SYNOPSIS:

JIM CRAMER, co-host: All right. Take a look at this.

Former President BILL CLINTON: If you believe it is good policy to pay for my tax cuts with the Social Security checks of working men and women and borrowed money from China and Japan, you should vote for them. If not, John Kerry is your man.

CRAMER: All right. Former President Clinton at the Democratic convention on the tax cut. Our next guest also has rather strong opinions on taxes. This is Paul Krugman, New York Times columnist, professor of economics at Princeton and author of "The Great Unraveling" just out in paperback. Welcome back to the show, Professor. When Clinton raises the issue about whether it was--he got too great a tax break, it's not necessarily a mistake to think that, but at the same time, if he really felt that way, he could give to it charity, he could write a check to the government, or he could start a new business with the money. I mean, I've been struggling with this because I was a big beneficiary of the tax cut. And I feel like I can do something good with it. Am I wrong? What's the right view on this?

Professor PAUL KRUGMAN ("The Great Unraveling" Author): Well, you know, that's holding people to a kind of hard standard. That's like saying that everybody who supported the war in Iraq should volunteer and send their children to the war, oh, and contribute a lot of money to--you know, gratis to the military to help pay for it. Come on, that's not the point. The point is have we given tax cuts for very affluent people at a time when we are in deficit, when we actually don't have a way to pay for programs that, you know, ordinary middle class, hardworking Americans depend on? And that is true. That's--Clinton says, that and he has his own personal way of putting that. But it's completely right.

LARRY KUDLOW, co-host: Well, Paul, let me pursue this. I'm sure you saw the story in The New York Times which came from the IRS, was written by David Cay Johnson, , who is a very straight shooter. In 2001 and 2002, the country experienced a big income loss, 5.1 percent. That's the recession driving the deficit. The middle class actually did better. It was the upper-income people that got slaughtered.

Prof. KRUGMAN: Yeah, that was capital gains, but we...

KUDLOW: But, Paul, they didn't get their tax cut until 2003.

Prof. KRUGMAN: They got two...

KUDLOW: That's the point I'm making about the deficit. It couldn't have happened because they didn't get it for three years later.

Prof. KRUGMAN: You forgot about the 2001 tax cut, Larry. Look, here's the number we have. Right now we're thinking that the deficit's going to come in around $450 billion this fiscal year. Of that, about $270 billion is the Bush tax cuts.

KUDLOW: Oh.

Prof. KRUGMAN: Flat number, right, OK? It's not all the tax cuts, but it's mostly the tax cuts. And if you look into the out years, if you look at what will happen if we ever do get a full economic recovery, we still have a lousy budget prospect and it's primarily, you know, the further out you go, the more it's the Bush tax cuts that do it.

KUDLOW: All right. Some people--some people disagree and argue that the recession caused half of the deficit...

Prof. KRUGMAN: No.

KUDLOW: ...even 60 percent.

Prof. KRUGMAN: Larry, there's just no way to make that.

KUDLOW: But let's--I know, let's...

Prof. KRUGMAN: You can take the Congressional Budget Office numbers and they say that...

KUDLOW: I've seen numbered wracked up many different ways and now there's IRS data, too.

Prof. KRUGMAN: No, Larry.

KUDLOW: But let me ask you this, a more basic question than arguing over deficit base lines, which is really not a great game. Do you believe in tax incentives? The point that Jim Cramer made is, if you tax something less, you can invest it, you'll have a greater incentive to invest it. But if you raise the cost of capital on dividends and cap gains, then you might stop the investment funding of businesses and jobs. Are you worried about that?

Prof. KRUGMAN: Larry, right now we have the lowest tax rates on all of these things you're talking about that we've had in a long time. You know, no one is talking about raising tax levels back to the level that they were; you know, high income, top marginal rates back to the level that they were under that socialist Dwight Eisenhower. We're only talking about rolling back tax cuts that were sold to the American people a couple years ago on the basis of there's plenty of money and also sold on the basis of false claims that these were largely middle-class tax cuts, which they are not.

