This is a rush transcript from "The Journal Editorial Report," April 14, 2007.

PAUL GIGOT, HOST: This week on the "Journal Editorial Report," hold on to your wallet. Congress just lit a fuse for the biggest tax increase in history. We have the details as this year's filing deadline approaches.

Media darling no more. Senator John McCain is under fire in the press for his staunch support for the war in Iraq. Will it sink his presidential hopes or pay off with the republican base?

Our panel weighs in, after the headlines.

(NEWSBREAK)

GIGOT: Welcome to the "Journal Editorial Report." I'm Paul Gigot.

The millions of Americans struggling this weekend to decipher their complicated tax forms may find is hard to look on the bright side when it comes to the American tax code.

But earlier this week I spoke with renowned economist Arthur Laffer and asked him if we do, in fact, have a better system than in decades past.

(BEGIN VIDEOTAPE)

ARTHUR LAFFER, ECONOMIST: It's much better, Paul. We have dropped the highest rates dramatically and broadened the tax base. Even though we have a long way to go, it is a lot, lot better than it was back then. Miles. Unrecognizably better.

GIGOT: Better for incentives, business incentives, investor incentives? Is that what you mean, the economic growth part. It is not less complicated.

LAFFER: No, no, it's not less complicated but incentives are better.

You know, it's amazing. When Kennedy came into office, Paul, the highest federal marginal tax rate was 91 percent. That was on all income. I mean it wasn't just unearned or whatever. Just think had how high that is. Kennedy cut it from 91 percent to 70 percent. Now it is 35 percent. It probably should be lower, but it is well in the range of reasonableness.

GIGOT: All right. Take us up to the present. You were a big supporter of the Bush tax, cuts particularly the ones of 2003.

LAFFER: Yes, sir.

GIGOT: Which brought the investment tax rates on capital gain and dividend down to 15 percent. Looking over the last four or five years, what's the record of those tax cut? Did they work?

LAFFER: Oh, yes. They really worked. The thing that amazes me is, if you look at the deficit, I mean, — you know, the president was in a very tough spot when he took office. Nine months after he came into office we had September 11. We already had a collapsing stock market a year before he took office. So all of the things were working against him. And he did the tax cuts and strong defense.

And you know, if you look at the economy today, there has never been a better economy on planet earth than the U.S. today. The budget deficit's one of the smallest in the last 35 years. Only 5 or 6 that are smaller as a share of GDP. The economy is roaring. The unemployment rate's 4.5 percent, very little inflation. It is a beautiful economy.

I think Bush did a great job on the economy.

GIGOT: But note, a lot of people disagree with that. And there is a big debate in Congress now with whether or whether or not those tax cuts, which expire in 2010, after 2010, should in fact be extended.

LAFFER: I know.

GIGOT: What would be the economic impact if they were not extended, would there be a negative economic impact? How soon would we feel it? Would it have to wait until 2011 or would you feel the impact earlier?

LAFFER: You know, if they did the whole thing, it would be amazing to me. If they let them all expire it would just be an amazingly huge tax increase. And it would have a horrendously negative effect on the economy. That, I will say just point blank.

And the effects on the stock markets and on interest rates would occur before that. In fact perhaps quite substantially before that.

But, Paul, I honestly don't believe that's going to happen. I just can't imagine anyone making the case to let those tax cuts expire when you have such a small deficit. When you have such a great, strong, economy. I would love to run against the guy that wants to let them expire.

GIGOT: The Democrats are already talking in Congress about doing something. They need to do something to ease the bite of the alternative minimum tax, which, as you know, hits more and more taxpayers every year. I think 4 million people in 2006, 20 million in 2007, if Congress doesn't act.

What would your advice be to the Democrats who say we need $60 billion, $70 billion, $80 billion — money somewhere, to ease that AMT burden?

LAFFER: Well, if they can find it in spending, I would go along with it. That would be a good idea for them to do it in spending. But if they try other tax increases to match this static number, this pay-go number, that would be a huge mistake. I think they would be this thwarted in their expectation of revenues. Because I don't think it'll pay off.

GIGOT: But what should they do?

LAFFER: Just get rid of the AMT. Yes. Just get of the AMT with no offset or spending cuts. But you know, they have that rule internally they made for themselves, which is the pay-go rule...

GIGOT: The pay-as-you-go, which says any tax cuts have to be offset by tax increases or entitlement spending cuts elsewhere.

LAFFER: That's correct. That's exactly right. Now the entitlement spending cuts I think make sense. But if you try to do a tax increase somewhere else I think it makes no sense. It is counter productive.

