Download Supply-Side Economics

Supply-Side Economics
by James D. Gwartney
Supply-side economics provided the political and theoretical foundation for a remarkable
number of tax cuts in the United States and other countries during the eighties. Supply-side
economics stresses the impact of tax rates on the incentives for people to produce and to use
resources efficiently. A person's marginal tax rate—the tax rate she pays on an additional
dollar of income—determines the breakdown between taxes, on the one hand, and income
available for personal use, on the other. Since they directly affect the incentive of people to
work, to save and invest, and to avoid and evade taxes, marginal tax rates are central to
supply-side analysis.
An increase in marginal tax rates reduces the share of additional income that earners are
permitted to keep. This adversely affects output for two major reasons. First, the higher
marginal rates reduce the payoff that people derive from work and from other taxable
productive activities. When people are prohibited from reaping much of what they sow, they
will sow more sparingly. Thus, when marginal tax rates rise, some people, those with working
spouses for example, will opt out of the labor force. Others will decide to take more vacation
time, retire earlier, or forgo overtime opportunities. Still others will decide to forgo promising
but risky business opportunities. These reductions in productive effort shrink the effective
supply of resources and thereby retard output.
Second, high marginal tax rates also encourage tax shelter investments and other forms of
tax avoidance. As marginal tax rates rise, investments that generate paper losses from
depreciable assets become more attractive. So, too, do business activities that present
opportunities to deduct expenditures on hobbies (for example, collecting antiques, raising
horses, or traveling) and personal amenities (luxury automobiles, plush offices, and various
fringe benefits). Thus, people are directed into activities because of tax advantages rather
than profitability. Similarly, they are encouraged to substitute less desired tax-deductible
goods for more desired nondeductible goods. Waste and inefficient use of valuable resources
are a by-product of this incentive structure.
It is important to distinguish between a change in tax rates and a change in tax revenues.
Because higher tax rates discourage work effort and encourage tax avoidance and even tax
evasion, the tax base will shrink as the rates increase. When something is taxed more heavily,
you will get less of it. Therefore, an increase in a tax rate causes a less than proportional
increase in tax revenue. Indeed, economist Arthur Laffer (of "Laffer curve" fame) popularized
the notion that higher tax rates may actually cause the tax base to shrink so much that tax
revenues will decline.
This inverse relationship between a change in tax rates and the accompanying change in tax
revenues is quite likely when marginal tax rates are high, but unlikely when rates are low. An
analysis of the incentive effects for different tax brackets illustrates why this is true. Suppose
that a government with progressive income tax rates ranging from a low of 15 percent to a
high of 75 percent cuts tax rates by one-third. The top tax rate would then fall from 75
percent to 50 percent. After the tax cut, taxpayers in the highest tax bracket who earn an
additional $100 would get to keep $50 rather than $25, a 100 percent increase in the
incentive to earn. Predictably, these taxpayers will earn more taxable income after the rate
reduction, and the revenues collected from them will decline by substantially less than a third.
In fact, given the huge increase in their incentive to earn, the revenues collected from
taxpayers confronting such high marginal rates may actually increase.
The same 33 percent rate reduction will cut the bottom tax rate from 15 percent to 10
percent. Here, take-home pay per $100 of additional earnings will rise from $85 to $90, only a
5.9 percent increase in the incentive to earn (compared to the 100 percent increase in the top
bracket). Because cutting the 15 percent rate to 10 percent exerts only a small effect on the
incentive to earn, the rate reduction has little impact on the tax base. Therefore, in contrast
with the revenue effects in high tax brackets, tax revenue will decline by almost the same
percent as tax rates in the lowest tax brackets. The bottom line is that cutting all rates by a
third will lead to small revenue losses (or even revenue gains) in high tax brackets and large
revenue losses in the lowest brackets. The share of the income tax paid by high-income
taxpayers will rise.
The inflationary seventies created a receptive environment for the supply-side view. As
inflation pushed numerous taxpayers into higher and higher marginal tax brackets, supplyside economists argued that high taxes were a major drag on economic growth. Furthermore,
according to the supply-side view, the top rates could be reduced without a significant loss in
revenue.
During the great tax debate of 1975 to 1986, the opponents of the supply-side view argued
that it was unrealistic to expect lower tax rates to lead to increased tax revenues. According to
the critics an increase in the tax base that was large enough to increase revenues would
require an unrealistically large elasticity of labor supply (increase in hours worked due to
higher after-tax wages). In response the supply-side proponents stressed that reductions in
tax avoidance activities, as well as labor-supply effects, would enlarge the tax base when the
rates were reduced. According to the supply-side view the combination of a decline in tax
avoidance and increase in business activities would permit lower rates with little or no loss of
revenues in the top tax brackets. At the same time, most supply-side economists, though
perhaps not all, noted that reductions in low tax rates would lead to revenue losses.
Empirical studies of tax cuts that happened during the twenties and sixties buttressed the
supply-side position. Prodded by Secretary of the Treasury Andrew Mellon, three major tax
cuts reduced the top marginal tax rate from 73 percent in 1921 to 25 percent in 1926. In
addition, the tax cuts eliminated or virtually eliminated the personal income tax liability of
low-income recipients. The results were quite impressive. The economy grew rapidly from
1921 through 1926. After the rates were lowered, the real tax revenue (in 1929 dollars)
collected from taxpayers with incomes above $50,000 rose from $305.1 million in 1921 to
$498.1 million in 1926, an increase of 63 percent. In contrast, the real tax liability of those
with less than $50,000 of income declined by 45 percent. Thus, as the tax rates were cut, the
revenues collected from high-income taxpayers rose, while those collected from lower-income
taxpayers declined. The tax cuts of the twenties substantially increased the percent of taxes
paid by the wealthy.
