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Sunday, October 22, 2006

Supply-Side Economics: Used and Abused

Jonathan Chait has a question for the president. If it's true that tax cuts raise tax revenues as he claims, and if it's also true that he has restrained spending like he says he has in his speeches, then why do we still have such a large deficit?

Bush's Silly Budget Logic, by Jonathan Chait, Commentary, LA Times: Alan D Viard, a former Bush White House economist currently at the conservative American Enterprise Institute, recently told the Washington Post: "Federal revenue is lower today than it would have been without the tax cuts. There's really no dispute among economists about that."

He's right. There's no dispute among economists. Conservative, moderate or liberal, every credentialed economist agrees that the Bush tax cuts caused revenues to drop. There is, however, a dispute between economists and pseudo-economists. Supply-siders may be laughed at by real economists, but they still enjoy a strong following among politicians, including, alas, the president of the United States. Here is what President Bush said a week and a half ago:

"They said that we had to choose between cutting the deficit and keeping taxes low — or another way to put it, that in order to solve the deficit we had to raise taxes. I strongly disagree with those choices. Those are false choices. Tax relief fuels economic growth, and growth — when the economy grows, more tax revenues come to Washington. And that's what's happened. It makes sense, doesn't it?"

Well, no, it doesn't make any sense at all. Bush, of course, is correct that tax revenues have risen over the last few years. This is normal.

Except in certain extreme theoretical conditions, tax cuts cause revenues to fall, and tax hikes cause them to rise. The economy also can affect revenues. During an expansion, revenues can rise unusually fast, and during a recession, they can drop unusually fast. ...

In the same speech in which he claimed that his tax cuts have caused revenues to rise, Bush bragged that he's "restraining spending." So why do we still have a deficit? I mean, he says he's kept spending down, he's caused revenues to skyrocket and the economy is going great guns. Why are we still in the red?

And if Bush's own economists say his tax cuts caused revenue to drop — and Viard isn't the only one — then how can he continually get away with insisting the opposite?

As the evidence against the Laffer curve continues to accumulate, it's getting harder to sell the myth that tax cuts pay for themselves, or at least I hope it is. Because of that, tax-cut advocates will likely retreat to an efficiency argument to support their cause.

One note. Jonathan Chait says:

Supply-siders may be laughed at by real economists...

Not quite. There are real economists that are supply-side advocates. But supply-side economics has been misused and misrepresented to suit political ends and that has tarnished its reputation, something that could have been avoided if those "real economists" had voiced strong opposition to claims made on behalf of the theory that were clearly wrong or wishful thinking at best.

Supply-side economics in the right hands, those of qualified real business cycle theorists who are interested in how the world works rather than supporting an ideology or political party, has a lot to offer. For example, I read an interesting paper last week ("A Theory of Demand Shocks") that combines a real business cycle framework with a new classical style Lucas island model information structure, where the information extraction problem concerns productivity shocks. But that is just the tip of a large iceberg of very good research on real business cycles.

My view is that the debate over which view is correct - real business cycle stories of aggregate fluctuations or new Keynesian style microfounded friction models - is not all that productive. My objection comes when people dismiss the demand side entirely. I believe both supply and demand shocks are important sources of aggregate fluctuations and that models synthesizing New Keynesian - Real Business Cycle theoretical models by imposing rigidities or other frictions on a real business cycle structure (augmented with an enhanced demand side) is ultimately where we will end up.

    Posted by on Sunday, October 22, 2006 at 03:00 AM in Budget Deficit, Economics, Politics, Taxes | Permalink  TrackBack (1)  Comments (16)

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