To critics of supply-side economics, the whole thing was never anything except hokum cooked up to justify big tax cuts for the rich. Some critics even suggest that the supply-siders were put up to devising their theories at the behest of those that would benefit from the tax cuts.1
In reality, the supply-siders got their theories from perfectly respectable sources. I know because I was there. As the previous chapter notes, respected economists like Robert Mundell sowed the seeds of supply-side economics in theoretical work published in obscure academic journals. But they also got their ideas from history. While the Kennedy tax cut was their most important historical influence, they were also aware of other tax cutting episodes, such as those in the 1920s.
Although it is often asserted that supply-side economics was a failure due to the deficits of the 1980s, its basic propositions have, in fact, been thoroughly incorporated into mainstream economic thinking. Economists today are much more sensitive to the incentive effects of taxation than they were before supply-side economics came along. But as with Keynesian economics, the supply-side model became overused and misapplied. This was clearly evident during the administration of George W. Bush. He and other high ranking officials of that administration frequently asserted that all tax cuts raise revenue, something the original supply-siders never believed. They thought that some very special tax cuts might pay for themselves right away, and that others wouldn't lose as much revenue as static estimates assumed, but they also knew that a lot of tax cuts had no growth or behavioral effects at all and were pure revenue losers. By the end of the George W. Bush administration, supply-side economics had become a caricature of itself, largely disconnected from its original principles.
It will come as a surprise to many people that the intellectual origins of supply-side economics can be traced to a fourteenth-century Muslim philosopher named Ibn Khaldun. In his masterwork, The Muqaddimah, he argued that high taxes were often a factor in causing empires to collapse, with the result that lower revenue was collected from high rates. “It should be known that at the beginning of the dynasty, taxation yields a large revenue from small assessments. At the end of the dynasty, taxation yields a small revenue from large assessments,” Khaldun wrote.2
It may seem implausible that this ancient philosopher could have exercised any direct influence on 1970s American policy makers. However, there is a paper trail. In 1971 the Journal of Political Economy published an article about Khaldun by economist Jean David Boulakia, which quoted the passage above. Mundell had been editor of that journal until just before this article appeared, and he was responsible for accepting it for publication.3 On September 29, 1978, the Wall Street Journal published a long passage from The Muqaddimah. It was probably this excerpt that caught Ronald Reagan's eye. He referred to Khaldun by name during an October 1, 1981, press conference.
Another unlikely influence was Jonathan Swift, the famous satirist and author of Gulliver's Travels. In a 1728 article he noted the negative effect of high tariff rates on government revenue. His catchy phrase, “in the business of heavy impositions, two and two never make more than one,” influenced many eighteenth-century thinkers regarding the deleterious effect of tax rates on revenue, including David Hume, Adam Smith, and Alexander Hamilton.4
These eighteenth-century thinkers unquestionably were influential in the development of supply-side economics. Supply-siders often drew parallels between their views on tax cutting and those of the Founding Fathers.5 Adam Smith's work in particular was well known to the Founding Fathers as well as to all supply-siders, who would find the following quote from The Wealth of Nations (1776) especially apt: “High taxes, sometimes by diminishing the consumption of the taxed commodities, and sometimes by encouraging smuggling, frequently afford a smaller revenue to the government than what might be drawn from more moderate taxes.”6
The Founding Fathers also found inspiration in the work of political philosopher Baron de Montesquieu, who wrote in The Spirit of the Laws (1748): “Liberty produces excessive taxes; the effect of excessive taxes is slavery; and slavery produces a diminution of tribute.”7
Another influence on supply-siders was nineteenth-century economist Jean-Baptiste Say. I began the first chapter of my 1981 book, Reaganomics, with this observation: “In many respects, supply-side economics is nothing more than … Say's law of markets rediscovered.”8 By this I meant that Say had placed supply above demand in importance to the economy. Aggregate demand can be stimulated easily by printing money; calling forth additional work and production is much harder. Hence, economic policy should be more concerned with the production of goods and services than with the stimulation of demand. As Say put it, “The encouragement of mere consumption is no benefit to commerce; for the difficulty lies in supplying the means, not in stimulating the desire of consumption. … It is the aim of good government to stimulate production, of bad government to encourage consumption.”9