The results of the Kennedy-Johnson tax cuts of the midsixties were similar. Between 1963 and
1965, tax rates were reduced by approximately 25 percent. The top marginal tax rate was cut
from 91 percent to 70 percent. Simultaneously, the bottom rate was reduced from 20 percent
to 14 percent. For most taxpayers the lower rates reduced tax revenues. In real 1963 dollars
the tax revenues collected from the bottom 95 percent of taxpayers fell from $31.0 billion in
1963 to $29.6 billion in 1965, a 4.5 percent reduction. In contrast, the real tax revenues
collected from the top 5 percent of taxpayers rose from $17.2 billion in 1963 to $18.5 billion in
1965, a 7.6 percent increase. As in the case of the tax cuts of the twenties, the rate
reductions of the sixties reduced the tax revenue collected from low-income taxpayers while
increasing the revenues collected from high-income taxpayers.
Major tax legislation passed in 1981 and 1986 reduced the top U.S. federal income tax rate
from 70 percent to approximately 33 percent. The performance of the U.S. economy during
the eighties was impressive. The growth rate of real GNP accelerated from the sluggish rates
of the seventies. U.S. economic growth exceeded that of all other major industrial nations
except Japan.
The critics of the eighties tax policy argue that the top rate reductions were a bonanza for the
rich. The taxable income in the upper tax brackets did increase sharply during the eighties.
But the taxes collected in these brackets also rose sharply. Measured in 1982-84 dollars, the
income tax revenue collected from the top 10 percent of earners rose from $150.6 billion in
1981 to $199.8 billion in 1988, an increase of 32.7 percent. The percentage increases in the
real tax revenue collected from the top 1 and top 5 percent of taxpayers were even larger. In
contrast, the real tax liability of other taxpayers (the bottom 90 percent) declined from $161.8
billion to $149.1 billion, a reduction of 7.8 percent. These findings confirm what the supply-
siders predicted: the lower rates, by increasing the tax base substantially in the upper tax
brackets, caused high-income taxpayers to pay more taxes. In effect, the lower rates soaked
the rich.
Probably the most detailed study of the tax changes in the eighties was conducted by
Lawrence Lindsey of Harvard University. Lindsey used a computer simulation model to
estimate the impact of the eighties' tax-rate changes on the various components of income.
He found that after the tax rates were lowered, the wages and salaries of high-income
taxpayers were approximately 30 percent larger than projected. Similarly, after the rate cuts
capital gains were approximately 100 percent higher than projected, and high-income
taxpayers' business income was a whopping 200 percent higher than expected. Lindsey
concluded that the main supply-side effects resulted from (a) people paying themselves more
in the form of money income rather than fringe benefits and amenities, (b) increases in
business activity, and (c) a reduction in tax shelter activities. His findings undercut the
position of those supply-side critics who had assumed that substantial supply-side effects were
dependent on a large increase in labor supply.
Studies linking rate changes with changes in tax revenue measure the short-term effects of
tax policy. But because taxpayers take time to adjust, revenues are even more responsive to
rate changes in the long run. James Long and I conducted a study that found that taxpayers
in states with lower marginal tax rates had much lower deductions and much lower
expenditures on tax shelters than taxpayers in states with higher marginal rates. We found
that when the combined federal-state marginal tax rate rises above 50 percent, the
government's tax revenues decline. Lindsey estimates that the government's revenue begins
declining at even lower tax rates, approximately 35 percent.
Supply-side economics influenced tax policy throughout the world in the late eighties. Of
eighty-six countries with a personal income tax, fifty-five reduced their top marginal tax rate
during the 1985-90 period, while only two (Luxembourg and Lebanon) increased their top
rate. Countries that substantially reduced their top marginal tax rates include Australia, Brazil,
France, Italy, Japan, New Zealand, Sweden, and the United Kingdom.
Reflecting the dominant Keynesian view at the beginning of the eighties, most economists
thought that tax changes influenced output and revenue primarily by changing the demand for
goods and services. Both research and the tax policy changes of the eighties, however,
indicate that supply-side incentive effects are quite important. While controversy continues
about the precise magnitude of the supply-side effects, the view that marginal tax rates in
excess of 40 percent exert a destructive influence on the incentive of people to work and use
resources wisely is now widely accepted among economists. This was not true prior to the
eighties. An important piece of evidence for the shift in thinking is a 1987 statement by the
Congressional Budget Office (CBO), which had been critical of the supply-side claims and had
always assumed in its revenue projections that taxpayers did not respond at all to changes in
tax rates. The CBO wrote: "The data show considerable evidence of a very significant revenue
response among taxpayers at the highest income levels." This change in thinking is the major
legacy of supply-side economics.
About the Author
James D. Gwartney is a professor of economics at Florida State University. He was previously
chief economist of the Joint Economic Committee of the U.S. Congress.
Further Reading
Canto, Victor A., Douglas H. Joines, and Arthur B. Laffer. Foundations of Supply-Side Economics. 1983.
Federal Reserve Bank of Atlanta. Supply-Side Economics in the 1980s. 1982.
Henderson, David R. "Are We All Supply-Siders Now?" Contemporary Policy Issues 7, no. 4 (October 1989): 116-28.