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Supply Side Economics

Update 8/24/04: Made some minor revisions and reworded the conclusion.

It occurred to me a while back that one thing that sometimes separates conservatives from liberals is that conservatives tend to know more about economics, and liberals know more about sociology (yes, I know this isn’t always the case). Furthermore, that experts in economics tend to look down upon sociology and other social sciences as not being real sciences, even though economics itself is also a social science, indeed, as Brian Leiter notes, one with a very poor track record of predictive success, which is why it’s called the “dismal science.” After all, with all the mathematics involved, it’s easy to forget that it all relies on a model of human behavior, often a crude one.

And if you can stomach yet another overgeneralization, it seems to me that conservatives often try to take advantage of many liberals’ aversion to economics to pull a fast one on them. Case in point? Supply-side economics, which is often misunderstood or misinterpreted badly by both sides, but is often used by conservatives against liberals who don’t know enough economics to know they’re being had. Again, I’m no expert, but I think I can clear this up a bit. Now, Art Laffer actually had the right idea with the Laffer Curve, but people forget that this was not the only thing about supply-side economics, or indeed, even the primary selling point.

Why It’s “Supply Side”, Not “Demand Side”

What most people don’t realize is where the term “supply-side” originally comes from. When Dubya pitched his tax cuts, he talked about them stimulating demand. After all, the more money Joe Sixpack gets to keep in his paycheck, the more he tends to spend. And when you’re in the middle of a recession, you need to stimulate growth by giving companies more incentives to build more and hire more. Increasing demand for their products and services is an obvious way to do that.

But they don’t call it “demand-side” tax cuts. Why? Because when Reagan came into office, the economy wasn’t in a recession. The biggest problem facing the economy was the rampant inflation that had plagued Nixon, Ford, and Carter. For those not familiar, inflation occurs when aggregate (total) demand is too high compared to aggregate supply, which causes prices to increase. Normally, this isn’t too much of a problem, because supply and demand eventually reach equilibrium again at this new price point. The problem is when aggregate demand continues to outstrip supply over an extended period of time. Eventually, people’s expectations change.

Once people expect prices to increase, two things happen: 1) they buy things sooner, before prices can increase further 2) they ask for raises to keep up with their cost of living. Instead of bringing things back into balance, both of these increase demand even more, creating a vicious cycle — a cycle that is very tough to break (note, the same thing can occur in the other direction, deflation, which is what Japan has been facing for a while now).

So what everybody forgets is that Reagan and Laffer pitched tax cuts as an anti-inflationary measure. Laffer claimed that when you lower taxes, people get to keep more of their paychecks, and they have a bigger incentive to work harder to earn raises in salary. This means their productivity goes up, increasing the amount of goods and services that they produce. That increases supply (thus the name), thereby reducing inflation.

Sounds good, right? Well, true as that may be, it totally ignores the fact that this tax cut also increases demand — the exact effect Dubya was going for to stimulate the economy (this recession was caused by excess inventory — or too much supply). Indeed, a tax cut stimulates demand much more directly than it stimulates supply. When you cut taxes, Joe Sixpack will spend almost all of the extra cash. But unless his marginal tax rate is 50%, he already gets to keep most of whatever raise he can earn. At a 30% tax rate, he gets to keep 70 cents of each dollar. Cutting that to 20% means he gets to keep 80 cents of each dollar. This extra 10 cents per dollar is probably not going to motivate him to increase his productivity nearly enough to offset his increase in spending.

The Laffer Curve

The Laffer Curve is the part everybody has heard about but often misunderstands, and it’s the part that George H.W. Bush called “Voodoo Economics.” As I pointed out, it was not the selling point of the tax cuts. Instead, it was the defense used against critics who said it would cause deficits. Now, Laffer does not claim that lowering taxes will always increase federal revenues. What he says is that the relation between revenues and the tax rate is not an ever-increasing line, but a curve that goes up and down like this (no, not that straight line underneath the text, the graph you get when you click on the link, you goof!). As you increase taxes, revenues increase until you reach a certain point where people keep so little of their paycheck that they lose all incentive to work very hard. Thus, increasing taxes beyond this point will choke productivity and the economy, resulting in revenues dropping. Cutting taxes back down will get the economy growing again, thus increasing revenues.

In a nutshell, increasing taxes will increase revenues if you’re on the left side of the curve, but decrease revenues if you’re on the right side of the curve. This is actually true. Of course, the trick is figuring out which side of the curve you’re on. I recall seeing an interview with Art Laffer where he simply suggests cutting taxes and seeing whether revenues increase or decrease (obviously, the converse would also be true, but he generally doesn’t say that). Conservatives thus point out the fact that overall, revenues increased during Reagan’s time in office despite (or because of) his large tax cuts.

Paul Volcker

Well, the problem is that the “experiment” Laffer suggests only works if nothing else changes, because how fast the economy grows is affected by more than just taxes. It’s primarily affected by interest rates. This is why the Chairman of the Federal Reserve Board is sometimes called the second most powerful man in the world (the most powerful, of course, being Eric Cartman). At the time, the Fed Chair was Paul Volcker. He knew a tax cut would not fight inflation, but just make it worse. He also knew the only way to end inflation was to completely crush the demand out of the economy, even if it meant causing a recession. So he raised interest rates sky high, and indeed, this did cause a recession in 1982 — but it also finally ended inflation (this is why I mentioned Reagan was not the right man to credit for ending inflation, among other things).

Once inflation was dead, Volcker lowered interest rates much lower than they ever were in the 70’s. His predecessors had always tried to fight inflation by keeping rates high, but were never willing to raise them so high to cause the recession like Volcker did, thus did a half-assed job of it, only succeeding at holding the economy back from its true potential. But now, Volcker could finally take his foot off the brakes and let the economy roar, and revenues predictably increased. I talk a little more about Volcker’s role in my tribute to Reagan.

Where Are We On the Curve?

So you just can’t tell whether or not the tax cut would have increased revenues if interest rates remained flat. However, if we were on the right side of the curve, increasing taxes should lower revenues (the part that supply-siders rarely point out). And we all know George H.W. Bush and Clinton raised taxes, and yet, revenues increased to the point where we had surpluses. I think it’s pretty clear, then, that we’re on the left side of the curve. Indeed, since our tax rates are far lower than those in Europe, and since Europe’s economy is still growing, we’re probably a long, long way away from the right side of the curve.

So there you have it, and hopefully that’ll give you some ammunition to use against the inevitable supply-sider at cocktail parties who tries to explain the Laffer Curve. The thing to remember is that the Laffer Curve is true. Where we are on the curve, however, is the question, and the evidence doesn’t seem to indicate that we’re on the right side of the curve. And since most supply-siders are used to arguing with people over whether or not the Laffer Curve exists, this should be quite the Laffer curve ball for them.

Okay, that was bad.