Dialog on Economics: Keynes vs. Supply-Side

[J's comments in red; mine in black.]

W has reported Dave's opinion that no reputable economist subscribes to supply-side theory. Here's a link to the homepage of Robert Mundell, whose biography describes him as "a pioneer of the theory of the monetary and fiscal policy mix, the theory of inflation and interest, the monetary approach to the balance of payments, and the co-founder of supply-side economics." In 1999 Mundell received the Nobel Prize in economics in recognition for his having "established the foundation for the theory which dominates practical policy considerations of monetary and fiscal policy in open economies." Mundell was a colleague of the better-known supply-side advocate Arthur Laffer at Chicago. It's not surprising that university economics departments should have a leftist and statist bent, and this makes it the more remarkable that "the co-founder of supply-side economics" should receive international recognition for his work on the fiscal and monetary policies that sustain economic growth in open economies.

first of all, i never said that "no reputable economist" is a supply sider--rather that there are few left, especially after 1) david stockman and other reagan ideologues repudiated the doctrine in the mid-80's, a time when even reagan raised taxes; and 2) 8 fat years under non-supply-side clinton.

as far as mundell goes, rather than inundating you with the opinions of the majority of peer-reviewed macroeconomists, many of whom you might be ready to dismiss as liberal ivory tower statists, i'll just direct you to the nobel prize site itself, where you can read for yourself WHY mundell got the prize. let me spoil the surprise for you: contra the WSJ, it has nothing to do with his supply-side research that appeared in the autumn of his career, but with his well respected and ahead-of-its time analysis (begun in the 60's) of the globalization of investment capital and how monetary policy would have to change when money moved from country to country in response to interest rates and other factors.

What you said this morning is that the only place supply-siders can be found is in "cushy, ideologically driven think tanks" (which gives me license to disregard anything you ever forward from Brookings, etc.). In fact, the fellow who's half of the brain power behind supply-side theory is at the top of his profession. So perhaps we can get back to arguing the theory rather than citing how many experts support mine vs. yours.

Stockman was never a supply-sider, he was a deficit hawk. He grew disillusioned with Reagan when the old man persisted in the conviction that cutting tax rates was needed to revive the economy even if Congress couldn't be persuaded to cut spending to compensate for the initial revenue loss. When pushed to by deficit hawks in Congress, Reagan increased taxes but not income tax rates, however, which he continued to pull down, lowering the top rate from 70% in 1981 when he took office to 50% in 1983 to 28% in 1988. (Chief among the congressional hawks was Bob Dole, who ran as a tax cutter in 1996, and lost in part because this was clearly political opportunism on his part -- and in part because he was the worst Republican candidate since Alf Landon.) How many genuine supply-siders can you find who "repudiated the doctrine in the mid-80s"? Not Jack Kemp, e.g.

In 1997, Clinton cut the capital gains rate from 28% to 20 and eliminated taxes on home sales up to $500,000. Let's see -- were the stock and housing markets and federal revenue up or down after 1997?

I will be happy to get back to arguing theory with you, but I do think it is significant that there are very few professional economists on your side. From Aristotle to Cicero and beyond it has been perfectly acceptable when arguing about public matters, policy matters, to make arguments that appeal to authority on an issue—to logicians it may be a fallacy, but Aristotle and everyone after him in the rhetorical tradition considered such appeals to be a perfectly acceptable part of practical reasoning. Especially since you and I are not professional economists, it is important to pay attention to sources of authority on the matter when evaluating claims, and your sources are suspect. You and I both have a stake in the open, peer-reviewed system of knowledge discovery that is academia. I'm sure we would both be a bit suspicious of a medical journal that was sponsored by Bristol-Myers Squibb. Many of your supply-side experts are on the payroll, in one way or another. And don't try to make a straw man from my earlier hyperbole. I know that you can point to a handful of independent professional economists who are still supply-siders—but there are precious few of them, and that, I think, is significant.

