Supply-Side Economics Explained

Paul Craig Roberts

Supply-Side economics burst onto the economic policy scene in Washington, D.C., on September 21, 1975 in the Sunday Washington Star in an article I had written for US Representative Jack Kemp that provided a supply-side economic basis for his capital formation bill. Subsequently, I generalized the supply-side approach when I realized that changes in marginal tax rates altered relative prices and could shift the aggregate supply side curve. Until that time, economists assumed that fiscal policy only impacted the aggregate demand curve.

Today 42 years after this article and 36 years after the passage of the Economic Recovery Tax Act that constituted the supply-side economic policy of President Reagan, there is still scant understanding of the economics that cured stagflation and enabled Reagan to pressure the Soviets to end the Cold War.

For example, in Wikipedia’s account Supply-Side economics is presented as a claim that cutting tax rates increases tax revenues. This is ignorant nonsense.

As the Assistant Secretary of the Treasury for Economic Policy, I had the central role in the implementation of Supply-Side economics. On US Representative Jack F. Kemp’s staff as economic counsel and in the House of Representatives as Chief Economist for the Republicans on the House Budget committee, I wrote the Kemp-Roth bill that addresses stagflation and that President Reagan adopted as presidential policy. As staff associate of the Joint Economic Committee in the US Senate I convinced some Republicans and the most important majority Democratic committee chairmen that Supply-Side economics was the way out of the stagnation trap. The first Joint Economic Committee annual reports endorsing Supply-Side economics came from committee chairman Lloyd Bentsen, a Texas Democrat. My book, The Supply-Side Revolution, peer-reviewed and published by Harvard University Press in 1984, explains the theory of Supply-Side economics and provides empirical evidence and the history of Reagan’s policy.

A few years ago Harvard University Press informed me that China had published a Chinese language edition of The Supply-Side Revolution. I have a copy on my bookshelf. On my wall hang letters from President Reagan thanking me for the implementation of the Supply-Side economic policy. On another wall is a letter from President Reagan to the French Ambassador and Finance Minister on the occasion of the ceremony that presented me with the French Legion of Honor for my services to economics. In his letter Reagan says “Craig is the architect of the economic policies of my administration.” I have the US Treasury’s Meritorious Service Award for “outstanding contributions to the formulation of US Economic Policy.”

Yet the Wikipedia account of Supply-Side economics excises both me and the content of Supply-Side economics. In our place are the accumulation of decades of propaganda against “Reaganomics.”

The missing subject matter becomes even stranger when we take into account the fact that I wrote the peer-reviewed New Palgrave Dictionary of Money and Finance (Macmillan, London, 1992) entries on Supply-Side Economics and the Laffer Curve. The New Palgrave is the premier economic encyclopedia. It is extraordinary that anyone would be so careless as to write a Wikipedia economics entry without consulting The New Palgrave. I also wrote the entry for the McGraw-Hill Encyclopedia of Economics.

The Laffer curve is not a theory. It is not Supply-Side economics. It is an expository device that illustrates that both high and low tax rates can produce the same tax revenues. There is nothing wrong with this demonstration.

The economic policy of the Reagan administration was most certainly not based on tax rate reductions paying for themselves in increased revenues. The Treasury’s revenue forecast of the Reagan tax rate reduction was the Treasury’s traditional static revenue forecast that every dollar of tax cut would lose a dollar of tax revenue. In other words, it was a worse forecast of revenue loss than the Keynesian economists predicted. Keynesians predicted that some of the revenues would be regained from increased employment and output. Walter Heller, chairman of the Council of Economic Advisors under President John F. Kennedy said that the Kennedy reduction in marginal tax rates, on which Reagan’s reduction was modeled, paid for itself in increased revenues.

Possibly. But the Reagan Treasury—in which I was entrenched with two deputies of my choosing, US Rep. Jack Kemp’s support, President Ronald Reagan’s support, Treasury Secretary Don Regan’s support, former Treasury Secretary William E. Simon’ support, the House Republicans’ support, support from influential Democrats and Republicans in the Senate, and support from the Wall Street Journal where I was associate editor prior to my Treasury appointment—based its revenue forecast on the traditional Treasury static revenue estimate that every dollar of tax cut would lose a dollar of revenue. This is a fact not subject to dispute. It is in the public record.

So how did the fabricated fake news story originate that Supply-Side economics was a theory that cutting taxes would increase tax revenues. It originated from three sources.

One was that in those days Republican economics consisted of fear of deficits. Cutting taxes would at least initially worsen the deficit and, from Wall Street’s point of view, would lead to higher interest rates that would sink their stock and bond portofilios. The result was that Wall Street economists campaigned against Supply-Side economics, and misrepresentation was part of their attack.

A second was that Supply-Side economics challenged Keynesian demand management policy by its emphasis on supply. In other words, Supply-Side economics took the leadership over economic policy away from the long-entrenched Keynesians. Academic economists aggressively defended their turf and misrepresentation—“trickle-down economics,” “voodoo economics”— was part of their attack.

The third was that in order to reassure Senate Republians who were prone to hysteria over federal budget deficits, Budget Director David Stockman, against my advice, raised the inflation forecast in the five-year budget projection in order to forecast higher GDP and, thereby, higher tax revenues. The higher the inflation forecast, the higher the nominal GDP and the tax base that it provided.

I argued, correctly as it turned out, that inflation would come in lower than Stockman’s figures and that our opponents would place the blame for the budget deficits on the tax rate reductions instead of blaming the faulty inflation forecasts. However, the argument that the Republican Senate could not be trusted to vote for a budget that projected deficits carried the day and brought the consequences that I predicted.

What produced the unequitable distribution of income in the 21st century was not the Reagan marginal tax rate reductions, but the offshoring of high-productivity, high value-added, high wage jobs by global US corporations. When a country moves its middle class manufacturing and professional skill jobs abroad, it decapitates itself by reducing both personal income and personal income tax revenues.