John Stuart Mill made much the same point. In addition to quoting Say and Mill in my book, I was aware of my contemporaries in twentieth-century economics, such as Thomas Sowell and W. H. Hutt, who were rehabilitating Say's Law.10 Say's concern with incentives for production led him easily into the idea that high taxes can reduce revenue by stifling output. “Taxation pushed to the extreme,” he wrote,
has the lamentable effect of impoverishing the individual, without enriching the state. … The diminution of demand must be followed by diminution of the supply of production; and, consequently, of the articles liable to taxation. Thus, the taxpayer is abridged of his enjoyments, the producer of his profits, and the public exchequer of its receipts. … This is the reason why a tax is not productive to the public exchequer, in proportion to its ratio; and why it has become a sort of apophthegm, that two and two do not make four in the arithmetic of finance. Excessive taxation … extinguishes both production and consumption, and the taxpayer into the bargain.11
The idea that high rates can reduce revenue was also known to nineteenth-century trade theorists, who noted that high tariff rates often reduced tariff revenue. The American statesman John C. Calhoun made one of the clearest statements of this. While serving in the U.S. Senate in 1842, he made this observation about the revenue effects of tariffs:
On all articles on which duties can be imposed, there is a point in the rate of duties which may be called the maximum point of revenue—that is, a point at which the greatest amount of revenue would be raised. If it be elevated above that, the importation of the article would fall off more rapidly than the duty would be raised; and, if depressed below it, the reverse effect would follow: that is, the duty would decrease more rapidly than the importation would increase. If the duty be raised above that point, it is manifest that all the intermediate space between the maximum point and that to which it may be raised, would be purely protective, and not at all for revenue. … [A]ny given amount of duty, other than the maximum, may be collected on any article, by two distinct rates of duty—the one above the maximum point, and the other below it.12
So widespread was this view that in 1861 the New York Times said it was “a well known principle of political economy that duties which are too high are as unproductive of revenue as those which are too low.” Indeed, in the 1880s, trade protectionists explicitly supported tariff rates so high that they were intended to lose revenue by reducing imports.13 Advocates of cigarette tax increases often make the same point today. Their goal, they say, is not so much to raise revenue as to reduce smoking. In the words of New York Mayor Michael Bloomberg, “If it were totally up to me, I would raise the cigarette tax so high the revenues from it would go to zero.”14
In the twentieth century a number of economists wrote about the limits of taxation from the point of view of revenues. An early contribution was by economist Edwin Cannan, who posited a version of the Laffer curve by pointing out that a 100 percent tax rate would raise zero revenue. During World War II there was much discussion of the limits of taxation, focusing mainly on labor supply. In the postwar era, economist Colin Clark argued that excessive taxes become inflationary above 25 percent of the gross national product. John Maynard Keynes agreed with Clark that “25 percent taxation is about the limit of what is easily borne.” Keynes had previously noted, “Aggressive taxation may defeat its own ends by diminishing the income to be taxed.”15
In Human Action, Austrian economist Ludwig von Mises added his voice to the debate in 1949, writing, “The true crux of the taxation issue is to be seen in the paradox that the more taxes increase, the more they undermine the market economy and concomitantly the system of taxation itself. … Every specific tax, as well as a nation's whole tax system, becomes self-defeating above a certain height of rates.”16
Political scientist C. Northcote Parkinson, famous for his law about work expanding to fill the time for its completion, put forth a second law about expenditures rising to meet income. In The Law and the Profits (1960), he suggested that there were diminishing returns once taxes reached 20 percent of national income. And in a 1973 article economist Richard B. McKenzie found that “it is distinctly possible on theoretical grounds that statutory rate increases may result in lower tax collections for some groups (i.e., lower effective rates).”17
In short, the ground was well plowed long before the first supplysider showed up making the case that excessive tax rates can reduce government revenue and that, conversely, lower rates can, under certain conditions, raise revenue.