CRAMER: All right. Paul, try to think--can you help me try to figure out why--not loaded question, just trying to understand. If we have huge deficits, I would have thought that the 10-year Treasury at this point would have been, say, at 5 3/4, 6, not 4 1/2. But I also would have thought that the stock market would have done better; with the income tax cuts, but also more importantly with the capital gain and with the dividend breaks. Why do you think the stock market has done so poorly in terms of attracting inflows vs. many other assets in the last three or four years?

Prof. KRUGMAN: OK. That--let me say, I think the stock--first of all, your business is trying to understand stock markets. I don't try too often because it's too easy to--you know, to just have a hard time understanding the psychology. But I think what we're looking at is a combination of different offsetting things. We had a stock market that was way overvalued at the end of the big--you know, the big boom. And then since then, we've had, on the one hand, kind of sluggish economy and people getting off some of that irrational exuberance. On the other hand, although economic growth over the last few years, taken as a whole, is not too good at all, an awfully high proportion of that has gone to profits. So profits are better and, you know, I don't think it's a mystery. If you look at historical valuation norms, the stock market is actually--still looks a little bit high. And we can argue about whether that's right or not but there's no mystery here.

KUDLOW: Paul, why not go to a national sales tax, which would allow to us abolish the incredible-crazed income tax and maybe even, if not get rid of the IRS, slim it down by about 6,000 pages? How about a national sales tax?

Prof. KRUGMAN: Well, you know, the only way to make a national sales tax really work is--and, you know, you probably--I suspect you know more than you're letting on. The only actual practical way to do that is a value-added tax, which is what, you know, most European countries rely on a lot. And the funny thing about that is, although it doesn't require as big an IRS, it actually imposes paperwork burdens on business that are a lot bigger. The actual enforcement collection cost of VATs is much higher than our system. Our system runs on very few resources compared to what most other countries do because we have an income tax that, at least historically, people have tended to pay because we have been relatively honest. If that's going away, which is one of the things David Cay Johnson talks about a lot, then that's a real concern.

KUDLOW: One last one, Paul. Slashing the corporate tax rate, we're really not competitive at 35 percent. Heaven forbid, even Western Europe is lower. Could--I mean, that's just a tax on investors and the workers of the company. Would you advocate a big drop in the corporate tax rate?

Prof. KRUGMAN: I would advocate some cut if we actually enforced the taxes we have. You know that the effective rate is more like 15 than 35.

KUDLOW: So take out the loopholes.

Prof. KRUGMAN: If you actually--yeah. If you actually look, I mean, one of the bigger, longer term stories about our deficit is that, in fact, corporate tax collections have plunged. They're down to levels--I should know this, but as a share of GDP, I think you really have to go back to the Roosevelt administration to find them this low and maybe even before that. And so actually I'd say, you know, maybe lower the statutory rates but, by God, actually collect the taxes from those corporations.

CRAMER: Now you and Paul are going at it. Don't you have a debate coming up?

KUDLOW: I think we're on the radio tomorrow, Diane R...

Prof. KRUGMAN: We're on the radio tomorrow morning.

KUDLOW: But I want...

CRAMER: Now wait a minute...

Prof. KRUGMAN: Oh, we'll talk about life, the universe and everything tomorrow morning.

KUDLOW: I think the headline today is Kudlow and Krugman Agree on Lower Corporate Taxes.

Prof. KRUGMAN: By the way, I also agree that the Fed should not tighten, so we're on the same page.

CRAMER: Good!

KUDLOW: Oh, my God.

CRAMER: All right. Excellent. All right. Excellent.

KUDLOW: All right. Paul, I've known you a long time, good man, thank you for coming on the show. We appreciate it.

Prof. KRUGMAN: Great.

KUDLOW: Good luck on the new paper edition of the book.

CRAMER: Absolutely.

KUDLOW: Next on K&C, we talk satellite radio. Later on, can you track the election through the market?

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Originally broadcast, 8.2.04