GIGOT: Looking ahead from here, if were you to advise presidential candidates of either party what should be done, as they go into the 2008 campaign, what's the single most important proposal they could make, given the current tax code, to improve incentives and improve our economic performance?

LAFFER: In the realistic area, if you want to be realistic, I'd say extending the tax cuts Bush put in is probably the key issue going forward in a practical sense.

Obviously I would love to see us move to a flat tax, something along those lines. But as a practical matter, I think just letting the tax cuts continue, passing them, making them permanent is the right thing to do.

GIGOT: That's would be your number one priority? You don't think you need a flat tax, as other countries in Eastern Europe move to lower rates and flat tax. The rest of the world is just standing by. And we are sitting here, say, fat and happy.

I mean, how are we going to remain competitive with these other countries?

LAFFER: I shouldn't smile so much because of that fat and happy. No. You know we should match it. Should do the flat tax. We started the revolution back in the late '70s and early 80's.

And frankly, now these other countries are catching up and doing really well. Look what will happen in France. I mean, I saw in the "Wall Street Journal" your piece on that. There is a real chance the French will rediscover the word entrepreneur.

It is exciting what is going on in the rest of the word. And I would like to see the U.S. make the next step and become a leader again.

I don't think it is in the cards in the next year or two, Paul. If we can get the tax cuts, making them permanent, that would be great. And then we should move on to a more serious structural reform.

GIGOT: All right, Art Laffer, thanks very much for sharing those insights. Good to see you again.

LAFFER: Thank you, Paul

(END VIDEOTAPE)

GIGOT: More tax talk when we come back, including why the Democrats' new pay-as-you-go budget rules may end up costing you a bundle.

John McCain is betting it all on Iraq, pinning his presidential hopes on the success of the surge. Will it pay off?

Our panel weighs in on those topics, and the Duke Lacrosse case when the "Journal Editorial Report" continues.

(COMMERCIAL BREAK)

GIGOT: Welcome back. While the media has been focusing on the presidential horse race and the war in Iraq, Congress is busy pulling a fast one on American people. Both the House and Senate passed budget resolutions that would make a major tax hike all but inevitable.

Joining the panel this week, "Wall Street Journal" Columnist Kim Strassel, Editorial Board Member Jason Riley, and in San Diego, Editorial Board Member Steve Moore.

Well, Steve, you have been saying that we weren't going to get a tax hike before 2008. What are the Democrats up to with these five year budget plans?

STEVE MOORE, WSJ EDITORIAL BOARD MEMBER: Well, the Democrats, Paul, have put themselves in a box because a few months ago they passed something called the pay-go budget rules, which say any tax cut has to be offset with a tax increase.

Now we have a situation where 26 million — 26 million Americans are going to be confronted with the alternative minimum tax, the tax that was supposed to be for rich people, next year unless they change the rules.

The problem is they can't change those rules unless they increase taxes majorly on other people. That's the box they are in now.

GIGOT: What do they plan to do, Steve? Are they going to move ahead with a tax increase on somebody else, probably you or other people who have certain incomes?

MOORE: Rich people like you, Paul. I mean what they are talking about is taxing corporate CEOs, the top 1 percent. The problem they have is the problem that the soak-the-rich people always have. There is not enough revenue there. That means the middle class will be hit with tax increases, the same people they say they will give relief to on the AMT.

GIGOT: But, Jason, the president and Republicans won't let that kind of tax increase go away because — go through because it would mean a partial repeal of the Bush tax cuts of 2003, which they're not going to let. So if he vetoes it or they block it in the Senate, how do Democrats get out of the box?

JASON RILEY, WSJ EDITORIAL BOARD MEMBER: They will try to press the issue. The reason they will do so, as Steve said, it will hit 26 million, 27 million people next year. A disproportion number of them live in blue democratic states, California, New Jersey, New York, where there are high taxes. So the Democrats have a political problem here.

And it won't be easy for them to solve because their solution is not to cut spending, because they are Democrats, but it is to shift the tax burden elsewhere and to increase it on the wealthy Americans.

So what to do, the way they want to solve the problem, there's not much political pay off. They are trying to shield a number of Americans from being affected by the tax. But most Americans won't appreciate it because they don't pay it now. But the people they raise taxes on, in order to shield the others, will definitely feel the pinch and blame Democrats.

