Alan Reynolds: What Supply-Side Economics Means

By Alan Reynolds

April 26, 2007
Found at Townhall.com

In “The Seven Fat Years,” Robert Bartley, the legendary former editor of The Wall Street Journal, wrote: “On March 26, 1976 Herb Stein coined a label, the ‘supply-side fiscalists,’ telling a conference at the Homestead Resort in Virginia that it consisted of ‘maybe two’ economists. Alan Reynolds passed this along to Jude (Wanniski), who promptly appropriated the label, though dropping ‘fiscalists’ as awkward and misleading.” The label was new, but the basic concepts had been explained in Wanniski’s Journal article of Dec. 11, 1974, “It’s Time to Cut Taxes.”

In 1977, Bruce Bartlett went to work for Jack Kemp, the congressional quarterback for what eventually became President Reagan’s first round of tax rate reductions.

In a recent New York Times article, Bruce wrote: “I think it is long past time that the phrase (supply-side economics) be put to rest. … It has become a frequently misleading and meaningless buzzword that gets in the way of good economic policy. Today, supply-side economics has become associated with an obsession for cutting taxes under any and all circumstances. No longer do its advocates in Congress and elsewhere confine themselves to cutting marginal tax rates — the tax on each additional dollar earned — as the original supply-siders did. Rather, they support even the most gimmicky, economically dubious tax cuts with the same intensity. … Today, it is common to hear tax cutters claim, implausibly, that all tax cuts raise revenue.”

Labels aside, those remarks are nothing new. In a July 2004 column, Bartlett correctly remarked that, “The vast bulk of tax cuts since 2001, in revenue terms, have gone for tax rebates, kiddy credits and other measures having no impact on marginal incentives.”

Of course such “gimmicky tax cuts” lose tax revenue. But Wall Street Journal columnist Robert Frank, writing on economist Greg Mankiw’s blog, recently imagined he had witnessed “the supply-sider Bruce Bartlett now conceding that tax cuts for top earners don’t boost total tax revenues.” Bartlett conceded no such thing. Revenues have risen impressively since the 2003 reduction of tax rates, and nearly all of the gains are from top earners, including profits, capital gains and dividends.

In 2004, Bartlett wrote that “with federal revenues at just 15.8 percent of gross domestic product (GDP) — well below their historical level of 18 percent — I don’t think our economy is overtaxed.” The Congressional Budget Office now estimates federal revenues of 18.6 percent of GDP this year and 19 percent next year.

Phrases intended to describe complex ideas in a word or two, such as Keynesian or monetarist, invariably become misused or hijacked after three decades. But such semantic abuses can’t be halted by Bartlett’s white flag. Like it or not, the phrase “supply-side economics” will doubtless continue to be used and abused.

Bartlett says, “The context in which the term had meaning no longer exists, and therefore it has become a barrier to communication.” That context refers to a debate about the appropriate “policy mix” in a situation of double-digit inflation combined with severe recession, as in 1974-75 or 1980-82. The supply-side innovation, from Nobel Laureate Bob Mundell, was to suggest that (1) monetary policy is the right tool to keep inflation in check, and that (2) the focus of tax policy should be shifted from short-term accounting results (deficits) toward improving longer-term incentives for productive work and investment. The first part of that package is actually monetarist, and neither part ever ceases to be relevant to inflation and economic growth, respectively.

I wrote a paper on “The Fiscal-Monetary Policy Mix” for the Fall 2001 Cato Journal. It began by saying: “In the early postwar years, during the heyday of fiscal fine-tuning … the predominant view was that the main function of monetary policy was to ‘stimulate’ debt-financed purchases by keeping interest rates low. Inflation was first considered a useful lubricant to be traded for lower unemployment, and inflation could be reduced only by tolerating high unemployment. In the late ’60s and early ’70s, when the shrinking dollar proved less popular than expected, inflation was routinely described by a thermal metaphor (‘overheating’) and regarded as an endemic problem to be endlessly ‘fought’ by using fiscal policy (a surtax) and incomes policy (wage-price controls), but never monetary policy.”

The context of my remarks was the conventional unwisdom that gave us LBJ’s surtax in 1968 and Nixon’s price controls in 1971. In a blog commenting on Bartlett’s piece, New York Times columnist Paul Krugman was irritated by Bartlett’s comment that “Keynesians of that era” thought “monetary policy is impotent and inflation is caused by low unemployment.” Krugman replied: “I was a grad student at MIT — the great Keynesian stronghold — in the 1970s, and this bears no resemblance to what was being taught. In fact, I still have my copy of Dornbusch-Fischer, ‘Macroeconomics,’ the 1978 edition — and it doesn’t make any of those assertions.”

By 1978, however, supply-side ideas were even getting attention in textbooks. In the 1978 edition of Campbell McConnell’s best-selling “Economics” text, the “Last Word” on fiscal policy was a paper of mine that is still online at taxfoundation.org. The 1978 Dornbusch-Fischer text found supply-side tax policy “intriguing” and thought we may well need “fiscal policies that operate on aggregate supply.”

