Sacred Cows, Vol. 1.: Trickle down economics.

Ronald_Reagan_televised_address_from_the_Oval_Office,_outlining_plan_for_Tax_Reduction_Legislation_July_1981Today, let’s take a break from the distractions provided by the Syrian airbase attack and the escalating tensions over North Korea, and return to legislative priorities which are bound to come up in the coming year.   Chief among them is clearly going to be tax reform.

Republicans have uniformly and invariably made attempts to cut taxes, primarily on the wealthy, in every Republican administration during which they have been able to do so since the 1980s. Tax reform was one of Trump’s stated goals during his campaign, and it is clearly in the crosshairs of the Republican congressional majorities.  Indeed, the stalled healthcare reform bill, the American Health Care Act (AHCA) recently floated by Paul Ryan and supported by Trump, attempted to set the stage for larger tax cuts by cutting back on Obamacare’s tax on high earners – and Paul Ryan certainly holds out tax reform as his highest priority.   Once unforced errors and rudderless foreign policy issues recede – assuming they do – it is inevitable that the GOP will once again try to hand a huge tax cut to the rich, the costs of which will be borne, most likely, by the most vulnerable populations.

It is an article of faith among Republicans of all stripes that lower taxes are good for the economy. The problem is that facts tend to undercut that belief.

The general idea of cutting taxes on the rich and on corporations as a catalyst to economic growth is broadly considered “supply side” or “trickle down” economics. The idea first seems to have taken root in the late seventies.  Then, it was argued that lower tax rates would improve private sector incentives, leading to higher employment, productivity, and output in the US economy. George H.W. Bush, during the 1980 Republican primary, when he was opposing Ronald Reagan, referred to the extreme version of this theory espoused by Reagan as “voodoo economics.” In the Reagan formulation, a cut in tax rates was predicted to result in an increase in tax revenue, and thus not increase the government deficit.  This is what is referred to as the “Laffer Curve” effect, after an early proponent of this idea.

These theories have been tested in the real world, and the data strongly shows that cutting tax rates does not increase tax revenues.  If this is the central theory of supply side economics, it is based on a fantasy.  However, no matter how many times it fails, it is an article of faith in the GOP that trickle down works – even if the cognoscenti recognize that this is just a talking point, and that the real reason these policies are pursued is because wealthy donors pay lots of money to make sure that they are pursued.

It is part of the GOP perspective on this issue that taxes essentially discourage work, because they lower the after-tax return from work.  Economic conservatives who favor supply side economics also assert that taxes discourage saving and investment, since they lower after-tax returns on investment yields (although those yields continue to be taxed at a substantially lower rate than actual income earned through work, and have been for years).

Under the supply side theory, lower tax rates on wage income should increase the labor supply – under the somewhat questionable assumption that people will not choose to be employed if their wages are taxed at higher rates.  Although this seems to be an absurd assumption on its face, if its validity is assumed, then, the theory goes, the increase in labor supply driven by low tax rates will increase employment.  This sudden surge of re-entry into the labor market will result in increased tax revenues from all these people who were only sitting at home unemployed because tax rates didn’t make it worth their time to work and earn wages.  Already, you can see we’re getting into some questionable assumptions underpinning the theory.  But let’s continue.

Under supply-side theory, one 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. If this were to happen, the theory goes, interest rates would go down 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.

Those were the arguments in favor of trickle-down. And while most economists would agree with the theoretical idea that lower taxes increase labor supply and savings, the big empirical question is whether the effects of cuts in tax rates on labor supply and savings are small 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 very poor workers whose marginal tax rate can be quite high. When the very poor – those who qualify for welfare and medical benefits – go to work, they may end up being worse off when working for very low (but taxed) wages, making the  “opportunity cost” of working relatively high. This may be an important aspect of social policy, but it probably does not have a large effect in the aggregate. The effect on saving, though, is thought by some to be substantial but there is wide disagreement on this issue as well.

So why was this theory derided both at the time and now as “voodoo” economics? Because there is a very large question about whether the theoretical promised effects of tax cuts have any basis in reality.  As mentioned above, the central notion that is still being sold is that tax cuts provide such large incentive effects that tax cuts would actually raise tax revenue, since the tax base would grow so much.

