Neera Tanden for Democracy Journal: Burying Supply-Side Once and for All:
Issue #29, Summer 2013
Burying Supply-Side Once and for All
To read the other essays in “The Middle-Out Moment” symposium, click here.
If you are going to base all your efforts to win political power on a single economic theory, as conservatism has over the last 30 years, you might want to make sure it works. But that’s what’s so surprising about supply-side economics: Despite the fact that its central claim has been belied by decades of economic experience, it persists.
Supply-side economics assumes that lower tax rates boost economic growth by giving people incentives to work, save, and invest more. A critical tenet of this theory is that giving tax cuts to high-income people produces greater economic benefits than giving tax cuts to lower-income folks. Essentially, the more money the rich are able to keep, the more the whole economy will grow.
But the evidence reveals two fundamental problems with this story. First, its primary prediction is wrong—giving tax cuts to the rich does not increase economic output or create new jobs. Instead, tax cuts for middle- and low-income taxpayers are much more effective at boosting macroeconomic activity. Second, supply-side theory misunderstands the actual mechanism by which tax rates influence macroeconomic activity. While supply-siders maintain that lower rates at the top incentivize people to earn more money, the evidence shows that tax cuts boost output mostly by putting money in people’s pockets and thereby stimulating demand.
These empirical findings carry an important lesson for our tax policy: Rather than increasing inequality by throwing away revenue on tax cuts for the rich, we should ensure that middle- and lower-income Americans have enough after-tax income to maintain strong consumption levels, especially during economic downturns. Moreover, by perpetually fetishizing tax cuts for the top rates, conservatives have disregarded other policies that are more effective at spurring economic growth. Given the mounting evidence against supply-side economics, it’s time for conservatives to go back to the drawing board and come up with a reality-based economic agenda.
The Theory Behind Supply-Side Economics
Supply-side economics starts with a reasonable intuition: If you let people keep more of the income they earn, they will have an incentive to earn more income. Based on this intuition, supply-siders predict that lowering tax rates will encourage people to work, save, and invest more by increasing the after-tax returns from these activities. And they conclude that all this additional working, saving, and investing will generate faster economic and job growth.
Based on this story, supply-siders believe tax cuts will provide a bigger economic boost if they’re directed at rich people, as opposed to middle- and lower-income people. One reason is that rich people can afford to work less when tax rates are high, whereas lower-income people need to work enough to make ends meet regardless of the tax rate. Giving tax cuts to the rich therefore should generate a bigger uptick in work. A second reason is that economists typically think that people’s incomes correspond to the economic value of their labor. According to that logic, incentivizing a CEO to work a few more hours a week is thought to be more economically beneficial than incentivizing a janitor to work the same number of extra hours. A third reason is that rich people can afford to save most of their tax cuts, which in turn will increase investment. In contrast, lower-income people often need to spend the extra dollars.
But the real question for policy-makers is whether modest shifts in the top marginal rates make much of a difference. Sure, taxing wealthy people’s marginal income at 95 percent may create a disincentive to make more money. But are rich Americans really going to work and save a lot less just because income above $400,000 is now taxed at 39.6 percent rather than 35 percent? Given the centrality of supply-side theory to conservative economic arguments, one might imagine we’d have plenty of historical evidence that rich people do in fact respond to such changes in tax rates. But the evidence is in, and it shows no such thing.
History Proves the Supply-Siders Wrong
The best place to start this empirical inquiry is to look at what actually happens when top tax rates change. Do growth and employment shoot up when high earners get a tax cut? Does the economy tumble when their taxes rise?
At first glance, the historical record seems to offer little to support the supply-side story. Consider the last decade. In 2001, President Bush cut the top rate on capital gains and dividend income down to 15 percent from 20 percent—a rate that had already been reduced from 28 percent by President Clinton four years earlier—and cut the top rate on normal income down to 35 percent from 39.6 percent. And yet in the decade that followed we witnessed the worst economic performance since the Great Depression. From 2001 to 2008, before the crisis, economic growth was anemic at best, averaging 2.5 percent. By contrast, although the top tax rate was above 90 percent throughout the Eisenhower years, the economy grew at an incredible pace during the 1950s, with annual growth averaging more than 4 percent. And the jobs picture is even more stark: Under George W. Bush, total jobs grew only 0.8 percent during his term, while under Bill Clinton they grew by 20.7 percent, and under Dwight Eisenhower, 7.1 percent.
