Fiscal Policy and Supply-Side Economics (ECON 272)

Supply - Side Economics

A main character:  Arthur Laffer and others

Supply-side economists focus on incentives -- especially the incentive to work or not.  Their main assumption is that people work more if their wage is increased (in general).  Therefore, cutting taxes (increasing wages) will lead to more work effort, a larger tax base, and therefore, more tax revenue.  This is based upon the assumptions regarding the theory surrounding the “Laffer Curve.”

Incentives and work -- which is correct:

Substitution Effect:

Income Effect:

The Laffer Curve (the relationship between tax rates and tax revenue): GRAPH

The Theory:

If the government increases marginal tax rates, that will decrease additional income that earners keep, thereby affecting output (productivity) for 2 reasons:

1. ­ Marginal tax rate increases, this decreases the payoff people derive from work (for example, when this occurs many with working spouses opt out of the labor force), less work, less productivity (incentives have changed – people choose leisure over work in the labor/leisure trade-off).

2. ­ Marginal tax rate increases, people (including those operating businesses) turn to tax shelter investments to avoid excess taxes (for example, investments that generate paper losses from depreciated assets) or move their businesses to places where tax rates are lower .  Therefore people are spending resources on tax avoidance (or tax evasion) instead of on productive activities. Real productivity is lower than it could be because resources are wasted producing goods that are valued less than their cost of production -- many goods are produced that otherwise would not have been produced if it wasn't for people trying to avoid taxes.  Those resources could have produced goods that actually made peoples lives better off (in absence of the taxes).

Trickle Down: 

Policy Conclusions:

Cut income taxes in order to increase tax revenue (through an increase in productivity and tax collection).

The main supply-side (tax cut) effects are:

• increase in business activity
• reduction in tax shelter activities - less tax evasion and less tax avoidance (including people paying themselves more in the form of money income rather than fringe benefits and amenities)

And therefore: there is an increase in the tax base and therefore, possibly, also an increase in tax revenue.

Furthermore, there is an increase in the share of income tax paid by high income taxpayers when the higher bracket tax rates are cut (i.e., the rich end up paying more of the total tax bill).

The "Curve" aside - the supply-side argument can be seen as a long-run strategy to increase economic growth, not a short-run policy tool to deal with a recession, for example.  A cut in income taxes stimulates productivity - which is what is necessary for long term economic growth.

Empirical Evidence - Review on Your Own

From History - the U.S.:  Four major income tax cuts in the United States -

Keep in mind that tax revenue collected by the U. S. federal government has typically increased over time.  The question is - does it increase at a higher rate after a major income tax cut.  According to data, it does.  Numbers from the U.S. Budget Office.

1922-1928 (Coolidge Tax Cuts)

When the federal income tax was enacted in 1913, the top rate was just 7 percent. By the end of World War I, rates had been greatly increased at all income levels, with the top rate increased to 77 percent (for income over $1 million). After five years of high tax rates, rates were cut sharply under the Revenue Acts of 1921, 1924, and 1926. The combined top marginal normal and surtax rate fell from 73 percent to 58 percent in 1922, and then to 50 percent in 1923 (income over $200,000). In 1924, the top tax rate fell to 46 percent (income over $500,000). The top rate was just 25 percent (income over $100,000) from 1925 to 1928, and then fell to 24 percent in 1929.

So the top marginal tax rates were cut from 73% to 25% (-48%).

Revenues received by the federal treasury increased from $719 million in 1921 to more than $1.1 billion 1929. That's a 61% increase (there was zero inflation in this period).

Real tax revenue collected from incomes of $50,000 and above increased from $305.1 million to $481.1 million (+63%). Real tax revenue collected from those who made less than $50,000 dropped by 45%.

1963-1965 (Kennedy Tax Cuts)

JFK’s tax cuts were passed in the summer of 1964. The top marginal tax rates were reduced from 91% to 70%. The bottom rates were reduced from 20% to 14%.

From 1965 to 1968, total federal revenue rose by 30%, from $117 billion to $153. 

Tax revenues of the bottom 95% of taxpayers fell from $31 billion to $29.6 billion (-4.5%). Tax revenues of the top 5% of taxpayers rose from $17.2 billion to $18.5 billion (+7.6%).
 

1981-1986 (Reagan Tax Cuts -- supply-side tax cuts)

Top U.S. federal income tax rates declined from 70% to approx. 33% (and was 28% when he left office).

Tax payments and the share of income taxes paid by the top 1% climbed sharply. For example, in 1981 the top 1% paid 17.6% of all personal income taxes, but by 1988 their share had jumped to 27.5%, a 10 percentage point increase.  The share of the income tax burden borne by the top 10% of taxpayers increased from 48.0% in 1981 to 57.2% in 1988. Meanwhile, the share of income taxes paid by the bottom 50% of taxpayers dropped from 7.5% in 1981 to 5.7% in 1988.

2003-2008 (Bush Tax Cuts - supply-side tax cuts)

Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRAA) and Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA)

JGTRRA accelerated the gradual rate reduction and increase in credits passed in EGTRRA. The maximum tax rate decreases originally scheduled to be phased into effect in 2006 under EGTRRA were retroactively enacted to apply to the 2003 tax year. In addition, the child tax credit was increased to what would have been the 2010 level, and "marriage penalty" relief was accelerated to 2009 levels.

There were also capital gains tax cuts in both.

The Bush tax cuts had sunset provisions that made them expire at the end of 2010. But were extended by a two-year extension that was part of a larger tax and economic package, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010.