A Note on Supply-Side Thinking

by Reihan Salam

While perusing Laura Kalman’s Right Star Rising, a political history of the rise of the political right from 1974 to 1980, I came across a reference to an article by John Brooks on the origins of the supply-side movement in the April 19, 1982 issue of The New Yorker. The article is very insightful. It’s worth noting that Ronald Reagan was very resistant to making extravagant claims regarding the impact of tax cuts on revenues, much to the frustration of the supply-siders. He favored reducing taxes that discouraged individual initiative, yet he was not a supporter of reducing taxes in any and all circumstances. Reagan and his closest advisors were also very cautious about arguing that tax cuts would raise revenue — in many instances, the team was more inclined to argue that the revenue decreases would be less than what we’d see under static analysis, which is about right. Reagan also saw spending cuts as the high priority, saying in the run-up to his 1980 presidential campaign:

Frankly, I’m afraid this country is just going to have to suffer two, three years of hard times to pay for this binge we’ve been on.

Robert Mundell, the Canadian economist widely considered one of the architects of the supply-side revolution and a 1999 Nobel Laureate, offered thoughtful remarks on the limits of compassion, the virtues of Keynesian economics in a downturn, and, most strikingly, the following:

Incidentally, the idea you should always cut taxes is absurd. After all, in the end you’ve got to pay for government expenditures. 

Arthur Laffer had a number of interesting things to say.

Of supply-siders general, Laffer says, “A problem I have with people who follow us is that they don’t recognize the theory’s shortcomings. They go too far. I don’t think you cut Social Security or unemployment insurance in a down economy. To do that is — well, immoral. You cut those things in an up economy. I might agree with Mundell that Keynesian policy is the right one in a depression. But I seldom write things like that. As I see it, my role is not to be balanced and eclectic. As an academic scholar, I give you a model, presumably constructed thoroughly and professionally. Then you can use it, or part of it, or none of it. When I talk about taxes, I talk about taxes. I don’t say that nothing else matters. My speciality is taxes, not sociology or anthropology. I make a lot of mistakes, but never because of bias. As a professor, I shiver at the thought of making public policy. You should never let a professor run your country. But you should listen to what he has to say.”

To Laffer’s great credit, he comes across as a very humble, thoughtful scholar, who recognizes his limitations. Consider his argument that one should cut spending in an up economy rather than a down economy. This resembles the argument advanced by scholars at the left-of-center Center on Budget and Policy Priorities when they oppose property tax caps: efficiency gains don’t automatically result from limits on tax revenue; rather, efficiency gains derive from concerted efforts to improve efficiency. This is, of course, trivially true, yet it raises the question of why a bureaucracy would pursue efficiency gains if it had all the revenue it needed to continue with business-as-usual. Organizational discipline is far more often a product of necessity rather than choice. It is difficult to imagine municipal governments laying off even ineffective teachers and police officers when times, and coffers, are flush.

Of course, entitlement spending is different. There are virtually no administrative costs involved in cutting Social Security checks. There is an obvious logic to cutting Social Security benefits when times are flush — people are more affluent, and presumably less reliant on the safety net — yet it is politically unimaginable. Why would legislators won’t to provoke the inevitable outrage if there is no pressing fiscal reason to do so?

So Laffer leaves us with a puzzle. If it is immoral to make cuts when the economy is down yet politically impossible to make cuts when the economy is up, how exactly will we impose organizational discipline on the public sector? 

I mention this because I don’t think many conservatives fully understand how damaging the supply-side idea has been to the case for a smaller, more effective, more disciplined government. On July 14th, Len Burman of the Tax Policy Center made the following argument in congressional testimony on the future of individual tax rates:

The message during the last decade seems to have been not that spending and tax cuts were available at a discount, but that they were free. Spending for wars, Medicare expansion, and “no child left behind” happened at the same time that taxes were falling. Citizens could be forgiven for forgetting that there is any connection between spending and taxes.

My guess is that if President Bush had announced a new war surtax to pay for Iraq or an increase in the Medicare payroll tax rate to pay for the prescription drug benefit, both initiatives would have been less popular. Given that the prescription drug benefit only passed Congress by one vote after an extraordinary amount of arm-twisting, it seems unlikely that it would have passed at all if accompanied by a tax increase. [Emphasis added.]

Moreover, tax cuts that aren’t paid for with spending cuts indirectly increase the size of government.

If top tax rates are cut from 40 percent to 35 percent for a while, but then raised to 45 percent to pay back the resulting debt, the 5 percentage point increase in rates reduces growth by much more than the temporary 5 percentage point rate cut boosted it.

As a general rule, stable tax rates impose less economic cost than volatile ones. For that reason, it would be far better to raise taxes soon to reduce the deficit than to postpone action for many years. The longer we wait, the higher tax rates would have to be to restore balance. And income tax rates of 50 or 60 or 70 percent would entail huge economic costs compared with a 40 percent rate.

I personally consider a 40 percent top rate unacceptably high, which is all the more reason to get serious about sustainable tax reform. The problem will only get worse if we continue kicking the can down the road.

Daniel Shaviro made this case very effectively in a 2004 essay on “the new age of big government.” As we all know, the fiscal position of the U.S. federal government has deteriorated dramatically since then. Shaviro’s arguments are counterintuitive, which is why they merit close attention. I’ll revisit the subject. 

The Agenda

NRO’s domestic-policy blog, by Reihan Salam.