Supply-side economics

Three different Laffer curves: t* represents the rate of taxation at which maximal revenue is generated and the curve need not be single-peaked nor symmetrical

The Laffer curve embodies a postulate of supply-side economics: that tax rates and tax revenues are distinct, with government tax revenues the same at a 100% tax rate as they are at a 0% tax rate and maximum revenue somewhere in between these two values. Supply-siders argued that in a high tax rate environment lowering tax rates would result in either increased revenues or smaller revenue losses than one would expect relying on only static estimates of the previous tax base.[12][13]

This led supply-siders to advocate large reductions in marginal income and capital gains tax rates to encourage greater investment, which would produce more supply. Jude Wanniski and many others advocate a zero capital gains rate.[14][15] The increased aggregate supply should result in increased aggregate demand, hence the term "supply-side economics".

The New Palgrave Dictionary of Economics reports that estimates of revenue-maximizing tax rates have varied widely, with a mid-range of around 70%.[16] A 2012 study found a consensus among leading economists that reducing the US federal income tax rate would raise GDP, but not by enough to offset the losses from a lower tax rate and therefore deficits would increase relative to a baseline without the cuts.[17]

After World War I, the highest tax bracket, which was for those earning over $100,000 a year (worth at least $1 million a year now), was over 70 percent.[38] The revenue acts of 1921, 1924 and 1926 reduced this tax rate to less than 25 percent, yet tax revenues actually went up significantly.[39]

Gene Smiley at the Foundation for Economic Education explains: "The share of income taxes paid by the higher net income tax classes fell as tax rates were raised. With the reduction in rates in the twenties, higher-income taxpayers reduced their sheltering of income and the number of returns and share of income taxes paid by higher-income taxpayers rose".[40]

Democratic President John F. Kennedy advocated a drastic tax-rate cut in 1963 when the top income tax rate was 91%, arguing that "[t]ax rates are too high today and tax revenues too low, and the soundest way to raise revenues in the long run is to cut rates now".[41] The Revenue Act of 1964 emerged from Congress and was signed by Kennedy's successor Lyndon Johnson on February 26, 1964. The stated goals of the tax cuts were to raise personal incomes, increase consumption and increase capital investment.

Ronald Reagan gives a televised address from the Oval Office, outlining his plan for tax reductions in July 1981

In the United States, commentators frequently equate supply-side economics with Reaganomics. The fiscal policies of Republican Ronald Reagan were largely based on supply-side economics.

Reagan made supply-side economics a household phrase and promised an across-the-board reduction in income tax rates and an even larger reduction in capital gains tax rates.[42]

During Reagan's 1980 presidential campaign, the key economic concern was double digit inflation, which Reagan described as "[t]oo many dollars chasing too few goods", but rather than the usual dose of tight money, recession and layoffs, with their consequent loss of production and wealth, he promised a gradual and painless way to fight inflation by "producing our way out of it".[43]

Switching from an earlier monetarist policy, Federal Reserve chair Paul Volcker began a policy of tighter monetary policies such as lower money supply growth to break the inflationary psychology and squeeze inflationary expectations out of the economic system.[44] Therefore, supply-side supporters argue that Reaganomics was only partially based on supply-side economics.

However, the Congress under Reagan passed a plan that would slash taxes by $749 billion over five years. Critics claim that the tax cuts increased budget deficits while Reagan supporters credit them with helping the 1980s economic expansion that eventually lowered the deficits and argued that the budget deficit would have decreased if not for massive increases in military spending.[45] As a result, Jason Hymowitz cited Reagan—along with Jack Kemp—as a great advocate for supply-side economics in politics and repeatedly praised his leadership.[46]

Critics of Reaganomics claim it failed to produce much of the exaggerated gains some supply-siders had promised. Paul Krugman later summarized the situation:

When Ronald Reagan was elected, the supply-siders got a chance to try out their ideas. Unfortunately, they failed.