KIM STRASSEL, WSJ COLUMNIST: Either that or tax time is about to become more unpleasant. You either raise taxes or cut spending. They won't be able to do either. They are trying to find ways to get more money out of the people that pay taxes. This tax gap idea, that you go after and find $300 million from people who should be paying more to the IRS.

GIGOT: But is there that kind of money there?

STRASSEL: No.

GIGOT: We hear this money exists, but it means sending more IRS agents out to people or squeezing some people.

STRASSEL: Putting new rules in effect that make the whole tax situation, the whole tax process more onerous. They have always looked for it. Never found it — the pot of gold.

MOORE: Here's what is crazy about this debate, Paul. If you look at the tax situation now, in the last three years, we had $780 billion in increased tax revenues. So the tax system, with cuts in place, have created record flows of tax revenues. And that will reverse course if we raise rates.

GIGOT: There's another thing about the tax that I want to talk about, which is it progressivity. Because if — we have a chart here to show people. If you look at what the share of all income taxes the top 1 percent of taxpayers pay, it is 35.6 percent of all taxes — are paid by the top 1 percent. The bottom 50 percent pay 3.4 percent of all taxes. It does show the tax code is already progressive. I guess some people want to make it more progressive but how much money can you squeeze out of those folks, Steve?

MOORE: Well, the most important point on that is the percentage of taxes that are paid by that richest 1 percent, have actually gone up during the Bush presidency not down. Where are those big tax cuts for the rich?

GIGOT: Well what do you think about Republicans? How will they handle this?

Is this is a chance for them, Kim, to reclaim what they hope will be their tax consulting bone fides and spend-block the Democrats?

STRASSEL: Yes, especially the case if you look at the top Republican candidates out there running for president at the moment. Look down the road on the issues we talked about. The tax cuts are going to expire. AMT will hit and that would mean a surplus.

But if you are Republican presidential candidate and promise to keep the tax cuts in place and fix the AMT, you are not left with much. That means if you want to off further tax cuts to voters out there, you have to come up with big thinking, some really big plans on entitlement spending, on simplifying the tax code. and this is an opening for someone to be bold and inspired.

GIGOT: We're going to have to watch and see if they follow your advice, Kim.

All right, when we come back, media darling no more. John McCain comes under attack for his staunch support for the war in Iraq. It may hurt him with the press, but will it help him with the Republican base?

(COMMERCIAL BREAK)

(BEGIN VIDEO CLIP)

SEN. JOHN MCCAIN, R-ARIZ.: We, who are willing to support this new strategy and give General Petraeus the time and support he needs, have chosen a hard road. But it is the right road. It is necessary and just. Democrats, who deny our soldiers the means to prevent an American defeat, have chosen another road. It may appear to be the easier course of action, but it is a much more reckless one. And it does him no credit, even if it gives him an advantage in the next election.

(END VIDEO CLIP)

GIGOT: Senator John McCain in an address to cadets at the have a military institute. The first of three major policy speeches, trying to get his campaign back on track, defending the U.S. strategy in Iraq and further alienating his sometimes fair-weather friends in the media.

Kim, what does this week tell you about the John McCain strategy and his chances for being our next president?

STRASSEL: I think what you saw this week was remarkable and sort of impressive. This is a campaign that is struggling. Having trouble raising money. It went through a shake up of top staff. Can't keep up in the polls for people that haven't announced for president yet, like Fred Thompson. It is having a hard time.

And yet that's normally a cue for a politician to put their head down. Instead, John McCain goes out and talks about the most politically unpopular subject there is in America at the movement.

That's not necessarily bad. I mean, this is a guy, if there is one thing people are impressed with him about, even the base who have had complaints over global warming, over taxes over campaign finance, they do respect him as being a principled person. They do think he's an honest individual.

GIGOT: You think this is smart political strategy, in addition to being principled stand on the war.

STRASSEL: This is John McCain, in addition to being principled, putting forward the thing that people are always often impressed with the most. His character.

RILEY: As a political strategy though, we'll have to see. I think the way the media love affair has ended should be a cautionary tale for Obama, among with other people. Media darling.

GIGOT: Yes, we are fickle, aren't we, Jason.

RILEY: But McCain has a problem in that he has supported the war effort, but not necessarily the tactics. And McCain is probably thinking, if I had been commander in chief, things would be going better in Iraq. And he hoping voters would make that distinction.

The question is whether his political fate will be tied to the war effort, even if we are not fighting the war the way he has been calling for us to fight this war for what long time.

Steve, why do you think John McCain is having a hard time getting conservative voter support?

