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Supply-side economics
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Supply-side economics is a school of macroeconomic thought that argues that economic growth can be most effectively created using incentives for people to produce (supply) goods and services, such as adjusting income tax and capital gains tax rates, and by allowing greater flexibility by reducing regulation. The term supply-side economics was coined by journalist Jude Wanniski in 1975, and popularized the ideas of economists Robert Mundell and Arthur Laffer.
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Encyclopedia
Supply-side economics is a school of macroeconomic thought that argues that economic growth can be most effectively created using incentives for people to produce (supply) goods and services, such as adjusting income tax and capital gains tax rates, and by allowing greater flexibility by reducing regulation. The term supply-side economics was coined by journalist Jude Wanniski in 1975, and popularized the ideas of economists Robert Mundell and Arthur Laffer. Today, supply-side economics is often conflated with the politically rhetorical term "trickle-down economics."
The typical policy recommendation of supply-side economics is to achieve the proper level of marginal tax rates, which, by virtue of the high rate of taxes in general, equates with cutting of taxes. Maximum benefits are achieved by optimizing the marginal tax rates of those with high incomes and capital investments who are deemed most likely to increase supply and thus spur growth. Keynesian macroeconomics, by contrast, contends that tax cuts should be used to increase demand, not supply, and thus should be targeted at cash-strapped, lower-income earners, who are more likely to spend additional income.
Many early proponents argued that the size of the economic growth would be significant enough that the increased government revenue from a faster growing economy would be sufficient to compensate completely for the short-term costs of a tax cut, and that tax cuts could, in fact, cause overall revenue to increase.
Historical origins
Supply-side economics developed during the 1970s in response to the Keynesian dominance of economic policy, and in particular the failure of demand management to stabilize Western economies during the stagflation of the 1970s, in the wake of the oil crisis in 1973. It drew on a range of non-Keynesian economic thought, particularly Austrian school thinking on entrepreneurship and new classical macroeconomics. The intellectual roots of supply-side economics have also been traced back to various early economic thinkers such as Ibn Khaldun, Jonathan Swift, David Hume, Adam Smith and Alexander Hamilton.
As in classical economics, supply-side economics proposed that production or supply is the key to economic prosperity and that consumption or demand is merely a secondary consequence. Early on this idea had been summarized in Say's Law of economics, which states: "A product is no sooner created, than it, from that instant, affords a market for other products to the full extent of its own value." John Maynard Keynes, the founder of Keynesianism, summarized Say's Law as "supply creates its own demand." He turned Say's Law on its head in the 1930s by declaring that demand creates its own supply. However, Say's Law does not state that production creates a demand for the product itself, but rather a demand for "other products to the full extent of its own value." A better formulation of the law is that the supply of one good constitutes demand for one or more other goods.
In 1978 Jude Wanniski published The Way the World Works in which he laid out the central thesis of supply-side economics and detailed the failure of high tax-rate progressive income tax systems and U.S. monetary policy under Nixon in the 1970s. Wanniski advocated lower tax rates and a return to some kind of gold standard, similar to the 1944-1971 Bretton Woods System that Nixon abandoned.
In 1983, economist Victor Canto, a disciple of Arthur Laffer, published The Foundations of Supply-Side Economics. This theory focuses on the effects of marginal tax rates on the incentive to work and save, which affect the growth of the "supply side" or what Keynesians call potential output. While the latter focus on changes in the rate of supply-side growth in the long run, the "new" supply-siders often promised short-term results.
The supply-siders were influenced strongly by the idea of the Laffer curve, which states that tax rates and tax revenues were distinct -- that tax rates too high or too low will not maximize tax revenues. Supply-siders felt that in a high tax rate environment, lowering taxes to the right level can raise revenue by causing faster economic growth. They pointed to the tax cuts of the Kennedy administration and the high rates of the Hoover and Nixon administrations in justification.
This led the supply-siders to advocate large reductions in marginal income and capital gains tax rates to encourage allocation of assets to investment, which would produce more supply. Jude Wanniski and many others advocate a zero capital gains rate. The increased aggregate supply would result in increased aggregate demand, hence the term "Supply-Side Economics".
