The flawed logic of supply-side economics

From about 1945 to about 1975, U.S. economic policy was influenced by the ideas of the British economist John Maynard Keynes.  He said the key to economic prosperity was consumer demand for goods and services.  As long as people are willing and able to buy things, it was thought, business owners and managers supposedly would find a way to provide them.  In recessions, the job of government was to keep things on an even keel by providing unemployment compensation, engaging in public works, easing interest rates and whatever else it took to keep money in circulation.

President Reagan

The Reagan administration based its policy on a new and opposing theory which was a radical departure from Keynesianism.  The new theory was that savings and investment, not demand, were the key to prosperity.  The new theory was that it is the “supply side,” not the “demand side,” that matters.  And the key to the demand side is to lower the marginal tax rate – the additional tax you will pay if you increase your income another dollar.

Suppose you are someone who is in the 95 percent tax bracket during the 1950s.  Would you want to risk investing your money, knowing that all you would get back is 5 cents on the dollar?  Would you strive to earn extra income, knowing all you could keep is 5 cents on the dollar?  Or would you just want to sit back, enjoy yourself and spend your money on luxurious living?

Along comes the Kennedy administration, and cuts the top bracket to 70 percent.  The government loses very little in revenue, but it increases your return on investment, or on extra work, sixfold. So you, as a rich person, have six times more incentive to work and invest than you did before.

In 1978, during the Carter administration, the top capital gains tax rate was cut from 70 percent to 28 percent.  In 1981 and 1986, during the Reagan administration, the top personal income tax rate was cut in two steps from 7o percent to 28 percent.  The upper-bracket earner got to keep 72 cents on the extra dollar rather than just 30 cents.  This meant that the person could invest in something only half as profitable or twice as risky as before and still come out ahead.  The logic of the theory said this should result in a surge in investment, and prosperity for all.

This seemed plausible to a lot of people at the time.  I myself thought it was worth a try.  But in fact U.S. economic performance was no better when the top tax rate ranged from 28 to 39 percent than when it ranged from 70 to 95 percent.  But when you stop and think about it, this should not have been surprising.

The flaw in the theory, as I now think with hindsight, is that it did not take into account the effect of taxes on losses as well as gains.  When the marginal tax rate is at 70 or 95 percent, an investor has less to gain than when it is at 28 or 39 percent, but also less to lose.  The loss is tax-deductible, meaning that the actual loss is only 30 cents or 5 cents on the dollar.

That consideration applies to entrepreneurs and venture capitalists who are risking their own money.  The equation is different for financiers and corporate executives who are using other people’s money.  Under the new tax regime, a hedge fund manager, for example, has much more to gain but nothing more to lose.  The worst that can happen is the manager loses his job, and the manager will have put away enough millions of dollars that this will not be a subject of concern.

The new tax regime incentivizes managers – and not just corporate managers – to extract more compensation from their organizations, even if it comes at the expense of those who are doing the work.  Economists call this “rent-seeking” – looking for ways to obtain income without creating value. When the top tax rate was 70 or 95 percent, the extra income might not have seemed worth the public backlash.  Under supply-side economics, the incentive for rent-seeking is greater, but the backlash is no greater.

Click on How Bank Executives Piled Up Risk for Own Reward for an article by Simon Johnson in the New York Times that illustrates what I’m talking about.  I do NOT claim to know whether bankers’ behavior would have been different under a different tax policy, only that tax policy affects economic incentives.

Click on A Few Graphs Describing the Reagan Presidency for statistics on comparing U.S. economic performance in the Reagan era with other U.S. presidencies, compiled by Mike Kimel, co-author of the book Presimetrics. I took the graph above from Kimel’s Presimetrics Blog.

[2/16/11]  I took material originally written as the second part of this post and made it into a separate post. Click on The starving beast and the Laffer curve to read it.

[2/25/11]  Click on The Reagan Years for a menu of links to statistical information compiled by Steve Kangas on the Reagan era’s economic policies.

[3/4/11]  Click on Reagan Revolution Home to Roost – In Charts for economic data from Campaign for America’s Future.

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