Supply Side Economics: Do Tax Rate Cuts Increase Growth and Revenues and Reduce Budget Deficits ? Or Is It Voodoo Economics All Over Again?

Act I: Supply Side Economics in the 1980s

Act II: The Return of Voodoo Economics in the 1990s

Act I: Supply Side Economics in the 1980s

It is well known that are among the variables that influence the decisions made by consumers/workers and firms. In the late seventies, the label "Supply Side Economics" was applied to the argument that lower tax rates would improve private sector incentives, leading to higher employment, productivity, and output in the US economy. George Bush, in the days when he was an opponent of Ronald Reagan in the 1980 primaries, referred to an extreme version of this theory espoused by Reagan as "voodoo economics." In this version a cut in tax rates was predicted to result in an increase in tax revenue, and thus not increase the government deficit (the famous Laffer Curve effect). We're going to run through the arguments for such incentive effects, and try to evaluate the policy.

Taxes enter many decisions, but the two most important are probably that they discourage work, since they lower the aftertax return from work, and they discourage saving and investment, since they lower aftertax returns. (A third, which we will not explore here, is that taxes distort investment decisions by taxing different types of capital unequally. Housing, for example, gets a free ride.) We know that the countries that invest the most (measured as the ratio I/Y) also grow the fastest, on average, so maybe this is important (or maybe the causality goes the other way, with the US investing less because it has fewer good opportunities). Whatever the case, let's examine the effect of taxes on wage and capital income.

A lower tax rate on wage income should increase the labor supply. Given the labor demand function, this increase in labor supply will increase employment, reduce the pre-tax real wage and increase the post-tax real wage.

Now turn to saving. We would expect lower taxes on interest and capital gains, as well as tax-sheltered saving plans like IRAs and 401(k) plans, to make saving more attractive and lead to an increase in savings. In equilibrium, this will lower real rates of interest as more saving flows into capital markets, and raise investment. Over time this investment leads to higher capital, more productive labor, and higher output and wages. (This is the long-run dynamics effects of this policy change).

That was the argument. While most economists would agree with the theoretical idea that lower taxes increase labor supply and savings, the crucial empirical question is whether the effects of cuts in tax rates on labor supply and savings are mall or larger. Most empirical evidence from a very large set of studies suggests that that the effect on labor supply is probably small, except on relatively poor workers whose marginal tax rate can be quite high (when they work, they may lose welfare and medical benefits, so the "opportunity cost" of working can be high). This may be an important aspect of social policy, but it probably does not have a large effect in the aggregate. In the graph, this would show up as a fairly steep labor supply curve, so that a shift up has little effect on employment.

The effect on saving, though, is thought by some to be substantial but there is wide disagreement on this issue as well. There is some question how responsive saving is to tax incentives, but a number of economists, including Martin Feldstein of Harvard, think the effect is important. Some argue that the saving rate in the US is smaller than in most other major economies, perhaps because US tax law is less friendly to saving than other countries'. One of the important policy questions is whether we should amend the tax system to make saving more attractive.

So why "voodoo" economics? There is some question about the magnitude of these effects, and the theory was way oversold at the time. Many "supply siders" argued that the incentive effects were so large that a reduction in tax rates would actually raise tax revenue, since the tax base would grow so much. There's no sign that this happened, and indeed most economists were pretty skeptical of this prediction at the time. Quite to the contrary, the budget deficits exploded in the 1980s after tax rates were cut by Reagan in 1981. The response of private savings and labor supply to the Reagan tax cuts was minimal: the labor supply did not increase and the effect on private savings was swamped by the reduction in public savings (the increase in the budget deficit). Since labor supply and savings increased only marginally, government revenues did not increase (relative to GDP) and the budget deficit became very large. The Laffer curve hypothesis was was flatly contradicted. Moreover, the 1980s tax cuts did not increase the rate of growth of GDP and productivity, nor the investment and savings rates. Note the following facts:

1. It is true that the economy grew quite fast from 1983 to 1989 but such a pickup in growth was a standard recovery of growth and fall of unemployment from the depths of the severe recession of 1981-1982 (the unemployment rate went above 10% in 1982).

2. The private saving rate continued to decline slowly in the 1980s. In the 1973-1980, private saving averaged 7.8 percent of the economy, and dropped to 6.9% in 1986 and 4.8% in 1989. In other words, the saving rate was significantly lower after the 1981 tax cut than before it.