Furthermore, in response to inflation, supply-siders called for indexed marginal income tax rates, as monetary inflation had pushed wage earners into higher marginal income tax brackets that remained static; that is, as wages increased to maintain purchasing power with prices, income tax brackets were not adjusted accordingly and thus wage earners were pushed into higher income tax brackets than tax policy had intended.
Supply-side economics has been criticized as essentially politically conservative. Supply-side advocates claim that they are not following an ideology, but are reinstating classical economics. Yet, supply-siders such as Jude Wanniski have argued for lower tax rates to increase tax revenues, and that redistribution of income through taxation was essential to the health of the polity -- a fact which is anathema to traditional conservatives.
Some economists see similarities between supply-side proposals and Keynesian economics. If the result of changes to the tax structure is a fiscal deficit then the 'supply-side' policy is effectively stimulating demand through the Keynesian multiplier effect. Supply-side proponents would point out, in response, that the level of taxation and spending is important for economic incentives, not just the size of the deficit.
The Reagan administration justified such changes in socioeconomic terms with the argument that "a rising tide lifts all boats".
Marx and Smith
Both supply-siders and their opponents have been keen to claim the mantles of thinkers as diverse as Karl Marx and Adam Smith. Jude Wanniski has claimed both as supply-side thinkers due to their advocacy of a gold monetary standard and more specifically their focus on the agents of production in an economy. Barton Biggs, chief investment strategist of Morgan Stanley, described Wanniski's book about supply-side economics, The Way the World Works, as the "most important" economic book published since Marx's writings.
Supply-side vs. Monetarism
Supply-side supporters disagreed with Chicago school monetarist Milton Friedman by arguing that cutting tax rates alone would be sufficient to grow GDP, lift tax revenues and balance the budget.
Friedman, however, retained a more conventional monetarist view, believing that while tax cuts were on the whole desirable, money supply was the crucial variable.
Fiscal policy theory
Supply-side economics holds that increased taxation steadily reduces economic trade between economic participants within a nation and that it discourages investment. Taxes act as a type of trade barrier or tariff that causes economic participants to revert to less efficient means of satisfying their needs. As such, higher taxation lead to lower levels of specialization and lower economic efficiency. The idea is said to be illustrated by the Laffer curve. (Case & Fair, 1999: 780, 781).
Crucial to the operation of supply-side theory is the expansion of free trade and free movement of capital. It is argued that free capital movement, in addition to the classical reasoning of comparative advantage, frequently allows an economic expansion. Lowering tax barriers to trade provides to the domestic economy all the advantages that the international economy gets from lower tariff barriers.
Supply-side economists have less to say on the effects of deficits, and sometimes cite Robert Barro’s work that states that rational economic actors will buy bonds in sufficient quantities to reduce long term interest rates. Critics argue that standard exchange rate theory would predict, instead, a devaluation of the currency of the nation running the high budget deficit, and eventual "crowding out" of private investment.
According to Mundell, "Fiscal discipline is a learned behavior." To put it another way, eventually the unfavourable effects of running persistent budget deficits will force governments to reduce spending in line with their levels of revenue. This view is also promoted by Victor Canto.
The central issue at stake is the point of diminishing returns on liquidity in the investment sector: Is there a point where additional money is "pushing on a string"? To the supply-side economist, reallocation away from consumption to private investment, and most especially from public investment to private investment, will always yield superior economic results. In standard monetarist and Keynesian theory, however, there will be a point where increases in asset prices will produce no new supply, that is where investment demand will outrun potential investment supply, and produce instead, assets inflation, or in common terms a bubble. The existence of this point, and where it is should it exist, is the essential question of the efficacy of supply-side economics.
Monetary policy theory
Some supply-siders advocate that monetary policy should be based on a price rule. The aim of monetary policy should be to target a specific value of money irrespective of the quantity of money that must be created or withdrawn by the central bank to achieve this target. This contrasts with monetarism's focus on the quantity of money, and Keynesian theory's emphasis on real aggregate demand. The important difference is that to a monetarist the quantity of money, specifically represented by the money supply is the crucial determining variable for the relationship between the supply and demand for money, while to a Keynesian adequate demand to support the available money supply is important. Keynes famously remarked that "money doesn't matter".
