If you raise tax rates, you collect more revenue per dollar of tax base. But the dynamic affect is if you raise tax rates, you make the activity less attractive and there will be less of that activity, which will reduce tax revenue. These two effects, the dynamic and the static always work in opposite directions. Sometimes when you cut tax rates the dynamic effect dominates and you collect more revenue, sometimes when you raise tax rates the static effect dominates and you collect less revenue. This is the whole function of the Laffer Curve to show under what circumstances which ones operate.

ac: Is the old story that you thought it up at that Washington dinner in 1974 and wrote it on the back of a napkin true?

AL: I didn't think it up there. I'd been lecturing to my classes about it forever. But that is where I did explain it. That was a dinner with Rumsfeld and Cheney back in '74 and I laid it out for them. That was when the WHIP Inflation Now Program was coming out of the Ford Administration which was a 5% tax surcharge. I was arguing with the two of them not to expect 5% more revenues from 5% surcharge. You may get more revenues but you won't get 5%, and in fact you may even lose revenues.

ac: Is cutting taxes ever not the right policy for the U.S. Government?

AL: It is not the right policy many, many times. Goodness gracious, we need a good strong solid tax system. It is just the way it is right now. We have gone overboard on taxes and especially on progressive taxes. And it is doing damage to the very things you and I want. If it worked I wouldn't mind supporting it, but it really doesn't. The dream in America has always been to make the poor rich, not to make the rich poor. Whenever you tax rich people, you are going to get less of them. When you subsidize the poor, you are going to get more of them. You have got to understand basic incentives to know how to solve these problems. You just can't just go up on a podium and squawk some clichés when it is a real serious target for analysis and understanding. It bothers me a lot that people don't analyze it as professionally as they should.

ac: Tell us a little about how you are spending your time now?

AL: I have two firms, one of them that I have had forever. One of them is called Laffer Associates, which is an economic research and consulting firm that I started in the late '60s. The other is Laffer Investments, which is a money management firm. I run these companies with my family. As you know, I have six children and nine grandchildren so I have a lot of family members in here. We are having loads of fun doing it. We are a pretty large firm. I don't know exactly how many clients we have but it must be about 300 or maybe 350.

ac: You held important positions in Government early in your career. Would you ever consider going back into Government?

AL: No. I mean I was there. I was the first chief economist when the OMB was formed. I was George Schultz' right-hand person. My title was pretentiously 'The Economist.' I loved it but I don't ever want to go back and be full time. Now with the President, the real President, Ronald Reagan, I would go in once a month and spend the day with him and then come back home. And that is the role I like and that I am good at. I am not good at these long days and long meetings and compromise and all that stuff. Those are the roles for people like Cheney and George Schultz, and Bush — some of the others. My personality is not made for that.

ac: Good answer. Now I am going to list a number of subjects that are noise in the media right now and that people are concerned about. I'd like your reaction as to whether each is a serious concern or not to be concerned about. Starting with the U.S. Current Account Deficit?

AL: All of these issues, if we are going to go through a list, they are very serious issues, The question is whether they warrant active policy intervention. I don't believe that the current account deficit requires intervention. The reason being simply that there is a double entry bookkeeping system. The current account deficit is one and the same as the capital account surplus. Now when you think of the U.S. having a capital account surplus, which we do, ask yourself the question would you rather have capital lined up on our borders trying to get into the country or out of the country. All this capital is trying to get into the U.S. We have had a deficit on trade and a surplus on capital almost forever because almost everyone wants to invest in the United States. For me, I like that relationship.

ac: So that would lead to a similar answer on the trade deficit?

AL: The current account is the trade deficit plus services so I answer the two one and the same. The trade deficit plus the service deficit equals the capital account deficit.

ac: What the about the recent and continuing fall of the dollar?

AL: You know what has happened is that the dollar was extraordinarily strong in 2002. Let's use the Euro. It was maybe 83 cents to the Euro versus $1.17 when the Euro opened for trading in 1999. So we had appreciated enormously up through 2002. With the change in policies abroad and what is going on here, I think that it is perfectly appropriate that the dollar weaken, that the terms of trade of the U.S. weaken to about where they are now. If it went much further, I'd start focusing on it. Right now, I think that it just about in the right range. I think that you will see in the next 12-18 months a major, major reduction in the U.S. account capital surplus, i.e., the trade deficit.

The conversation continues on page 2