Bartlett says: “I still think (supply-side economics) was the right cure for the economic problems we were facing in the late 1970s. I also think it embodies some fundamental truths that are applicable at all times. But these fundamental truths, such as the idea that high marginal tax rates are bad for the economy, are now almost universally accepted.” That is almost true. Mainstream economics almost universally accepts “optimal tax theory” and the “elasticity of taxable income” — elegant elaborations of original supply-side themes. If incentives didn’t matter, then we might as well discard the word “economics,” not just supply-side (incentive-based) microeconomics.

Greg Mankiw is a “new Keynesian” scholar who thinks tax incentives matter a lot. Ed Prescott is a “real business cycle” scholar who thinks tax incentives matter even more. But Mankiw, Prescott, Martin Feldstein and others still quarrel with their retrograde peers. Being “almost universally accepted” is almost good enough, but not quite. When tax policy in most countries is as close to optimal as Hong Kong’s, I will gladly stop mentioning supply-side economics.

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Today’s Brew 3-7-07

Excerpt:

Though inflation is traditionally viewed as a monetary phenomenon, Bernanke pointed to demand from China and other formerly dormant countries as major contributors to rising energy and commodity prices in recent years. He also cited a study that showed oil prices in 2005 would have been as much as 40 percent lower absent demand from those economically resurgent countries.

The question then is whether demand itself can be inflationary. No doubt a shortage of oil met by stable or rising demand would drive up its price, along with the prices of oil byproducts. Where this theory breaks down is that if demand for certain products is pushing prices up, demand in other areas must be falling, and in the process, driving other prices down. The net effect of demand-driven inflation is zero.

Today’s Brew 10-27-06

Justin Fox has an interesting commentary or analysis at Time.com:

The path from supply-side economics to deficit spending.

At its core, supply-side economics is the economics that reigned before John Maynard Keynes came along. You could also call it traditional economics, neoclassical economics, or mainstream economics. It assumes that people respond rationally to economic incentives, and unfettered markets arrive at something close to optimal results. Saving, in this worldview, is a good thing–because savings are always put to use in productive investments that make the economy grow.

Today’s Brew 10-18-06

Larry Kudlow pointing out interesting stuff about JFK:

JFK the Supply-Sider

“Our true choice is not between tax reduction, on the one hand, and the avoidance of large federal deficits on the other…[A]n economy hampered by restrictive tax rates will never produce enough jobs or enough profits…It is a paradoxical truth that tax rates are too high today and tax revenues are too low, and the soundest way to raise revenues in the long run is to cut rates now.” – Democratic President John F. Kennedy in a December 14, 1962 speech at the Economic Club of New York.

(Note: After JFK cut taxes across the board, the inflation-adjusted economy expanded by more than 42 percent over the next seven years. The icing on the cake? During that same period, federal revenues climbed from $94 billion in 1961 to $153 billion in 1968, an increase of 62 percent (33 percent after adjusting for inflation). History is clear – tax cuts do not result in revenue cuts. As we discovered in 1961, 1981, 1997 and 2003, cutting taxes actually increases revenues. Today’s tax-loving Dems might want to take a page out of JFK’s playbook…)

Today’s Brew 10-5-06

Thanks to Larry Kudlow for this:

Schumpeter’s Gales of Creative Destruction

Richard Rahn hit the nail on the head in his Washington Times op/ed earlier this week:

The “real do-gooders,” in the sense that their actions really do alleviate poverty and make life better for their fellow man, are entrepreneurs who create real jobs, goods and services that make our lives better, and those political leaders who have reduced unnecessary regulations and strengthened property rights, such as Margaret Thatcher, Ronald Reagan and Mart Laar (the former Estonian prime minister who led the reforms in his country)…

Governments cannot create jobs; they can only destroy jobs in the private sector by increasing taxation on the productive to create a “new government job.” Many of those who attack Wal-Mart or other business people for not paying “high enough” wages, or the rich for not paying “enough” in taxes, have never created a productive job in their lives, nor have they ever had the imagination or energy to create any new good or service to make our lives better. Yet, they often refer to themselves and are indeed called “do-gooders.” What a perversion of the language.

Today’s Brew 11-2-05

John Tamny writes at National Review Online:

The Boon of Big Oil Profits

Lawmakers must understand that cheaper fuel is on the horizon.

Excerpt:

Back in 1980, in the midst of the last era of expensive oil, oil companies represented 28 percent of the S&P 500’s value. This investment boom stimulated exploration and led to an oil “glut” in the 1980s and ’90s. In this new environment, cheaper oil and lower oil-company profits meant that investment moved elsewhere, and with this asset redeployment, oil-company share of the S&P 500 fell to 7 percent. The latter number arguably foretold today’s energy prices to the extent that they’re a demand, as opposed to a weak-dollar, phenomenon.

Notably, oil companies now comprise 10 percent of the S&P’s value, and the number will presumably rise as oil companies report earnings and are subsequently rewarded with higher valuations. This change in the S&P’s makeup heralds cheaper oil in the future.

Also, record profits attract imitators and innovators. Canadian oil company Suncor Energy is an example of innovation at work. It has devised a way to extract crude from oil sands, and the consensus is that this process will greatly expand the amount of proven reserves around the world. Happily, investors have rewarded Suncor; its stock is up 400 percent over the last five years, a timeframe in which the Dow has been flat while the S&P 500 and Nasdaq have been down.