This is an area where supply-side theory has been particularly influential. Under macroeconomic theory, the general level of price was based on the strict increase in price of a basket of goods. Under supply-side theory, the rate of inflation should be based on the substitutions that individuals make in the market place, and should take into account the improved quality of goods. In the late 1980s and through the 1990s, under Presidents of both American political parties, shifts were made in the calculation of the broadly followed measure of inflation the "Consumer Price Index for Urban Consumers", or CPI-W, which reflected supply-side ideas on substitution. The argument for factoring in goods quality was not accepted, which has led supply-side economists to claim that the real CPI is actually between 0.5% and 1% lower than the stated rate.
This area represents one of the points of contention between conservative economic theorists who argue for a quantity of money theory of inflation, including Austrian economics, many strict gold standard economists and traditional monetarists, and supply-side theorists. According to the increases in money supply during the 1990s, the real rate of inflation must be higher than is currently stated. These economists argue that the cost of housing is understated in the CPI-W, and that the inflation rate should be between 0.5% and 1% higher. It is for this reason that many central bankers, investment analysts and economists follow the GDP deflator which measures the total output of the society and the prices paid for all goods, not merely consumer goods.
Some supply-siders view gold as the best unit of account with which to measure the price of fiat money, which is defined as a money supply not directly limited by specie or hard assets. Hence the purest supply-siders are in general advocates of a gold standard. However the reverse is not true; many gold standard advocates are harsh critics of supply-side economics.
Supply-side economists assert that the value of money is purely dictated by the supply and demand for money. In fiat money system the government has a legislated monopoly on the supply of base money. Hence it has some control over the value of money. Any decline in the value of money (or appreciation) is then viewed by some as the result of errant central bank policy.
Effect on Tax revenues
Many early proponents argued that the size of the economic growth would be significant enough that the increased government revenue from a faster growing economy would be sufficient to compensate completely for the short-term costs of a tax cut, and that tax cuts could, in fact, cause overall revenue to increase. Some hold this was borne out during the 1980s when, advocates of supply-side economics (so-called “supply-siders") claim, tax cuts ultimately led to an overall increase in governmental revenue due to stronger economic growth. Other economists, however, dispute this assertion. Some contemporary economists do not consider supply-side economics a tenable economic theory, with Alan Blinder calling it an "ill-fated" and perhaps "silly" school on the pages of a 2006 textbook. Greg Mankiw, former chairman of President George W. Bush's Council of Economic Advisors, offered similarly sharp criticism of the school in the early editions of his introductory economics textbook. In a 1992 article for the Harvard International Review, James Tobin wrote, "[The] idea that tax cuts would actually increase revenues turned out to deserve the ridicule…" While few modern economists claim that tax cuts will completely pay for themselves, some empirical and theoretical research suggests that tax cuts do help to pay for themselves through increased economic growth, though the end result, even conservative economists contend, will be a significant reduction in revenues. The Reagan administration was the first to implement supply-side policies and call them that. Some maintain that they failed to deliver the promised benefits.
Supply side proponents Trabandt and Uhlig argue that "static scoring overestimates the revenue loss for labor and capital tax cuts", and that instead "dynamic scoring" is a better predictor for the effects of tax cuts.
U.S. monetary and fiscal experience
Supply-side economists seek a cause and effect relationship between lowering marginal rates on capital formation and economic expansion. The supply-side history of economics since the 1960s hinges on the following key turning points:
The 1970s
In 1971, Richard Nixon ended the convertibility of the US dollar into gold, which meant the end of the Bretton Woods system. Commodity prices, including oil and gold particularly, which had been rising steadily in response to the dollar glut, spiked upwards. The supply-side explanation for this event is that taxation on investment had depleted the incentive to capital investment either in new sources of materials or in substitute goods, which when combined with eroding confidence in the U.S. dollar cause it to be rapidly devalued. Many supply siders agree with gold investors in saying that the value of commodities remained constant and that it was the dollar that devalued.
