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Hal Snarr: Supply-side or Something-d-o-o Economics? Anyone?

March 17, 2017


The way that macroeconomics is politically applied today produces a rift that separates it into demand-siders and supply-siders. Demand-siders advocate for temporary changes like tax cuts, higher government expenditures, and lower interest rates to stimulate aggregate demand when the economy is in a high-unemployment rut. The former pair of policies, however, produce budget deficits. To pay them off, demand-side economics proposes temporary changes in fiscal policy like higher tax rates or cuts in government expenditures. Although these policies pay down deficits, they are politically unpopular and have little chance of being enacted. Oddly, this is not the case with temporary interest rates hikes by the demand-siders at the Fed. In fact, most expect it since overstimulated aggregated demand needs to be pushed back down to head off the inflation that economic stimulus creates.

Supply-siders, like Robert Mundell and Art Laffer, focus on stimulating aggregate supply by setting marginal tax rates low and reducing government regulations. These policies reduce the costs of production and regulation compliance. The increase in the supply of goods and services that results lowers prices, which puts more money in the pockets of consumers. The increase in product supply also raises the demand for labor. More people working results in greater product demand. In total, as economic activity swells, tax receipts rise at lower tax rates.

The Laffer curve is the relationship between a tax rate and the revenue it generates. It is a core principle of supply-side economics. It got its name during a 1974 dinner attended by Jude Wanniski, Art Laffer, Donald Rumsfeld, and Dick Cheney. Although a 14th-century Muslim philosopher, Ibn Khaldun, discussed the relationship in The Muqaddimah, Wanniski dubbed it the Laffer curve after Laffer drew it on a napkin to show why President Ford’s tax increase would not raise tax revenue. (For the complete story, go to LafferCenter.com.)

The Laffer curve was the topic of discussion in Ferris’ economics class while he was ditching high school in the classic 1986 movie, Ferris Bueller’s Day Off. According to Ferris’ Economics Teacher, played brilliantly by Ben Stein, the Laffer curve explains why the Hawley-Smoot Tariff Act of 1930 did not work as intended:

In 1930, the Republican-controlled House of Representatives, in an effort to alleviate the effects of the… Anyone? Anyone?… the Great Depression, passed the… Anyone? Anyone? The tariff bill? The Hawley-Smoot Tariff Act? Which, anyone? Raised or lowered?… raised tariffs, in an effort to collect more revenue for the federal government. Did it work? Anyone? Anyone know the effects? It did not work…

The Laffer curve indicated by the arrow in the above picture suggests that tax receipts max out at the green dot. Tax revenue is zero at the red dot because a 100% tax rate drives all economic activity underground. Tax revenue is zero at the yellow dot since the tax rate is 0%. Raising the tax rate along the curve from the yellow dot to the green dot raises tax receipts as it reduces legitimate economic activity. Raising the tax rate from the green dot to the red dot reduces tax receipts because it drives increasingly more economic activity underground.

The Laffer curve does not imply what the “optimal tax” rate is for a given year. In the figure below, tax receipts peak at a 20% tax rate on the red Laffer curve, but at 50% and 80% on the black and blue Laffer curves. These curves simply say that tax receipts rise when the tax rate is raised from a very low level or is lowered from a very high level.

The Laffer curve also suggests there is a limit to the amount of money that government can seize from the public via taxation. Thus, elected officials interested in balancing the fiscal budget can only spend up to the tax revenue that the optimal tax rate generates. At any other tax rate, a budget deficit occurs.

The figure above can also be used to demonstrate how the optimal tax rate for a given country evolves over time. If people and capital are free to move across borders, the tax rates in other nations will affect a country’s optimal tax rate. Suppose all governments had their tax rates set at 80% at one point. If all but the government of nation A reduced their tax rates to 50%, and then to 20%, firms and citizens in nation A will eventually move to other countries to avoid paying an 80% tax rate. This implies that a country’s optimal tax rate can fall as other nations reduce their tax rates.

A temporary reduction in the tax rate has no effect on an economy’s long-run productive capacity. However, since it temporarily reduces production costs and raises disposable incomes, aggregate demand and short run aggregate supply shift outward. With long run aggregate supply unchanged, the economy ends up in an inflationary gap, the situation where unemployment is below its natural rate. Since this creates a bidding war for labor, aggregate supply falls back before the tax-rate cuts sunset. Aggregate demand retreats after the tax-rate cuts sunset.

For supply-side economics to work, low tax rates must be permanent. This is so because it creates certainty, which is important to firms as they adjust their long run plans. Instead of moving operations overseas, they expand domestically. This shifts long run and short run aggregate supply outward at a pace higher than what would have prevailed otherwise. Aggregate demand increases too after the lower tax rate boosts disposable incomes. In theory, supply-side economic policy results in no inflation over the long run and ever-expanding GDP. In practice, however, low tax rates are never permanent since Congress cannot bind future Congresses to the policies it enacts.

The above suggests that it is difficult to evaluate supply-side economics. The curve below is a crude estimate of the U.S. Laffer curve. The horizontal axis is the top marginal income tax rate (from TaxPolicyCenter.org). The vertical axis is real per capita tax revenue. It equals individual income tax receipts (from Table 2.1 of the OMB’s Historical Tables) divided by population and by the GDP Implicit Price Deflator. Since real per-capita tax receipts are in log-scale, the red line in the graph implies that per-capita tax revenue falls by 1.8% if the top marginal tax rate is raised from 39.6% to 40.6%. With 2015 income tax receipts of $1.5 trillion, or $4,785 for each of the 322 million Americans, this estimate implies that a 1-point increase in the top marginal tax rate will lower annual federal income tax receipts by $28 billion.

The graph on the left in the figure below supports the Laffer effect. After accounting for the effects of the 2001 and 2009 recessions, the trends in this graph show that people in the upper half of the income distribution generally paid an increasingly greater share of all income taxes collected as the top marginal tax rate was lowered to 39.1% in 2001, 38.6% in 2002, and 35% in 2003.

The graph above on the right shows the relationship between the growth rates in real GDP and federal tax receipts. The red line in this graph implies that each percentage point increase in economic growth increases the growth rate of tax receipts by 1.8 percentage points. This suggests that pro-growth policies push the Laffer curve upward. Thus, those who advocate for a large welfare state should perhaps become supply-siders or embrace their pro-growth policies.

Supply-side economics has its critics. Does it even exist if Congress cannot bind future Congresses to a low tax rate that it enacts? Austrian Economics regards it with the same esteem as it regards monetarism. Monetarists legitimized the Fed when they concluded that it was here to stay. Supply-siders legitimize expenditures on welfare and warfare programs and theft via income taxation when it supports the tax rate that maximizes tax receipts. When these pragmatists accepted a little government intervention, they left open the door to the creeping tyranny of the State that Murray Rothbard warns of in chapter 12 of his 1962 book, Man, Economy, and State.

The solution to the new normal, anemic economic and wage growth, that mainstream economics seems to be embracing is not more demand-side or supply-side tinkering. The solution is a restoration of the economic and personal liberty that we once cherished. In our heart of hearts, we know this to be true. The long run evidence is everywhere. Prices fall and quality rises in markets that are relatively free of government ownership, management, or subsidization. Prices rise, quality stagnates, or moral hazard is rampant in enterprises owned, regulated, managed, or subsidized by government.

 

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