Part 2-A Verbatim Essay ON Supply Side Economics

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This is a continuation of MY berbatim Essay on Supply Side Economics.

Submitted: February 06, 2008

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Submitted: February 06, 2008




Critics of supply-side economics pointed to the lack of academic economics credentials by movement leaders such as Jude Wanniski (bachelor's degree in political science and a master's degree in journalism from the University of California, Los Angeles) and Robert Bartley (bachelor's degree in journalism from Iowa State University and a master's degree in political science from the University of Wisconsin) to imply that the theories were bankrupt. Mundell in his Nobel Prize lecture (awarded for unrelated work in optimum currency area) countered that the success of price stability was proof that the supply-side revolution had worked. The continuing debate over supply-side policies tends to focus on the massive federal and current account deficits, increased income inequality and its failure to actually promote growth.

Many critics of supply-side economics are actually critics of politicians and pundits who misunderstand the Laffer curve, typically claiming that every tax cut will increase revenues. For example, in 2006 Sebastian Mallaby of The Washington Post quoted George W. Bush, Dick Cheney, Bill Frist, Chuck Grassley, and Rick Santorum misstating the effect of the Bush Administration's tax cuts. On January 3, 2007, George W. Bush wrote an article claiming "It is also a fact that our tax cuts have fueled robust economic growth and record revenues." Andrew Samwick, who was Chief Economist on Bush's Council of Economic Advisers from 2003-2004 responded to the claim:

You are smart people. You know that the tax cuts have not fueled record revenues. You know what it takes to establish causality. You know that the first order effect of cutting taxes is to lower tax revenues. We all agree that the ultimate reduction in tax revenues can be less than this first order effect, because lower tax rates encourage greater economic activity and thus expand the tax base. No thoughtful person believes that this possible offset more than compensated for the first effect for these tax cuts. Not a single one.

Only cutting tax rates to the right of the Laffer curve's peak rate will increase revenues. Cutting tax rates to the left of the peak rate will decrease revenues. Depending on the model and values of variables that are used, some have estimated the peak rate to be between 60-80% for labor tax and 50-60% for capital tax

Some politicians and supply-side advocates may misunderstand the Laffer curve. They claim that every tax cut will increase revenues, when the curve clearly shows that only cutting tax rates to the right of the peak rate will increase revenues. Cutting tax rates to the left of the peak rate will decrease revenues. Since Reagan's income tax cuts in the 1980s did not increase receipts, the Laffer curve would suggest that further tax cuts will not increase revenues either, since the economy is apparently to the left of the peak. The Bush administration has been reporting record revenues, however those are, once again, coming from FICA taxes, not the income taxes which were cut. Between 2000 and 2004, income tax revenues fell from $1,004.5 billion to $809 billion, while FICA tax revenues increased from $652.9 billion to $733.4. Since 1997, the US Treasury has been reporting the combination of income tax and FICA tax revenues, so decreases in income tax revenues are hidden by increases in FICA tax revenues. Depending on the model and values of variables that are used, some have estimated the peak rate to be between 60-80% for labor tax and 50-60% for capital tax

The paradigm of a tax system which rewards investment over consumption was accepted across the political spectrum, and no plan not rooted in supply-side economic theories has been advanced in the United States since 1982 (with the exception of the Clinton tax increases of 1993) which had any serious chance of passage into law. In 1986, a tax overhaul, described by Mundell as "the completion of the supply-side revolution" was drafted. It included increases in payroll taxes, decreases in top marginal rates, and increases in capital gains taxes. Combined with the mortgage interest deduction and the regressive effects of state taxation, it produces closer to a flat-tax effect. Proponents, such as Mundell and Laffer, point to the dramatic rise in the stock market as a sign that the tax overhaul was effective, although they note that the hike in capital gains may be more trouble than it was worth.

Cutting marginal tax rates can also be perceived as primarily beneficial to the wealthy, which commentators such as Paul Krugman see as politically rather than economically motivated.

The 1990s

Supply-siders blame the 1991 recession on the Federal Reserve, and argue that Clinton's tax increases, since they did not change marginal capital gains tax rates, left the supply-side nature of the 1986 tax bill in place. Similarly, supply-side economists have argued that since the early phases of the massive tax breaks of George W. Bush's first two years were based on credits and not cuts in marginal rates, they did not act to stimulate the economy, although the effect on individual income remains the same.

More generally, traditional economists point to the "overhang" of deficits from the Reagan era, the S&L bailout, the effects of a ballooning federal budget deficit, the defense budget cuts which began in earnest in 1989, and the expectation of a lack of continued fiscal discipline as the source of the recession. These arguments blame the legacy of Democratic Deficits forced upon Reagan, rather than deficits created by Reagan's own administration. Critics of supply-side economics often argue the inflated government deficits that accompanied the arrival of supply-side economics are of greater concern than the economic and stock market success of supply-side theory.

A Trojan Horse

Stronger critiques of supply-side economics dismiss the entire project as a Trojan horse for reducing marginal tax rates on upper income brackets and ultimately a failure. These critiques are found in Samuel Bowles' work, which argues that real productivity fell under supply-side taxation regimes on a unit-worker basis. Paul Krugman of Princeton called supply-side economics "Peddling Prosperity" and dismissed it as being unworthy of serious economists in a 1994 book written for the general audience.

David Stockman, Ronald Reagan's budget director, admitted that the 1981 tax cut was a Trojan horse:

The hard part of the supply-side tax cut is dropping the top rate from 70 to 50 percent—the rest of it is a secondary matter. The original argument was that the top bracket was too high, and that's having the most devastating effect on the economy. Then, the general argument was that, in order to make this palatable as a political matter, you had to bring down all the brackets. But, I mean, Kemp-Roth was always a Trojan horse to bring down the top rate.

