This is a partial transcript from "The Journal Editorial Report," June 10, 2006, that has been edited for clarity.

PAUL GIGOT, HOST, JOURNAL EDITORIAL REPORT: A much-hyped democratic political wave failed to form Tuesday, as the GOP managed to hang on to a seat vacated by former Congressman Randy "Duke" Cunningham in California's special election — this as Democratic primary voters chose state treasurer Phil Angelides as the party's candidate to challenge Governor Arnold Schwarzenegger this November.

Here with insight on the politics and economics of America's largest state is economist Arthur Laffer. He joins us from San Diego.

Art, welcome to the program.

ARTHUR LAFFER, ECONOMIST: Thank you very much, Paul. It's a pleasure to be with you.

GIGOT: I've known you for years as an optimist on California. But lately you have been pretty downbeat on the political and economic trends in the state. Does the outcome of Tuesday's election make you feel any more optimistic?

LAFFER: Oh, sure it does, yes. We were very fortunate to be able to defeat Proposition 82, which would have raised the income tax in California by 1.7 percentage points. And that was huge.

GIGOT: That's the Rob Reiner proposition.

LAFFER: The Rob Reiner proposition, and it went down in flames. You know, you still got to put it in balance. Forty percent of the people still thought it was appropriate to absolutely exploit people who have high incomes. So even though we defeated it, and it's wonderful, there still is a residual problem out there.

Angelides winning was a problem. I thought Steve Westly had a very nice proposal as a democratic candidate for governor. He lost. But Brian Bilbray — I mean that's the seat that you're talking about — won and won fairly handily. I think that's a wonderful thing as well.

GIGOT: Well, Phil Angelides, the treasurer, has said explicitly — in fact, he started his campaign with a pledge to raise taxes. Does this mean that we're going to have, in November, a big battle over taxes between Arnold Schwarzenegger and the Democratic candidate?

LAFFER: I imagine we will. But I don't think anyone will be taking the position, Paul, that we should be cutting taxes. I mean I really hope that the governor does take that position. But I don't expect it.

I think Angelides will want raise them. And the governor will oppose raising taxes, which will be fine, because I think the governor will beat Angelides.

But still, I would love to see someone aggressively take the position of reforming the tax codes in California and actually cutting taxes here.

GIGOT: Well, California has a top marginal rate of about, I think it's 10.3 percentage points. That is on the highest earners. And that is one of the highest rates across the country. I think you have to live in New York City to actually pay a higher rate. Is that...

LAFFER: It’s incredible, isn't it? It's just amazing.

GIGOT: Is that the single — in your view, is that the single biggest economic problem in California?

LAFFER: Well that's one of the single biggest ones. I think the governor's — you know, when the governor came out with the state of the state address in January, I was disappointed. I mean seriously, he swung and took the position of being pro the unions of fire fighters, the teachers, the nurses.

Now, we all love them individually. But as collective organizations, they really are anti-growth, anti-California.

And then the governor went for a large infrastructure spending as well. And then to top it off, he went for an increase in the minimum wage, which as you know, Paul, is really detrimental to the poor, the minorities, the disenfranchised, whenever the economy slows down. That's what the killer is.

So I was sort of disappointed the way the governor switched positions. And that's literally a long-run problem as well.

GIGOT: But you know the governor. And he started two and a half years ago as a reformer when he came in. He did some things on the budget, on workers compensation. What do you think is driving him in this new direction?

LAFFER: Well I think it's politics that's driving him in the new direction. But the governor, when he came in, was great. And I love the governor personally. He is one of the finest men I have ever known and really competent and really together.

But on these issues, I just have to take exception. I think he is taking the wrong turn. And you know I wish he'd come back to the tax-cutting, pro-growth, free enterprise governor that he should be. But California's politics are not friendly to that.

GIGOT: Well, that may be the case. That's what he might feel that he has to do to get elected. But let's talk about the state budget, which when the governor came in was swimming in red ink, as you know. And now they have got a big new surge of revenues. I think $7.5 billion this year in expected revenues.


GIGOT: Is this something he can point to, to say look I've turned the state around? Or is this something that you worry about being maybe temporary and we're going to be back into red ink if the economy slows?

LAFFER: It's the whole volatility of revenues, Paul, that is the real problem here. Because our tax system is so progressive that whenever we have a slight downturn, especially in asset values, we run huge deficits. And when we have a recovery we run huge surpluses, which leads this government to spend more and never control spending.

What we need is a low flat-rate tax here in the state of California to really keep revenues in line with the economy of California. But I don't think that's going to happen any time soon. I don't see the political move for that.

So the surge in revenues is just the counterpoint to the huge drop that Gray Davis suffered. And it is the volatility of those revenues that is really the problem of California, not whether we get a surplus this week or a deficit next week. It is the volatility that causes bad policy.

GIGOT: So you're saying that actual lower rate, top rate, flat tax rate would lead to a longer term better budget, because you would have kind of a steadier increase in revenues, notwithstanding what you think it would do to help the economy.

LAFFER: Oh, yes. I mean, that's exactly right. When these assemblymen and senators and governors and other people there get this huge flush of revenue, Paul, what they do is they spend it. And they build in new programs.

And so then when the economy naturally comes to a downturn in revenues, which it does, they then don't cut those programs back. What they do is then try to raise taxes, i.e., the 10.3 percent tax rate we now face, all the little nickel-and-dime taxes all over the state. It's a travesty, what the volatility of revenues has done to public policy here in California.

GIGOT: Okay, Art. Well, we hope somebody there is listening to you. Thanks very much for coming and joining us today.

LAFFER: My pleasure, Paul. Thank you.

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