Although he credited supply-side economics for being more successful than monetarism which he claimed "left the economy in ruins", he stated that supply-side economics produced results which fell "so far short of what it promised", describing the supply-side theory as "free lunches".[47]

Income tax revenues in constant dollars decreased by $2.77 billion in that year. FICA tax revenue increased because in 1983 FICA tax rates were increased from 6.7% to 7% and the ceiling was raised by $2,100. For the self-employed, the FICA tax rate went from 9.35% to 14%.[48] The FICA tax rate increased throughout Reagan's term and rose to 7.51% in 1988 and the ceiling was raised by 61% through Reagan's two terms. Those tax hikes on wage earners, along with inflation, were the source of revenue gains in the early 1980s.[49]

It has been contended by some supply-side critics that the argument to lower taxes to increase revenues was a smokescreen for "starving" the government of revenues in the hope that the tax cuts would lead to a corresponding drop in government spending, but this did not turn out to be the case. Paul Samuelson called this notion "the tape worm theory—the idea that the way to get rid of a tape worm is [to] stab your patient in the stomach".[50]

There is frequent confusion on the meaning of the term "supply-side economics" between the related ideas of the existence of the Laffer Curve and the belief that decreasing tax rates can increase tax revenues. Many supply-side economists doubt the latter claim while still supporting the general policy of tax cuts. Economist Gregory Mankiw used the term "fad economics" to describe the notion of tax rate cuts increasing revenue in the third edition of his Principles of Macroeconomics textbook in a section entitled "Charlatans and Cranks":

An example of fad economics occurred in 1980, when a small group of economists advised Presidential candidate, Ronald Reagan, that an across-the-board cut in income tax rates would raise tax revenue. They argued that if people could keep a higher fraction of their income, people would work harder to earn more income. Even though tax rates would be lower, income would rise by so much, they claimed, that tax revenues would rise. Almost all professional economists, including most of those who supported Reagan's proposal to cut taxes, viewed this outcome as far too optimistic. Lower tax rates might encourage people to work harder and this extra effort would offset the direct effects of lower tax rates to some extent, but there was no credible evidence that work effort would rise by enough to cause tax revenues to rise in the face of lower tax rates. [...] People on fad diets put their health at risk but rarely achieve the permanent weight loss they desire. Similarly, when politicians rely on the advice of charlatans and cranks, they rarely get the desirable results they anticipate. After Reagan's election, Congress passed the cut in tax rates that Reagan advocated, but the tax cut did not cause tax revenues to rise.[51][52]

The chart shows average federal tax rates paid by various levels of the income distribution. During the Clinton era, taxes on upper incomes were higher than during the Reagan era.[53] Paul Krugman explained how higher taxes on higher income persons, combined with higher job creation under Clinton, represented a counter-example of the supply-side tax-cut doctrine.[54] Krugman linked his own version of this chart to the preceding article, illustrating the average tax rate of the top 1%.[55]

President Clinton presided over the budgets for fiscal years 1994–2001. From 1998 to 2001, the budget was in a surplus for the first time since 1969. Economists Jeffrey Frankel and Peter Orszag summarized Clintonomics in a 2001 paper: "It sought to adopt some of the pro-market orientation associated with the ascendancy of the Republicans in the 1980s, and marry it with traditional Democratic values such as concern for the environment and a more progressive income distribution."[56]