What is Supply-Side economics? Supply-Side economics is a correction to Keynesian demand-side economics. In Keynesian theory, the supply function is fixed and changes only very slowly with technology and discovery of new resources. Supply is passive and aggregate demand, the summation of consumer demand, investment demand, and government demand determine employment and economic growth.

If consumer and investor demand are insufficient to maintain full employment, the Keynesians say that the government can add to demand by running a deficit in its budget. The government can create a deficit by holding spending constant and cutting taxes, or it can hold taxes constant and overspend the revenues. The Keynesian policymakers preferred the latter fiscal policy, because it let them expand the size and responsibilities of government. In other words, Keynesians could use their employment policy also for social engineering. Content in this role, they didn’t think about the supply-side of the economy.

It was the neglect of the supply-side of the economy that had produced stagflation, which required a rising rate of inflation in order to maintain full employment. Supply-Side economics showed that the Keynesian picture was incomplete and corrected it. Keynesians emphasized that fiscal policy impacted aggregate demand. Supply-Side economists showed that fiscal policy directly impacts aggregate supply.

The Keynesian policy of pumping up consumer demand with easy monetary policy while suppressing the response of output with high marginal tax rates resulted in prices rising more than output. This is the explanation of stagflation. As Assistant Secretary of the US Treasury in charge of US domestic economic policy, this was my challege.

Supply-side economics says that the aggregate supply schedule is not dependent merely on technology and discovey of new resources. The ability to produce is also determined by the incentive effects of tax rates.

The supply of labor is dependent on choices on the margin between work and leisure, and the supply of savings is dependent on choices between current consumption and future income.

Supply-side economics introduced into macroeconomic policy the valid point that the cost of leisure is the foregone income from not working and that the cost of current consumption or immediate enjoyment is foregone future income from not saving and investing.

In other words, taxation is a cost of production. A high marginal tax rate on labor makes leisure inexpensive in terms of after-tax foregone income from not working A high tax rate on saving makes current consumption cheap in terms of foregone future income.

In other words, Supply-Side economics introduced microeconomics into macroeconomics and should have won a Nobel prize.

Keynesian demand management relied on easy monetary policy to stimulate consumer demand and relied on high tax rates to reduce purchasing power and restrain inflation. The result was that the high tax rates curtailed output while the easy monetary policy pushed up consumer demand. The result was that prices rose.

The Supply-Side policy was a tremendous success. The US economy has not experienced worsening “Phillips curve” trade offs between inflation and employment since the Reagan economic program went into effect. Stagflation is a problem of the past until new policy errors revive it.

Yet, this entire story is totally missing in the Wikipedia account of Supply-Side economics.

In 1989 I wrote an assessment published by the Institute for Political Economy of the results of Reagan’s supply-side policy. It was republished in The Public Interest, by a think tank in England, and in peer-reviewed premier economic publications in Germany and Italy, such as Zeitschrift fur Wirtschaftspolitik and Rivista Di Politica Economica.

Despite the abandance of factual information, propaganda has prevailed.

Here is my assessment of the Reagan Administration’s Supply-Side policy as I wrote it in 1989:

Supply-Side Economics, Theory and Results: An Assessment of the Amercian Experience in the 1980s

Paul Craig Roberts

Republished from January 1989

THE INSTITUTE FOR POLITICAL ECONOMY

Printed in the United States

Permission to quote from or to reproduce materials in this publication is granted when

due acknowledgement is made

Table of Contents

Chapter I – Introduction 1

Chapter II -Theory of Supply-Side Economics 4

Chapter III – Some Empirical Studies of the Relative

Price Effects of Fiscal Policy 9

Chapter IV – Implementation and Results of Supply-Side

Economics in the United States 15

Chapter V – Conclusion 33

References 37

About the Author 40

I. Introduction

When John F. Kennedy was elected President of the United States in 1960, Keynesian demand management entered its American heyday. Keynesianism had been entrenched in the universities for a decade or more, and a generation of journalists and civil servants had been in­culcated in its principles. There were few critics, and no one paid them any attention. Demand management had free reign and rode off into stagflation and political destruction during the administration of Presi­dent Jimmy Carter.

Two decades later when Ronald Reagan was elected President, another fiscal revolution occurred, but this time few people and prac­tically no academics were familiar with the supply-side principles at its core. It was a policy born in the congressional budget process and frustrations with stagflation and worsening trade-offs between inflation and unemployment. In the autumn of 1978 the Democratic Congress passed what was later known as Reaganomics – tax rate reductions combined with reductions in the growth of federal spending – but the measure was killed by President Carter’s announcement that he would veto the measure. Nevertheless, the Congress rejected the Carter­ Administration’s tax reform legislation, designed to close “loopholes” without lowering tax rates, and cut the capital gains tax rate. The supply­-side revolution had begun.

In its 1979 Annual Report and again in 1980, the Joint Economic Committee of Congress called for the implementation of a supply-side fiscal policy. During the 1980 presidential campaign the Senate Finance Committee endorsed a supply-side tax cut. The Democrats in the Senate wanted to be identified with the new policy. However, they refrained from passing the tax cut before the presidential election, because it would appear to be an endorsement of Republican Ronald Reagan over their own candidate. The Senate leadership decided to wait until after the November election to pass the tax cut. Unexpectedly, Reagan’s victory also cost the Democrats control of the Senate, and the tax cut issue was delivered firmly into Republican hands.

The Reagan White House, with the exception of Martin Anderson, was staffed with people who were unfamiliar with the change in economic thinking that Congress had undergone in the previous four years. Gratuitously uninformed and confident from control of the Senate, the White House staff maneuvered to deny congressional Democrats any credit for the 1981 tax rate reduction. When Democrats in the House of Representatives saw that they were being denied a part in the historic legislation in order to give President Reagan a political “victory,” they devised their own tax cut. It was just as supply-side in content as the administration’s. Indeed, there was no way to differentiate the two bills politically until Reagan decided to add the indexation of the personal income tax (beginning in 1985) to his measure.

