This is a partial transcript of "Special Report With Brit Hume," Dec. 15, 2004, that has been edited for clarity.

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BRIT HUME, HOST: A current ABC News/Money magazine poll found that more people think the economy is getting worse than think it’s getting better. And the largest number of people in the survey thought the economy was staying about the same.

Well, who better to ask about such attitudes than Dr. Martin Feldstein of Harvard University, a former head of the Council of Economic Advisors (search) under President Reagan, who also took part in today’s discussions at the White House on the state of the economy. Here he is.

Dr. Feldstein, welcome.

MARTIN FELDSTEIN, PROFESSOR, HARVARD UNIVERSITY: Nice to be with you.

HUME: What do the numbers tell you about the state of the economy?

FELDSTEIN: That I can’t understand why people are as uncertain or as negative about it. When I look at the economy, I see an economy that’s growing at an above-trend pace, almost 4 percent in the last quarter, indeed for the year, 3.7 percent.

That’s a very good rate of economic growth. We’ve added about 50,000 jobs in the last two months, employment is up, inflation is low. It’s a very good economy.

HUME: Now, part of the discussion at today’s event was the tax code (search) and what to do about the tax code. What in your view as an economist, looking at the economy as a whole, needs to be cured about the tax code as it affects the economy overall?

FELDSTEIN: Well, of course the most fundamental problems are high marginal tax rates.

HUME: That means what?

FELDSTEIN: That when you earn an extra $100, if you’re the typical taxpayer, about 40 of those dollars go in taxes.

HUME: As opposed to a smaller percentage of the dollar you earned before? Right?

FELDSTEIN: That’s right. That’s right.

HUME: So as you earn more, you pay not only more in the sense of taxes, but a higher percentage of taxes.

FELDSTEIN: Exactly. And it’s that higher percentage of taxes on the last dollars that we earn that affect people’s incentives.

HUME: How?

FELDSTEIN: Do they want to become entrepreneurs, do they want to take a low-risk job in which well, maybe they’ll earn less but on an after-tax basis it doesn’t matter as much.

Do they want to put out some more effort in order to get a promotion? Well, that effort is perhaps not worthwhile in their mind, given that the government is going to take a large chunk of the increased income.

Do people want to save more, provide the funds that we need to invest in business equipment to help the economy grow faster and raise the standard of living? Well, not if the government is going to take 40 percent of those returns on that savings.

So I think it’s these high marginal tax rates, high tax rates on additional income, whether it’s from working or from saving and investing.

HUME: What’s the answer to that problem?

FELDSTEIN: Well, basically it is tax reform and it is bringing down those high marginal tax rates.

HUME: Well, bringing down the tax rates, in and of itself, is not usually what is regarded as tax reform, that’s just called cutting taxes, correct?

FELDSTEIN: Well, it depends on how you cut taxes. And I think cutting taxes that bring down the top rate is important. I think changing the tax treatment of savings and investment is important. So the changes that were made in the last few years on dividends and capital gain, I think that was a fundamental improvement because it provides an incentive.

HUME: The question always comes on these proposals; you’re talking about people here who make more money rather than less money. And you’re talking about what Democrats and many in the media would refer to as the rich. How do you counter the argument politically that this is basically a set of proposals to benefit principally the rich. What does the little guy, the low wage earner, or the lower-wage earner get out of this kind of tax reform, as you call it?

FELDSTEIN: Well, the tax cuts that were enacted in these last few years, the last four years did benefit everybody. Everybody saw their tax bills go down.

But there’s also an indirect benefit. If the economy grows faster, if the economy has more investment so that the jobs are better jobs, that’s going to affect everybody, not just the individuals whose taxes are being cut. If there’s more entrepreneurship in the economy, then the people who get jobs, as a result of those entrepreneurial activities, are going to be better off.

So I think one has to ask not just what is the tax cut do for the individuals who are directly affected, but also what does it do for the people who are in general in the labor force, in the economy?

HUME: Now, the response to that is ah, Dr. Feldstein. You’re of the Reagan administration. You’re talking once again about trickle-down economics. What do you say to that?

FELDSTEIN: It worked. It worked. And what I would say is that the reason why the United States creates better jobs and stronger growth than our friends in Europe, where the growth rate is less than half ours, where the unemployment rate is 9 percent in comparison to our 5.4 percent, is in part because we have a economy that’s smaller, we have tax rates that are lower.

HUME: An economy that is smaller?

FELDSTEIN: I’m sorry, a government that is smaller than the economy. And we have tax rates that are lower, so that the scope for incentives in the U.S. economy work better.

HUME: Why does that does seem to be a clear distinction between the U.S. and Europe, in terms of the size of the tax bite and the role of the government in those economies.

Why have Europeans’ political figures, who presumably have some exposure to these arguments, do not seem responsive to them?

FELDSTEIN: They’ve gotten into a trap, I think. They have built up a large welfare state (search). They’ve built up a lot of transfer programs; even more generous, much more generous unemployment benefits that last a year or longer, for example.

HUME: In other words, it takes some of the insecurity out of life, which may be a spur to economic activity.

FELDSTEIN: Well, that’s part of it but also is very expensive to keep those programs going. And it’s very hard politically to undo something, even if the political leaders themselves in private are prepared to admit they wish it could be otherwise.

HUME: Dr. Feldstein, thank you.

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