Supply-siders would like to believe that their theory is the product of academic study. But it's not. It was born in partisan political magazines, not professional journals. While there are many professional economists who support tax cuts, few of them do so on supply-side grounds. Instead, most of them fall into the category of those who want government to be smaller, and don't believe, as supply-siders do, that by cutting taxes the economy will grow to such a degree that tax revenue will rise to levels that will match or exceed levels under a higher tax scheme. Even Bush's own economic advisors are not naive enough to believe in supply-side theory. N. Gregory Mankiw, the Harvard economist who is currently chairman of Bush's Council of Economic Advisers, described Reagan's supply-side advisers as incompetent and unscrupulous. And the head of the Congressional Budget Office, Douglas Holtz-Eakin, who was chosen by Bush, reported last year that spending cuts would be needed to offset lost revenue from Bush's tax cuts: in other words, no supply-side effects would compensate for the cuts. Finally, there's Irving Kristol, who in 1995 admitted that he supported supply-side theory because of its "political possibilities," even though he doubted its "economic merits."

Now to the Reagan years. The problem with looking at the growth under Reagan as proof of supply-side theory is that the data don't show that Reagan's tax cuts had much to do with it. The test is whether the tax cuts produced more growth in the economy than occurs during a normal business cycle recovery. Between 1979 and 1989, the growth rate was 3%. But between 1973 and 1979 the growth rate was...(drum roll)...3%. Hard to find confirmation of supply-side theory there.

Okay, now to Clinton, since you brought him into this. Here's the part of the Clinton story that's the relevant one for testing supply-side theory. 1989 the top 1% of families were taxed at the rate (federal taxes) of 28.9%. By 1995, under Clinton, that rate had risen to 36.1% With such an increase in the marginal tax rate on high-income tax payers, supply-siders predicted doom. But of course what we got was lower unemployment, a budget surplus, and a rate of growth in productivity not seen in decades.

The point is not that tax cuts are bad--they can do some good things including stimulating demand, since more people with more money in their pockets can buy more stuff. But supply-side theory, which as I understand it states that if top marginal tax rates are reduced then the potential loss of tax revenue will be offset by growth in the economy, is at best a theory that the data don't support, and at worst an ideological dogma which tries to pass for a credible economics theory (eg. Keynesian theory) in the eyes of intelligent and reputable people like yourself.

Our exchange reminds of a quip: "Chemistry came from alchemy, astronomy came from astrology -- what do you suppose will ever come from economics?" I note a site that complains (from the left) that academic economics "has increasingly become an intellectual game played for its own sake and not for its practical consequences for understanding the economic world" and advances a corrective approach; supply-side theory could be described as a comparable protest from the right. It's the creation not of politicians but of two academics, Robert Mundell and Arthur Laffer. It's not their fault that politicians found the theory persuasive and so moved to implement it, rather than waiting for academic economists to impartially consider the theory in learned journals (fat chance -- one might as well wait for the JFK School of Government to endorse the Bush pre-emption doctrine). Not that supply-side hasn't received academic support against the grain, as the column I'm forwarding indicates, citing the International Monetary Fund and Nobel laureate Robert Lucas (Univ. of Chicago). Mundell's basic paper on supply-side dates from 1962; just so we're clear, Mundell's argument about the effects of lowering tax rates dates from the same period as his Nobel-winning work and isn't something he came upon in his dotty retiirement. The problems he tends to look at concern the effects on capital of shifts in exchange rates (which lead to flows of capital from country to country) and monetary and fiscal policy (which affect the value of the return on capital put at risk).

Mundell and Laffer advanced a corrective to Keynesian economics that can be summed up in three words as "Individual incentives matter," including the incentives created (intentionally and unintentionally) by the tax code. The insight they worked out was already nicely stated in 1946 by Henry Hazlitt (called by H. L. Mencken "one of the few economists who could really write"): "When a corporation loses a hundred cents of every dollar it loses, and is permitted to keep only fifty-two cents of every dollar it gains, and when it cannot adequately offset its years of losses against its years of gains, its policies are affected. It does not expand its operations, or it expands only those that are attended with a minimum of risk. People who recognize this situation are deterred from starting new enterprises. Thus old employers do not give more employment, or not as much more as they might have; and others decide not to become employers at all. Improved machinery and better-equipped factories come into existence much more slowly than they otherwise would. The result in the long run is that consumers are prevented from getting better and cheaper products to the extent that they otherwise would, and that real wages are held down, compared with what they might have been.