3. The labor force grew at an average rate of 1.6% over the 1982-89 period, about the same as during the previous four years.

4. Overall labor productivity grew rapidly before 1973 and much less rapidly since then. In the entire period after 1973, the annual growth rate of productivity has been very close to 1.1 percent. It average around 1.1 percent also in the 1980s.

5. Budget deficits that were equal to 40b US$ in 1979 (-1.7% of GDP) and 74b US $ in 1980 (-2.7% of GDP) increased to 221b US $ by 1986 (5.2% of GDP).

6. The public debt to GDP ratio increased from 26.1% in 1979 to 41.2% in 1986.

For a more detailed discussion read an economic analysis of the Reagan years of Supply Side tax cuts and an economic analysis of why tax cuts do not increase economic growth.

Read next Krugman's two articles in Slate on Supply Side Economics and its Its Decline. A more detailed analysis by Krugman of supply-side economics is presented in his book "Peddling Prosperity", Norton, 1995.

For a systematic overview of supply side views look at the CATS (Citizens for an Alternative Tax System) site and Polyconomics, Inc. , the Web site of Jude Wanniski, one of the early gurus of supply-side economics.

Act II: The Return of Voodoo Economics in the 1990s

Scene I: The 1993 Clinton Deficit Reduction Package

By the time Clinton came to power in 1993, the effects of the supply side policies of the 1980s on the fiscal conditions of the U.S. were clear: the budget deficit in 1992 was 290b US $ or 4.9% of GDP and the public debt to GDP ratio equal to 50.6%. The deficit reduction plan that Clinton proposed was based on a limited increase in income tax rates (only for the very rich), an increase in various indirect taxes and a slowdown in the real growth of government spending.

At the time of the passage of the deficit reduction plan, supply-siders critics of the package argued that the increase in tax rates would:

1. Push the economy into a recession and reduce long-term growth.

2. Increase the budget deficits as individuals would reduce their labor supply and savings would be reduced.

3. Increase real interest rates because of the increase in deficits.

The effects of the deficit reduction plan turned out to be very different from the dismal prediction of supply siders:

1. The budget deficit fell from 290b US $ in 1992 (4.9% of GDP) to 104b US $ in 1996 (1.2% of GDP). The debt to GDP has started to fall after having continuosly increased since 1978.

2. The economy boomed in 1993 and 1994 after the 1990-91 recession and the economy grew at solid an average rate of 2.8% in the 1992-96 period.

3. Real interest rates have remained stable (they are at 2% in 1996 at the short-end of the maturity structure) and significantly lower than the high rates of the 1980s (5% in real terms).

While the effects of the 1993 deficit reduction package clearly contraded the gloomy forecasts of the critics, there has been a revisionist attempt to argue that the increase in the income tax rate for the wealthy in 1993 reduced so much their labor supply and income that it led to a reduction in the revenues collected form the top income individuals. On this debate, we follow the account of Peter Passell in the article "Do Tax Cuts Raise Revenue ? The Supply Side War Continues" (NYT 11/16/95).

In a study published in 1995, Dan Feenberg and Prof. Martin Feldstein of Harvard University calculated that raising the taxes of the rich in 1993 collected only one third of the revenues expected if these taxpayers had not changed their economic behavior. Since the levy on individuals with taxable incomes below $150,000 ($135,000 if we include the elimination of the ceiling on the Medicare payroll tax), they argued that this group was a good control for an experiment about the effects of higher tax rates on revenues.

They argued that if the adjusted gross income of the rich (defined as individuals with adjusted gross income above $200,000) had increased at the same rate as that of the upper middle class (incomes in the 50,000 to 200,000 range), it would have grown by 2.9%. Instead, the taxable income of the group with incomes above $200,000 fell by $ 31billion. So, instead of collecting an extra $ 16 billion in taxes from this group, the government ended up collecting only an extra $ 5 billion (a third of the amount it should have if the incomes of this group had grown at the same rate as the control group). This appeared to be the Laffer Curve at work, a basic tenent of supply side economics.

Unfortunately for the hypothesis, the fall in the incomes of the very rich after 1993 was not due to a reduction in their labor supply but rather a simple tax- shifting of incomes from 1993 to 1992 in expectation of the increase in tax rates. In fact:

1. If 1991 (rather than 1992) is compared with 1993, there is no reduction in expected income and no shortfall in revenues.