Clinton signed the Omnibus Budget Reconciliation Act of 1993 into law, which raised income taxes rates on incomes above $115,000, created additional higher tax brackets for corporate income over $335,000, removed the cap on Medicare taxes, raised fuel taxes and increased the portion of Social Security income subject to tax, among other tax increases. Frankel and Orszag described the “progressive fiscal conservatism" of the 1993 package: "Such progressive fiscal conservatism combines modest attempts at redistribution (the progressive component) and budget discipline (the fiscal conservative component). Thus the 1993 package included significant spending reductions and tax increases. But it concentrated the tax increases on upper-income taxpayers, while substantially expanding the Earned Income Tax Credit, Head Start, and other government programs aimed at lower earners." President George H.W. Bush had raised marginal income tax rates in 1990.[56] CBO reported in 1999 that: "In the absence of changes in tax laws, total revenues tend to grow over a period of years at the same average rate as the economy. But 1998 marked the fifth consecutive year in which growth in revenues outstripped growth in national income. Tax increases enacted in 1993 helped boost revenues in 1994 and 1995, but rapid growth in taxes on capital gains realizations, increases in taxable incomes as a share of GDP, and other exceptional factors have driven the increases relative to GDP since then."[57]

The bill was strongly opposed by Republicans, vigorously attacked by John Kasich and Minority Whip Newt Gingrich as destined to cause job losses and lower revenue.[58]

In 2008, the Center for American Progress compared economic and budgetary results from two supply-side periods (1981-1992 and 2001-2007), against the Clinton era (1993-2000) as a counter-example where tax rates were increased contrary to supply-side theory. In terms of growth in wages, real investment, and GDP, results were better during the Clinton era. While the tax cuts in the supply-side periods contributed to greater deficits, the tax increases of the Clinton era contributed to surpluses.[59]

Economist Paul Krugman wrote in 2017 that Clinton's tax increases on the rich provided counter-example to the supply-side tax cut doctrine: "Bill Clinton provided a clear test, by raising taxes on the rich. Republicans predicted disaster, but instead the economy boomed, creating more jobs than under Reagan."[54]

Supply-side economist Alan Reynolds argued that the Clinton era represented a continuation of a low tax policy (from the 1980s):

In reality, tax policy was not unambiguously better in the eighties than in the nineties. The highest income tax rate was 50 percent from 1983 to 1986, but below 40 percent after 1993. And the capital gains tax was 28 percent from 1987 to [1997], but only 20 percent in the booming years of 1997-2000. On balance, there were good and bad things about both periods. But both the eighties and the nineties had much wiser tax policies than we had from 1968 to 1982.[60]

In 2003, Alan Murray, who at the time was Washington bureau chief for CNBC and a co-host of the television program Capital Report, declared the debate over supply-side economics to have ended "with a whimper" after extensive modeling performed by the Congressional Budget Office (CBO) predicted that the revenue generating effects of the specific tax cuts examined would be, in his words, "relatively small".[30] Murray also suggested that Dan Crippen may have lost his chance at reappointment as head of the CBO over the dynamic scoring issue.

Before President George W. Bush signed the 2003 tax cuts, the Economic Policy Institute (EPI) released a statement signed by ten Nobel prize laureates entitled "Economists' statement opposing the Bush tax cuts", which states:

Passing these tax cuts will worsen the long-term budget outlook, adding to the nation’s projected chronic deficits. This fiscal deterioration will reduce the capacity of the government to finance Social Security and Medicare benefits as well as investments in schools, health, infrastructure, and basic research. Moreover, the proposed tax cuts will generate further inequalities in after-tax income.[62]

Nobel laureate economist Milton Friedman agreed the tax cuts would reduce tax revenues and result in intolerable deficits, though he supported them as a means to restrain federal spending.[63] Friedman characterized the reduced government tax revenue as "cutting their allowance".

A 2008 working paper sponsored by the International Monetary Fund showed "that the Laffer curve can arise even with very small changes in labor supply effects", but that "labor supply changes do not cause the Laffer effect".[64] This is contrary to the supply-side explanation of the Laffer curve, in which the increases in tax revenue are held to be the result of an increase in labor supply.[65] Instead their proposed mechanism for the Laffer effect was that "tax rate cuts can increase revenues by improving tax compliance". The study examined in particular the case of Russia which has comparatively high rates of tax evasion. In that case, their tax compliance model did yield significant revenue increases:

