SUPPLY SIDE ECONOMICS IS NONSENSE

The following commentary by Michael Meeropol was broadcast over WAMC radio on Friday, May 3, 2007

WHAT IS “SUPPLY SIDE ECONOMICS?”

The debate over the tax cuts that President Bush convinced Congress to pass in 2001, 2002 and 2003 has often centered around the fairness of those cuts[1]. Why do most of the benefits of the cuts accrue to the richest people in the country?

There is an answer and it goes to the heart of one of the great debates in the field of economics, – the debate about so-called supply side tax cuts.[2]

Just last month, Bruce Bartlett, former Reagan Administration economist, published an OP ED piece in the New York Times in which he baldly asserted that history has vindicated the main tenets of Supply-Side Economics.[3] That approach is summarized by Bartlett as follows: " … incentives matter, … high tax rates are bad for growth.”

What he means by this is that raising revenue using a graduated income tax, with rates on high income tax-payers of 70% or 50% will so damage incentives that these individuals will refrain from saving and from investing. The rest of us will suffer from a sluggishly growing economy or, worse, lose our jobs.[4]

Thus, supply siders argue that the way to increase economic growth is to cut income tax rates, especially on high income individuals. That’s why the Bush Administration has supported the abolition of the Estate Tax and the tax on Dividend income received by individuals (not pension funds – those are already tax exempt).

These reduced tax rates will supposedly stimulate economic activity on the part of investors and make more investment funds available to start-up businesses. The alternative approach to stimulating the economy comes from the work of the British economist Keynes. In his major work, written during the Great Depression, Keynes argued that when the economy is growing sluggishly, the appropriate response is to use government fiscal policy (tax cuts or spending increases – both would work) and/or monetary policy (lower interest rates) to stimulate total spending.[5]

Bartlett both caricatures Keynesian economics and blames it for the stagflation of the 1970s.[6] He argues that the supply siders have the right policy prescriptions for the economy as evidenced by the economic successes of the Reagan Administration.[7]

But he does not tell us the actual predictions made by the supply siders in 1981 when the Reagan Administration passed a three year tax cut.

Those predictions were that the cut in individual income tax rates would, 1) stimulate individual activity which would, over time, raise income tax revenue; 2) stimulate a higher rate of personal savings, and 3) reduce the budget deficit over time.[8]

I won’t bore you with numbers but none of these predictions came true. 1983 was the year the full tax cut was phased in and it was also the end of the 1981-82 recession. 1983-1989 were years of recovery. But even by 1989, following those years of recovery, income tax revenue was still a lower percentage of GDP than in 1983. Personal savings fell below 6% of GDP by 1989 – it had been above 6% -- 6.6% of GDP -- in 1983. Finally the Federal Deficit as a percentage of GDP was no lower in 1989 than it had been in 1980 before Reagan was elected – it had ballooned for most of the 1980s. Economic growth and business investment were higher on average in the decades before 1981 and after 1989 even though income tax rates were higher than during 1981-1989.[9]

Meanwhile, the Bush Administration has utilized massive tax cuts and budget deficits to recover from the 2001 recession and the economy still isn’t growing as fast as it did in the late 1990s when the top income tax rates were significantly higher than they are now.

Far from being vindicated, supply side economics has flunked the main test – the test of historical experience.

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[1] See, for example, Robert Pollin, Contours of Descent (NY: Verso, 2003): 94-102.

[2] For a short introduction see Surrender: 46-48.

[3] Bruce Bartlett, “How Supply Side Economics Trickled Down” New York Times, 6 April, 2007.

[4] For more details on supply side economics, see Jude Wanniski “The Mundell-Laffer Hypothesis,” Public Interest 39 (spring 1975): 31-57.

[5] Keynes’ work is The General Theory of Employment Interest and Money (London 1935). Virtually all Principles of Economics textbooks have presentations of what they claim are Keynesian economics, but unfortunately these often depart from Keynes’ own approach. A good intermediate level treatment is in Macroeconomics (James Galbraith and William Darity, Jr.): 9—17, 25—40, 84—130.