At the same time the Mundell-Fleming model of currency flows gained greater credence when it was codified into a single set of equations, and became increasingly influential in neo-liberal economics. The argument for a floating currency regime had first been adopted by Friedman, but supply-side economists such as Wanniski typically argued that exchange rates should be fixed relative to gold. Mundell was the author of the influential view that it was Johnson's budget deficits that were the cause of inflationary pressure. However, as Lester Thurow pointed out, the standard model of inflationary pressure shows that Johnson's peak year of deficits would have created only a small upward pressure, that instead it was persistent American trade deficits through the 1960s which had a greater effect on the imbalance between the value of the U.S. dollar and the gold to which it was, in theory, convertible.
Stagflation
Robert Mundell believes Nixon's failure to cut taxes in the early 1970s to be the cause of stagflation, his argument being that the incentive for individuals to invest was reduced to below zero. Measuring the S&P 500 in inflation-adjusted terms, the stock market lost half of its value between the market peak of 1972 and its bottom in 1982, with money seeking better returns in real estate and commodities instead. The argument from the supply-side point of view then goes on to state that the cuts in capital gains tax rates that were part of the 1981 tax package returned incentives to invest. The Keynesian point of view is that after a long bear market, money had fled from stocks and was set to return, once the expectation of inflation had been reduced. Neither of these two arguments fully accounts for the rise of equities over the course of the "long Bull Market" of 1982-2000.
The importance of this argument needs to be seen in light of the effects of the inflation of the late 1970s, where credit became constricted, as interest rates rose rapidly, and the number of borrowers who could qualify for even standard mortgages fell. Inflation acted as a tax on wage increases, because the highly progressive income tax system of the time meant that more and more households suffered from "bracket creep" - in which a wage increase would be reduced in value by the increased taxes collected. The effects of inflation produced, in 1980, a strong political consensus for a change in basic policy.
Reaganomics
Ronald Reagan made supply-side economics a household phrase, and promised an across the board reduction in income tax rates and an even larger reduction in capital gains tax rates. (Case & Fair, 1999: 781, 782). When vying for the Republican party presidential nomination for the 1980 election, George H.W. Bush derided Reagan's supply-side policies as "voodoo economics". However, later he seemed to give lip service to these policies to secure the Republican nomination in 1988, and is speculated by some to have lost in his re-election bid in 1992 by allowing tax increases. (See: "Read my lips: No new taxes.")
The centerpiece of the supply-side argument is the economic rebound from the 1980-1982 double dip recession, combined with the continued fall in commodity prices. The "across the board" tax cuts of 1981 are seen as the great motivator for the "Seven Fat Years". Critics of this view point out that the "rebound" from the recession of 1981-1982 is exactly in accordance with the "disinflation" scenario predicted by IS/LM models of the late 1970s: essentially that the increases in fed funds rates squeezed out inflation, and that federal budget deficits acted to "prime the pump". This model had been the basis of Volcker's federal reserve policy.
In 1981, Robert Mundell told Ronald Reagan that by cutting upper bracket taxation rates and lowering tax rates on capital gains, national output would increase so much that tax revenues would also increase. Mundell claimed that the economic expansion would also mop up excess liquidity and bring inflation back under control. After the tax cuts were implemented, nominal revenues quickly returned to - and ultimately surpassed - previous levels. While revenues dropped as a share of GDP, supply-siders note they intended for this fall to happen, since cutting tax rates would preclude a rise in taxes collected relative to national income.
The question of whether the tax cuts proved Mundell's predictions correct has sparked much debate between supply-siders and mainstream economists. While nominal revenues rebounded after the tax cuts, mainstream economists note that comparing nominal tax collections over time fails to take into account inflation. By converting tax revenues from nominal to real terms, these economists have shown that tax revenues did not surpass their 1981 levels until 1987.
Defenders of supply-side economics also complain that the focus of the debate on government revenue tends to ignore the societal benefits of economic growth, primarily lower levels of unemployment, higher wages for workers and lower prices for consumers. This is a rhetorical argument derisively known as trickle-down economics, and should be viewed as distinct from the economic theory of supply-side economics.