It was not just theoretical discussions about lower tax rates raising revenues that influenced supply-side thinking. They were also aware of actual experience, most especially in the United States during the 1920s and 1960s. Herb Stein's Fiscal Revolution in America (1969) was an invaluable resource on the history of these episodes. Indeed, Jude Wanniski told me that Stein's discussion regarding the belief by politicians in the 1920s that lower tax rates might raise revenue was the first he ever heard of the idea.18
The federal income tax came into being permanently in 1913 with a top statutory rate of just seven percent. Due to the extraordinary revenue demands of World War I, however, tax rates were sharply increased; by war's end, the top rate had risen to 77 percent. Although Republican presidents of the 1920s got most of the credit for reducing wartime tax rates, the initiative actually began in Woodrow Wilson's administration.19 Indeed, in his 1919 State of the Union address, Wilson used supply-side arguments to urge tax rate reduction:
The Congress might well consider whether the higher rates of income and profits taxes can in peace times be effectively productive of revenue, and whether they may not, on the contrary, be destructive of business activity and productive of waste and inefficiency. There is a point at which in peace times high rates of income and profits taxes discourage energy, remove the incentive to new enterprise, encourage extravagant expenditures and produce industrial stagnation with consequent unemployment and other attendant evils.
Treasury Secretary Andrew Mellon, who served continuously through the administrations of Warren G. Harding, Calvin Coolidge, and most of Herbert Hoover, spearheaded the tax reduction effort. By 1929, he managed to get the top statutory rate down to just 24 percent. In his book, Taxation: The People's Business (1924), Mellon made plain his belief that high tax rates on the wealthy lowered government revenue and that lower rates would raise revenue. As he put it:
The history of taxation shows that taxes which are inherently excessive are not paid. The high rates inevitably put pressure upon the taxpayer to withdraw his capital from productive business and invest it in tax-exempt securities or to find other lawful methods of avoiding the realization of taxable income. The result is that the sources of taxation are drying up; wealth is failing to carry its share of the tax burden; and capital is being diverted into channels which yield neither revenue to the government nor profit to the people.20
The evidence strongly indicates that the tax cuts of the 1920s did indeed raise revenue among those most affected by the rate reductions. Historian Benjamin Rader concluded, “Despite sharply reduced tax rates for upper income groups … the wealthy paid a larger share of the federal tax burden at the end of the decade than at the beginning.”21 Economists Gene Smiley and Richard H. Keehn confirm this conclusion:
Though the marginal tax rates were cut much more for the highest income taxpayers, the effective burden of taxation shifted away from the lower-income taxpayers toward the higher-income taxpayers. The resulting decline in tax avoidance, in conjunction with economic growth, led to some increase in personal income tax receipts despite the huge tax cuts from 1921 through 1926. Thus, the tax rate cuts worked much as Mellon and other early “supply-side” supporters had argued that they would.22
Supply-siders were also aware of examples at the state and local level where relatively easy opportunities for moving to other jurisdictions magnified the economic impact of tax changes. Economist Ron Grieson, for example, concluded in 1980 that Philadelphia's income tax was so high that it was reducing city revenues below what lower rates would have brought in.23
Adding important institutional support to the growth of supply-side economics in the late 1970s was the congressional Joint Economic Committee under the leadership of its chairman, Senator Lloyd Bentsen, Democrat of Texas. In the 1950s and 1960s the JEC had been a hotbed of Keynesian economics, so the intellectual collapse of that school hit the committee hard, leading to much soul-searching on the part of both its members and staff.24 By 1979, the JEC started to make a break. In a number of hearings and staff studies, the committee began placing increasing emphasis on the role of supply in the economy, concluding that inadequate incentives for saving and investment lay behind the national economic malaise.