While White House political neophytes were threatening the new policy by denying the Democrats any credit, conservatives, who wanted a rapid victory over inflation at any cost, permitted a disastrous monetary policy during 1981-82. Encouraged by political conservatives, the New York bond houses, and its own fears over inflation, the Federal Reserve inflicted the severest recession in the postwar era. These two er­rors combined to create a political problem for Reagan. He had picked a fight with Democrats over an issue they were willing to support and claimed a victory over them just as the economy entered deep recession. The Democrats and their allies in the media were quick to take revenge, and budget deficits resulting from the recession were blamed on Reagan’s tax cut before the rate reductions were even phased in. By January 1982 large deficits were being attributed to Reagan’s supply­ side policy even though the first significant cut in taxes was not effective until July 1982 and the second cut was not scheduled until July 1983.

The lack of understanding outside the Congress of the nature of the new policy allowed both opponents and proponents of supply-side economics to caricature it, often ruthlessly, as the belief that across-the­ board tax rate reductions are self-financing. Today the policy is widely misunderstood as the belief that tax cuts pay for themselves in increased revenues. This misunderstanding has made it easy for the budget deficits to be blamed on the 1981 tax rate reduction.

The “Laffer curve” was confined to political rhetoric and jour­nalistic caricatures. It played no analytical role in the development of a supply-side economic policy in the U.S. Congress during 1975-80 or in the development or implementation of the Reagan Administration’s economic policy. No one ever proposed to cut only the top tax rates, and the supply-side policy was not designed to secure more revenues for the government or to balance the budget.

The supply-side policy was directed toward overcoming the economy’s inability to grow without rising inflation and toward revers­ing the decline in the competitive position of the U.S. During the 1970s productivity growth declined sharply. Policymakers were confronted with worsening “Phillips curve” trade-offs between inflation and unemployment, ending in both rising inflation and unemployment. In 1971 the U.S. merchandise trade deficit turned negative and grew dramatically during the latter part of the decade despite the continuous fall in the dollar exchange rate.

Keynesian economists could not explain these developments or of­fer elected policymakers an escape from the problems. This failure created an opportunity for supply-side economics, which argued that the policy of pumping up demand while neglecting incentives to produce had resulted in stagflation. As incentives eroded, each additional incre­ment of demand called forth less real output and more inflation. Supply­-siders argued that improved incentives and less costs imposed by govern­ment would result in a greater supply and more efficient use of produc­tive inputs. The supply-side policy is an anti-inflationary one, because its goal is to increase real output relative to demand.

The social welfare implications are clear and were understood by all in the debate over U.S. economic policy that set the stage for “Reaganomics.”

The purpose of this paper is to explain concisely and accurately the analytical and empirical basis of the new fiscal policy and to use freely available official statistics to correct widespread misconceptions of the impact that the supply-side policy has had on the US economy. Reaganomics was more than tax reductions and fiscal policy. It also comprised a monetarist policy and a policy of limited economic deregulation. This study does not deal with the regulatory aspects of Reaganomics, and the discussion of monetary policy is limited to its relationship to the “twin deficits.”

Some of the striking results of Reaganomics were not anticipated. For example, the extraordinary increase in wealth that resulted from the sharp rise in stock and bond prices was not generally expected, because most financial market gurus predicted that inflationary fears would keep the financial markets in the doldrums. The rise in the dollar and the currency’s prolonged strength was not anticipated by forecasters for basically the same reason. In 1981 the economics profession from left to right interpreted supply-side economics as an inflationary policy. The Federal Reserve was advised by its consultants that monetary policy was the junior partner, a “weak sister” that would be overwhelmed by ex­pansionist fiscal policy — predictions which reflected economists’ lack of knowledge of the basis and origin of the new fiscal policy as well as a firm belief in the “Phillips curve.”

II. Theory of Supply-Side Economics

In the U.S. in the 1980s, a second post-war fiscal revolution occurred. Keynesian demand management of the economy was replaced by supply-side economics — a policy that focuses on individual incen­tives. This change represents a fundamental shift in thinking about fiscal policy. In the Keynesian approach, a fiscal change operates to alter demand in the economy. A tax rate reduction, for example, raises the disposable income of consumers, who then spend more. With govern­ment spending held constant, increased consumer spending stimulates supply and moves the economy to higher levels of employment and GNP. In this view, the size of the deficit determines the amount of stimulus.

In contrast, supply-side economics emphasizes that fiscal policy works by changing relative prices or incentives. High income tax rates and regulations are seen as disincentives to work and production regardless of the level of demand. To understand the difference in em­phasis between Keynesianism and supply-side economics, consider the removal of a tariff that is high enough to prevent trade in a commodity. When the tariff is repealed, no revenues are lost, no budget deficits result and no money is put into anyone’s hands. Yet clearly economic activity will expand, because the disincentive is removed. Nothing in demand management captures this effect.

Supply-side economics brought a new perspective to fiscal policy by focusing on the relative price effects. Lower tax rates encourage saving, investing, working, and risk-taking. As people switch into these ac­tivities out of leisure, consumption, tax shelters and working for nontax­able income, the incentive effects cause an increase in the market supply of goods and services – thus the name “supply-side economics.” As people respond to the higher after-tax income and wealth, or greater profitability, incomes rise and the tax base grows, thus feeding back some of the lost revenues to the Treasury. The savings rate also rises, providing more funds for government and private borrowing.

Relative Price Effects of Fiscal Policy

The relative-price argument is straightforward. There are two im­portant relative prices. One governs people’s decisions about how they allocate their income between consumption and saving. The cost to the individual of allocating a dollar of income to current consumption is the future income stream given up by not saving and investing that dollar. The present value of that income stream is influenced by marginal tax rates. The higher the marginal rate, the lower is the value of the income stream. High tax rates make consumption cheap in terms of forgone in­come, and the saving rate declines, resulting in less investment.

The other important relative price governs people’s decisions about how they allocate their time between work and leisure or between leisure and improving their education and skills. The cost to a person of allocating additional time to leisure is the current earnings given up by not working (for example, overtime on Saturday) or the future income given up by not taking courses to improve skills. The value of the forgone income is determined by the rate at which additional income is taxed. The higher the marginal tax rates, the cheaper the price of leisure. Absenteeism goes up, willingness to accept overtime declines, and peo­ple spend less time improving their work skills.

