Supply-Side Economics

(Reaganomics, Trickle Down Economics)

 

 

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):

 

 

 
 

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 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.

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

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).

In The Way The World Works, Jude Wanniski, one of the leading gurus of the "supply-side" school, calls for  discovering the actual shape of the "Laffer Curve."

That part of "The Curve" at which government revenue is maximized should be pinpointed and fiscal policy implemented to assure that the economy is moved to that point without further delay.

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.

 

Empirical Evidence?

More Recently:  Canadian Reforms

There have been quite a few recent corporate tax reforms in Canada, which is America’s largest trading partner. Since 2000 these have included:

Cutting the federal statutory tax rate from 29.12 percent to 15 percent and cutting the average provincial tax rate from 13.3 percent to 11.1 percent.

Eliminating most federal and provincial capital taxes, which were levies on a measure of business assets.

Removing sales taxes on capital goods in most provinces as a result of harmonizing provincial sales taxes with the federal Goods and Services Tax (a form of value-added tax).

Adopting generally more neutral capital cost allowances for the corporate income tax.

Scaling back some of the special preferences under the corporate income tax.

The cut in corporate tax rates does not seem to have lost Canadian governments much, if any, revenues. The combined federal-provincial tax rate fell from 42.4 percent in 2000 to 29.4 percent in 2010. (The rate has fallen further since then). Despite this 31 percent cut and the 2009 recession, tax revenues as a share of gross domestic product (GDP) have remained roughly constant due to rising corporate taxable income (more multi-national corporations have moved into Canada because of the lower tax rates).

 

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).

Revenues (from all taxes) to the U.S. Treasury nearly doubled.  Revenues increased from roughly $500 billion in 1980 to $1.1 trillion in 1990.

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)

EGTRRA generally reduced the rates of individual income taxes:
  • a new 10% bracket was created for single filers with taxable income up to $6,000, joint filers up to $12,000, and heads of households up to $10,000.
  • the 15% bracket's lower threshold was indexed to the new 10% bracket
  • the 28% bracket would be lowered to 25% by 2006.
  • the 31% bracket would be lowered to 28% by 2006
  • the 36% bracket would be lowered to 33% by 2006
  • the 39.6% bracket would be lowered to 35% by 2006

The EGTRRA in many cases lowered the taxes on married couples filing jointly by increasing the standard deduction for joint filers to between 174% and 200% of the deduction for single filers.

Additionally, EGTRRA increased the per-child tax credit and the amount eligible for credit spent on dependent child care, phased out limits on itemized deductions and personal exemptions for higher income taxpayers, and increased the exemption for the Alternative Minimum Tax, and created a new depreciation deduction for qualified property owners.

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.

Income tax revenue rose, going from $925 billion in 2003 to $1.53 trillion in 2007.  

Total federal revenue for 2008 dropped slightly, down to $2.52 trillion, because a recession started that year.   During the same period, income tax revenue dropped slightly in 2008, down to $1.45 trillion.

After the Bush tax cuts, the top 1% paid a larger share of all federal income taxes than before.  In 2007 the top 1% of taxpayers earned 22.8% of the nation's income, yet paid 40.4% of all federal income taxes, whereas in 2004 the top 1% paid 36.89% of all federal income taxes. So the percentage of income taxes paid by the top 1% went up (this also means that in 2007 the top 1% paid more in federal income taxes than the bottom 95% paid.)

 

Criticisms of the Theory:
 

1. Some critics claim that the elasticity of labor supply is very low:

    Wage elasticity of labor supply:

 

Therefore, a change in the tax rate does not actually change people's work or output very much.

However, these elasticity estimates are typically short-run estimates.  Most studies do show that the long run estimates are much higher.  For example, Edward Proscott's famous cross-country studies "found that the elasticity of the long-run labor supply was substantially greater than in the short-run supply and that differences in tax rates between France and the Unites States explained nearly all of the 30 percent shortfall of labor inputs in France compared with the United States." (James D. Gwartney, "Supply-Side Economics")

2.  Regarding "discovering the shape of the Laffer curve" to find out what tax rate will maximize government tax revenue: 

    The obvious question that some economists would ask is, how do we ever find out the actual shape of "The Curve" and where we are on it?

    If, for sake of the argument, it was accepted that such a "Curve" exists somewhere out there, it is important to realize that it would be nothing more than the cumulative subjective estimations of a multitude of individuals about the relative advantages of work vs. leisure, consumption vs. savings, etc.

"The Curve" would be no more fixed or stable than the expectations and preferences of the individuals in a particular community. Changes in people's valuations, revisions in expectations about the political, social or economic climate and new discoveries of cost-saving production techniques would all work to make any hypothecated "Laffer Curve," a shifting, shadowy entity whose position and shape would be as fluid and erratic as the imaginative minds of the individuals who comprise the elements living under "The Curve."

3.  Probably an even more important criticism than the theoretical difficulties of determining the position and shape of "The Curve" is the assumption that the goal of fiscal policy should be the maximizing of governmental revenues.

    Why is that a good policy goal?  Maximizing government revenue means you are also maximizing the opportunity cost of those resources taken away from the productive sector of the economy.  In a way, this is contradictory to the theory. 

    Cut taxes to increase productivity - the increase in productivity will generate more tax revenue - then decrease productivity by moving resources out of the productive sector of the economy.

4  Although a secondary idea that comes out of the theory is that the relatively rich end up paying more of the tax revenue -- the relatively rich might still end up better off compared to those who, most especially, don't pay income taxes.  Because the theory of supply-side economics is “tax-cuts on income and capital gains,” it stands to reason that the immediate beneficiary is going to be those with significant income. In the United States, the wealthiest 50% of households pay more than 95% of the income taxes and the wealthiest 5% pay 50% of the income taxes. If one group is getting taxed and the other is not, a tax cut will effectively increase the disposable income of taxpayers relative to non-taxpayers. If Jane is in the top 5% of incomes and Bob is in the lowest 5%, a tax cut raises Jane's income but has no effect on Bob because Bob was not paying taxes in the first place. Some would object to this. 

However, the benefits of the tax revenue being spent are another issue.  Do those who pay income taxes benefit more or less (relative to what they pay) than those who pay nothing?