There’s no sign that this ever happened, and most economists were pretty skeptical of this prediction at the time. Indeed, when Reagan cut tax rates in 1981, budget deficits exploded.  Moreover, the response of private savings and labor supply to the Reagan tax cuts was minimal.  Labor supply did not increase and the effect on private savings was swamped by the reduction in public savings (i.e., 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:

Although the economy grew quickly from 1983 to 1989, this was largely due to 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).

The private saving rate declined slowly through the 1980s. Between 1973 and 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.

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.

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 averaged around 1.1 percent also in the 1980s.

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

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

These facts are all extremely well laid out in Paul Krugman’s 1995 book, “Peddling Prosperity”, Norton, 1995.  Based on the above, it would seem that the benefits that the proponents of supply-side economics as promised by Reagan simply did not materialize when enacted into law.   By the time Clinton took office in 1993, the effects of the supply-side policies of the 1980s were abundantly clear:  the budget deficit in 1992 was 290 billion dollars, or 4.9% of GDP, and the public debt-to-GDP ratio was 50.6%. Clinton proposed a deficit reduction plan which 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.

Supply-side proponents, at the time, criticized the Clinton proposal. They argued that it would push the economy into a recession and reduce long-term growth. They also argued that the increase in tax rates on higher earners would increase budget deficits, as individuals would reduce their labor supply and savings would be reduced.  Finally, they argued that the Clinton proposal would increase real interest rates because of the presupposed increase in deficits.

The supply-siders couldn’t have been more wrong on these issues if they tried. Once enacted, the Clinton plan reduced the budget deficit from 290 billion dollars in 1992 (4.9% of GDP) to 104 billion dollars in 1996 (1.2% of GDP). The debt to GDP started to fall after having continuously increased since 1978. Moreover, 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. Real interest rates also remained stable through the first Clinton term and were significantly lower than the high rates of the 1980s.

While the effects of the 1993 deficit reduction package clearly contradicted the gloomy forecasts of the critics, there has been an unrelenting and plainly 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 from the top income individuals.

Despite the evidence of the Reagan years, as compared to the Clinton era, when the federal government recognized a surplus for a period of time, Republicans – no doubt urged on by their wealthy donors – continued to advocate for tax cuts.  They got them under George W. Bush in 2001.  To this day, in fact, we are still living, by and large, with the tax code from the Bush era—with the only differences being further tax cuts signed by President Barack Obama.

Once again, the results which supply-side proponents promised simply did not materialize.   But investment growth during both supply-side eras (the 1980s and the 2000s) lagged far behind that of the 1990s when taxes were higher.  Productivity growth was also marginally weaker than that of the 1990s in both supply-side eras.  Growth in GDP, particularly in the Bush era, was particularly weak.  Employment growth after the 1993 tax increases outpaced that of both the 1980s supply-side period and the 2000s supply-side period. Again, the most recent supply-side period was especially bad for employment growth, averaging just 1.5 percent increases a year.

Supply-side theory asserts that when the tax burden on the rich is reduced, it will eventually help everyone. And conversely, if you raise taxes on the rich, then everyone will end up paying the price. If this were true, we should have seen robust income growth for middle-class families under supply-side policies and stagnation under the higher-tax regime. But we saw just the opposite. After the tax increases under Clinton, income for the median household grew at nearly twice the rate as it did under the supply-side tax policies. It should also be noted that Kansas, under the leadership of Governor Sam Brownback, a huge proponent of supply-side benefits, has found itself in a fiscal crisis after enacting a set of supply-side tax policies.  Meanwhile the more recent rhetoric emerging from the GOP argues that rewarding the highest earners (whom Republicans refer to as “job creators”) will result in increased employment for the rest of the population.  This ignores the fact that companies do not hire additional employees merely because they pay lower taxes.  Instead, they will only increase hiring when demand conditions are such that additional employees are needed.   This talking point is clearly refuted by the lack of data to back it up, and the plethora of data which contradicts it.

While this does not mean that low taxes are bad and high taxes are better, it does show that the Republican orthodoxy on the question of taxes certainly bears some scrutiny, and can even be said to be demonstrably false in practice. It is part of the larger overall anti-government ideology which has been espoused by the GOP – an ideology which is questionable or even false at its core.   And in my next column, I will discuss why the Republican anti-government narrative is similarly a false narrative.