Bring Back Voodoo Economics

Understanding Supply Side Economics

By Henry Oliner

It has been derided as voodoo economics by George H.W. Bush and contemptuously as 'trickle down' economics by opponents from the left and some from the right.  When Ronald Reagan embraced supply side economics many Republicans and Democrats were skeptical.  When unemployment shot up to 11 percent and interest rates spiked to 20%, Reagan's own party and even members of his cabinet were questioning the wisdom of cutting taxes at the high end of the rates.

High unemployment, painful as it was, helped bring inflation under control.  Interest rates and unemployment fell.

Supply side economics has retained a bitter opposition.  Economics is often not intuitive:  at first glance the proposition seems illogical, but after further consideration and analysis it proves to make good sense. Unfortunately few issues get beyond first glances before minds are ossified, and fail to understand the principle.

It is not immediately intuitive that decreasing tax rates (percentages) can possibly yield greater tax revenue (dollars).  It is unsatisfactory to describe the process as a trickledown effect: that by leaving more money in the hands of the wealthier taxpayers that they will generate more income that will trickle down to the less fortunate.  Supply side theory states that this can happen, but it does not apply in unlimited situations.

The famous graph shows a bell with zero tax rates on one extreme and a 100% tax rate on the other extreme.  It assumes that with a zero tax rate no tax revenues will be generated.  This seems obvious except for those very few who will voluntarily share their wealth with the government.  On the other extreme a 100% tax rate will also generate no tax revenues since few people will work for no compensation.

As you move from a zero tax rate to 5%, and gradually higher you will generate increasing revenue up to a point.  Revenue dollars are also increased as you drop from 100% downward to a point where further cuts generate no additional revenue.  Theoretically, at some point between the extremes there is a rate that maximizes revenue; where either raising or lowering tax rates will generate less revenue dollars.  

The curve of course is a model, and in reality the bell is not a smooth symmetrical shape and the shape may change over time.  But the bell model demonstrates two realities: first is that lowering tax rates does not always increase revenues, nor does raising taxes always increase revenues. Furthermore, depending on your position on the curve, raising tax rates can decrease revenues and lowering taxes can increase revenues.

Secondly it shows that there are usually two different rates that will generate the same revenues.  Assume the graph shows that a 30% tax rate and a 70% tax rate will generate the same revenue.  There are some who would prefer the 70% rate because it would make the wealthier pay a bigger share of the bill.  Why would we care whether the rate is 30% or 70% if it generates the same dollar revenue?

The answer is that the 30% rate will support a larger growing economy, more innovation and startups, and lower unemployment.  If we can choose from two rates why not choose the rate that is much more likely to generate a robust growing economy?  It is not a matter of wealthier people generating more wealth that trickles down. It is a matter of stimulating a wider distribution of wealth generating activity.

How much improvement a lower tax will generate depends largely what it is being dropped from, competitive tax rates in other countries, and the type of tax considered.  A tax on personal income for most people is hard to avoid. If a worker making  $800 a week gets a 3% increase in taxes there is little he can do about it.  If taxes on capital gain are increased it is very easy to avoid by simply holding onto investments longer, by moving assets into tangible matter such as art or collectibles, or by simply investing less.  The undesirable irony here is that a tax increase is more likely to raise revenue if it is levied on those at the lower end of the income spectrum.  This may have been the secret to Bill Clinton's economic success; having raised income taxes and lowered taxes on capital gains and dividends.

Reagan's economic miracle was largely fueled by a shift of trillions of dollars from tangible assets, sought to protect investors from the ravages of inflation in the 1970's, to financial assets that fueled the dramatic stock market growth and entrepreneurial activity.  Reagan's success was as much because of the control of inflation as it was the reduction in taxes and regulation.

Supply side theory stresses the value of a stable dollar and the elimination of frictions toinvestment and income growth. Such frictions can be increases in taxes or regulation. 

With a different background such reductions in friction costs may not yield the same growth as the Reagan years, and there is a threshold that must be reached to move a population that does not trust the government to stay with any policy for a long enough period of time to benefit them.  Timid moves will cause little change, and even larger moves must also be accompanied with a restoration of trust and consistency.

But those who quickly dismiss supply side theory as 'trickle down' show little understanding of the reality or the theory.  Supply side programs have been successful for Democrats under Kennedy and Clinton, and for Republicans such as Coolidge and Reagan.

This administration is joining the ranks of Lyndon Johnson, Richard Nixon and Jimmy Carter as those who failed to understand this theory reality and devastated the economy as a result.