By 1980 the JEC was a full-blown advocate of supply-side economics, despite having a majority of liberal Democrats, such as Senators Edward Kennedy of Massachusetts and George McGovern of South Dakota. Its annual report that year was titled, “Plugging in the Supply Side.” Bentsen summarized the committee's new view in his introduction:
The 1980 annual report signals the start of a new era of economic thinking. The past has been dominated by economists who focused almost exclusively on the demand side of the economy and who, as a result, were trapped into believing that there is an inevitable trade-off between unemployment and inflation. … The Committee's 1980 report says that steady economic growth, created by productivity gains and accompanied by a stable fiscal policy and a gradual reduction in the growth of the money supply over a period of years, can reduce inflation significantly during the 1980's without increasing unemployment. To achieve this goal, the Committee recommends a comprehensive set of policies designed to enhance the productive side, the supply side of the economy.25
The JEC also injected itself into the debate over econometric modeling. A 1980 hearing strongly supported the idea that existing models were too heavily based on Keynesian assumptions and gave short shrift to the economy's supply side. Partly as a consequence of the JEC's prodding, the commercial econometric firm Data Resources, Inc. changed its model to incorporate more supply-side features.26
The JEC's conversion to supply-side economics was extremely important in adding respectability and bipartisanship to the idea. For example, it led Leonard Silk, economics columnist for the New York Times, to write sympathetically about the new philosophy: “A major change is on the way in economic theory and policy; that change will involve a deeper integration of supply-side and demand-side economics, and an integration of thinking about both the long and short run. The change is long overdue.”27
Even after Ronald Reagan had taken office and liberal Representative Henry Reuss, Democrat of Wisconsin, replaced the more conservative Bentsen as chairman of the JEC, it remained skeptical of old-fashioned Keynesianism. Said Reuss in 1981, “We have learned from our mistakes in the past. We've given up blind pursuit of Keynesian demand acceleration.” Supply-side economics was important in depriving demand-side economics of “an undeserved primacy,” he added.28
Less was heard about supply-side economics after the 1980s because so much of what the original supply-siders were trying to accomplish had been achieved. That is, many supply-side propositions that were highly controversial when first made in the 1970s are now accepted as conventional wisdom among professional economists.
The federal income tax has been under attack by the economics profession for more than a decade. The attack comes from two directions: supply-siders who believe that progressive income taxation impairs economic incentives, and more traditional economists who would substitute a progressive expenditure tax for the income tax. … Today, it is fair to say that many, if not most, economists favor the expenditure tax or a flat rate income tax.38
Perhaps the best evidence that supply-side economics has entered the mainstream is Robert Mundell's Nobel Prize in 1999. Although his citation does not mention any of his relevant work in this area, it would be naive to think that the Nobel committee was unaware of it, since Mundell was often referred to as a supply-side “guru” in the popular press.60 It is also well known that the committee thoroughly researches all aspects of a candidate's life and work before making an award. Therefore, it is reasonable to assume that the committee was well aware that in giving Mundell the Nobel Prize for his work in international macroeconomics and monetary theory would be seen as recognition of his work in supply-side economics as well.61
Supply-siders can also claim a piece of 1995 Nobel Prize–winner Robert Lucas. In a neglected 1990 article, he declared himself to be a born-again supply-sider:
I have called this paper an analytical review of “supply-side economics,” a term associated in the United States with extravagant claims about the effects of changes in the tax structure on capital accumulation. In a sense, the analysis I have reviewed here supports these claims: Under what I view as conservative assumptions, I estimated that eliminating capital income taxation would increase capital stock by about 35 percent. … The supply-side economists, if that is the right term for those whose research I have been discussing, have delivered the largest genuinely free lunch I have seen in 25 years in this business, and I believe we would have a better society if we followed their advice.62
By 1996 even the Clinton administration said that it was practicing supply-side economics. “Our growth policies are supply side,” claimed Council of Economic Advisers Chairman Joseph Stiglitz.63
Of course, supply-side economics still has its critics. In 2001, Gerard Baker, economics columnist for London's Financial Times, referred to “quack theories about supply-side tax cuts.”64 However Floyd Norris, a columnist for the New York Times, was more sympathetic:
Two decades ago, the supply-siders performed a valuable service. They persuaded a popular new president, who had been elected as a fiscal conservative, to slash taxes and claim that no budget deficit would result. Lower tax rates, they said, would miraculously bring higher tax revenues. That proved to be wrong. But it was a good idea nonetheless. The United States was going through painful economic times, and the tax cut provided real relief for the majority who were not to be victims of the cutbacks that were needed to make American businesses more competitive. The economic stimulus helped to end a severe recession.65
Despite this success and George W. Bush's oft-stated support for supply-side economics, his administration proved to be its downfall. Policies with no meaningful connection to supply-side principles were proposed as being based on them. And even when the correct supply-side view was understood, Bush and his supporters were quick to cast it aside whenever political expediency demanded it. In the end, his administration represented a bastardized version of supply-side economics that had more in common with the caricature of it depicted by its opponents than anything approximating its core principles.