"There is a similar effect when personal incomes are taxed 50, 60, or 70 percent [the top bracket when Hazlitt wrote]. People begin to ask themselves why they should work six, eight, or nine months of the entire year for the government, and only six, four, or three months for themselves and their families. If they lose the whole dollar when they lose, but can keep only a fraction of it when they win, they decided that it is foolish to take risks with their capital. In addition, the capital available for risk-taking itself shrinks enormously. It is being taxed away before it can be accumulated. In brief, capital to provide new jobs is first prevented from coming into existence, and the part that does come into existence is then discouraged from starting new enterprises" (ECONOMICS IN ONE LESSON, p. 38).

Modern economies are hugely complex, and so is the effect of government fiscal policy on them. I can see all sorts of argument about the effects of a particular change in income tax rates. What I can't see is ignoring the effects on incentives that Hazlitt describes. Considering such effects in the formulation of fiscal policy is what supply-side theory calls for. So if you have an economy yielding $10 billion of annual personal income and a presidential candidate proposes to cut taxes from 50% to 25%, a static Keynesian analysis will warn that thus reducing tax rates will cut government revenues by half. A supply side theorist will point out that since the individuals earning the income will now keep 75% of their earnings rather than 50%, they will have an incentive to produce more, and this increased productivity will offset the amount of revenue that is lost when the rate is lowered. In the event that the economy doubles its output to $20 billion, the government will lose no revenue from the income tax at all (since 25% of $20 billion yields the same $5 billion that the government heretofore extracted from a $10 billion economy).

Peer review is a function of Kuhn's "normal science" and tends to ensure that contributions to learned discussion don't neglect the conventional wisdom of a discipline (the regnant paradigm, in Kuhnspeak). When a disciplinary revolution occurs and an alternative is proposed to the paradigm that defines normality, the reaction of entrenched interests is an unreliable indicator of the value of the proposed paradigm shift. So it's not surprising if economists developing a fifth-generation Keynesian paradigm don't rush to embrace a radical alternative to it, and I don't think that circumstance tells us anything much about the model's validity. I would suggest there's a moral case for the policy as well as a "green eyeshade" defense: if government expenditures can be funded by a less intrusive levy than currently exists in a society (one that empowers the government less), it's in the interest of individual liberty that the state begin to do so. I would think a guy with a libertarian streak vis-à-vis banned substances etc. would see the desirability of this. Maybe if it were someone besides Jack Kemp and me arguing for it.

It is not a matter of controversy that when people are taxed too much they don't invest. That's common knowledge, even among Keynesians. If THAT is supply-side theory then anyone with half a brain must be a supply-sider. The issue is whether marginal tax cuts, by spurring investment, will generate enough revenue to pay for themselves. And that is what the data have not shown. I'll be generous here: there are a lot of variables involved, and just because the data haven't shown it yet doesn't mean they never will. But until they do, I'll remain, like the majority of academic economists as well as President Bush's most important economic advisors (e.g., N. Gregory Mankiw and Douglas Holtz-Eakin), a skeptic.

On to the Laffer Curve....

No one denies that what the Laffer curve shows is true, that at both extremes of the curve--at a 0% tax rate and at a 100% tax rate--the government collects no money! The basic concept is nothing new--it was pointed out by the classical French economist Frederic Bastiat in the 19th Century (and as you mention by Henry Hazlitt in 1946, and by others). What is under dispute at any given moment is the rate of taxation at which maximum revenue can be generated (known as "the optimal tax rate"). During the Reagan years when supply-siders rose to prominence, many congressional Repubs as well as, yes, Dems also, believed that government was taxing on the right side of the curve--the region to the right of the optimal tax rate, where higher tax rates result in lower tax revenue. Even at the time, when there was something of a congressional consensus about this, there were also many skeptics including the vast majority of professional economists in addition to, as we learned later, some of Reagan's own advisors (e.g. Stockman). Several careful studies that appeared at the time argued that, on the basis of analyses of historical tax rate data, the government was in fact taxing well on the left side of the curve.

In researching for this email I found this interesting anecdote: In the 1980's, Nobel prize winning economist Paul Samuelson noticed that there was a consensus among professional economists that the optimal tax rate was no higher than 80%, and so speculated that Reagan's embrace of supply-side theory may have been a perfectly rational (though out-of-context) response to having been taxed (and having seen the effects of his peers being taxed) upwards of 90% during WWII. Worth pondering anyway.