2. As Clinton was elected in November 1992, high income earners anticipated higher tax rates in 1993 and tried to realize the income in 1992. A New York state survey shows that two-thirds of Wall Street year-end bonuses were paid in December 1992, well above the one-third usually paid before theend of the year.

3. Treasury Department studies suggests that all in told $ 20 billlion of income was shifted back from 1993 to 1992. Therefore most of the income that Feldstein and Feenberg argued that was destroyed by a reduction in labor supply, was instead realized a year earlier.

Scene II: The Forbes Flat-Tax Proposal

In 1996, Steve Forbes run for the nomination to be the Presidential candidate of the Republican Party on the basis of a single policy proposal: changing the current progressive income tax system to a "flat tax" rate on income. While an analysis of the merits of a flat income tax (that is a disguised consumption tax in the Forbes formulation) is complex (see the home page on the flat-tax/consumption tax controversy), the flat-tax proposal was another variant of supply side economics. In the opinion of Forbes, such a flat tax would siginificantly increase the growth rate of the US economy and the rate of productivity growth by stimulating labor suply, savings and investment. In the view of Forbes, the growth of the economy would increase from the average 2.5% of the 1990s to 4% or even 5% per year.

Economists have been always wary of claims that some policy could change the growth rate of GDP as opposed to its level. There is of course a big difference between a policy change that affects the level of GDP from one that affects the growth rate of GDP. For example, most studies of the potential output effects of a complete liberalization of world trade suggest that the level of GDP would increase in the long- run by about 1% relative to its alternative path. So, real GDP 20 years from now would be only 1% higher than it would be 20 years from now if there is no change in trade policies. If, instead, such a policy change had the effect of increasing the growth rate of the economy (rather than its level) by 1% per year, real GDP would be 30% higher 20 years from now relative to its alternative path. Quite simply, if anything can increase the growth rate of GDP , rather than just its level, the welfare benefits of such a policy would be huge.

Now, if we consider, the Forbes tax plan, there is no evidence of any sort that the growth rate of the economy would double from 2.5% to 5% if we adopted a flat tax. The claim is simply preposterous. Most economists would argue that the effects, if any, are likely to be only on the level of GDP: it is hard to proof that any policy could affect the long-run growth rate of an economy and the 1980s experiments with tax rate cuts confirm that there was no permanent growth effects.

Even those serious economists and scholars that do believe that there might be a positive growth effect of such a policy reform, argue that the growth effects of a flat-tax would be much smaller than those claimed by Forbes. Consider for example the view of a leading conservative economist, Rober Barro from Harvard University:

"A movement to a flat rate tax - with no change in government spending - would stimulate economic growth, but is hard to quantify the effect. Empirical evidence across countries indicates that a cut in non productive government spending and taxes by 1% of GDP raises growth by about 0.1% per year. If taxes are made less distorting but are not eliminated , the effect would be smaller, perhaps half as great. Thus, if the 8% of GDP raised by federal income taxes were instead raised by a flat tax, then growth would be increased by roughly 0.4% a year. This effect is much smaller than that claimed by Forbes, but the benefits would still be enourmous" (Wall Street Journal 2/22/1996).

So, in the best scenario, the long-run growth rate of the economy would increase from 2.5% to 2.9% per year (not to 5%). Even that estimate is clearly overstated and the likely growth effect might be close to zero.

In fact, the scenario described by Barro assumes that the flat-tax would be revenue neutral (i.e. it would still collect the 8% of GDP reveneues raised by the current income tax). However, the Forbes flat-tax plan was not revenue neutral. Most independent studies of this proposals reached the conclusion, that similarly to the tax rate cuts of the 1980s, a flat tax would lead to a fall in revenues and an very siginificantly increase in the budget deficit (the revenue shortfall would be over $ 120 billion per year or about 1.7% of GDP). As discussed above, the tax rate cuts of the early 1980s led to a surge of the budget deficit (from $ 40b in 1979 to $ 220 b in 1986) and a significant increase in real interest rates. The crowding-out effect of this budget deficit national savings and investment led to a fall in the private savings rate and a fall in the amount of national savings (relative to GDP). Since one of the main channell through which a flat tax should increase output and growth is the positive effect on national savings and investment, the evidence (from the 1980s tax cuts and the 1993 deficit reduction) suggests that a dlat tax would depress savings and investment through its effect on the budget deficit. Therefore, any potential growth rate effect (even the tiny ones predicted by Barro) would disappear.