The abandonment of supply-side principles by George W. Bush occurred very early. Although he put forward a campaign tax plan that had been devised by supply-siders such as Lawrence Lindsey, Bush himself was responsible for watering down the supply-side elements. In particular, there was heavy emphasis on doubling the child credit as well as the creation of many other tax credits for charitable giving, education, health, and other purposes.66 This was in keeping with Bush's desire to be seen as a “compassionate conservative.”
Historically, supply-siders strenuously opposed tax credits because they generally don't affect incentives at the margin.67 The preferred supply-side approach to tax-cutting involves reductions in tax rates or provisions that reduce taxable income because the tax saving is a function of one's marginal tax bracket. By contrast, tax credits are subtracted directly from one's tax liability and have no impact at the margin because all taxpayers are treated the same regardless of their income or tax bracket. This is precisely why tax credits are politically attractive—they are perceived as more fair. But once a tax credit has been created, pressure quickly builds to make it refundable so that even those with no tax liability will benefit. When this happens, there is no meaningful difference between a tax cut and an increase in government spending.68
The second abandonment of supply-side principles by George W. Bush came soon after he took office. Rather than reformulate his campaign tax proposal to reflect changing economic conditions, he decided to simply add a tax rebate on top. Although both theory and experience said that consumers were likely to save, rather than spend, any rebate, politicians of both parties were anxious to be seen as responding aggressively to the economic slow-down that was becoming increasingly apparent.
In a revealing episode reported by journalist Ron Suskind, Bush's chief economic adviser, CEA Chairman Glenn Hubbard, went to see him to explain that a vast amount of economic research showed that rebates are a very ineffective means of stimulating the economy.69 Hubbard told Bush that the rebate was “bad policy.” Rather astonishingly, Bush responded, “I don't ever want to hear you use those words in my presence again.” What words, Hubbard asked? “Bad policy,” Bush replied. “If I decide to do it, by definition it's good policy. I thought you got that.”70
The tax rebate was signed into law on June 7, 2001. Taxpayers received an advance rebate on their 2001 taxes based on their 2000 taxes. They got back 10 percent of their 2000 tax payment up to $ 300 for a single person and $ 600 for a couple. Thus, anyone without a tax liability in 2000 was ineligible, which excluded many of those with incomes too low to pay any taxes. Presumably, these would also have been the people most likely to spend the rebate. By limiting the rebate to those with a positive tax liability, the legislation virtually ensured that rebates would go primarily to those with relatively high incomes who would probably save all of it.71
Retailers were underwhelmed by the response to the rebates. Sears, for example, decided not to even bother doing any advertising linked to them.72 Numerous polls found that the vast bulk of those receiving rebates planned to save the money or use it to pay down debt, which amounts to the same thing for the economy. A July Gallup poll found that 47 percent of respondents would use the money to pay down debt, 32 percent planned to save it, and just 17 percent thought they would spend more. A Bloomberg poll in September found 42 percent paying off debts, 28 percent saving the rebate, and just 15 percent spending it. An October University of Michigan poll found 85 percent of respondents either saving the rebate or using it to pay down debt, with just 15 percent spending it.
According to the Commerce Department, disposable personal income increased by $ 215.2 billion in the third quarter of 2001 as the rebates were paid out. However, personal saving jumped to $ 261.6 billion, up from just $ 88.7 billion in the second quarter. In short, 80 percent of the increase in disposable income was saved, meaning that there was very little stimulus to spending.