MOORE: It is the reasons Kim mentioned. Problem with taxes and campaign finance. But you look at the field of republican candidates and the one thing that I think the American people want, especially Republican voters, is somebody who stands for something and somebody who doesn't flip- flop. This is the problem Mitt Romney had had in his campaign.

We had it right in our editorial this week. This really was John McCain's finest hours. And the line he used was perfect when he said I'd rather lose this election and win the war. And that's something that will resonate with Republican voters.

RILEY: In a recent "L.A. Times" poll, four in 10 Republican primary voters say the war is there number one issue. Yet in that same poll, McCain trailed Giuliani by 17 points. Giuliani, who has no foreign policy experience. And trailing people like Fred Thompson, who haven't even declared.

GIGOT: But what does it tell you about McCain's failure do get voters, ifs he has been stalwart on the war. And I agree he has been.

STRASSEL: As Steve said, it goes back to some of his bigger problems. One thing that's interesting is McCain coming out here is having an effect on the GOP presidential field. You look at these guys. It is not like they have been wishy-washy on the war. But they have not been out and kind of firmly in the same camp as McCain has been.

Since he has given his speeches, you have heard a couple of them firm up just a little bit, Romney and Giuliani, be a little more forceful about how they would handle the war. He is having an effect in leading the field on this.

GIGOT: Jason, quickly, on our friends in the media turning. It didn't help John McCain in 2000 that the media loved him. Could it help him this time that the media doesn't like him, particularly among Republican voters?

RILEY: It might. I don't know, as a political strategy, if you want go out and upset the media, thinking it would help you in the polls. But it might.

STRASSEL: But he has other things he's still got to fix.

GIGOT: All right. Thank you. We'll we are going to have to go.

We have to take one more break. When we come back our "Hits and Misses" of the week.

(COMMERCIAL BREAK)

GIGOT: Winners and losers, picks and pans, "Hits and Misses," it's our way to calling attention to the best and the worst of the week.

Item one, justice at Duke. North Carolina's attorney general drops all charges against three former lacrosse prayers — Kim?

STRASSEL: I'd argue the most revealing statement that came out this week was from one of the young men who had been exonerated, who had said, "Look people, we are as innocent today as we were a year ago."

And this is a case of a moralizing media, of an ambitious prosecutor, of a cowardly Duke University staff taking what should have been an allegation, that should have been treated with a great deal of suspicion, and instead turning it into this issue of race and wealth and hysteria. And not at all for the right reasons. This was all because they wanted to sell newspapers. It was because you wanted to fit in with political correctness or, in the case of Michael Nifong, the prosecutor, were you politically ambitious.

But it was never about getting down to justice. So America should be happy this is done. But the misses are legion here for everyone in this.

GIGOT: They sure are. OK, thanks, Kim.

Next, Republican presidential candidate, Rudy Giuliani has a new southern strategy — Jason?

RILEY: Well, Rudy was in Alabama, recently, and was asked about flying the confederate flag over state houses. And he simply said it is a state rights issue. I am going to leave it at that.

And I think Giuliani had an obligation to go further and talk about what this flag's history it and what it symbolizes for millions of Americans. And that is that it's slavery and secession and Jim Crow and opposition to civil rights. and I think Rudy didn't go there because he is pandering to southern voters, which it is a little surprising for a former New York City mayor to start talking like George Allen and Trent Lott.

GIGOT: OK, Jason.

Finally, a frosty start to the baseball season as spring snow forces the cancellation of a record number of games — Steve?

MOORE: Yes, to paraphrase Mark Twain, the coldest winter I ever spent was spring time in Wrigley Field. You've had record numbers of games cancelled in Cleveland. They had a foot and a half of snow. In Cincinnati, the game time temperature for the Cincinnati Reds game was lower than any since Cincinnati-Bengal's game in the last five years.

What does this prove about global warming? Absolutely nothing. These are normal weather patterns.

But back in January, we had three or four days of record high temperatures. And the global warming crowd said this proves global warming.

I think what we have to do is maybe have Al Gore get out of Hollywood and go to a baseball game in Cleveland or Cincinnati and maybe just, well, chill out.

GIGOT: All right, Steve. Enjoy sunny San Diego.

That's it for this week's edition of the "Journal Editorial Report." Send us your e-mails to jer@foxnews.com. And visit us on the web at www.foxnews.com/journal .

Thanks to Kim Strassel, Jason Riley and Steve Moore.

I'm Paul Gigot. Thanks to all of you for watching. We hope to see you right here next week.

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