Supply-siders often credit President Reagan’s huge 1981 tax cut with spurring robust growth in the ensuing years. But while growth was strong during the 1980s, it was stronger still in the years following President Clinton’s 1993 tax increase on top earners. Whereas GDP grew at an average annual rate of 3.5 percent during the seven years following the 1981 cut, it grew at 3.9 percent per year over the seven-year period following the 1993 tax increase. In addition, nonresidential fixed investment also grew at an annual rate of over 10 percent during those seven years, compared to a rate of less than 3 percent in the years following both the 1981 and 2001 cuts. At the same time, median household income and real hourly earnings both grew faster after the 1993 tax increase than after the 1981 tax cut.
A recent paper by the nonpartisan Congressional Research Service also found no correlation during the postwar years between economic growth and the top tax rates on normal income and capital gains. Moreover, it found no discernible relationship between top tax rates and either investment or private savings, stating that the “reduction in the top statutory tax rates appears to be uncorrelated with saving, investment, and productivity growth.” Obviously, there are many factors that contribute to growth, but economic history clearly shows that there is no correlation between low taxes on the wealthy and high growth rates for the country.
Of course, this economic history alone does not settle the question of whether there are causal links between top tax rates and economic growth. But economists have used a variety of techniques to answer this question. And it turns out that contrary to supply-side’s central thesis, the wealthy are precisely the wrong people to whom to give tax cuts. A recent paper by Owen Zidar, formerly a staff economist at the Council of Economic Advisers, finds overwhelming evidence that tax changes for lower-income people have a far bigger impact on output and employment than tax changes for higher-income people. The paper finds that whereas a “one percent of GDP tax cut for the bottom 90% [of earners] results in roughly 3 percentage points of GDP growth over a two year period,” tax changes for the top 10 percent (those earning incomes above roughly $112,000) turn out to have a negligible and statistically insignificant effect on GDP growth and job creation. Indeed, these impacts grow exponentially larger the lower you travel on the income spectrum.
A growing body of scholarship also suggests that supply-siders are fundamentally mistaken about why tax cuts generate economic activity. Supply-siders believe that tax cuts promote growth primarily by encouraging people to earn more money, which is why they predict that lowering top rates will have an especially big impact. But in showing that this prediction is wrong, Zidar also finds that tax changes for low- and middle-income taxpayers produce big changes in consumption, whereas tax changes for high-income taxpayers do not. The fact that consumption and economic output tend to move in tandem suggests that tax cuts primarily influence output not by incentivizing people to earn more, but by enabling low- and middle-income taxpayers to spend more. Or in other words, tax changes appear to be influencing the economy not through the supply side, but through the demand side.
Recent work by economists like Austan Goolsbee, Emmanuel Saez, and David and Christina Romer backs up this idea by showing that tax changes actually have surprisingly small effects on people’s pretax incomes. For example, a new paper by the Romers finds that large increases in top marginal rates during the interwar years had a minimal effect on rich people’s incomes. And although tax changes sometimes appear to produce large year-to-year variations in income, work by Goolsbee and others has shown that these variations mostly just reflect shifts in how income is reported. These findings directly undercut the supply-side argument that tax rates dramatically influence individuals’ behavior, causing them to earn more income when rates go down and earn less when rates go up. Instead, they suggest that people are fairly unresponsive to tax rates when it comes to how much income they earn.
The Persistent Attraction of Supply-Side Theory
If the supply-side theory isn’t backed up by the evidence, why has it dominated conservative thinking and Republican Party platforms for over three decades?
It’s probably not a coincidence that the biggest beneficiaries of supply-side policies happen to be the same wealthy Americans who bankroll the Republican Party, along with the conservative media and think-tank infrastructure. But I don’t think this is simply a story of bad-faith arguments driven by cynical self-interest. The fact is that there’s something quite seductive about the idea that the best way to stimulate growth is to give yourself a tax cut. And if you happen to be an affluent conservative, there’s also something very appealing about a theory that says that your work and your savings are principally responsible for driving the economy forward. In other words, policy arguments in favor of tax cuts for the rich to induce more wealth generation neatly coincide with and reinforce a world view that holds that individuals become rich only through their own prowess, not because of the investments of others, or heaven forbid, the luck of the draw.