In the United States, commentators frequently equate supply-side economics with Reaganomics. The fiscal policies of Ronald Reagan were largely based on supply-side economics. During Reagan's 1980 presidential campaign, the key economic concern was double digit inflation, which Reagan described as "Too many dollars chasing too few goods", but rather than the usual dose of tight money, recession and layoffs, with their consequent loss of production and wealth, he promised a gradual and painless way to fight inflation by "producing our way out of it". Switching from an earlier monetarist policy, Federal Reserve chair Paul Volcker began a policy of tighter monetary policies such as lower money supply growth to break the inflationary psychology and squeeze inflationary expectations out of the economic system. Therefore, supply-side supporters argue, "Reaganomics" was only partially based on supply-side economics. However, under Reagan, Congress passed a plan that would slash taxes by $749 billion over five years. As a result, Jason Hymowitz cited Reagan—along with Jack Kemp—as a great advocate for supply-side economics in politics and repeatedly praised his leadership.
Critics of "Reaganomics" claim it failed to produce much of the exaggerated gains some supply-siders had promised. Krugman later summarized the situation: "When Ronald Reagan was elected, the supply-siders got a chance to try out their ideas. Unfortunately, they failed." Although he credited supply-side economics for being more successful than monetarism which he claimed "left the economy in ruins", he stated that supply-side economics produced results which fell "so far short of what it promised," describing the supply-side theory as "free lunches". Krugman and other critics point to increased budget deficits during the Reagan administration as proof that the Laffer Curve is wrong. Supply-side advocates claim that revenues increased, but that spending increased faster. However, they typically point to total revenues even though it was only income taxes rates that were cut. That table also does not account for inflation. For example, of the increase from $600.6 billion in 1983 to $666.5 billion in 1984, $26 billion is due to inflation, $18.3 billion to corporate taxes and $21.4 billion to social insurance revenues (mostly FICA taxes). Income tax revenues in constant dollars decreased by $2.77 billion in that year. Supply-siders cannot legitimately take credit for increased FICA tax revenue, because in 1983 FICA tax rates were increased from 6.7% to 7% and the ceiling was raised by $2,100. For the self employed, the FICA tax rate went from 9.35% to 14%. The FICA tax rate increased throughout Reagan's term, jumping to 7.51% in 1988 and the ceiling was raised by 61% through Reagan's two terms. Those tax hikes on wage earners, along with inflation, are the source of the revenue gains of the early 1980s. But, despite much debate on if tax rate cuts increased revenues, the Reagan policies of the 1980s succeeded in a dramatic raise in economic growth in following the tax cuts, reversing the economic decline of the 1970s.
It has been contended by some supply-side critics that the argument to lower taxes to increase revenues was a smokescreen for "starving" the government of revenues and who hoped that the tax cuts would lead to a commensurate drop in government spending. However, this did not turn out to be the case on the spending side; Paul Samuelson called this notion "the tape worm theory—the idea that the way to get rid of a tape worm is [to] stab your patient in the stomach". Supply-side advocates like Wanniski counter that social and fiscal conservatives who supported the supply-side prescription on tax policy for this reason were misguided and did not understand the Laffer Curve.
There is frequent confusion on the meaning of the term 'supply-side economics', between the related ideas of the existence of the Laffer Curve and the belief that decreasing tax rates can increase tax revenues. But many supply-side economists doubt the latter claim, while still supporting the general policy of tax cuts. Economist Gregory Mankiw used the term "fad economics" to describe the notion of tax rate cuts increasing revenue in the third edition of his Principles of Macroeconomics textbook in a section entitled "Charlatans and Cranks":
Criticism
Critics of supply-side economics point to the lack of academic economics credentials by movement leaders such as Jude Wanniski and Robert Bartley to imply that the theories were bankrupt. Mundell in his Nobel Prize lecture (awarded for unrelated work in optimum currency area) countered that the success of price stability was proof that the supply-side revolution had worked. The continuing debate over supply-side policies tends to focus on the massive federal and current account deficits, increased income inequality and its failure to promote growth.