Physicians who encountered a 50 percent tax rate after six months of work were faced with working another six months for only 50 percent of their actual earnings. Such a low reward for effort encouraged doc­tors to share practices in order to reduce their working hours and enjoy longer vacations. The high tax rates shrunk the tax base by discouraging them from earning additional amounts of taxable income. The high tax rates also drove up the cost of medical care by reducing the supply of medical services.

The effect of tax rates on the decision to earn additional taxable in­ come is not limited to physicians in the top bracket. Studies by Martin Feldstein at the National Bureau of Economic Research found that in many cases the tax rates on the average worker left almost no gap be­tween take-home pay and unemployment compensation. Feldstein found that a 30 percent marginal tax rate made unemployment suffi­ciently competitive with work to raise the unemployment rate by 1.25 percentage points and to shrink the tax base by the lost production of one million workers. Blue collar professionals also encounter disincen­tive effects even at “moderate” tax rates. Take the case of a carpenter facing a 25 percent marginal tax rate. For every additional $100 he earns, he is allowed to keep $75. Suppose his house needs painting and he can hire a painter for $80 a day. Since the carpenter’s take-home pay is only $75, he would save $5 by painting his own house. In this case the tax base shrinks by $180- $100 that the carpenter chooses not to earn and $80 that he does not pay the painter.

Studies by Professor Gary Becker of the University of Chicago have shown that capital and labor are employed by households to pro­duce goods and services through nonmarket activities — for example, the carpenter paints his own house. Goods and services produced in this way are not subject to taxation. Therefore the amount of capital and labor that households supply in the market is influenced by marginal tax rates. The higher the tax rates, the more likely it is that people can in­crease their income by using their resources in non-market activities or in the ‘black’ economy. A clear implication of household economics is that marginal tax rates influence the amount of labor and capital that is used to produce taxable income.

The progressive income tax was devised to “soak the rich.” In prac­tice it works as a barrier to upward mobility and discourages people from making their best effort. As a result, the tax system can make it more difficult for the average taxpayer to achieve financial in­dependence. It is this barrier to success that supply-side economists at­ tacked. The greater the extent of private success, the smaller the need for public assistance and the lower the burden of government. Supply-side economics is not anti-government. It simply accepts the fact that government is costly by nature and maintains that the greater the incen­tives and opportunities to earn income, the smaller will be the size and burden of government.

Supply-side economics has also brought a new perspective to the impact of interest rates and taxation on the cost of capital. Traditional­ly, interest rates have been stressed as the important factor in the cost of capital. According to this perspective, higher government revenue from increased taxation can spur capital investment by lowering deficits and interest rates or by building budget surpluses and retiring debt. Recent studies, however, have found taxation to be a major factor in the cost of capital (Roberts, et. al., 1985, 1986a, 1986b, and 1986c). As taxation also reduces investment, the only certain way to reduce “crowding out” is to cut government expenditure.

Some economists argued that the real tax burden is measured by the total amount of resources that the government removes from the private sector by taxing and borrowing. They therefore argued that a tax cut that is not matched dollar for dollar with a spending cut just means the government takes by borrowing what it formerly took by taxing.

The total resources claimed by government is a better measure of the tax burden than tax revenues alone. But this adding up of concrete resources can make us blind to another measure of the real tax burden — the production that is lost to disincentives. It is difficult to see the pro­duction that does not take place because the government has made it un­profitable, but it is nevertheless a part of the tax burden.

From the viewpoint of this more complete measure of the tax burden, a tax cut can be real even if it is not matched dollar for dollar with a spending cut. That is because a reduction in marginal tax rates changes relative prices and causes people to shift into work out of leisure and into investment out of current consumption. These shifts will occur even if people expect that in the future taxes might be raised to pay off any government debt incurred by cutting tax rates. In the meantime, however, the additional work and investment expands the tax base; to make good on the deficit, future tax rates would not have to be raised as much as they were cut. Moreover, if the government did need more tax revenues in the future to pay off debts, it could raise them by some other type of tax, such as a consumption tax, which does not have the disincen­tive effects of high marginal income tax rates.

The importance of supply-side economics lies in its claim that fiscal policy works through relative price changes or incentives. This claim is not an assertion of the “Laffer curve.”

Keynesian Criticism

Keynesians objected to the fiscal emphasis on relative price effects (Roberts, 1984). They argued that the elasticities of response of work and saving to tax rates were zero or negative, and they questioned whether incentive effects would deal effectively with an immediate economic stabilization problem. Neither objection withstood analysis. The long-run consists of a series of short-runs. If policies that are effective over a longer period are neglected because they do not have an immediate impact, and if policies that are damaging over the longer period are adopted because they initially have beneficial results, then policy-makers will inevitably find that they have no solution for the crisis they have provoked. In the U.S. this happened during the period of stagflation in the mid- 1970s.

Some Keynesians argued that the incentive effect of lower tax rates would be perverse. It would let people reach their targeted levels of in­come sooner and, therefore, they would work less. This could be true for individuals but not in the aggregate. If everyone responded to a tax cut by working less, total production would fall and people would not be able to maintain their living standard while working less. The argument that people would take their tax cut in the form of increased leisure undercut the Keynesian interpretation of expansionary fiscal policy just as thoroughly as it undercut the supply-side interpretation that was its target. When Keynesians realized this, they abandoned this argument. The argument that incentive effects are perverse in the aggregate failed, because it was an attempt to aggregate a series of partial equilibrium analyses (individual responses to a change in relative prices) while ignoring the general equilibrium effects.

