Supply side economics remains controversial and poorly understood both by its critics who think it is just ‘trickle down’ economics: a thinly veiled rationalization to improve the lives of the wealthy at the expense of the poor, and by many of its proponents who think that cuts in tax rates will always increase tax revenues.
Both are wrong. I wrote Understanding Supply Side Economics for American Thinker (6/24/11), to address those who cannot look beyond the ‘trickle down’ description.
Secondly it shows that there are usually two different rates that will generate the same revenues. Assume the graph shows that a 30% tax rate and a 70% tax rate will generate the same revenue. There are some who would prefer the 70% rate because it would make the wealthier pay a bigger share of the bill. Why would we care whether the rate is 30% or 70% if it generates the same dollar revenue?
The answer is that the 30% rate will support a larger growing economy, more innovation and startups, and lower unemployment. If we can choose from two rates why not choose the rate that is much more likely to generate a robust growing economy? It is not a matter of wealthier people generating more wealth that trickles down. It is a matter of stimulating a wider distribution of wealth generating activity.
The first objective is to find the rates that generate the most revenue, but possibly even more important is to find the tax rate that supports the most robust and growing economy.
We must also distinguish between statutory rates and effective rates. The statutory rate is the scheduled bracket rate but the effective rate is the rate paid after deductions. Effective rates have fallen much less sharply than statutory rates.
Deductions give the government an opportunity to direct tax cuts to their preference. Tax deductions for mortgage interest, for example, became one of many factors that contributed to the glut in housing supply we now face. The real power of politics is often exercised in the granting of tax deductions.
Equally important to the distinctions between statutory and effective rates is the understanding of marginal tax rates. What affects economic activity and growth is not the total or average tax rate but the tax burden on the next (marginal) dollar of income. In the 1970’s inflation pushed people into higher tax brackets. The combination of a higher rate with less purchasing power was exceptionally devastating to economic growth. This is another reason why the control of inflation was as critical to Reagan’s success as the reduction in friction costs.
The term ‘supply side’ is less descriptive of the theory itself than the fact that it was offered as an alternative and a critique of Keynesian economics which was focused on demand stimulation.
While supply side theory is most commonly associated with Arthur Laffer and the Laffer curve, the theory was not of his origin. He was noted for the simple bell curve he drew on a napkin for Donald Rumsfeld and Deck Cheney in the 1970’s. The principle author was Robert Mundell, who won the Nobel Prize in economics. In his acceptance speech, A Reconsideration of the Twentieth Century Mundell applied the theory throughout recent history.
In 1924 Calvin Coolidge gave a speech that showed his understanding of Mundell’s principle long before the name ‘supply side’ was ever applied to it.
The Laffer Curve applies to taxes but it is really a consideration of all friction costs. Government mandates and regulations that also burden production must be considered. Milton Friedman noted the Permanent Income Theory which basically noted that one time stimulants do little because consumers and investors will only respond to how their continuous and permanent income is impacted. I contend that our tax laws have been so inconsistent and erratic that whatever impact they may have in theory are negated by a simple lack of trust.
Theories are explained in a vacuum, but in application there are other factors that must be considered. Because of this, tax cuts alone will have limited impact if they are accompanied by growth in other friction costs. There are other factors such as overall debt, foreign competition, and the existing economic environment that will either facilitate or obstruct the impact of economic policy.
But the best statement on supply side may have come from one of the comments on my article posted by a reader at American Thinker:
The left loves to obfuscate the language. Let us un-obfuscate it: “supply-side economics” is simply “economics”. It is the way the world works. It’s known, it’s proven and it’s real. Anything else, whether it is called “Keynesian economics” or “stimulus” or “priming the pump” or whatever specious buzzword the “intellectuals” call it today, is just smoke and mirrors. Stimulus has never worked — unless the goal is to destroy an economy and enrich and empower a small cabal of tyrants.