Many critics of supply-side economics are actually critics of politicians and pundits who misunderstand the Laffer curve, typically claiming that every tax cut will increase revenues. For example, in 2006 Sebastian Mallaby of The Washington Post quoted George W. Bush, Dick Cheney, Bill Frist, Chuck Grassley, and Rick Santorum misstating the effect of the Bush Administration's tax cuts. On January 3, 2007, George W. Bush wrote an article claiming "It is also a fact that our tax cuts have fueled robust economic growth and record revenues." Andrew Samwick, who was Chief Economist on Bush's Council of Economic Advisers from 2003-2004 responded to the claim:
You are smart people. You know that the tax cuts have not fueled record revenues. You know what it takes to establish causality. You know that the first order effect of cutting taxes is to lower tax revenues. We all agree that the ultimate reduction in tax revenues can be less than this first order effect, because lower tax rates encourage greater economic activity and thus expand the tax base. No thoughtful person believes that this possible offset more than compensated for the first effect for these tax cuts. Not a single one.
The Congressional Budget Office (CBO) has estimated that extending the Bush tax cuts of 2001-2003 beyond their 2010 expiration would increase deficits by $1.8 trillion dollars over the following decade. The CBO also completed a study in 2005 analyzing a hypothetical 10% income tax cut and concluded that under various scenarios there would be minimal offsets to the loss of revenue. In other words, deficits would increase by nearly the same amount as the tax cut in the first five years, with limited feedback revenue thereafter.
Some politicians and supply-side advocates may misunderstand the Laffer curve. They claim that every tax cut will increase revenues, when the curve clearly shows that only cutting tax rates to the right of the peak rate will increase revenues. Cutting tax rates to the left of the peak rate will decrease revenues. Since Reagan's income tax cuts in the 1980s did not increase receipts, the Laffer curve would suggest that further tax cuts will not increase revenues either, since the economy is apparently to the left of the peak. Between 2000 and 2004, income tax revenues fell from $1,004.5 billion to $809 billion, while FICA tax revenues increased from $652.9 billion to $733.4. Since 1997, the US Treasury has been reporting the combination of income tax and FICA tax revenues, so decreases in income tax revenues are hidden by increases in FICA tax revenues. Depending on the model and values of variables that are used, some have estimated the peak rate to be between 60-80% for labor tax and 50-60% for capital tax.
The paradigm of a tax system which rewards investment over consumption was accepted across the political spectrum, and no plan not rooted in supply-side economic theories has been advanced in the United States since 1982 (with the exception of the Clinton tax increases of 1993) which had any serious chance of passage into law. In 1986, a tax overhaul, described by Mundell as "the completion of the supply-side revolution" was drafted. It included increases in payroll taxes, decreases in top marginal rates, and increases in capital gains taxes. Combined with the mortgage interest deduction and the regressive effects of state taxation, it produces closer to a flat-tax effect. Proponents, such as Mundell and Laffer, point to the dramatic rise in the stock market as a sign that the tax overhaul was effective, although they note that the hike in capital gains may be more trouble than it was worth.
Cutting marginal tax rates can also be perceived as primarily beneficial to the wealthy, which commentators such as Paul Krugman see as politically rather than economically motivated.
The economist John Kenneth Galbraith noted that supply side economics was not a new theory. He wrote, "Mr. David Stockman has said that supply-side economics was merely a cover for the trickle-down approach to economic policy—what an older and less elegant generation called the horse-and-sparrow theory: If you feed the horse enough oats, some will pass through to the road for the sparrows." Galbraith claimed that the horse and sparrow theory was partly to blame for the Panic of 1896.
The 1990s
Supply-siders blame the 1991 recession on the Federal Reserve, and argue that Clinton's tax increases, since they did not change marginal capital gains tax rates, left the supply-side nature of the 1986 tax bill in place. Similarly, supply-side economists have argued that since the early phases of the massive tax breaks of George W. Bush's first two years were based on credits and not cuts in marginal rates, they did not act to stimulate the economy, although the effect on individual income remains the same.