Today many economists claim that their analysis always incor­porated supply-side effects and that they were only opposed to an alleged claim that the 1981 tax rate reduction would pay for itself. In fact, a decade ago practically every economist was arguing that people respond to incentives in perverse ways. They argued that people have a targeted level of income regardless of the cost of acquiring it, so that a tax cut would allow them to reach their target net income by working less. Lester Thurow, now a dean at Massachusetts Institute of Technology, actually employed this reasoning to argue for a wealth tax. According to Thurow, a wealth tax is a costless way to raise revenue, because the “income effect” runs counter to, and dominates, the “substitution effect.” Therefore, it will cause people to work harder in order to maintain their desired post-tax wealth. Such confused thinking was responsible for the neglect of the relative price effects of fiscal policy in post-war economic management.

Economists were slow to see the flaw in the argument against incen­tives. Take something simple, like an assertion that a fixed work-week precludes adjustment of the labor supply to tax-rate changes. This sounded reasonable enough to many who did not realize that the “ad­justments” were reflected in the quality and intensity of work. Thus higher absenteeism and turnover, longer average duration of unemploy­ment, and labor demands for shorter work-weeks and more paid vaca­tion were all responses to high marginal tax rates on wages and salaries. The Keynesian concept of the economy as an unstable private sec­tor that had to be stabilized by fiscal and monetary policies served as a pretext for the expansion of government. It also served the interests of economists by transforming them from ivory-tower denizens to public­ spirited social activists, a transformation which increased their power and enlivened their life styles. Unemployment can always be said to be too high. And the rate of economic growth can always be judged below “potential.” Before the supply-side challenge to the Keynesian policymakers, there was always a “scientific” economic reason for expanding government spending programs that enlarge the constituen­cies of the Congress and the Federal bureaucracy at the expense of private property rights and economic freedom.

III. Some Empirical studies of the Relative Price effects of Fiscal Policy

A number of economists have assessed the responsiveness of sav­ing, labor force, and tax revenues to changes in tax rates. The following is a brief summary of empirical studies that have found the responses to be significant.

Saving

The 1964 Kennedy income tax reductions were intended to increase aggregate demand by stimulating consumption leading to additional em­ployment and output. Marginal tax rates were cut approximately 20 per­cent for each bracket, and corporate tax rates were cut 10 percent. Pop­ular economics textbooks have reinforced the view that the tax cuts in­creased demand and propelled a recovery. However, studies by Paul Evans (1981) and the U.S. Treasury (Roberts, 1984) have found that the recovery occurred despite a fall in the propensity to consume. The evidence shows that after the marginal tax rate reduction went into ef­fect, people spent a smaller percentage of their income. In 1964, actual consumer expenditures dipped below the trend rate. By 1967, consump­tion was at least $17.5 billion below the previous trend — a sum larger than the size of the personal tax cut (measured in constant dollars).

People were actually consuming a smaller percentage of their in­come and saving a larger percentage after the tax rate reduction than before. Following the tax reduction there was a significant increase in the real volume of personal saving, and the personal saving rate rose sharply, reversing the decline begun in the 1960s. The personal saving rate remained high for nearly a decade until demographic changes and rising marginal tax rates pushed it down.

In 1964 real personal saving rose $6.6 billion above the trend pro­jected prior to the reduction in marginal tax rates. The gain in saving was 74 percent of the tax cut. In the next two years saving increased $10.2 billion and $10.8 billion above the previous trend, a gain equal to 72 percent of the tax cut. In 1967 saving was $19 billion above the previous trend — a gain equal to 121 percent of the size of the tax cut.

This increase in saving released resources from consumption, thus allowing a rapid growth in business investment. In real terms, capital spending (for both the expansion of the capital stock and the replace­ment of worn-out stock) had grown at an annual rate of 3. l percent dur­ing the 1950s and early 1960s through 1962. The remainder of the 1960s saw real capital spending rise over twice as fast, increasing 6.8 percent annually. The rate of growth from 1963 to 1966 was especially marked. While growth was high in the corporate sector, small business invest­ment showed the greatest improvements.

The acceleration of investment greatly enhanced the economy’s ability to produce. The net stock of capital had grown 3.5 percent an­nually between 1949 and 1963, but with the tax cuts it rose to a 5.0 per­ cent growth rate for the remainder of the decade. Keynesian economists claim that the investment boom resulted from the investment tax credit passed in 1962, which allowed businesses a direct deduction from their taxes for certain investments. However, the sharp rise in investment could not have taken place if consumers had not released resources from consumption by saving a larger share of their incomes.

Professor Michael Boskin of Stanford University (1978) found that the total elasticity of saving (income and substitution effects combined) was positive at around 0.3 to 0.4. While the size of this response has since been disputed by other studies, Boskin’s elasticities are commonly used in econometric studies. Boskin predicted that raising the after-tax rate of return to saving would “increase income substantially” and “remove an enormous dead-weight loss to society resulting from the distortion of the consumption-saving choice.”

Another interesting conclusion of Boskin’s study is that people will not only respond positively to changes in the relative price of saving or lower tax rates, but also that a larger share of total income will be transferred from capital to labor. Boskin confirms earlier studies in­ dicating that the elasticity of substitution between capital and labor is less than one, so that an increase in the capital-labor ratio (following an increase in saving) leads to a corresponding increase in labor’s share of total income. Boskin wrote that:

“the current tax treatment of income from capital induces an astounding loss in welfare due to the distortion of the consumption/saving choice . . . . Reducing taxes on interest income would in the long run raise the level of income and transfer a substantial portion of capital’s share of gross income to labor.”

Allen Sinai, Andrew Lin and Russell Robins (1983) examined the 1981 tax rate reduction. They found that private saving was influenced by the greater rate of return allowed by lower tax rates and that the economy would have performed much more poorly in 1981-82 had it not been for the 1981 tax rate reduction. They also found that the cash flow effects of the tax cuts reduced the burden of loan repayment and interest charges on debt, thereby strengthening personal and business balance sheets.

