Supply-Side Economics Contradictions Live on in Washington

Politicians have always faced the temptation to give their constituents tax cuts.    But in recent decades “conservative” presidents have enacted large tax cuts that have been anything but conservative fiscally, and have justified them by appealing to theory.   In particular, they have appealed to two theories:   the Laffer Proposition, which says that cuts in tax rates will pay for themselves via higher economic activity, and the Starve the Beast Hypothesis, which says that tax cuts will increase the budget deficit and put downward pressure on federal spending.     It is insufficiently remarked that the two propositions are inconsistent with each other:   reductions in tax rates can’t increase tax revenues and reduce tax revenues at the same time.    But being mutually exclusive does not prevent them both from being wrong.

The Laffer Proposition, while theoretically possible under certain conditions, does not apply to US income tax rates:  a cut in those rates reduces revenue, precisely as common sense would indicate.    As detailed in a new paper of mine “Snake-Oil Tax Cuts,”  for the Economic Policy Institute, this conclusion was the outcome of the two big experiments of recent decades: the Reagan tax cuts of 1981-83 and the Bush tax cuts of 2001-03.   It is also the conclusion of more systematic scholarly studies based on more extensive data.    Finally, it is the view of almost all professional economists, including the illustrious economic advisers to Presidents Reagan and Bush, even though it contradicted the views of their employers.  So thorough is the discrediting of the Laffer Hypothesis, that many deny that these two presidents or their top officials could have ever believed such a thing.   But abundant quotes  show that they did.

The Starve the Beast Hypothesis claims that politicians can’t spend money that they don’t have.  In theory, Congressmen are supposedly inhibited from increasing spending by constituents’ fears that the resulting deficits will mean higher taxes for their grandchildren.     The theory fails on both conceptual grounds and empirical grounds.   Conceptually, one should begin by asking: what it the alternative fiscal regime to which Starve the Beast is being compared?     The natural alternative is the regime that was in place during the 1990s, which I call Shared Sacrifice.    During that time, any congressman wishing to increase spending had to show how they would raise taxes to pay for it.   Logically, a Congressman contemplating a new spending program to benefit some favored supporters will be more inhibited by fears of constituents complaining about an immediate tax increase (under the regime of Shared Sacrifice) than by fears of constituents complaining that budget deficits might mean higher taxes many years into the future (under Starve the Beast).   Sure enough, the Shared Sacrifice approach of the 1990s succeeded.  Compare this outcome to the sharp increases in spending that took place when President Reagan took office, when the first President Bush took office, and when the second President Bush took office.    As with the Laffer Hypothesis, more systematic econometric analysis confirms the rejection of the hypothesis.

These matters are not solely of interest to historians or economists.   The presidential campaign of Senator John McCain appears set to drive its wagon down the same road in which Reagan and Bush have already worn deep ruts.   The candidate is apparently selling the same snake oil:  he says he believes that tax cuts increase revenues.   His principle policy director disavows the Laffer Principle, just as the economists who advised Presidents Reagan and Bush did.   But the views of the economic advisers are not what determines what these presidents do.

“The Queen in Alice in Wonderland  said that, with practice, she was able to believe as many as six impossible things before breakfast.   Most of us are more limited in our capacity for credulity.  If John McCain believes both the Laffer Proposition (tax cuts raise revenues) and Starve the Beast (higher revenues lead to higher spending, anathema to conservatives), then as a good conservative, his duty is clear.  He ought to run on a truly novel platform of higher tax rates!   Why?   Higher tax rates would reduce revenues (this is what Laffer says would happen) and thereby reduce spending (this is what Starve the Beast says would happen).

Seriously folks.   If McCain continues to propose extending the Bush tax cuts, he should at least be forced to choose between the Lafferite defense and the “Starve the Beast” defense. Only then can the rest of us know which of the two mutually inconsistent propositions to refute.

I will be discussing my paper, in a September 12 panel where Larry Summers and Gene Sperling also give their thoughts on Supply Side Economics, at a joint meeting of the Center for American Progress and the Economic Policy Institute.

Originally published at Jeff Frankel’s Weblog and reproduced here with the author’s permission.

4 Responses to "Supply-Side Economics Contradictions Live on in Washington"

  1. Radu Tomescu   September 19, 2008 at 7:35 am

    Professor Frankel’s point is very clear in a “reductio ad absurdum” argument, wherein we eliminate income tax entirely.

    • Jeff Frankel   September 22, 2008 at 6:06 pm

      Hey, Radu. What are you doing these days?

  2. Terry Rickard   September 19, 2008 at 8:05 am

    Give me a break. Professors Frankel’s point is reduced to absurdity by the obvious fact that an increase in tax rates to 100% would eliminate government revenues. Why is it so hard to understand that raising taxes above a certain threshold reduces economic growth and prosperity? And please don’t offer up the canard of Clinton’s tax increases. Clinton had the great good fortune to preside during a one-time technology-driven surge in productivity that produced windfall revenues to the government. He also took a holiday from history by slashing defense spending, which we’ve been paying for ever since.

    • Jeff Frankel   September 22, 2008 at 6:12 pm

      I had thought that I had been clear that of course we all believe that if tax rates approach 100% that tax revenue falls.I thought everyone agreed that the important issue is whether US income tax rates are in the range where an increase lowers revenue, and a cut raises revenue. This is the Laffer Proposition, and is what most of us are skeptical of. 100% is a straw man.(Although even here everyone has been a little too quick to say that revenue goes to zero. Some low-income workers — not the rich ! — face effective marginal tax rates in excess of 100%, and yet choose to climb the latter for reasons of self-respect etc. Admittedly, most people would react very adversely to 100% marginal taxation)