More generally, traditional economists point to the "overhang" of deficits from the Reagan era, the S&L bailout, the effects of a ballooning federal budget deficit, the defense budget cuts which began in earnest in 1989, and the expectation of a lack of continued fiscal discipline as the source of the recession. These arguments blame the legacy of Democratic Deficits forced upon Reagan, rather than deficits created by Reagan's own administration. Critics of supply-side economics often argue the inflated government deficits that accompanied the arrival of supply-side economics are of greater concern than the economic and stock market success of supply-side theory.
A Trojan Horse
Other critiques of supply-side economics dismiss the entire project as a Trojan horse for reducing marginal tax rates on upper income brackets and ultimately a failure. These critiques are found in Samuel Bowles' work, which argues that real productivity fell under supply-side taxation regimes on a unit-worker basis. Nobel laureate economist Paul Krugman of Princeton called supply-side economics "Peddling Prosperity" and dismissed it as being unworthy of serious economists in a 1994 book written for the general audience.
David Stockman, Ronald Reagan's budget director, admitted that the 1981 tax cut was a Trojan horse:
Research since 2000
In 2003, the Wall Street Journal declared the debate over supply-side economics to have ended "with a whimper" after extensive modeling performed by the Congressional Budget Office (CBO) failed to support the most extreme claims of supply-side policies. It was also suggested that Dan Crippen may have lost his chance at reappointment as head of the CBO for failing to support supply-side inspired dynamic scoring. This research undermines the claim that tax cuts can completely compensate for the initial loss of revenue due to the cut, but does acknowledge that resulting growth from the tax cut does replace some of the lost revenue, and the CBO has come under fire for using low estimates.
Before President Bush signed the 2003 tax cuts, the Economic Policy Institute (EPI) released a statement signed by ten Nobel prize laureates entitled "Economists' Statement Opposing the Bush Tax Cuts," which states that:
Nobel laureate economist Milton Friedman agreed the tax cuts would reduce tax revenues and result in intolerable deficits, though he supported them as means to restrain federal spending. Friedman characterized the reduced government tax revenue as "cutting their allowance".
Supporters of the Bush tax plan point out that the predictions of the EPI article differ from recent short-term trends. Specifically, the budget deficit shrank significantly during 2005, 2006, and 2007 and the length of time before Social Security becomes insolvent has improved slightly, rather than worsening as EPI predicted.
Later analysis of the Bush tax cuts by the Economic Policy Institute claims that the Bush tax cuts have failed to promote growth, as all macroeconomic growth indicators, save the housing market, were well below average for the 2001 to 2005 business cycle. These critics argue that the Bush tax cuts have done little more than deprive government of revenue, increase deficit and after-tax income inequality. In the two years since that report, though, growth has remained strong, and newer numbers dispute the conclusions of the EPI report. The Bush administration points to the long period of sustained growth, both in GDP and in overall job numbers, as well as increases in personal income and decreases in the government deficit.
The results of the tax cuts in the U.S. in 2001 and 2003 are mixed. While results show a temporary decline in tax receipts, they later recovered due to economic growth. In this analysis, it is difficult to discern the reason for the decreases in tax revenue because 2001 was the same year that the dot-com bubble burst. Total Federal Revenues in FY2000 were $2,025 billion (in inflation adjusted dollars). In 2001, President George W. Bush signed the Economic Growth and Tax Relief Reconciliation Act of 2001. Rather than wait for the start of the new fiscal year, income tax rate reductions started on July 1, 2001. In addition, rebate checks were sent to everyone that filed a 2000 income tax return (before Oct 1, the start of the new federal fiscal year). Federal revenues in FY2001 were $1,946 billion, $79 billion lower than in FY2000. More of the 2001 tax cut took effect at the start of FY2002, including cuts in the estate tax, retirement and educational savings. Federal revenues in FY2002 were $1,777 billion, $247 billion lower than in FY2000.