[6] Here is Bartlett’s caricature: “Among the beliefs held by the Keynesians of that era were these: budget deficits stimulate economic growth; the means by which the government raises revenue is essentially irrelevant economically; government spending and tax cuts affect the economy in exactly the same way through their impact on aggregate spending; personal savings is bad for economic growth; monetary policy is impotent; and inflation is caused by low unemployment, among other things.” I will comment on each assertion one at a time:

1) “Budget deficits stimulate economic growth.” Traditional Keynesian theory argues that when the economy is producing below its capacity, any boost to total spending (whether from budget deficits, increases in consumption, increases in investment or increases in exports) will raise total income by putting previously unemployed resources – people and factories and farms – to work. This was proven in 1935 when the Germans built the Autobahns putting many unemployed workers to work and giving them incomes to spend putting still other people to work. (This illustrated the principle of the multiplier which is at the heart of Keynesian economics. For one example, see Campbell McConnell and Stanley Brue Macroeconomics (17^th edition): 158-162. The original multiplier effect was introduced into economic theory in 1931. See R. F. Kahn, “The Relation of Home Investment to Unemployment,” Economic Journal (1931): 173-93.) Keynesians, however, have always argued that if the economy is utilizing its labor force and capital stock fully – in other words if we are at “full”employment – then any increase in aggregate spending (including as a result of budget deficits) will not increase economic growth but merely accelerate inflation. Keynesians, therefore, argued in 1967 that it was essential to raise taxes in order to reduce inflationary pressure because the US economy had driven the rate of unemployment down to 3.8% (below the target of 4% which was judged to be “full”employment at that time).

2) “The means by which government raises money is essentially irrelevant economically” and “Government spending and tax cuts affect the economy in exactly the same way through their impact on aggregate spending” actually are making the same point. Bartlett wants to highlight the fact that because Keynesians focus on aggregate spending, they ignore the incentive effects of the TYPES of taxes imposed on individuals and businesses to raise funds for government spending. Bartlett and other supply siders want to argue that you can raise income by stimulating more effort, savings, investment and innovation and that will produce more rapid economic growth than when you stimulate output by increasing spending. The main way to stimulate more effort, etc. is to cut the marginal tax rate on income. It is true that Keynesians believe that the surefire way to increase output when the economy is producing short of potential is to increase spending. It is also true that Keynesians have believed that the incentive effects of different kind of taxes are probably relatively small. (The period of very rapid growth for the US economy in the post World War II period featured very high marginal tax rates – the period of much lower marginal tax rates featured slower economic growth. For details see Surrender: 150-168.) However, Bartlett’s extreme statement would probably not be supported by any Keynesian today.

3) “Personal savings is bad for economic growth,” is one of the worst caricatures of Bartlett’s article. This actually refers to a specific problem that Keynes recognized that has come to be called the “paradox of thrift [or savings].” This concept is considered so archaic that current editions of Principles of Macro textbooks fail to refer to it. (For a reference see O. Blanchard, Macroeconomics, 4^th Ed. (Upper Saddle River, NJ: Pearson Prentice Hall, 2006]: 60. It is a very simple statement. If the rate of personal savings goes up and private investment does not go up to match that increase in personal savings, then because consumption falls when savings rises the resulting decline in spending will, indeed be “bad for economic growth.” Of course if investment goes up to match the increase in savings, then savings are NOT “bad for economic growth.” Any textbook in Principles of Economics from previous years when the paradox of thrift/savings was regularly taught would have this presentation. For Bartlett to write it the way he did is fraudulent. The real issue between supply siders and Keynesians is which way does causation go? Do decisions to raise savings create more investment (some supply siders are explicit that this happens) because the rise in savings lowers interest rates which stimulate investment? OR, as Keynesians would argue, do decisions to raise investment create more savings because the rise in investment raises incomes via the multiplier and thus increases savings?

4) “Monetary policy is impotent,” was the original view of some Keynesians during the 1940s and 50s. They looked at the experience of the Great Depression when interest rates were below 1% and decided that as a depression fighting tool, monetary policy was likely to be ineffective. The Central Bank could lower interest rates but couldn’t force businesses to borrow and invest. (There was a saying to describe this: “You can lead a horse to water, but you can’t make it drink.”). In the context of the post World War II period, Keynesians all agreed that manipulation of interest rates was an important component of any coherent policy to stimulate economic growth, reduce unemployment and restrain inflation. Actually, it is the right-wing MONETARIST economists who argued that discretionary changes in monetary policy by the Central Bank would be ineffective – and thus they recommended taking discretion away from the Central Bank and forcing it to raise the supply of money a fixed amount every quarter no matter what. (For details see Surrender: 42-3 and the footnote references). Again, Bartlett is incorrectly characterizing the position of Keynesian economists.