Using an augmented Data Resources model of the U.S. economy incorporating previously neglected effects of after-tax interest rates on saving, investment, and consumption, Sinai et. al. estimated that the net tax reductions introduced by the Reagan administration increased business saving by $27 billion during 1981-82 and that personal saving rose $48 billion above the baseline trend in 1982. Sinai et. al. concluded that in the absence of the tax cut, “the U.S. economy would have per­formed considerably worse in 1981 and 1982 than actually was the case,” with an additional loss in real GNP of about 1.6 percentage points. “The evidence indicates that ERTA (the Economic Recovery Tax Act of1981) has had major impact on U.S. economic growth.”

Effects on Revenues

Dr. Lawrence Lindsey (1986) of Harvard University has examined the revenue effects of capital gains taxation. Because capital gains are only taxed when an asset is sold, inclusion of gains in taxable income is largely discretionary from the point of view of the taxpayer. Conse­quently, tax rate sensitivity is greater for capital gains income than for other income types. Lindsey studied the evidence in tax returns from 1965-82. He concludes that capital gains tax revenues are maximized at 20 percent or lower, “with a central estimate of 16 percent.” In response to the Tax Reform Act of 1986 in which capital gains are treated as or­dinary income (except in 1987, when the tax rate on capital gains is limited to 28 percent), Lindsey estimates that taxpayers will respond to the higher tax rates by postponing — in some cases indefinitely — their sales of assets.

Lindsey (1988) has also researched the revenue effects of lowering the top tax rate from 70% to 50%. He found that taxpayers earning over $200,000 per year paid $18.3 billion more in taxes under the new tax code with a top tax rate of 50 percent than they would have been expected to pay under the old rates of up to 70 percent. He continues:

“The evidence also in dicates that upper-middle-income groups may have increased their labor supply dramatically as a result of the tax rate reductions, particularly the labor supply of the secondary earner in the family.”

Lindsey estimates that, “by 1985, the 1981 tax cuts had boosted real economic activity (GNP) by about 2 percent above what it would have been otherwise,” and states, “the equivalent of 2.5 million more people are working today as a result of the supply-side effects of the tax cuts.” He concludes, “the evidence from a wide range of studies shows that taxpayers are highly sensitive to tax rates in many of their economic ac­tivities.”

A U.S. Treasury Department study conducted by Michael Darby (1988) found that the 1978 and 1981 cuts in the capital gains tax rate raised revenue $15 billion by the end of 1985. The study also concluded that the evidence suggested that a capital gains rate reduction “from current high levels” would raise federal tax revenues. Moreover, in 1987 after the capital gains tax rate went up, many states including Massachusetts, New York, and California experienced an unexpected drop in revenues. Massachusetts projected a $430 million budget deficit for 1988 of which, according to Robert Tannenwald of the Federal Reserve Bank of Boston, one-fifth to one-third is due to the loss of revenues caused by the higher capital gains tax rate.

Professors James Gwartney and Richard Stroup (1982) have ex­amined the changes in the distribution of the tax burden following the Mellon tax cut of the 1920s and the Kennedy tax cuts of the 1960s. In the case of the Mellon tax cuts, named after Treasury Secretary Andrew Mellon, marginal tax rates that reached 73 percent in 1921 were reduced to a top rate of 25 percent by 1926. The effect on the economy was positive: “The economy’s performance during the 1921-26 period was quite impressive. Price stability accompanied a rapid growth in real out­put.”

Gwartney and Stroup found the shift in the tax burden equally im­pressive. By 1926 personal income tax revenues from returns reporting $10,000 or less dropped to 4.6 percent of total collections, compared to 22.5 percent in 1921. In contrast total income tax revenues from returns by people with incomes of $100,000 or more rose to 50.9 percent in 1926 from 28.1 percent to 1921. They conclude that “as a result of the strong response of high-income taxpayers, the tax cuts of the 1920s actually shifted the tax burden to the higher income brackets even though the rate reductions were greatest in this area.”

Their analysis of the Kennedy tax rate reductions (which cut the top rate from 91 to 70 percent) yields similar results. In 1965, after the tax rate reductions, collections from the highest 5 percent of income earners rose to 38.5 percent of the total from 35.6 percent in 1963. In contrast, the proportion of income tax revenues from the bottom 50 percent of tax returns fell from 10.9 percent in 1963 to 9.5 percent in 1965.

In testimony before the Joint Economic Committee of Congress in 1984, Gwartney noted that the Economic Recovery Tax Act of 1981 (ER­TA) yielded similar results. The reduction of the top marginal tax rate from 70 to 50 percent cut the tax rates paid by high-income earners by as much as 28.6 percent, but tax revenues collected from the rich increased. Revenues from the top 1.36 percent of taxpayers, the group that most benefited from the rate reductions, rose from $58.0 billion in 1981 to $60.5 billion in 1982. The proportion of the total income tax collected from the top 1.36 percent of taxpayers rose to 21.8 percent in 1982 from20.4 percent in 1981.

The tax liability of low-income taxpayers fell both in absolute terms and as a percentage of the total. Taxes paid by the bottom 50 percent of income earners fell from $21.7 billion in 1981 to $19.5 billion 1982, and the share shrank from 7.6 percent in 1981 to 7.0 percent in 1982. Gwart­ ney concludes that:

“far from creating a windfall gain for the rich, as some have charged, ERTA actually shifted the burden of the income tax toward taxpayers in upper brackets, including those who received the largest rate reductions as the result of the 50 percent rate ceiling.”

This seems to be a general conclusion supported by the empirical evidence from marginal income tax rate reductions in the United States. A Joint Economic Committee staff study, “The Mellon and Kennedy Tax Cuts: A Review and Analysis” (1982), found that tax cuts in the 1920s and 1960s led to a rise in tax revenue, particularly from the rich. During the decade of the 1920s despite, or because of, the tax cuts, Treasury Secretary Mellon was able to pay off 36% of the national debt.

