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Supply-Side Hype?
The Bush tax cut is now a real Laffer matter.


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Donald L. Luskin

The Senate’s surprise vote Tuesday to reduce the value of President Bush’s proposed tax-cuts by more than half has been played in the press as a major setback for the president’s agenda. But the way I see it, it’s actually great news: A tax-cut that was assumed to have zero chance just a month ago now has a floor under it of $350 billion.

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So now the real debate begins: How much more than $350 billion will the tax cut be? And exactly which of Bush’s many proposed cuts will survive? The debate won’t just be between Democrats and Republicans, either. The president’s own party is deeply divided at a fundamental conceptual level about the dynamics of budget cuts, tax cuts, and deficits, and the trade-offs between them.

At the center of the debate will be the extent to which the proposed tax cuts will contribute to budget deficits. Will they be a deadweight loss to federal revenues, or will the cuts stimulate enough economic growth to partially or wholly offset any revenue losses?

Tuesday the Congressional Budget Office published an analysis of the president’s budget and tax proposals that — for the first time — sought to answer that question in just those terms.

Meanwhile, some statements from the Bush administration about the stimulus-power of the tax-cut package have been very bold. The president said in a speech earlier this year that “growth will bring the added benefit of higher revenues for the government.” Vice President Cheney said ” . . . the president’s package will generate new growth, it will expand the tax base, and thus increase tax revenue to the federal government ultimately.”

Those are very politically incorrect statements. In these deficit-obsessed days the idea that tax cuts could stimulate self-financing economic growth — what used to be called “supply-side economics” — can hardly be uttered without embarrassment. Today it seems supply-side economics is always referred to in the media as a “discredited theory.” The conventional wisdom has it that it was responsible for the “catastrophic Reagan deficits.” And the critics never fail to remind us that the first President Bush once dissed supply-side economics as “voodoo economics.”

In its hey-day during the Reagan years, supply-side economics was embraced — and, in the end, probably abused — by very diverse political interests. There were those who believed (or pretended) that it promised a fiscal perpetual-motion machine through which infinite government spending could be financed by infinite tax cuts. And there were those who believed (or pretended) that it would be just fine if the tax cuts reduced revenues — because that would force a bloated government to cut spending. Bruce Bartlett has noted here that the Reagan administration itself was scrupulously circumspect in its supply-side claims.

Let’s step back from the politics and ask one simple question: Does the idea of supply-side economics make fundamental good sense or not?

I say that it does. It’s so simple: Tax rates that are too high can be self-defeating, and so lowering them can increase total revenues. Bartlett told me that this idea can be traced all the way back to Jonathan Swift, who wrote in 1728 that “in the business of heavy impositions, two and two never make more than one.” He noted that economists and philosophers from Smith, Montesquieu, Say, and Mill, to von Mises and Keynes, wrote about the basic principle.

In the modern era, of course, no economist is more closely associated with supply-side economics than Arthur Laffer. He embodied the idea as the famous Laffer Curve, which illustrates that government will earn no revenues at all if tax rates are either zero or 100%. Somewhere in between is a tax rate at which government revenue is maximized. So when rates are too high — too near 100% — revenues can be increased by cutting taxes.

I spoke to Laffer last week, and his confidence in this simple idea is as great as when he first sketched the Laffer Curve on a cocktail napkin in 1974 for Richard Cheney, who was then assistant to White House chief of staff Donald Rumsfeld. He told me, “Prior to that it was presumed that a 10% increase in taxes would lead to a 10% increase in revenues. That was clearly wrong.”

He’s clear that the Laffer Curve itself is only “a pedagogic device designed to explain the feedback effects” from changes in tax rates. As such, it is hard to dispute that it is correct, at least in theory. But it doesn’t say precisely what the revenue impact of any one particular tax policy will be.

As general guidance, Laffer gave me five common-sense questions to ask, to make an intelligent guess about whether a given tax cut is likely to lead to a supply-side revenue increase.

— Is the existing rate very high? Can it be assumed that it has been holding back economic activity?

— Are you are willing to wait for the incentive effects of lower rates to take effect?

— Is there a way that people can actually change their behavior to take advantage of the tax-cut? Can they work harder, invest more, and so on?

— Is there presently a lot of tax-evasion activity? Is the cost of that evasion high enough so that people will stop evading when the tax is cut?

— Is there some other tax mechanism that could receive the additional revenues? For instance, if capital-gains taxes were cut would higher workers’ wages cause income-tax revenues to go up?

Applying these five questions to Bush’s tax-cut plan gets you a mixed bag of answers. The elimination of the double taxation of dividends and retained earnings would score five “yeses” — but allowing an above-the-line deduction for long-term-care insurance may well score five “no’s.”

Overall, Laffer told me, “I love Bush’s tax plan. It’s great.” But as the debate moves forward, the winning strategy for the GOP will be to stay clear about which proposed tax cuts might pay for themselves, and which won’t.

The best thing that could happen now would be for Bush administration to “compromise” by throwing out the tax cuts that don’t pay for themselves — the ones that are really just another form of government spending. If the strongly pro-growth supply-side features of Bush’s plan — such as eliminating the double taxation of dividends and retained earnings — are what remain, the total-value tax cut may look smaller, but its long-term contribution to the economy will be much, much bigger.



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