5) Finally, Bartlett argues that Keynesians believed that “Inflation is caused by low unemployment.” Actually, Keynesians believed that inflation occurs when there is an attempt to increase total spending when unemployment is very low (at the “full” employment level). Thus, they recommended wage and price controls during World War II, high taxes during the Korean War, and a tax increase to finance the Vietnam War after 1967. Keynesians also acknowledged, however, that there was such a thing as “cost-push” inflation that could occur even when unemployment was well below the full employment level. For a very Keynesian interpretation of the combination of cost-push inflation and unacceptably high unemployment (called “stagflation”) in the 1970s, see Alan Blinder Economic Policy and the Great Stagflation (NY: Academic Press, 1979). See also, Surrender: 51-57. Once again, Bartlett unfairly caricatures Keynesian analysis.

Blaming Keynesian economists for the stagflation of the 1970s is partially correct. Since Keynesian economics’ tool for dealing with the economy is to raise or lower spending, it is incapable of combating both inflation and unemployment at the same time. That is why President Richard Nixon imposed wage and price controls in 1971 and why President Gerald Ford flip-flopped from recommending a tax increase to fight inflation in the Fall of 1974 and a tax cut to fight recession in the Winter of 1975. But Keynesian economics didn’t cause the problem – it just had no way to simultaneously solve both parts of that problem.

[7] And what were those correct policies? Here is Bartlett again: “Based on insights derived from the Nobel-winning economists Robert Mundell, Milton Friedman, James Buchanan and Friedrich Hayek, the supply-siders developed a new program based on tight money to stop inflation and cuts in marginal tax rates to stimulate growth.” What he left out was the fact that it took a fifteen month recession associated with the tight money policies to “stop inflation” between August of 1981 and January of 1983. Though inflation was already below 4% in 1982, unemployment stayed above 9% through 1983. Supposedly, the tax cuts were supposed to usher in an era of explosive growth but in fact, though the tax cuts finally ended the recession (with help from rising government spending as well), the unemployment rate did not fall below 6% till 1988 and the average rate of growth of the economy from the bottom of the recession in 1983 to the end of the recovery in 1990 was lower than in the recovery between 1974 and 1980 – during the “bad old days” when according to Bartlett, Keynesian economic policy had caused stagflation. In other words, Barlett’s assertion is flatly wrong. The policies did not cure stagflation. First they made the economy worse in order to cure the inflation (any depression or prolonged recession will do that) and then they did not permit the economy to grow very fast during the recovery in order to keep inflation “tamed” and thus, unemployment stayed quite high and growth, as a result, was relatively slow.

[8] This is the theory of supply side economics. Bartlett attempts to fudge the issue by presenting his version of the conclusions of supply side economics: " … incentives matter, … high tax rates are bad for growth, and … inflation is fundamentally a monetary phenomenon.” On the first point, the question is – how much do incentives matter? The evidence from the 1980s indicates – not so much. On the second point, the comparative data for the various ups and downs of the economy between 1960 and 2000 indicates how much this assertion has been disproven by historica. experience. Finally, the last point is either a meaningless tautology or false. Inflation occurs as a result of a variety of causes. Once inflation begins, monetary growth occurs with it. In other words, there is a correlation. The argument between monetarists and Keynesians is about the direction of causation.

[9] In response to the Bartlett OP-ED piece, I submitted the following letter to the Editor of the NY Times. It was not published. I include it here with the references to the data on the bottom:

The predictions of supply side economics were that a cut in marginal individual income tax rates would 1) stimulate individual activity causing an increase in individual income tax revenue over time, 2) stimulate a higher rate of personal savings, and 3) reduce the federal
budget deficit over time.

The following table shows none of these came true. 1982 was the first year the tax reductions were felt. 1983 was the year the full tax cut had been phased in. 1983-1989 were the years of recovery from the recession. Where is the increased savings? Where is the increased
government revenue from the income tax? The budget deficit finally comes down but in 1989 it is no lower than it was in 1980 (it was 2.7% of GDP then).

Year Individual In- Personal Sav- Federal Deficit

come taxes as ings as a per- as a percen-

a percentage centage of tage of GDP

of GDP GDP

1982 9.5 8.3 4.0

1983 8.9 6.6 6.0

1984 7.6 8.0 4.8

1985 7.9 6.6 5.1

1986 7.8 6.0 5.0

1987 8.3 5.1 3.2

1988 7.9 5.3 3.1

1989 8.1 5.2 2.8

Sincerely,

Michael Meeropol

Every number in the table is from the ECONOMIC REPORT OF THE

PRESIDENT, 2004. GDP from p. 284. Federal Income Tax receipts from p.

379, Personal Savings from p. 320, the Federal Budget Deficit as a

percentage of GDP from p. 378.