Supply-Side Suspicions

©2003 by Dale Franks

Arnold Kling recently argued in a TCS article that devotees of Supply-Side economics are weakening the conservative position on the size of government. Supply-Siders are now arguing that tax cuts can be sustained without worrying about revenue effects, or the possibility of increasing interest rates due to financing Federal budget deficits. This is indeed, a change to the Supply-Side argument, and it might be worth looking into the reliability of Supply-Side arguments in general, in order to try and gauge how trustworthy such an argument is.

Economist Art Laffer, as the story goes, supplied one of the key arguments for Supply-Side tax cuts by drawing a simple curve on a napkin to explain the relationship between tax cuts and Federal revenues. Jude Wanninski popularized the "Laffer Curve" (a slightly more complicated version of which is shown below) in his influential book, "How the World Works". Simply put, the Laffer Curve postulates that there are two tax rates at which the government receives the same amount of revenue.

If the government has a tax rate of 0%, then the government receives no revenue, because no one is taxed. By the same token, a tax rate of 100% produces no revenue, since all economic activity stops. Hence, both a 0% and 100% tax rate produce the same revenue.

There is, at some point on the Laffer Curve, an "Equilibrium Point". This is the tax rate at which government revenues are maximized. From the Equilibrium Point, tax revenues will fall when tax rates are either raised or lowered.

Notice, though, that the Laffer Curve contains only the most generally defined data points. What is the tax rate at which the equilibrium point is reached? What is the tax rate at Points A or B? The Laffer Curve doesn't tell us.

Indeed, we don't even have any real idea what the equilibrium point is, except to note that it is the highest rate at which the population consents to be taxed. During a major war, the citizenry might be satisfied with the equilibrium point moved quite far to the right, willingly paying high taxes in order to contribute to their national survival. In an era of peace and plenty, the equilibrium point might shift farther to the left.

Now, there isn't an economist in the world who doesn't believe that something very much like the Laffer Curve exists. Nor are there too many economists who won't admit that confiscatory tax rates severely hinder economic growth. But knowing those things apparently don't help us much when it comes to the specifics of tax policy and revenue growth.

As a general proposition, of course, tax cuts are a good thing. Individuals deserve to be taxed as lightly as possible, because they deserve the right to enjoy the fruits of their labor, and not have it confiscated by the government. This is a first principle based in the ideal of individual liberty. Tax cuts also promote economic growth, as people are free to spend more of their money on the goods and services they desire.

But the Supply-Siders' argument went farther than that. They proposed that tax cuts would cause such a large measure of economic growth that revenue for the government would increase substantially. In the 1970's and early 1980s, with the high marginal tax rates at the time, and high inflation pushing people into higher tax brackets even though their real income was unchanged, it seemed to be a fairly reasonable argument to say that we were at Point B on the Laffer Curve. Almost any tax relief, it was argued, would move us to the left of the curve, and bring us closer to the equilibrium point. While some short-term deficits might result, the Supply-Siders argued, increased revenues would eliminate them in a fairly short time. On this basis, the Reagan tax cuts were implemented.

The end result was that during the Reagan Years (1981-1988) Federal Government receipts increased by only 14.9% (when measured in constant 1996 Dollars to account for inflation). Compare this with the 27.3% revenue growth from 1973-1980, or the 19.8% revenue growth of 1989-1996. Deficits, meanwhile, skyrocketed.

In 1994, I talked weekly on my radio program with Paul Craig Roberts, who was a Deputy Undersecretary of the Treasury in the Reagan administration, and a staunch supply-sider. (TCS Enviro-Sci host Sallie Baliunas was also an occasional guest, although not about tax policy.) During this time, while the Clinton Administration pushed for and obtained its tax increases, Roberts would assure me regularly about the dire consequences to come for the economy. Higher taxes, he argued, would stop economic growth, and lead us back into recession.

Instead, between 1993 and 2000, Federal receipts rose from $1.23 trillion to $1.88 trillion, an increase of 52.3%. There are, it seems, many things other than marginal tax rates that matter when it comes to economic growth.

Between 1981 and 1983 the nation was mired in horrible back-to-back recessions, with double-digit unemployment as the Fed squeezed interest rates higher and higher to combat the inflationary trends of the 1970s. Federal receipts actually declined by 10.6% during those years.

In the 1990s, the information revolution and the huge increases in productivity it engendered more than compensated for any effect the Clinton tax policies might have had. Indeed, while it is true that revenues for the Federal Government grew by 28.4% from 1983-1988, following the recessions of the early 80s, that performance is worse than any six-year period of the Clinton administration. Indeed, in the six years after the Clinton tax increases, revenue grew by 36%. Supply-Siders are fond of blaming the tax increases of President George H.W. Bush for the 1991 recession, but have more difficulty explaining why the Clinton tax increases didn't have the same effect.

Moreover, with marginal tax rates at their current relatively low levels, the Supply-Siders have even more difficulty making the argument that we are still substantially on the right side of the Laffer Curve. If current marginal tax rates are close to the equilibrium point, then further tax reductions move us closer to Point A on the curve, which means revenues will drop, rather than rise. Hence, a real danger exists that further tax cuts will contribute substantially to higher deficits. The "revenue increase" argument is essentially closed off for them; therefore, they are left with the rather paradoxical arguments that government deficits can put downward pressure on government spending, while at the same time assuring us that such deficits will not increase interest rates.

Supply-Side theory does real damage to the conservative arguments for limiting the size and scope of government. If lower taxes lead to higher revenues, then what restrains the government from simply growing larger in order to take advantage of increased revenues? If increasing deficits do not put long-term pressure on higher interest rates, then what stops the government from simply spending more money, secure in the knowledge that the price of borrowing won't increase? How does either of these propositions put downward pressure on government spending? These arguments amount to little more than declaring that there is a free lunch.

The Supply-Siders were wrong when they overestimated the revenue increases of the Reagan tax cuts. They were wrong when they predicted a range of hideous negative effects from the Clinton tax increases. Perhaps we would do well to be a bit skeptical when they assure us that continuing, long-term deficits will be harmless.

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