To illustrate the potential effects of tax rate cuts on tax revenues consider the example of Russia. Russia introduced a flat 13 percent personal income tax rate, replacing the three tiered, 12, 20 and 30 percent previous rates (as detailed in Ivanova, Keen and Klemm, 2005). The tax exempt income was also increased, further decreasing the tax burden. Considering social tax reforms enacted at the same time, tax rates were cut substantially for most taxpayers. However, personal income tax (PIT) revenues have increased significantly: 46 percent in nominal and 26 percent real terms during the next year. Even more interesting PIT revenues have increased from 2.4 percent to 2.9 percent of GDP—a more than 20 percent increase relative to GDP. PIT revenues continued to increase to 3.3 percent during the next year, representing a further 14 percent gain relative to GDP.[64]

During his presidency, President Bush signed the Economic Growth and Tax Relief Reconciliation Act of 2001 and Jobs and Growth Tax Relief Reconciliation Act of 2003.

In 2007, the Bush administration pointed to the long period of sustained growth, both in GDP and in overall job numbers as well as increases in personal income and decreases in the government deficit.[66]

An analysis of the Bush tax cuts by the Economic Policy Institute claims that the Bush tax cuts have failed to promote growth since all macroeconomic growth indicators were well below average for the 2001–2005 business cycle. These critics argue the Bush tax cuts have done little more than deprive the government of revenue necessary to keep a balanced budget.[67]

In 2003, a Congressional Budget Office study was conducted to forecast whether currently proposed tax cuts would increase revenues. The study used dynamic scoring models as supply side advocates had wanted and was conducted by a supply side advocate. The majority of the models applied predicted that the proposed tax cuts would not increase revenues.[30]

In 2006, the CBO released a study titled "A Dynamic Analysis of Permanent Extension of the President's Tax Relief".[68] This study found that under the best possible scenario making tax cuts permanent would increase the economy "over the long run" by 0.7%. Since the "long run" is not defined, some commentators[69] have suggested that 20 years should be used, making the annual best case GDP growth equal to 0.04%. When compared with the cost of the tax cuts, the best case growth scenario is still not sufficient to pay for the tax cuts. Previous official CBO estimates had identified the tax cuts as costing an amount equal to 1.4% of GDP. According to the study, if the best case growth scenario is applied, the tax cuts would still cost an amount equal to 1.27% of GDP.[69]

This study was criticized by many economists, including Harvard Economics Professor Greg Mankiw, who pointed out that the CBO used a very low value for the earnings-weighted compensated labor supply elasticity of 0.14.[70] In a paper published in the Journal of Public Economics, Mankiw and Matthew Weinzierl noted that the current economics research would place an appropriate value for labor supply elasticity at around 0.5.[71]

In May 2012, Sam Brownback, Governor of the state of Kansas, signed into law the "Kansas Senate Bill Substitute HB 2117",[72][73] which cut state income taxes deeply and was intended to generate rapid economic growth. The tax cuts have been called the "Kansas experiment",[74] and described as "one of the cleanest experiments for how tax cuts effect economic growth in the U.S."[75] The law cut taxes by US$231 million in its first year, and cuts were projected to total US$934 million after six years.[76] They eliminated taxes on "pass-through" income (used by sole proprietorships, partnerships, limited liability companies, subchapter S corporations,[74][73] for the owners of almost 200,000 businesses, and cut individual income tax rates as well.[76]

The original bill proposed by Brownback offset the losses expected to result from the cuts with increases in the state sales tax, as well as the elimination of numerous tax credits and deductions, but by the time the bill came to the governor to be signed these had been removed.[77] Brownback then argued that the cuts would pay for themselves by increasing revenue by boosting the state's economic growth.[78] Supporters pointed to projections from the conservative Kansas Policy Institute predicting that the bill would lead to a $323 million increase in tax revenue.[79]

