Supply Side Economics Contradictions Live on in Washington

Politicians have always faced the temptation to give their constituents tax cuts.    But in recent decades “conservative” presidents have enacted large tax cuts that have been anything but conservative fiscally, and have justified them by appealing to theory. In particular, they have appealed to two theories: the Laffer Proposition, which says that cuts in tax rates will pay for themselves via higher economic activity, and the Starve the Beast Hypothesis, which says that tax cuts will increase the budget deficit and put downward pressure on federal spending. It is insufficiently remarked that the two propositions are inconsistent with each other:  reductions in tax rates can’t increase tax revenues and reduce tax revenues at the same time. But being mutually exclusive does not prevent them both from being wrong.   

The Laffer Proposition, while theoretically possible under certain conditions, does not apply to US income tax rates: a cut in those rates reduces revenue, precisely as common sense would indicate.  As detailed in a new paper of mine “Snake-Oil Tax Cuts,” for the Economic Policy Institute, this conclusion was the outcome of the two big experiments of recent decades: the Reagan tax cuts of 1981-83 and the Bush tax cuts of 2001-03. It is also the conclusion of more systematic scholarly studies based on more extensive data. Finally, it is the view of almost all professional economists, including the illustrious economic advisers to Presidents Reagan and Bush, even though it contradicted the views of their employers.  So thorough is the discrediting of the Laffer Hypothesis, that many deny that these two presidents or their top officials could have ever believed such a thing. But abundant quotes show that they did.

The Starve the Beast Hypothesis claims that politicians can’t spend money that they don’t have. In theory, Congressmen are supposedly inhibited from increasing spending by constituents’ fears that the resulting deficits will mean higher taxes for their grandchildren.

The theory fails on both conceptual grounds and empirical grounds. Conceptually, one should begin by asking: what it the alternative fiscal regime to which Starve the Beast is being compared? The natural alternative is the regime that was in place during the 1990s, which I call Shared Sacrifice. During that time, any congressman wishing to increase spending had to show how they would raise taxes to pay for it. Logically, a Congressman contemplating a new spending program to benefit some favored supporters will be more inhibited by fears of constituents complaining about an immediate tax increase (under the regime of Shared Sacrifice) than by fears of constituents complaining that budget deficits might mean higher taxes many years into the future (under Starve the Beast).

Sure enough, the Shared Sacrifice approach of the 1990s succeeded.  Compare this outcome to the sharp increases in spending that took place when President Reagan took office, when the first President Bush took office, and when the second President Bush took office. As with the Laffer Hypothesis, more systematic econometric analysis confirms the rejection of the hypothesis.

These matters are not solely of interest to historians or economists. The presidential campaign of Senator John McCain appears set to drive its wagon down the same road in which Reagan and Bush have already worn deep ruts. The candidate is apparently selling the same snake oil:  he says he believes that tax cuts increase revenues. His principle policy director disavows the Laffer Principle, just as the economists who advised Presidents Reagan and Bush did. But the views of the economic advisers are not what determines what these presidents do. 

The Queen in Alice in Wonderland said that, with practice, she was able to believe as many as six impossible things before breakfast. Most of us are more limited in our capacity for credulity. If John McCain believes both the Laffer Proposition (tax cuts raise revenues) and Starve the Beast (higher revenues lead to higher spending, anathema to conservatives), then as a good conservative, his duty is clear.  He ought to run on a truly novel platform of higher tax rates! Why? Higher tax rates would reduce revenues (this is what Laffer says would happen) and thereby reduce spending (this is what Starve the Beast says would happen).

Seriously folks. If McCain continues to propose extending the Bush tax cuts, he should at least be forced to choose between the Lafferite defense and the “Starve the Beast” defense. Only then can the rest of us know which of the two mutually inconsistent propositions to refute.

I will be discussing my paper, in a September 12 panel where Larry Summers and Gene Sperling also give their thoughts on Supply Side Economics, at a joint meeting of the Center for American Progress and the Economic Policy Institute.     

