Taking a Walk on the Supply Side

With the advent of Barack Obama's administration and a Congress with strong Democratic majorities, it would be reasonable to assume that the school of thought known as supply-side economics would be so out of favor that it wouldn't even bear mentioning. So it was interesting to see Nobel Prize–winning economist Paul Krugman open a column in the New York Times in late January this way:

"Old-fashioned voodoo economics--the belief in tax-cut magic--has been banished from civilized discourse. The supply-side cult has shrunk to the point that it contains only cranks, charlatans, and Republicans."

Well. Krugman's assertion was odd for a couple of reasons. First, the article wasn't even about tax cuts (it was about bank bailouts). Moreover, the timing was peculiar. The Obama administration had very recently brought on board an economist, Christina Romer, who has done some significant empirical work on the effects of tax changes, including supply-side effects. And her work shows, if any work can, the magical effects of changes in the tax code.

Romer had taken steps toward solving a puzzle that had long vexed economists: how does one determine the effects of tax changes on the economy when those changes are often made in response to changing economic and policy conditions? Teasing out the effect of the tax change signal from all the other noise (including monetary policy changes, oil price shocks, and so forth) is exceedingly difficult. But Romer and her economist husband, David Romer, have advanced knowledge of tax change effects in a way previous economists had not.

Arthur Laffer, Stephen Moore, and Peter Tanous point out in their book, The End of Prosperity: How Higher Taxes Will Doom the Economy--If We Let It Happen, how the Romers "found that 'tax increases are highly contractionary. The effects are strongly significant, highly robust, and much larger than those obtained [in earlier studies]. The large effect stems in considerable part from a powerful negative effect [from tax increases] on investment.' "

The Romers claim a tax increase of one percent of GDP yields a sizable decline in output of 3 percent of GDP. Their findings on how taxes influence investment--their supply-side effects--are startling: "The strong response of investment helps to explain why the output consequences of tax changes are so large."

The timing of this book's publication is peerless. For starters, there is a good deal of confusion lately about the tax issue, particularly on the political right, the traditional home of antitax sentiment. What's more, the tax issue is likely going to take on growing political importance, and soon, as the bill for entitlement obligations comes due on top of the massive spending currently under way in Washington. Let's take these two issues in turn.

If the tax cut issue has less resonance than it once did, this is not a reason to abandon everything that has been learned about the importance of tax rates to growth over the last two generations.

The argument swirling in some circles on the political right goes something like this: Tax rates have already been cut so much that they can't be cut much further. What's more, the tax issue has lost political punch--after all, President Obama ran successfully on a platform that included tax increases. Conservatives and Republicans need to de-emphasize the tax issue if they want to win votes from smart coastal elites and the middle class. Indeed, it's possible Republicans will need to propose tax increases themselves to demonstrate their serious commitment to fiscal sanity if they want to get elected down the road.

Weighing the merit of these arguments requires us to take stock of the relevant recent history on taxes and on broader supply-side policy initiatives, which this book does in stimulating detail.

Set the wayback machine to the late 1970s. The country was mired in stagflation--high inflation and unemployment. The top marginal tax rate was 70 percent. Mortgage rates were over 20 percent. Energy prices were ballooning while, between 1978 and 1981, real middle-class income levels fell. Reagan offered a road map out of the morass the country was in. He put growth and entrepreneurship at the center of his political vision. In Reagan's telling, the individual risk-taker, rather than the government, was the primary agent of economic change that advanced human welfare. According to this view, which seemed radical to many at the time, government-generated limits on individual initiative and growth were responsible for the problems the nation faced. A better tomorrow was possible given a series of daring policy moves: removing harmful regulations, licking inflation and strengthening the dollar, freeing and expanding trade, and unleashing entrepreneur-led growth via tax cuts. This was the supply-side vision.

These steps proved economically and politically potent. The Reagan years marked the beginning of "the greatest period of wealth creation in the history of the planet." During the bull market beginning in 1982 and extending to 2000, "stocks soared by 12 percent per year, raising the net worth of U.S. households by some $30 trillion" while the size of the economic pie ballooned. "In the twenty-five year boom launched by the Reagan policies," the authors note, "the average annual growth rate of real gross domestic product (GDP) was 3.4 percent per year. In Europe the growth rate…was only a bit over 2.0 percent. By the end of the Reagan years, the American economy was almost one-third larger than it was when the 1980s began."

New firms and industries were born as the American economy was reborn. As economists Carl Schramm and Bob Litan have pointed out, the era of big-firm capitalism, and its cozy relationship with big government, was ushered out and entrepreneurial capitalism built on knowledge industries was ushered in.

And it wasn't just the United States. The supply-side vision swept the globe, finding adherents to the gospel of tax cuts from the Far East to Eastern Europe. Sweden has eliminated its estate tax. Germany has slashed corporate tax rates. France has flirted with "offering employees new tax incentives to earn more money by working longer hours." This is a remarkable history of successful policy and politics. Coupled with the empirical work of the Romers and others demonstrating the harmful effects of high taxes to investment and growth, a heavy burden should rest on those hoping to raise taxes or to de-emphasize the importance of low tax rates to high economic performance. If the tax cut issue has less resonance than it once did, or has lost some of its power as a vote-getter, this is not a reason to abandon everything that has been learned about the importance of tax rates to growth over the last two generations.

It is true that in Washington these days, the talk is now of "higher income taxes, capital gains taxes, payroll taxes, energy taxes and hedge fund taxes." The financial crisis that began in 2007 and has morphed into a broader economic crisis now has advocates of free markets and supply-side policies on the defensive.

"In assessing the health of the American economy," the authors write, "we're worried about where the puck is going. So, evidently, are the shrewd and successful investors who make their money anticipating seismic economic and political changes--the tipping points--and reacting before the herd. All over the globe, capitalists are looking ahead at where the United States is headed, and for the first time in more than a generation, they don't like what they are seeing. What they are anticipating is the torrent of bearish policy mistakes that we wrote this book to warn about."

The storm clouds include protectionist trade measures, increased taxes on capital, a swelling deficit, cap-and-trade regulations on greenhouse gases, greater government intervention in health care, a resurgent labor movement, and a weak dollar. Most worrisome of all is the rise of what my colleague Christopher DeMuth calls "fusion enterprise," a phenomenon in which we witness "the intermingling of politics and power with finance and commerce, going beyond government regulation to the government as direct owner and market participant." Laffer, Moore, and Tanous are usually happy warriors, upbeat and full of good cheer. As they say at the outset of the book, "we're not doom and gloom people, we're natural optimists." But their forecast for the near future is not a sunny one. It is telling that they close with a chapter offering highly detailed advice on "protecting your investments in the troubled times ahead." To find out their recommendations you'll have to plunk down $27. Given the current climate for investment, it might be the most prudent purchase you'll be able to make for some time.

Nick Schulz is the editor-in-chief of The American and the DeWitt Wallace Fellow at AEI.

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