The Return of Supply Side

The good news is that supply-siders want to cut taxes. The bad news is ... well, let's accentuate the positive for the moment. The supply-siders reject Washington's tendency to think in static terms. To most politicians and bureaucrats, the economy is a pie for the tax collectors and special interests to slice up and gorge themselves on. Then they are shocked when the economy stops growing.

In truth, people respond to policy changes in ways Washington can't anticipate. When capital formation and value creation is taxed, there is less of it. Unlocking that capital by reducing taxes on income and investments is a sure path to economic growth. So far, the supply-siders are correct, and a big improvement on Keynesian-style D.C. economic theory.

Liberals say tax cuts only help the rich. But by definition, the rich are the ones with the financial means to invest and create jobs. If it's economic growth and restored prosperity that we're after, no plan that punishes the rich disproportionately is going to succeed.

The static attitude of Washington spills over into all areas of fiscal policy. Especially pernicious is the doctrine of "revenue neutrality," which says that tax cuts are forbidden unless they can be "paid for" with equal spending cuts. At the same time, the doctrine hasn't restrained spending. Thus taxes can never go down so long as static analysis prevails.

For that reason, the supply-siders have warned that fear of deficits is little more than a smokescreen for keeping deficits high. As political analysis, this is true. When the 104th Congress shifted its focus from cutting government to cutting deficits, it doomed itself to failure. In fact, in the sweep of American history, the debt has been reduced primarily in times of tax cutting.

The main trouble with this doctrine is that it puts too much emphasis on the incentives introduced by tax rate changes and not enough on the overall tax burden. For example, supply-siders at the Wall Street Journal disparage the idea of allowing tax credits for children because it doesn't cause people to churn their investment accounts. Guru Jude Wanniski has attacked Bob Dole's proposed tax credit as "very expensive for what it would yield in added economic growth."

Expensive for whom? The government, of course. But from the point of view of the family, it's a wonderful thing, as is any tax cut, anywhere any time. It allows people to keep more of their own money, an essential precondition for restoring prosperity.

Neglecting the overall tax rate leads to other errors. The supply-siders back flatter taxes, on grounds that progressive rates penalize wealth accumulation. But if these flatter taxes end up as higher taxes (as they do in most proposed reform packages), it would be for the worse. It's better to have three progressive rates of 15%, 28%, and 33 % than a flat rate of 30%. It's not the flatness that counts so much as the overall level.

It's a danger to view taxes as a tool for social or economic planning, even when the planning involves policy changes friendly to the free market. People's actual behavior will always surprise the planners. One example: if taxes were dramatically lowered working mothers might decide to leave the work force, thus causing a statistical "loss of jobs," fewer tax receipts, and, even, a supposed economic slow-down. Would supply-siders tolerate this, even if American families were made better off?

The strength of supply-side doctrine is its attention to the disincentives that high marginal tax rates create for saving and investment, the pillars of economic growth. Its weakness is that it does not go far enough: it's not just ascending marginal rates that dampen economic growth, but all taxes that redistribute wealth from the private to the public sector. The overall level of all taxes – including payroll taxes, excise taxes, and inheritance taxes – matters just as much as how those taxes are structured and which sectors they hit.

So much for the soft claims of supply-siders. In the best light, it's classical economics marketed for our times, and praiseworthy as far as it goes. But there is another side to supply-side tax doctrine that deserves more scrutiny, beginning with its claim that tax cuts tend to pay for themselves. This is a doctrine constructed mainly for political advantage. It relieves tax-cutting candidates from having to specify spending cuts.

The empirical example usually cited to prove this claim comes from the 1980s: rates went down, growth went up, while revenue went up. Sadly, the data usually consider only income tax rates, which were indeed cut, and leave aside all other taxes, which were vastly increased. For example, the primary text defending the 1980s, Robert Bartley's The Seven Fat Years, suppresses all discussion of Reagan's tax increases.

Ironically, it was Bob Dole who watered down the tax cut of 1981, and eventually pushed through a reversal when he served as chairman of the Senate Finance Committee. Dole claimed frequently on background to the New York Times that tax cuts are potentially inflationary.

The ink was barely dry on 1981's tax cuts when Dole and Pete Domenici devised new tax increases totaling $48 billion. By the end, this had ballooned to $122 billion, and it included a repeal of the third installment of cuts. Dole shepherded it through the Senate on a partisan vote, with Democrats voting against tax increases. In light of what was then the largest tax increase in U.S. history, it's hardly surprising that revenue increased.

There's an even darker side to supply sideism, typified by Jack Kemp's wild spending when he was head of Housing and Urban Development. While calling for tax cuts, he demanded far more for his own department than even a Democratic Congress would consider. As Jeff Tucker has pointed out, if Kemp's requests had been approved, HUD would have grown by half, as it was, he managed to expand it by a third.

Was this the exception to the supply-side rule? Sadly not. Their writings express the view that we can keep the mixed economy just as it is – dominated by the world's largest system of transfer payments – so long as we reconfigure the tax code. Private enterprise can be enlisted, unwittingly, to pay for ever-higher public spending.

To make tax cuts a reality and a public benefit, government must be made to curb its appetite for spending. Without such a curb, the spending will be paid for in other ways: through increased borrowing, which crowds out private investment, or through debt monetization.

A similar problem spoils supply-side monetary policy. Many advocate a gold price rule for monetary management. But the chief benefit of gold is that it shackles the ability of government to borrow and monetize debt. All that government spends must be collected in taxes or else. Loose money is absolutely prohibited. The benefits of gold derive from the fiscal discipline it imposes, the discipline supply-siders reject as "root-canal economics."

Should we cut taxes? The more the merrier. It doesn't matter whether it's socialists, free marketeers, or supply-siders doing the cutting, so long as the burden of government is reduced. But let's not fool ourselves into thinking that tax cuts can make today's socialistic policies fiscally feasible. The goal is to hinder the planners – whether they seek to control what the people demand, supply, or both.