Research since 2000

In 2003, the Wall Street Journal declared the debate over supply-side economics to have ended "with a whimper" after extensive modeling performed by the Congressional Budget Office failed to support the most extreme claims of supply-side policies. It was also suggested that Dan Crippen may have lost his chance at reappointment as head of the CBO for failing to support supply-side inspired dynamic scoring. This research undermines the claim that tax cuts can completely compensate for the initial loss of revenue due to the cut, but does acknowledge that resulting growth from the tax cut does replace some of the lost revenue, and the CBO has come under fire for using low estimates.

Before President Bush signed the Supply-side tax cuts, the left-leaning Economic Policy Institute (EPI) released a statement signed by ten Nobel prize laureates entitled "Economists' Statement Opposing the Bush Tax Cuts," which states that:

Passing these tax cuts will worsen the long-term budget outlook, adding to the nation’s projected chronic deficits. This fiscal deterioration will reduce the capacity of the government to finance Social Security and Medicare benefits as well as investments in schools, health, infrastructure, and basic research. Moreover, the proposed tax cuts will generate further inequalities in after-tax income.

Economist Milton Friedman supported Bush's proposed 2003 tax cut on the grounds that the tax cuts would reduce tax revenues, with the resulting deficits being effective in restraining federal spending.

Supporters of the Bush tax plan point out that the predictions of this article have been proven incorrect, in that the budget deficit has shrunk dramatically since 2003, and has not increased as the EPI statement had predicted. similarly, the length of time before Social Security becomes insolvent has improved slightly

Later analysis of the Bush tax cuts by the Economic Policy Institute claims that the Bush tax cuts have failed to promote growth, as all macroeconomic growth indicators, save the housing market, were well below average for the 2001 to 2005 business cycle. These critics argue that the Bush tax cuts have done little more than deprive government of revenue, increase deficit and after-tax income inequality. In the two years since that report, though, growth has remained strong, and newer numbers dispute the conclusions of the EPI report. The Bush administration points to the long period of sustained growth, both in GDP and in overall job numbers, as well as increases in personal income and decreases in the government deficit.

In 2006, the CBO released a study titled "A Dynamic Analysis of Permanent Extension of the President's Tax Relief.. This study found that under the best possible scenario, making tax cuts permanent would increase the economy "over the long run" by 0.7%. Since the "long run" is not defined, some commentators have suggested that 20 years should be used, making the annual best case GDP growth equal to 0.04%. When compared with the cost of the tax cuts, the best case growth scenario is still not sufficient to pay for the tax cuts. Previous official CBO estimates had identified the tax cuts as costing the equivalent of 1.4% of the GDP in revenue. If the best case growth scenario is applied, the tax cuts would still cost the equivalent of 1.27% of the GDP.

This study was criticized by many economists, including Harvard Economics Professor Greg Mankiw, who pointed out that the CBO used a very low value for the earnings-weighted compensated labor supply elasticity of 0.14. In a paper published in the Journal of Public Economics, Mankiw and Matthew Weinzierl noted that the current economics research would place an appropriate value for labor supply elasticity at around 0.5, although Dr. Mankiw notes, "unfortunately, the academic literature on this topic is far from conclusive."

In 2001, President George W. Bush signed the Economic Growth and Tax Relief Reconciliation Act of 2001. Federal revenues in 2001 were $1,946 billion (in constant, 2000 dollars). In 2002, the year the cuts went into effect federal revenues were $1,777 billion. In 2003, President Bush signed the Jobs and Growth Tax Relief Reconciliation Act of 2003. Federal revenues in 2003 were $1,665 billion, $281 billion lower than in 2001. Federal revenues in 2004 were 1,707 billion, and in 2005, $1,888 billion, $58 billion lower than in 2001. By 2006, tax receipts had recovered, totaling 2,037 billion, exceeding the 2001 tax revenue by 91 billion dollars, after adjusting for inflation.

Federal revenues include revenue from different taxes that were cut, stayed the same, or were raised. For example, the Social Security FICA tax rate stayed the same while the maximum income subject to the tax was increased each year , resulting in a tax increase for those earning more than the previous limit. Social Security tax revenues increased each and every year. Including increasing tax revenues from taxes that stayed the same or were increased hides the magnitude of the revenue decrease in taxes that were cut. Income tax rates were cut and total tax revenues were lower than the 2001 level each and every year from 2002-2005, a cumulative revenue decrease of $589 billion (measured in nominal dollars). But, by 2006, tax receipts had recovered, with the cumulative decrease in revenue expected to be fully recovered by 2009, or by 2010, once interest on the federal debt is factored in. Likewise Corporate income tax rates were cut and revenues were lower than the 2000 level each and every year from 2001-2004, but higher by 2005.

Supply-side economics in popular culture

Supply-side economics have been discussed and critiqued in books, songs and films. The social activist and cartoonist Dan Perkins (who writes under the pen name Tom Tomorrow) has repeatedly criticized the theory in his weekly cartoon, This Modern World.

The band Radiohead have alluded to their opposition to such policies in the song Electioneering.

It was also mentioned by Ben Stein in the popular 1986 movie Ferris Bueller's Day Off.

Comedian and author Al Franken lampoons Supply Side Economics in his 2004 book "Lies: And the Lying Liars Who Tell Them - A Fair and Balanced Look at the Right," in a comic book style chapter illustrated by Don Simpson entitled The Gospel of Supply Side.


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