Monday, September 10, 2012

Failed Supply-Side Economics?

(Written September, 2012)
 In the last couple of weeks, I’ve read several political commentaries that mention, just in passing, how supply-side economics were a dismal failure.  Typical of those were Joe Klein’s TIME magazine piece of September 3rd, where he wrote:  “In a way, neoconservatism is the Republican foreign policy equivalent of supply-side economics. It has been tried and failed.”  Similarly, President Obama, who I like overall and plan to vote for in November, said that supply-side economics was a theory that “has never worked “  (  I say that comments like these are made “just in passing”, because the failure of supply-side economics is so widely accepted as true these days that the claim often doesn’t even merit explanation.

But that’s a big problem, because it’s not true.  Here are three reasons why:

Robert Lucas wrote the following in 1995, 14 years after Ronald Reagan initiated the age of supply-side policies in America: “The supply side economists, if that is the right term for those whose research we have been discussing, have delivered the largest free lunch that I have seen in 25 years of this business, and I believe we would be a better society if we followed their advice.  The attraction of (supply-side economics) is not that it is pretty – though it can be – but that, given half a chance, it works.” (The Wall Street Journal, October 13, 1995)  Lucas explains his comments in more detail of course, but his message is pretty clear: supply-side economics, in fact, worked quite well.  Lucas, by the way, has been called the most influential economist of the final 3 decades of the 20th century, and received the Nobel Prize in Economics the same year he made those comments.  (  Wouldn’t you think that Nobel Prize-winning Lucas knows more about the topic than politicians running for office and pundits like Klein?   I would.

I’m not sure why the conventional wisdom (supply-side failed) ignores Lucas’ comments, but he is, after all, just one guy with an opinion.  So maybe he is wrong, or maybe the Journal misrepresented his views on the subject.  But here’s thing #2.  The main reason people say supply-side economics failed is the huge federal deficits caused by supply-side tax cuts during the Reagan years.  There were indeed large deficits during those years, but it’s not at all clear that they were caused by supply-side tax cuts. 

First of all, it’s not clear that lower tax rates were responsible for lower revenues to the Treasury in the 1980s and ‘90s.   Higher tax rates actually lowered tax revenues after the rate on capital gains was increased from 20% to 28% in 1986.  The politically-neutral Congressional Budget Office (CBO) “overestimated capital gains realizations by $527 billion between 1989 and 1992.”  A few years later, Congress’s Joint Committee on Taxation (JCT - also politically-neutral) projected that cutting the capital gains rate back to 20% from 28% in 1997 would reduce revenues by $21 billion.  Instead, the lower tax rate increased revenues by $38 billion.  (San Diego Union Tribune, May 12, 2006)   So while raising tax rates might increase federal revenues, and lowering tax rates might lower federal revenues, there do seem to be cases where the opposite occurred, in line with supply-side theory.

Secondly, the evidence indicates that the main source of budget deficits in the 1980s was the uninterrupted increases in government spending, not a decline in tax revenues.  The following chart shows that while tax receipts dropped for a couple of years in the early-80s (a natural result of the country being in a recession), the larger problem was that federal spending never did slow down.  In fact, the chart shows that by the mid-80s tax revenues were back to rising at a healthy rate, even with the supply-side cuts.  According to Bob Packwood, chairman of the Senate Finance Committee in the 1980s: “In 1982, when we were in the recession and we knew we had to narrow the deficit, Congress made a promise to Reagan: accept $1 in tax increases and we’ll give you $3 in spending decreases.  He signed the tax bill.  He never got the spending cuts (that Congress promised).” (Barron’s, April 24, 1995)   Rather clearly, excessive government spending was the main cause of the Reagan-era deficits, not supply-side tax cuts. 

Yet Reagan himself deserves blame for some of that big spending, as he ratcheted up money going to national defense in line his commitment to win the Cold War.  One can argue whether that spending was wise or effective, but one cannot claim that it was part of supply-side economics.  It quite simply was not; supply-side policies have nothing at all to do with increasing defense spending.

This leads us to important problem #3; most people don’t really understand what “supply-side economics” means.  Supply-side economics is an attempt to increase the supply of goods and services in an economy, using a variety of specific policies, or "levers".  Cutting marginal taxes and capital gains rates, while the most publicized of those, is only one possible lever.  Other supply-side levers include: reducing government regulation on businesses, privatizing public enterprises, increasing education and job-training, reducing discrimination, limiting the powers of labor unions, providing subsidies for key industries, improving infrastructure, and promoting free trade.

Again - the goal of policies like these is to increase the amount of stuff being produced in a country, which tends to create more jobs and lower inflation rates.  Hence, few if any people argue that increasing aggregate supply is a bad thing.  Some have a problem with the negative side-effects of certain supply-side levers, and it’s not clear that all of those levers worked during the Reagan/Bush years.  But overall, they seem to have done the trick, as Lucas argued and this chart shows.  Both inflation and unemployment rates started dropping dramatically after a couple of years of supply-side policies.  By the late-80s, unemployment was averaging about 6%, vs. 7.5% earlier; meanwhile, inflation dropped even more dramatically – from about 8% to around 3%.  This was truly a win/win for the nation.  And there’s good reason to believe that the much-vaunted successes of the Clinton years that followed were mainly the afterglow, ongoing effects, of these earlier policies.  But to repeat - tax cuts were only one part of this success story.

So look: Dismissive claims of the failure of supply-side economics are unfair and inaccurate.  They seem to be based on a selective and sometimes-flawed reading of history, supplemented by a misunderstanding of the actual nature of supply-side policies.  These days, economists are dubious about the ability of lower tax rates to increase tax revenues further, and few argue that rates are currently too high.  So tax cuts (and other supply-side policies) may not be the answer to today’s economic problems.  But it was a different world and a different economy 30 years ago, and back then they seemed to be just the ticket.  They worked; that’s what the evidence shows, in contrast to what Klein, Obama, and others snarkily aver today.  
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