The Return of Supply-Side Economics
In an article about the reduced political salience of the budget deficit, the Christian Science Monitor recently reported that President Bush’s fiscal policy "signals a return to supply-side economics." Let us hope so.
This Bush administration has of course been more supportive of tax cuts than any since Ronald Reagan’s. A Republican Congress increases the odds of these tax-cutting impulses finding their way into law. But too many members of the Bush economic team have touted tax cuts more on Keynesian than supply-side grounds. The president himself has publicly argued that tax cuts will spur consumer spending as if consumption truly drives the economy more than production.
Congressional Republicans also have a mixed supply-side record. Ever since Republicans first broke the Democratic stranglehold over the House of Representatives in the 1994 elections, they have promoted tax cuts. But only occasionally have these tax cuts taken the form of marginal income tax rate reductions. The Contract With America focused on tax credits and amelioration of the marriage penalty. The former does not necessarily enhance incentives to earn additional income while the latter is more of an issue of fairness and family tax relief than economic stimulus. If anything, the Senate Republican Conference has generally been even more divided on the appropriate nature of tax reduction than House Republicans. The biggest supply-side victory to actually originate in the Congress since Republicans have been in control is the capital gains tax cut Bill Clinton signed in 1997.
Yet President Bush’s comments on tax cuts and deficits following his November 13 Cabinet meeting were music to a supply-sider’s ears: "We have a deficit because tax revenues are down. Make no mistake about it, the tax relief package that we passed--that should be permanent by the way--has helped the economy. And that the deficit would have been bigger without the tax relief package." So where, policy-wise, should we go from here? According to the president, "There are two things we can do about that [the deficit]: One, stimulate the economy to create more revenues, and two, hold down spending."
Supply-side economics (which supply-siders have been fervently trying to rename for more than a decade with limited success) isn’t, as the Christian Science Monitor reports, merely the idea "that tax cuts actually increase government revenue, by stimulating the economy." All tax cuts are not equally stimulative. Marginal tax rates affect incentives to engage in productive economic behavior that will yield additional income. Increased marginal rates reduce the reward for work, savings, and investment while reduced rates increase the reward and thus accelerate economic growth by increasing that kind of activity. Faster economic growth enlarges the tax base to which a given marginal rate is applied. The Wall Street Journal’s Robert Bartley, a long-time supply-sider, suggest three criteria for a pro-growth tax cut: "Permanent, marginal and immediate."
This suggests the corrective action for the Bush tax cut passed in 2021. Only 10 percent of this tax cut has actually taken place with most of the stimulative reductions in marginal rates occurring between 2021 and 2021. The entire tax cut is set to expire in 2021. This is a large problem that has prevented the tax cut from boosting the economy back to its growth potential. Temporary and phased-in tax cuts have the tendency to move economic activity around without offering a permanent incentive enhancement. Gradually phasing in marginal rate cuts injects uncertainty into the tax code, especially in a political climate where leading Democrats advocate halting or reversing these tax cuts. Rebates do not add any incentives to create wealth or take risks. Even if no further tax cuts are contemplated (though another capital gains tax cut would be beneficial) and the Republican majority isn’t large enough for more sweeping tax reform, adjusting the Bush tax cut according to Bartley’s criteria would be enormously helpful from a growth perspective.
Nevertheless, the dialog about tax policy in Washington has been deeply confused for years. Many people believe that the experience of the 1990s demonstrates that tax increases reduce budget deficits and lower long-term interest rates, which in turn stimulates economic growth. Yet long-term interest rates fell even as the deficit rose in the 1980s. After Bill Clinton’s tax increase passed in 1993, interest rates actually began to climb again until the Republicans won control of Congress. They continued to fall after the 1994 elections and the budget did not actually go from deficit to surplus until after an agreement was reached between Clinton and the Republican Congress that included tax cuts. Interest rates remain low after the Bush tax cut.
In the context of today’s economy, with a $10 trillion GDP and a world supply of savings and debt holdings, it is difficult to fathom how every fluctuation of the federal balance sheet can truthfully be considered the authoritative determinant of interest rates and economic growth rates. As Bartley wrote earlier this year, "A true macroeconomics would be built not on abstract models, but on solid microeconomic foundations, involving what happens to workers, producers and savers in the real world."
In the real world, workers, producers and savers respond to changes in incentives and budget surpluses are caused by economic growth rather than vice versa. The federal government should strive to annually balance its budget to maintain basic fiscal discipline as well as to limit the growth of government to a rate Americans are willing to finance through taxes. But deficit hawks wrote extenuating circumstances into the balanced-budget constitutional amendments they proposed during the 1980s and ‘90s that implicitly recognize that war and recession are not times to take arbitrary policy steps (such as, hypothetically, deficit-reduction tax increases) in pursuit of a balance sheet.
Supply-side economics has been a victim of its own successes and failures. At the beginning of the Reagan administration, the U.S. was still in the throes of stagflation and wildly high interest rates. Working-class families were buffeted by unlegislated tax increases as "bracket creep" pushed them into higher tax brackets each year. The top statutory rate on "unearned" income was 70 percent. The Reagan tax cuts contributed to an economic boom and solved these tax inequities one by one. Both the Economic Recovery Act of 1981, which cut marginal rates 25 percent across the board, and the Tax Reform Act of 1986, which cut the top marginal rate to 28 percent and reduced the number of rates from 14 to two, dropped millions of lower-income individuals and households from the income tax rolls entirely.
This success also helped to create a situation where the bottom half of taxpayers only supply 4 percent of the income tax revenues. The top 10 percent provide 55 percent of income tax revenues. In this context, further marginal rate reductions are very easily distorted as "tax cuts for the rich." Any tax reduction that is likely to enhance incentives for taxpayers to earn their next dollar – and thus involve themselves in the economic transactions that create jobs and wealth – will be spun in this manner. While the 1990s introduced the new phenomenon of "real bracket creep," no longer were lower-income families seeing their tax bills rise due to inflation. Therefore, not all families equally felt the brunt of disastrous tax policies, which could now be tailored to raise taxes disproportionately on those liberal groups would describe as "rich."
Supply-siders also contributed to the undoing of their own policies by failing to favor reductions in government spending commensurate with the reductions in taxes they achieved. (They also tend to support artificially low interest rates and excess creation of dollars, but no more so than most of their mainstream economic opponents and probably less so than proponents of Clintonomics.) Most supply-siders were content to lower marginal rates and hope that the resulting economic growth would generate enough revenue to continue funding the welfare state. When this proved in adequate to feed the ravenous appetites of welfare statists for taxpayers’ money, taxes reversed their descent. The root cause of all counterproductive tax policy is endlessly rising government spending, yet few supply-siders were willing to make spending cuts a priority. The most notable political exception: outgoing House Majority Leader Dick Armey (R-Tex.).
This does not mean all aspects of supply-side theory should be summarily discarded. Federal policymakers should abandon their fixation on consumption and instead liberate the free market to increase output. If President Bush and congressional Republicans wish to revive the economy and beat back Democratic challenges in 2021, they would do well to take a page out of the supply-side handbook and promote lower tax rates to boost economic growth.
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