Effects on Employment and Effort

Massachusetts Institute of Technology economist Jerry Hausman has devoted much time and energy to studying the effect of taxes on work decisions. In a Brookings Institution study, Hausman (1981) reports the following:

“Although income and payroll taxes account for 75 percent of federal revenues, most economists have concluded that they cause little reduction in the supply of labor and do little harm to economic efficiency. The results of this study contradict that comforting view. Direct taxes on income and earnings significantly reduce labor supply and economic effi­ciency. Moreover, the replacement of the present tax structure by a rate structure that ­ proportionally taxes income above an exempt amount would eliminate nearly all of the distor­tion of labor supply and more than half of the economic waste caused by tax-induced distor­tions.”

In another study Hausman (1983) finds that, using 1975 data, labor supply was 8.2 percent lower than it would have been without federal in­come taxes, FICA taxes, and state income taxes. He notes in particular that:

“the effect of the progressiveness of the tax system is to cause high wage individuals to reduce their labor supply more from the no tax situation than do low tax individuals….Of course, this pattern of labor supply has an adverse effect on tax revenues because of the higher tax rates that high income individuals pay tax at.”

Measuring the effects on labor supply of the tax system and of a 10 and 30 percent reduction in marginal income tax rates, Hausman reports that a person earning a nominal wage of $3.15 an hour worked 4.5 per­ cent less than he would have in the absence of taxes. He would choose to work 0.4 and 1.3 percent more after 10 and 30 percent tax rate reduc­ tions. As income increases, the responses get larger. Taxes cause a per­son earning $10 an hour to reduce the number of hours worked by 12.8 percent. A 10 and 30 percent reduction would induce him to increase his work time by 1.47 and 4.6 percent, respectively.

Another interesting result of Hausman’s work is his calculation of the “dead-weight loss” incurred by the imposition of the progressive in­come tax system. He defines dead-weight loss as the amount an in­dividual would need to be given to be as well off after the tax, less the amount of tax revenues raised. Hausman found that there was an average dead-weight loss equivalent to 22.1 percent of tax revenue col­lected, which is income that is “lost” because of taxes. As income in­creases, so does dead-weight loss. A person earning $10 an hour, accord­ing to Hausman, has a dead-weight loss of 39.5 percent of tax revenue.

The impact of income maintenance programs on the work effect of low-income earners also clearly demonstrates the relative price effects of taxation explained by supply-side economists. The Seattle/Denver In­come Maintenance Experiments (SIME/DIME) were the fourth and most comprehensive of the experiments undertaken by the government in the 1960s and 1970s to examine the effects of a cash transfer program or negative income tax on low-income earners. People were given cash transfers of varying amounts, which guaranteed them incomes whether they worked or not. Their incomes were taxed so that when they began earning income above a certain level, the subsidy was gradually reduced to zero. The purpose of the study was to determine whether a cash transfer would be a more efficient way to transfer income to the poor than the variety of welfare programs already in existence.

The negative income tax lowers the relative price of leisure and, not surprisingly, the SIME/ DIME results, published in May 1983, show “a significant negative effect on hours worked per year.” Married males participating in the three-year cash transfer programs worked an average of 7.3 percent less than they would have in the absence of the negative income tax. Those who participated in the five-year program reduced their labor supply 13.6 percent, demonstrating that work disincentives rise with the permanence of income support programs. Wives and female heads of households showed a larger response to the cash transfer program.

When the cash transfer experiment ended, the report noted that labor supply increased:

“By the end of the first post-treatment year, labor supply for NIT-eligible husbands had again returned essentially to the same level as that for controls, indicating strongly both that the observed response was indeed a result of the treatment and that husbands can adjust their labor supply fairly rapidly to changed incentives.

Today in the U.S. no serious economist any longer denies the relative price effects of taxation. The arguments no longer dispute their existence but their precise magnitude. The supply­ side won, and the Keynesian emphasis that focused exclusively on the in­come effects of taxation has been superceded by a broader appreciation of fiscal policy.

IV. Implementation and Results of Supply-Side Economics in the United States

In August 1980 during the U.S. presidential campaign, the view of reputable economic forecasters was that tax revenues in succeeding years would be growing much faster than government expenditures, resulting in rapidly growing budget surpluses within three years. The Congressional Budget Office forecast a surplus of $37 billion in 1983, rising to $96 billion in 1984 and $175 billion in 1985. Reagan’s campaign ad­visers decided to take advantage of these surpluses and hook his presidential candidacy on the emerging supply-side movement in the Congress. These surpluses were calculated allowing for normal growth in government spending and a 40 percent increase in the defense budget during 1981-85 (Anderson, 1988).

The Republicans promised that instead of creating new government spending programs, they would return the money to the taxpayers by cutting tax rates. Despite the tax reductions, both revenues and expenditures would continue to grow absolutely, but the growth of both would be slowed and would decline as a share of GNP, reaching a goal of

19.3 percent of GNP in 1984 and a balanced budget.

In August 1981, President Ronald Reagan signed into law an across the board 25 percent cut in personal income tax rates to be phased in over three years with a provision to index the personal income tax in 1985 to prevent inflation from pushing taxpayers into higher tax brackets. In 1986, the President signed a tax reform bill further reducing personal in­come tax rates with a top statutory rate of 28 percent (33% for some up­per income ranges), down from 50 percent in the 1981 bill.

The 1981 bill also substantially reduced the taxation of business in­come. Tax rates were cut, and accelerated depreciation expanded business saving. In 1982 the Administration, panicked by the unexpected recession and large budget deficit, agreed to a tax increase that limited the benefits of accelerated depreciation and the investment tax credit. Despite the 1982 tax increase, depreciation was more rapid and business income was less heavily taxed than it was before the 1981 tax cut. In 1986 tax rates on business income were further reduced. However, the invest­ment tax credit was repealed, and depreciation periods were lengthened. The overall impact of the 1986 bill is yet to be calculated. The 1986 bill was motivated in part by an effort to reduce the tax distortions that influence the choice of investments. It ignored the more fundamental problem of the tax bias against saving that reduces the overall level of investment due to the multiple taxation of income from saving (Roberts, 1986a). Nevertheless, in the 1980s business saving is up sharply as a share of GNP.