And while Reagan, along with many of his advisors, was probably a true believer, I fear that supply-side theory is still used cynically by many conservatives in the way Stockman and Irving Kristol used it. Here is what Stockman said after he had broken with the other advisors: "The way they talked [Reagan's other advisors], they seemed to expect that once the supply-side tax cut was in effect, additional revenue would start to fall, manna-like, from the heavens. Since January, I had been explaining that there is no literal Laffer curve." Stockman admitted that he used supply-side theory as "a trojan horse for upper bracket tax cuts without economic justification." Stockman confessed that he painted an intentionally deceptive "Rosy Scenario" about tax revenues. Why? "The supply-side formula was the only way to get a tax policy that was really 'trickle down.' Supply-side is 'trickle-down' theory."

A look at the founding fathers....

Here's what I have found out about the three inventors of Supply Side Theory (You mention Laffer and Mundell, though Wanninski I have found is just as important):

Laffer has a Ph. D. in economics from Stanford and served as an advisor to Reagan, but again, what I'm finding about Laffer is that his ideas weren't terribly original, and can be explained in terms of both classical and Keynesian theory. (To be fair, the supply-siders see themselves as recovering classical economic theory.)

Every source I can find says that Mundell won the Nobel for his work on fiscal policy and international exchange rates--the 1962 Mundell-Fleming model--not for his supply-side theories (see again the text of the Nobel announcement). And I can find no reference, outside of docs from the Heritage Foundation and similar sources, that the Mundell-Fleming model relies on or implies supply-side theory. (To be fair I have also learned that at his acceptance speech before the Noble jury Mundell did give a defense of supply-side theory.)

I've read a bit of online material about, and by, Jude Wanniski. Wanniski, as I've learned, who coined the term "Supply Side Economics" has never been a professional academic economist. He was an associate editor of the Wall Street Journal for several years and went on to found an online school in 1997, which he still runs, called "Supply Side University." Hmmm....

Back to the issues....

What accounted for the big increases in non-corporate tax revenues during Reagan's presidency--besides the effects of the business cycle also seen in earlier decades (cf. my earlier email)--was an increase in payroll tax revenue, not an increase in income tax revenue. The government saw a big increase in payroll tax revenue following the signing of the Social Security Reform Act of 1983 which increased payroll tax rates. I'm asking honestly here, what do Cato / Heritage Foundation economists say in response to this? In my (admittedly perfunctory) search of both of their websites I can't find an answer. For now, I see no supply-side effects. (One more thing. It's hard to take these supply-side researches--like the ones I've now read from Cato / Heritage Foundation--as serious social science when they continually employ terms like "tax relief" in place of "tax cut." Isn't it usually conservatives who blame liberals for politicizing every field of knowledge?

Now to corporate taxes. Corporate tax revenues fell sharply after Reagan's early corporate tax cuts. They did surge later, but that was only after the passage of the 1986 tax reform law that broadened the base of what corporations were taxed on. The 1986 law closed loopholes, removed many tax-shelters, limited depreciation deductions, and eliminated the investment tax credit. Hard to see supply-side effects here either.

They way I see it, if you want to convince me (or any rational interlocutor) that supply-side theory is true, you still owe me the following:

1) An explanation of how tax revenue growth under Reagan can be attributed to supply-side policy in light of

a) what we know historically about normal business cycles,

b) the two major tax increases during the Reagan years that I detail above.

2) An explanation of how it is that both GNP and tax revenues increased at a higher rate under Clinton than under Reagan, despite increases in taxes.

3) An explanation of why Bush's tax cuts have not produced supply-side effects. (Supply-siders blamed the Fed [and Congress of course] for bad things that happened under Reagan, but this time around the Fed has supported Bush's policies. So what gives?)

Paradigm Shifts....

As far as your observation about Kuhn and paradigms goes, I accept in principle that it is difficult to determine how a scientific theory will fare when there are entrenched institutional players and professional stakes involved, but I'd be surprised to see a paradigm shift on account of supply-side theory. I'll be happy to be proven wrong. But historically most scientific paradigm shifts have been opposed by larger political forces, the Catholic Church for example. Supply-side theory is largely promulgated by the corporate plutocracy, and so seems not so much paradigm shifting to me as reactionary. The supply-siders themselves claim that their mission is to recover the supply-side orientation of classical economics (they cite both Smith and Marx). So it seems to me they are attempting, if you'll allow the analogy, a sort of pre-Copernican restoration.