In the view of a maintream economist, William Gale, a senior fellow at the Brookings Institution: "It is completely implausible that improving incentives to work, save and invest in a system that has already moved a long way in theright direction would make a significant difference to growth".

Scene III: The Dole Income Tax Cut Plan

The 1996 return of supply side economics started with the Forbes flat tax campaign and picked up momentum with the recommendations of the Kemp Commission, chosen by the Republican party to develop some proposals for tax reform. However, it reached its policy peak with the presidential campaign of Bob Dole. The economic policy centerpiece of the (failed) Bob Dole's presidential campaign was a proposal of a 15% across-the-board reduction in income tax rates. While Dole had made a career out of being a deficit hawk, his 1996 tax plan (and his choice of supply-sider Jack Kemp as VP candidate) represented a strategic adoption of supply side views. The economics of Dole's tax plan was simple: it would have led to a reduction in government revenues of over $ 500 billion over 7 years. Again, the rethorics of the plan was typical voodoo economics: tax rate cuts would stimulate labor supply, savings and investment so much that the budget deficits would be reduced rather than increased.

A more objective study of this tax plan suggested, instead, that even under the very optimistic scenarios about increased growth and reduced interest rates claimed by the plan, the overall effect of the plan would have been a shortfall of revenues, equal to 75% of the impact tax revenue reduction of the plan. In other terms, even a very sympatetic study of the Dole tax plan found that increase in labor supply, savings and investment following thetax cuts, would generate only 25 cents in increased revenues out of each $ in tax cuts, leaving the total net shortfall in revenues to 75 cents out of each dollar.

The reason why supply side effects do not work is very simple: the estimated responses of labor supply and savings to tax rate cuts are too small to generate the extra revenues that would maintain a tax rate cut revenue neutral.

Consider the evidence on each of these two effects.

1. The labor supply effect:

1.1. The maximum income tax bracket was reduced from 91% to 70% during the Kennedy presidency in the 1960s and then down to 50% by Reagan in 1981.3. However, the labor force grew at an average rate of 1.6% over the 1982-89 period, about the same as during the previous four years. So the first Reagan tax cuts of 1981 had no effect on labor supply.

1.2. The maximum tax bracket was reduced from 50% to 28% in 1986 but again this tax cut had no positive effect on labor supply. A study by Randall Mariger, an economist at the Federal Reserve Board, found that tax rates cuts increased the labor supply by less the 1% between 1985 and 1986.

1.3. The 1993 Clinton increase in the top marginal tax bracket to 39.6% had no effect on the labor supply of the rich, (see the discussion above).

2. The Effect on Savings:

2.1. The evidence is that the response of savings to the after-tax real return to savings is quite small. In the 1973-1980, private saving averaged 7.8 percent of GDP, and dropped to 6.9% in 1986 and 4.8% in 1989. In other words, the saving rate was significantly lower after the 1981 and1986 tax cuts than before it.

2.2. Computer simulations suggests that, even in the case of an extreme policy change, the elimination of all income taxes to be replaced by a tax on consumption only, private savings would increase only by 20%. In other terms, since private savings are about 5% of GDP, in the best scenario they would become 6% of GDP.

2.3 About 80% of savings are already sheltered from current taxation in pension plans that are tax-deferred. So, any policy change that increase the return to taxation would have minimal effects on savings.

So, in conclusion the verdict from history and empirical evidence is quite clear. Supply side economics is "voodoo economics". Reductions in tax rates (starting from initial moderate tax rate levels) do not siginificantly increase labor supply and savings, do not increase economic growth, do not raise total tax revenue and do not reduce budget deficits. Their likely effect on the level and growth rate on output is close to zero while they lead to significantly larger budget deficits.


Slate - Committee of Correspondence - Can Cutting Taxes Speed up Growth?
Does Cutting Tax Rates Increase Economic Growth?
Twisted Tales
What Do People Pay In Taxes?
Budget Reductions Under Dole Tax Plan #2
The New Republic: Kemp&Wanniski
Tax reform in WSJ 1/95
PoliticsNow - WP Economist Question Dole's plan

PoliticsNow - News - Dole's Economic Plan Needs A Hard Sell

Copyright: Nouriel Roubini, Stern School of Business, New York University, 1997.