Has everyone seen "Ferris Bueller's Day Off"? Assuming yes, you'll certainly remember Ben Stein's iconic turn as the affectless economics teacher, punctuating his monotone lecture with half-hearted invitations to class participation. ("Anyone? Anyone? Raised/Lowered? They raised tariffs...")
What's less commonly remembered is the substance of the Stein character's lecture. Interestingly, in real life, Stein is (in addition to being a hack writer and game show host) a hack economist, and he used his role in the film to expound on one of his favorite ideas: supply side economic theory. ("Anyone? Something-doo economics. Voodoo economics.") The ideas of supply side economic theory were used as window dressing by the Reagan administration to justify doing what they wanted to do anyway (that is, slash the marginal tax rates on the upper income brackets).
The (perhaps apocryphal) story goes that economist Arthur Laffer sketched out a graph representing his idea on a cocktail napkin. On the graph, the vertical axis represented government revenue, and the horizontal axis was the marginal tax rate. The plot itself looked like the St. Louis Arch, with the left and right "legs" going down to y=0. The thought that this illustrated was that if the marginal rate is zero, your revenue will be zero (because you're not collecting any money), and if the marginal rate is 100%, then your revenue will also be zero (because no one is going to go to work just to give the feds his whole paycheck) and that some marginal rate in between will maximize government revenue. So, in theory, if your tax rate is above a certain level, it should be possible to cut taxes and take in more money at the same time. The economic mechanic that is invoked to justify this is that more money in private hands means more money invested in the private sector, and thus more economic growth
As Stein alluded to, the senior Bush denounced this as "voodoo economics" when campaigning against Reagan in the 1980 primaries. Though once he was on board as vice president, Bush issued no further objections to the "Reaganomics" policy package, both he and Reagan contradicted Laffer's thesis in the face of (tax-cut spurred) declining government revenues by raising tax rates. With the ascension of Bush Jr., supply side theories were dusted off to justify three more rounds of tax cuts, again with dubious results.
So what is behind this? Laffer's reasoning looks sound enough, so let's unpack some of the assumptions behind it to see if we can't pinpoint its deficiencies.
The Laffer curve is the product of a school of thought that has ancestors in the laissez-faire capitalism of the early 20th century. This way of seeing the world holds that the innovation and industry of people and corporations drive economic growth, and that regulation, corruption, crime, and taxes are all impediments to growth, inasmuch as they prevent the investor from realizing the full benefit of his input.
There is truth to this. People are demonstrably reluctant to invest in areas where crime or corruption are rampant, and those areas suffer economically for it. And it's hard not to be sympathetic to the point of view that there is a non-zero amount of government process that exists for its own sake, and certainly, complying even with necessary regulations takes more time, money, and effort.
Particularly, in the case of taxes, the laissez-faire school considers them to be a disincentive to things that are taxed. Hence, "sin" taxes on cigarettes and alcohol. Want to protect domestic industry? Raise the tax on imports (tariffs). Want to reduce consumption? Impose a sales tax. Taxing things behaviors to discourage them is a mechanism that exists in the real world, that governments employ universally.
This lead to Reagan's "government is the problem" demagoguery. Government puts up barriers to economic growth in the form of regulations and taxes. Government should only exist in order to remove other barriers to growth, such as crime and corruption, and should do so only up to the point that the taxes and regulations necessary to accomplish that are not a bigger drag than the crime and corruption that they prevent. Hence, conservatives are also very quick to employ "law & order" rhetoric.
So that, as I understand it, is the conservative view that underpins what has been sold as supply-side economics. It is understandable and sympathetic, but I submit that this framework is an impoverished one, because it does not consider the ways in which government revenue collection promotes growth.
You heard me right. Government revenue collection promotes economic growth.
The first clue is that I am distinguishing between "taxes" and "revenue collection."
Here's the second: it doesn't make sense to make the same "taxes are a disincentive to the taxed" formulation for all money that the government collects. Are income taxes a disincentive to making more money? Of course not. Even at a 50% tax rate, if you get a $500 raise, that's still $250 going directly into your pocket. If booze costs twice as much because of liquor taxes, then you are economically limited -- at maximum, you could buy half the amount you could without the taxes. If the income tax rate is 50%, it does not follow that you will only work half the hours, or half as hard.
It turns out income tax is special, and is part of a bigger feedback loop that the idea of tax as disincentive doesn't capture. Laffer's curve probably works pretty well to describe other forms of taxation, like tariffs or sin taxes. But with income tax, you have to follow the dollars.