Despite predictions of rampant inflation, the Reagan economy was more successful than anyone thought possible. The Reagan expansion has not experienced the worsening “Phillips curve” tradeoff between employment growth and inflation that led to President Carter’s in­famous declaration of “malaise”. Despite the longest peacetime expansion

on record and 17 million new jobs, there has been no rise in the in­flation rate.

It is instructive to compare the Reagan recovery to the previous recovery. In the 58-month period from March 1975 through January 1980 (the beginning and end of the expansion from the 1974 recession), the unemployment rate fell 27 percent, the consumer price index (CPI) rose 48 percent, and gross private domestic investment rose 50 percent (1982 dollars). In contrast, during the first 58-month period of the Reagan expansion, (from November 1982 through September 1987), the unemployment rate fell 45 percent (about twice as much), the CPI rose 17 percent (only one-third as much), and gross private domestic invest­ ment grew 77 percent (about 50% more).

The Reagan economy is remarkable in many other ways. It has pro­duced the highest manufacturing productivity growth in the postwar period, averaging 4.6% annually since the recovery began in 1982, com­pared with 2.3% in the 1970s, 2.7% in the 1960s, and 2% in the 1950s. Since the Reagan recovery began, per capita real disposable personal in­come has grown 2.6% annually, compared with 1.8% in the 1970s, 3% in the 1960s, and 1.5% in the 1950s.

Moreover, the evidence shows that the tax burden has shifted up­ward in the Reagan years. The latest Treasury Department data show that between 1981 and 1986 the share of federal income taxes paid by the richest 1 percent rose from 18.1 to 26.1 percent — a 44 percent increase — while the share of taxes paid by the bottom 50 percent fell from 7.5 to 6.4 percent.

The Twin Deficits

Despite these successes, supply-side economics has been given a bad name as a result of the budget and trade deficits. Supply-side’s critics have blamed the deficits and the crisis of the day (the strong dollar, the weak dollar, the October 1987 stock market crash, the trade deficit, deb­tor nation status) on the 1981 tax rate reduction. Inevitably, they ad­vocate an increase in taxes as a panacea.

The administration’s embarrassment over the deficit was com­pounded by its delay in explaining the deficit. This failure resulted from an act of political opportunism and allowed the President’s critics to control the explanation of his policy for almost three quarters of a decade.

An objective account of the “twin deficits” must include the role of monetary policy. In early 1981, the Reagan administration asked the Federal Reserve to gradually reduce the growth rate of the money supply by 50 percent over a period of four to six years. Instead, while warning of future inflation from the tax cuts, the Fed collapsed the growth of the money supply and delivered 75 percent of this reduction in 1981. By 1982 inflation was at the low rate the Administration had predicted for 1986.

The result was the most severe recession in the postwar era and a totally unexpected collapse in the growth of nominal GNP . During 1981-86, nominal GNP was $2.5 trillion less than forecast (Roberts, 1987). The loss of revenues from this collapse of the tax base had not been an­ticipated, and the result was large budget deficits. Only in February 1988, did the Budget of the U.S. Government for Fiscal Year 1989 finally acknowledge that the large budget deficits that have plagued Reagan had originated in the “1981-82 economic downturn and the concomi­tant decline in the inflation rate.”

In early 1982, however, the Administration decided to take credit for the rapid fall in the inflation rate despite the fact that its economic and budget plans had predicted no such result. This attempt to claim credit prevented the Administration from holding the Federal Reserve responsible for wrecking the budget and left the White House with “triple-digit” deficits hanging around Mr. Reagan’s neck. The Ad­ministration never recovered from this public relations fiasco.

In October 1987 the Treasury Department study, “Accounting for the Deficit,” belatedly documented that “the business cycle and com­pounding high interest rates – not changes in tax structure or program­matic spending – are the major causes of the major 1982-83 jump in the federal deficit.”

The Treasury study breaks the deficit down into its three com­ponents: structural, cyclical and net interest, which is net of the taxes the government collects on the interest it pays. The structural deficit, the gap between expenditures and receipts at full employment, is the smallest component. Only during 1984-86 did the federal structural deficit ap­proach the levels it frequently reached during the 1966-76 period. On a general government basis, which includes state and local budgets, the budget has been in structural surplus almost continually since 1977. This empirically refutes the propaganda that the tax cuts caused a structural deficit.

In contrast, the cyclical and net-interest components of the deficit are large. Beginning in 1980 the Federal Reserve’s high-interest-rate policy and the large cyclical deficits from the recession greatly increased the net interest component. By 1987 net interest accounted for two­ thirds of the federal deficit.

Critics have charged that these high interest rates were caused by the budget deficits. The truth is that high interest rates preceded the large deficits. An inverted-yield curve, with short-term rates above long-term rates, characterized the economy in 1979, 1980, and 1981. The inverted­ yield curve is an unmistakable sign that high interest rates were caused by stringent monetary policy. The federal-funds rate, an overnight rate set by the Fed, was higher than the interest rate on long-term triple-A cor­porate bonds from October 1978 to May 1980, from October 1980 to Oc­tober 1981, and from March 1982 to June 1982. In April 1980 the federal­ funds rate exceeded the corporate bond rate by 5.57 percentage points and in December 1980 by 5.69 percentage points. In January 1981, when Mr. Reagan was inaugurated as President, the gap peaked at 6.27 percentage points. Overall, interest rates peaked in 1981 with the budget deficit unchanged from its previous year’s level. The budget deficit peaked in 1986 at three times the size of the 1981 deficit, with the federal funds rate only one-third as high as it was in 1981.

The President and some of his supporters have attributed the budget deficit and debt buildup to Congress’ refusal to abide by its own budget rules. Few have been convinced. Although Congress has set aside the Budget Control Act of 1974 and discarded the budgets submitted by the Reagan Administration, congressional overspending does not add up to the amount of the cumulative deficit.

Early in 1982, the White House decided to put the tax cuts at risk in order to protect the Federal Reserve’s unexpectedly tough anti-inflation policy. Despite its supply-side tone, the administration could not bring itself to discard the Phillips curve inverse relationship between unemployment and inflation. It was an