Conservatives also seized on supply-side economics as a tool to shrink the size of government. As anti-government activists like Grover Norquist realized long ago, Americans usually aren’t so keen to slash public programs. But tax cuts offered a way to attack spending indirectly by starving the government of revenue, driving up deficits, and then forcing politicians to cut spending in response. The supply-side story synced up nicely with conservatives’ anti-government ideology—if, like President Reagan, you already believe that “government is the problem,” helping it survive with sufficient revenues is probably not going to be appealing.
All this empirical work carries at least three important lessons for policy-makers. First, giving new tax cuts to rich people is a very bad idea unless your goal is simply to make rich people richer. Unfortunately, supply-siders’ decades-long fixation on cutting top tax rates has done just that, thereby exacerbating economic inequality. We know that America’s hyperinequality is deeply unfair and that it is reducing upward economic mobility, corroding our democracy, and eroding social cohesion. But as the other contributors to this symposium make clear, widening inequality also poses a serious threat to America’s future economic growth.
Second, we could raise top marginal tax rates quite a bit without reducing future growth or job creation. Such a policy would have the dual benefits of raising badly needed revenue while also mitigating inequality.
Third, targeted tax cuts for lower-income Americans, especially refundable tax credits like the earned-income tax credit, can be a powerful way to boost the overall economy. This is especially true during recessions when aggregate demand falls and people are unemployed for extended periods of time. Under these circumstances, as Larry Summers and Brad DeLong have recently argued, fiscal stimulus can significantly improve long-term growth by getting the economy moving again and thus preventing lasting damage to the productivity of workers and physical capital.
But in addition to distorting American tax policy, perhaps the most troubling legacy of supply-side theory is that it has led generations of conservative politicians and policy-makers to obsessively focus on tax cuts as the tool to promote growth, to the exclusion of many others. This myopia has been especially harmful because tax cuts have significant opportunity costs. For instance, by reducing government revenue, they can crowd out high-return public investments in areas like education, scientific research, and infrastructure. These investments are critical to America’s long-term growth and we shortchange them at our peril.
Supply-side theory also fails to address the most pressing challenge the American economy has faced since 2008: namely, insufficient demand to foster economic growth. In a world where people don’t have enough money to buy things and thereby create more demand for goods, a policy that focuses attention on tax cuts for people who are not going to spend them is ineffective at best.
While progressives may not have all the answers to achieve equitable growth, conservatives have the wrong answers. If conservatives are serious about promoting economic growth and prosperity, they need to stop fetishizing tax cuts and start proposing policy ideas that are based on actual facts. Indeed, history would tell us that investing in the middle class and those who want to rise into it is the best long-term economic growth strategy.
TAGS: Middle Class
ISSUE #29, SUMMER 2013
Post a Comment
Comments (you may use HTML tags for style)
Privacy & Terms
Note: Several minutes will pass while the system is processing and posting your comment. Do not resubmit during this time or your comment will post multiple times.
Printer Friendly PDF
Neera Tanden is president and CEO of the Center for American Progress. She served on President Obama's health-reform team to pass the Affordable Care Act and was the policy director for Hillary Clinton's presidential campaign.
Advertise on Democracy
Democracy, Brennan Center Co-Host Money-in-Politics Event
Democracy: A Journal of Ideas: On May 7, the Brennan Center for Justice, a New York City-based public policy institute, hosted a panel discussion co-sponsored by Democracy and Demos on money in politics, the subject of Democracy’s centerpiece symposium in the Winter 2013 issue.
Washington Post Interviews Kleiman on Crime Policy
The Washington Post: In a March 28 post in The Washington Post’s Wonkblog, Dylan Matthews interviewed UCLA professor Mark Kleiman about his essay, “Smart on Crime,” in the current issue of Democracy.
Klein Cites Democracy Essay on Defense Spending
Bloomberg: In his Bloomberg View column on February 13, Ezra Klein discussed the politics of military spending and highlighted a number of quotes from former Representative Barney Frank’s feature contribution to Democracy’s Winter 2013 issue.