The reason for this is that in reality, government does more than remove barriers to economic growth. Government makes active investments in economic growth. Spending money on infrastructure, R & D, and especially education are investments in the public. And they are investments that the government is particularly suited to make, because of its own unique advantages. First of all, the government operates on a much longer time horizon than you or I or even most corporations can afford to. Secondly, the government has tools that let it recapture dividends from its investments even when the precise effects can't be pinned down. One of those tools is what we know of as income tax.
When the government educates kids, there's far more chance that they'll grow up to be the next generation's Thomas Edisons. When we get nice new things like light bulbs (or other value-adds like assembly lines or interchangeable parts or the internet), then everyone's quality of life goes up. When we create new ways to add value, new industries arise, and the economy grows. When the economy grows, and everyone is better off, then personal and corporate income is going to rise. And it will rise in proportion to the amount of value added. And the government should claim a dividend for that, so that it can reinvest in the next generation of R&D, and the next generation of infrastructure, and the next generation of kids. We all benefit from this generation's internet (or light bulb, or hydropower project), and we all chip in for the next one (fusion, hopefully).
The collectivity of the process is important, too, because we are all so differently blessed in our means. Imagine a lottery where the payout was $10,000, where 100 tickets were sold at $10 apiece. The expected value of the tickets is $100 apiece ($10,000/100 tickets), so you would be a fool not to buy one or twenty or all 100. Imagine, though, that you are a parent, and you only have $10, and you have to buy medicine for your kid. Now instead of a simple $10 versus $100 expected value calculation, you are weighing your child's life against a $100 expected value. The odds are with you on a dollar for dollar comparison, but in this case, your last $10 is worth more than a 1 in 100 chance of winning $10,000. What makes sense in this situation is to pool together enough people to buy all of the tickets, have each of them contribute as much as they like up to $1000 total cost for all the tickets, and then return 10 times as much to each contributor.
This is exactly what government does. The sorts of things that government invests in, like research and education, are exactly like lottery tickets with a huge payout versus the cost times the number of tickets. The problem is that even though your ticket is theoretically worth $100, you might not capture any money at all (there are 99 other tickets that also might win.) Thousands of projects get funded for every internet, so even though the internet represents a bigger value add than the billions of dollars spent on it plus all of the other R&D of its generation, it wouldn't make sense for a private entity to do that kind of research, because the chances of recapturing a dividend on it are just too small. Not only is the chance of a hit too small, but the time horizon is too long term, and the benefits too diffuse.
Getting back to Laffer, there are only four (actually, three, but we'll get to that) things that the government can do: change revenue rates, change spending rates, print money, and borrow money. Those 4 factors absolutely have to be in equilibrium. If you're going to lower taxes to reduce the "drag on the economy", you have to fiddle with at least one of the other three factors.
- If you reduce spending to pay for tax cuts, then you aren't giving the population a gift. You are under investing. You're leaving some of that 10 grand on the table. Certainly, there's a point of diminishing returns to this kind of investment -- it wouldn't do any good to pave the whole country, and there are a finite number of kids to educate, and only so many ideas to work on and people to work on them, but it is my opinion that the ceiling is pretty high.
- If you just print more money to pay for your tax cuts, then you simply generate inflation and the tax cuts are worthless (except to the extent that the tax cuts unequally affect different income levels, in which case the combination simply works to redistribute wealth.) What's the point of having twice as many dollars if they buy half as much?
- If you borrow, then you do two things. First, you give people with money more options for people to loan it to. If I'm the only person who's looking for a loan, and both Peter and Paul have extra money that they want to loan out, then I'll get a pretty good rate. If the feds want to borrow billions, all of a sudden the demand for credit goes way up. This makes it more expensive to borrow money, which counteracts the stimulative effect of giving investors more dollars through the tax cuts. Secondly, you've guaranteed future taxes, because the government can cut spending on anything at any time except debt service. So borrowing is just raising taxes at some indefinite point in the future. It's useful if you are in an economic trough, and can borrow against future accelerated growth, or otherwise can spend in a way that will give you a growth rate bigger than your interest rate. Otherwise, very very stupid.
So this is why I say government revenue collection promotes economic growth. Of the four possibilities I listed above, collecting a enough money to make judicious investments in the commonweal, paying as you go, is clearly the dominant strategy. It also shows why Laffer was full of crap -- Reagan and Bush II paid for their tax cuts with a mixture of borrowing and under investing, and we lost value as a consequence.