In 2003, President Bush signed the Jobs and Growth Tax Relief Reconciliation Act of 2003. Income tax rates were immediately reduced and rebate checks issued (without waiting for the new fiscal year). Federal revenues in FY2003 were $1,665 billion, $360 billion lower than in FY2000. Federal revenues in FY2004 were 1,707 billion, $318 billion lower than in FY2000. Federal revenues in FY2005 were $1,888, $137 billion lower than in FY2000, but by 2006 revenue had completely recovered (in inflation adjusted dollars), with receipts at $2,037 Billion, $12 billion higher than 2000. The cumulative total of federal revenues less than in FY2000 for the fiscal years 2001-2005 was $1.142 trillion, with that amount expected to be recovered by 2011, with 2012 expected to produce an additional $400 billion in excess revenue over 2000.
Federal revenues include revenue from different taxes that were cut, stayed the same, or were raised. For example, the Social Security FICA tax rate stayed the same while the maximum income subject to the tax was increased each year, resulting in a tax increase for those earning more than the previous limit. Social Security tax revenues increased each and every year. Including increasing tax revenues from taxes that stayed the same or were increased hides the magnitude of the revenue decrease in taxes that were cut. Income tax rates were cut and income tax revenues were lower than the FY2000 level each and every fiscal year from 2001-2005, a cumulative revenue decrease of $640 billion (measured in nominal dollars). But, by 2006 revenues exceeded the 2000 level. Likewise Corporate income tax rates were cut and revenues were lower than the FY2000 level each and every fiscal year from 2001-2004. But, by 2005 the inflation adjusted take exceeded that of 2000 by over 20%, and by 2006 nearly 50% higher.
In 2006, the CBO released a study titled "A Dynamic Analysis of Permanent Extension of the President's Tax Relief." This study found that under the best possible scenario, making tax cuts permanent would increase the economy "over the long run" by 0.7%. Since the "long run" is not defined, some commentators have suggested that 20 years should be used, making the annual best case GDP growth equal to 0.04%. When compared with the cost of the tax cuts, the best case growth scenario is still not sufficient to pay for the tax cuts. Previous official CBO estimates had identified the tax cuts as costing the equivalent of 1.4% of the GDP in revenue. According to the study, if the best case growth scenario is applied, the tax cuts would still cost the equivalent of 1.27% of the GDP.
This study was criticized by many economists, including Harvard Economics Professor Greg Mankiw, who pointed out that the CBO used a very low value for the earnings-weighted compensated labor supply elasticity of 0.14. In a paper published in the Journal of Public Economics, Mankiw and Matthew Weinzierl noted that the current economics research would place an appropriate value for labor supply elasticity at around 0.5,
although Dr. Mankiw notes, "unfortunately, the academic literature on this topic is far from conclusive."
A recent working paper sponsored by the IMF showed "that the Laffer curve can arise even with very small changes in labor supply effects" but that "labor supply changes do not cause the Laffer effect." This is contrary to the supply-side explanation of the Laffer curve, in which the increases in tax revenue are held to be the result of an increase in labor supply. Instead their proposed mechanism for the Laffer effect was that "tax rate cuts can increase revenues by improving tax compliance." The study examined in particular the case of Russia which has comparatively high rates of tax evasion. In that case, their tax compliance model did yield significant revenue increases:
Supply-side economics in popular culture
Supply-side economics have been discussed and critiqued in books, songs and films. The social activist and cartoonist Dan Perkins (who writes under the pen name Tom Tomorrow) has repeatedly criticized the theory in his weekly cartoon, This Modern World.
The band Radiohead have alluded to their opposition to such policies in the song "Electioneering". http://www.greenplastic.com/lyrics/electioneering.php
It was also mentioned by Ben Stein in the popular 1986 movie Ferris Bueller's Day Off.
Comedian and author Al Franken lampoons Supply Side Economics in his 2004 book "Lies and the Lying Liars Who Tell Them - A Fair and Balanced Look at the Right," in a comic book style chapter illustrated by Don Simpson entitled The Gospel of Supply Side Jesus.
See also
Further reading
External links
Supply Side Proponents
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- Portion of Mundell's Nobel Prize Lecture (awarded for unrelated work in optimum currency area) claiming that Supply Side Economics was responsible for growth, price stability and the collapse of the Soviet Union.
- Supply Side Library. A collection of essays and studies by Robert Mundell, Paul Craig Roberts, Stephen Entin and Alan Reynolds.
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Supply Side Critiques
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