Although the 2001 tax rebate was probably the best-timed countercyclical program of the postwar era, subsequent analysis found its impact to be modest at best. Studies based on surveys found virtually no impact whatsoever.73 The largest impact was found in a study of aggregate consumption, which estimated that it was 0.8 percent higher in the third quarter of 2001 and 0.6 percent higher in the fourth quarter than it would have been without the rebate. Since consumption represents about 70 percent of GDP, this suggests that GDP was higher by at most 0.56 percent in the third quarter and 0.4 percent higher in the fourth.74
Despite the failure of the 2001 rebate, the Bush administration responded to the growing economic crisis in 2008 by pushing through yet another rebate. I argued at the time that the money would have been better spent making a down payment on cleaning up the bad debts in the housing sector that were at the root of the problem, but to no avail.75 As predicted, the new rebate was just as ineffective as the last one.76 The economy moved into recession anyway.
Finally, even when Bush promoted tax cuts that had some semblance of genuine supply-side principles, he totally undermined their effectiveness by agreeing to have them phased-in and setting termination dates after which they would expire. Both factors considerably undermined their effectiveness. Supply-siders always argued that phase-ins are bad because people will put off behavioral changes until tax changes are effective and that only permanent tax changes would have meaningful economic effects.77
Much of George W. Bush's presidency always seemed to me like an effort to vindicate what he saw as his father's mistakes. George H. W. Bush stopped short of conquering Iraq in 1991, so his son felt compelled to finish the job in 2003. And it was George H. W. Bush who called supply-side economics “voodoo economic policy,” so perhaps his son thought he needed to be more of a supply-sider than any of those who actually formulated it.78 No serious supply-sider would have ever made the kinds of extravagant claims for Bush's tax cuts that he made for them.79 Among his claims were these:
“Make no mistake about it … the deficit would have been bigger without the tax relief package.”80
“These [tax] proposals will help stimulate investment and put more people back to work. … That growth will bring the added benefit of higher revenues for the government.”81
“One of the interesting things that I hope you realize when it comes to cutting taxes is this tax relief not only has helped our economy, but it's helped the federal budget… You cut taxes and the tax revenues increase.”82
“Supply-side economics yields additional revenues.”83
Bush's CEA, however, was much more restrained in its analysis of the economic and revenue effects of his tax cuts. As it explained, “Although the economy grows in response to tax reductions … it is unlikely to grow so much that lost tax revenue is completely recovered by the higher level of economic activity.”84
To be sure, some of Bush's tax cuts, such as the cut in the capital gains tax, did have supply-side effects and undoubtedly recouped much of the static revenue loss. But the vast bulk of Bush's tax cuts in dollar terms involved rebates and tax credits that had no supply-side effects whatsoever. Therefore, to claim, as Bush often did, that his tax policies as a whole had such strong supply-side effects that they paid for themselves is the grossest of exaggerations. The truth is that they increased growth a little, but at a very large cost in terms of federal revenue, and far less than would have been the case had the supply-side elements of Bush's tax cuts been made permanent and not been phased-in.
In my opinion, it is time for supply-side economics as a distinctive school of thought to go peacefully into the night. It is an idea that once had validity and made a real contribution to improving economic policy—but which became increasingly divorced from that contribution as time went by, and eventually found itself as a mere slogan without anything meaningful to say about current economic problems. The things that were right about supply-side economics have been fully incorporated into mainstream economics. To the extent that supply-side ideas have not been accepted, it is mainly because they are invalid.
To continue to maintain that there is a separate supply-side view of the economy or economic policy today creates unnecessary alienation between those who still call themselves supply-siders, on the one hand, and those who agree with most of what the original supply-siders were trying to accomplish on the other. These latter now see supply-side economics as either nothing more than an obsession for massively cutting taxes in response to every economic problem, an increasingly implausible justification for the failed policies of the George W. Bush administration, or an absurd belief that all tax cuts will pay for themselves.
Under these circumstances, I think it is time for supply-siders to declare victory and go home. The economic problems of today and those likely to arise in the future don't require a particular supply-side insight that is lacking in mainstream economics. To the extent that supply-siders continue to insist upon a separate identity, they only end up making enemies out of potential allies in the economics profession and the policymaking community.