ECON 364 – Topic Eleven

Supply Side Economics

From:  "Supply Side Economics" by James D. Gwartney

The Fortune Encyclopedia of Economics, ed. by David R. Henderson 

1.     Why and how are marginal tax rates central to supply-side analysis?

The role of incentives: 

2.     An increase in the marginal tax rate will reduce the share of additional income that earners are permitted to keep.  What are the two reasons that this adversely affects output?  Do supply-siders support Say's Law?

This is based upon the assumptions regarding the “Backward Bending Supply Curve of Labor” and the theory surrounding the “Laffer Curve.”

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).  

Review:  The Backward Bending Supply Curve of Labor:  (The labor/leisure trade-off) - substitution and income effects -

2.  Marginal tax rate increases, people turn to tax shelter investments to avoid excess taxes (for example, investments that generate paper losses from depreciated assets).  Therefore people are spending resources on tax avoidance instead of on productive activities.  

As tax rates rise, investments that generate paper losses from depreciable assets become more attractive.

So too do business activities that present opportunities to deduct expenditures on hobbies and personal amenities.

People are directed into activities because of tax advantages rather than profitability.

Encouraged to substitute less desired tax-deductible goods for more desired nondeductible goods.  

Waste and inefficient use of valuable resources are a by-product of this incentive.

3.     What is the difference between a change in tax rates and a change in tax revenues?  What is the "tax base?"  Why does, according to the supply-siders, an increase in tax rates create a less than proportionate increase in tax revenue?  Might there actually be an inverse relationship between tax rates and tax revenues?  Why?  Explain the Laffer Curve. 

The inverse relationship is likely when marginal tax rates are high, but unlikely when rates are low.

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

  4.  With a progressive income tax system, why might a tax cut for someone in the higher tax bracket give them a greater incentive to earn than it does for someone in the lower tax bracket? 

Tax rates cut by 1/3.  The guy in the 75% tax bracket goes to 50% -- keeps $50, rather than $25 of every additional $100 earned - a 100% increase in the incentive to earn.

The revenues collected from these guys might actually increase.

The guy in the 15% tax bracket goes to 10% -- keeps $90, rather than $85 of every additional $100 earned -- only a 5.9% increase in the incentive to earn.

So tax revenue would likely decline here.

The share of the tax revenue paid by higher income tax payers would go up.

5.    Why did the inflationary seventies create a receptive environment for the supply-side view?  What is tax bracket creep?

6.    Is there empirical evidence to support the supply-side view?  What did Lindsey's study conclude? Short run vs. Long Run?  What is the difference between a supply-side tax cut and a Keynesian tax cut?  Did the Supply-Side "movement" make an impact?

Lindsey:  Used computer simulation model to estimate the impact of the eighties’ tax-rate changes on the various components of income. 

Found with lower taxes, the wages and salaries of high-income taxpayers were approximately 30 percent larger than projected. 

After tax cuts capital gains were approximately 100 percent higher than projected, and high-income taxpayers’ business incomes was 300 percent higher than expected.

Concluded: 

a.  people paying themselves more in the form of money income rather than fringe benefits,

b.  increases in business activity,

c.  a reduction in tax shelter activity.

Short run effects of tax policy not a strong as long run.  Taxpayers take time to adjust, revenue are even more responsive to rate changes in the long run.

States study:  states with lower marginal tax rates had much lower deductions and much lower expenditures on tax shelters.

Government revenue begins declining at 50% (Long and Gwartney) or 35% (Lindsey).

Empirical Evidence:

1921-1926 (Coolidge Tax Cuts)

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

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-Johnson Tax Cuts)

The top marginal tax rates were reduced from 91% to 70%. The bottom rates were reduced from 20% to 14%.

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%. From 1981 to 1988 (1982-84 dollars), income tax revenue from the top 10% earners rose from $150.6 billion to $199.8 billion (+32.7%). Top 1% and 5% of taxpayer’s real revenue was even larger. Tax liability for the bottom 90% declined from $161.8 billion to $149.1 billion (-7.8%). Note the overall increase in tax revenue of $36.5 billion (considering only these two groups of taxpayers -- the top and bottom income earners).

Note:  the Bush tax cuts, taken together and measured as a % of national income are larger than Reagan's but smaller than Kennedy's.

Kennedy, Reagan, and Bush Tax Cuts in Historical Perspective

Source:  http://taxfoundation.org/bushtaxplan-size.htm