Brownback forecast his cuts would create an additional 23,000 jobs in Kansas by 2020.[73] On the other hand, the Kansas Legislature's research staff warned of the possibility of a deficit of nearly US$2.5 billion by July 2018.[76] Brownback compared his tax cut policies with those of Ronald Reagan, but also described them as "a real live experiment ... We'll see how it works."[80] The cuts were based on model legislation published by the conservative American Legislative Exchange Council (ALEC),[81][82] and were supported by The Wall Street Journal,[83][84] supply-side economist Arthur Laffer,[85] and anti-tax leader Grover Norquist.[86]

By 2017, state revenues had fallen by hundreds of millions of dollars[87] causing spending on roads, bridges, and education to be slashed,[88][89] but instead of boosting economic growth, growth in Kansas remained consistently below average.[90] A working paper by two economists at Oklahoma State University (Dan Rickman and Hongbo Wang) using historical data from several other states with economies structured similarly to Kansas found that the Kansas economy grew about 7.8% less and employment about 2.6% less than it would have had Brownback not cut taxes.[91][92] In 2017, the Republican Legislature of Kansas voted to roll back the cuts, and after Brownback vetoed the repeal, overrode his veto.[93]

According to Max Ehrenfreund and economists he consulted, an explanation for the reduction instead of increase in economic growth from the tax cuts is that "any" benefits from tax cuts come over the long, not short run, but what does come in the short run is a major decline in demand for goods and services. In the Kansas economy cuts in state government expenditures cut incomes of state government "employees, suppliers and contractors" who spent much or most of their incomes locally.[91] In addition, concern over the state's large budget deficits "might have deterred businesses from making major new investments".[91]

Economist Paul Krugman wrote in 2017: "Sam Brownback, governor of Kansas, slashed taxes in what he called a “real live experiment” in conservative fiscal policy. But the growth he promised never came, while a fiscal crisis did. At the same time, Jerry Brown's California raised taxes, leading to proclamations from the right that the state was committing “economic suicide”; in fact, the state has experienced impressive employment and economic growth."[54]

Gov. Brownback himself strongly rejected criticism of his cuts or any need to adjust the law,[94] declaring the cuts a success, blaming perceptions to the contrary on a “rural recession,” and on “the left media" which "lies about the tax cuts all the time”.[89]

President Trump implemented individual and corporate income tax cuts which took effect in 2018. Rutgers economics professor Farrokh Langdana claimed that the Trump tax cuts were an example of supply-side tax policy, citing a letter from economists long-associated with the supply-side theory describing them as such.[95]

The New York Times reported in November 2018 that the Trump tax overhaul "has fattened the paychecks of most American workers, padded the profits of large corporations and sped economic growth." Cautioning that "its still early but ten months after the law took effect, the promised 'supply side' bump is harder to find than the sugar-high stimulus." The writers explained that "It's highly unusual for deficits...to grow this much during periods of prosperity" and that "the fiscal health of the U.S. is deteriorating fast, as revenues have declined sharply" (nearly $200 billion or about 6%) relative to the CBO forecast prior to the tax cuts. Results included:

• Contrary to claims the tax cuts would pay for themselves, the budget deficit rose to $779 billion in fiscal year 2018, up 17% versus the prior year.
• Corporate tax revenues were down by one-third in fiscal year 2018.
• Stock buyback activity increased significantly.
• GDP growth, business investment and corporate profits increased.
• A typical worker in a large company got a $225 raise or one-time bonus, due to the law.
• Real wage growth (adjusted for inflation) was slightly slower in 2018 than 2017.[96]

The New York Times also reported in August 2019 that: "The increasing levels of red ink stem from a steep falloff in federal revenue after Mr. Trump’s 2017 tax cuts, which lowered individual and corporate tax rates, resulting in far fewer tax dollars flowing to the Treasury Department. Tax revenues for 2018 and 2019 have fallen more than $430 billion short of what the budget office predicted they would be in June 2017, before the tax law was approved that December."[97]