Comments

[john s. gordon:]

'supply-side' was always a fraud, especially under r.reagan. it is a mechanism for giving (out of the citizens' tax dollars) every millionaire an additional million $ to play with, under reagan all the yacht builders grew rich while everybody else suffered.

however there was one instance in history where tax cuts were followed by federal revenue increases - after 8 yrs of eisenhower stagnation kennedy saw that tax rates were too high & got them lowered. the resulting revenue increases were due to kennedy being president, not to the cut in rates.
> jack

2008 Sep 10 08:21 AM

[Tim Miles:]

You are both OK, Jeff and Jack. "Trickle down" economics and tax cuts (for the wealthy!) were always a cruel joke on the American middle class and the poor. Harry Truman, in stumping around America during the 1948 election campaign, charged that the Republicans were the party of "profiteers and the privileged." Not much has changed over the past 60 years.

2008 Sep 10 08:46 AM

[Fred S:]

We must get rid of the 'conservative' economic policy theories once and for all. There goal is to destroy the capabilities of government to function. Their policies have failed the test of the 'free market' which they hold so dear. The government is for the people not corporations. Reagan is dead, Reaganonomics is a sham, Laffer is a hack and Bush is totally incompetent.

2008 Sep 10 08:56 AM

[mouse:]

Wow! The neo-cons have not discovered this posting yet! Don't worry, they'll soon be here telling us all how much better off we all are, and how much better things are now than before they took over control of government policy......the facts to the contrary be damned. They are not about rational discourse, just propaganda.

2008 Sep 10 10:55 AM

[Tim Miles:]

The neocons also like to call people names when they can't find facts to prove their points. I usually find better things to do when that happens.

2008 Sep 10 11:05 AM

[John Lounsbury:]

Two comments:

1. Tax cuts do have a role in sound economic policy. There are times when the economy is contracting that temporary tax cuts can be stimulative. The key word is TEMPORARY. This concept is quite Keynsian and not Chicago school or traditional supply side.

2. Although not mentioned in the article, "trickle down" theories of supply siders fails to recognize the negative side to the very thing they keep touting as the driving force of a sound economy: the profit motive. If you give a wealthy capitalist more after-tax income he will use it in ways to further increase his income (except for what he spends). I'm assuming, in many cases, he is not a do-gooder socialist who would be charitable. To use a simile, the "liquid" benefit of lower taxes for the very top incomes is too often processed by the recipient so that he separates the components, keeping the nourishing fluids and trickling down the toxic waste.

Propagandists often use the statement "the top 1% of incomes pay 50% of the taxes".

I have a question: What percentage of aftertax income is retained by the top 1%. Do the top 1% have 20% of the taxable income? That would be the case if the average taxable income for the top 1% were approximately 20 times the average taxable income for the other 99%. If so, then the top 1% retain 10% of the aftertax income.

I think the average aftertax income for the top 1% is much more than the average aftertax income for the other 99%. I would like some researcher to study this.

An alternative tax strategy has higher tax rates for the top earners (say 1%) with tax incentives for investment in areas that would aim for such universally desirable goals as energy independence, businesses that increase domestic employment, cleaner environment, improved infrastructure, etc. Such investments would be made because capital invested would reduce the tax burden currently with the investor objective of obtaining future returns.

2008 Sep 10 11:46 AM

[John Lounsbury:]

I forgot to complement Prof. Frankel on a very lucid article.
I have bookmarked your weblog.

2008 Sep 10 11:49 AM

[milkchaser:]

Explain to me again why the gov't owns my money? Explain to me again why I am vassal to Congress? Explain to me again why there is always a justification for keeping tax rates high and never an excuse to cut spending?

2008 Sep 10 07:46 PM

[Xyrus:]

Milkchaser,

The answer is very simple. People keep electing the wrong people. Government costs money, and a lot of people profit from bigger government.

The RINO neo-cons are anything but fiscally conservative. In fact, they're really only socially conservative. If you want the government to cut spending and in turn cut taxes without driving our debt further through the roof, you'll have to vote for individuals like Ron Paul. No one else, including McCain, is going to reduce spending by any significant degree.

~X~

2008 Sep 10 09:04 PM