Is There a New Supply-Side Economics?

Austan Goolsbee, who is advising the campaign of Senator Barack Obama, talks about supply-side economics:

Is the New Supply Side Better Than the Old?, by Austan Goolsbee, Commentary, NY Times: The presidential campaign has brought back to the fore the vexing question of how much to tax high-income Americans. For the most part, the arguments have run strictly along party lines.

The leading Democratic contenders would allow President Bush’s tax cuts to expire for the very well-off... All the major Republican candidates have called for extending the Bush tax cuts indefinitely,... on the grounds that this would help the economy grow.

The Republicans have not been shy about claiming the old mantle of supply-side economics, proclaiming that tax cuts will pay for themselves by getting people to work harder or to start their own companies.

In some circles, supply-side economics fell into disrepute because it didn’t seem to work. ... But many critics have missed important research by some very prominent economists that has revived some supply-side ideas, giving them an aura of academic respectability. ...

The work of the new supply-siders shies away from the old claims that low taxes will generate an explosion of entrepreneurship or extra hours on the job. Instead, it just looks at the data. When top marginal rates fell, as they did under President Ronald Reagan in 1981 and 1986 or under President Bush in 2001 and 2003, taxpayers whose rates declined the most reported the biggest increases in income in the following years. The supply-side advocates attribute those gains to tax cuts and argue that the Laffer curve — which suggests that some tax cuts can pay for themselves — may live yet.

Some of the most important research was done by Lawrence B. Lindsey, former head of the National Economic Council under President Bush and now the senior economic adviser to ... Fred D. Thompson. But the origins of the current debate ... largely center on the work of the Harvard economist Martin Feldstein.

Professor Feldstein ... has always been known for his conservative views. He has brought more comprehensive data to bear and has made the most influential case; if you accept the evidence he offers, progressivity in the tax code appears very damaging. Raising taxes on high-income people seems to make the economy much less efficient and raises little revenue.

As he put it in a 2006 interview..., when you raise top marginal rates, “it shows up as lower taxable income.” He added: “A reduction in taxable income, whether it occurs because I work less or because I take my compensation in this other form, creates the same kind of inefficiency.”

But for all the renewed interest in supply-side ideas, the politicians espousing these views have missed three important points that have come out of the continuing academic debate.

First, the impact of high-income tax cuts depends on how much additional income a person can keep. When President John F. Kennedy cut top marginal rates to 70 percent from 91 percent, take-home pay more than tripled for these taxpayers, to 30 percent from 9 percent. That is a big difference. By contrast, letting the Bush tax cuts expire so top rates rise to 39.6 percent in 2011 from 35 percent, cutting the take-home share to 60.4 percent from 65 percent, hardly seems the stuff of tax revolution. [I think this part mixes up marginal and average tax rates, but the point that the change was much larger under Kennedy holds]

Second, other research has shown that the new supply-side movement missed a fundamental shift over the last 30 years — the dramatic, disproportionate rise in the compensation of high-income people. The new supply-siders have confused this shift with the impact of tax cuts. ...

[M]y calculations show that in the four years after top marginal rates were cut in 1981 and 1986, and in the three years after the rate cut of 2003, average real salaries (subtracting inflation) for the top 1 percent of earners grew 18.8 percent, 22.5 percent and 17.4 percent. But for the bottom 90 percent of earners over those periods, the average salary changes were 2.6 percent, minus 0.3 percent and minus 0.1 percent. A supply-sider might see this as evidence of the growth power of cutting top rates.

But the data also show that incomes at the top have been growing rapidly regardless of what happened to tax rates. In the four years after the increase in top marginal rates in 1993, average salaries grew 18.7 percent among the top 1 percent of earners and less than 0.1 percent for the bottom 90 percent.

Seeing the same pattern when taxes rose as when they fell indicates that tax cuts weren’t responsible. It suggests that cuts for high-income taxpayers likely gave windfalls to those whose incomes were already rising sharply because of broader market forces.

Third, recent research has documented that much of what the new supply-side economics attributed to tax cuts was really just the relabeling of income. Sometimes the increase in personal income was matched by an equal and opposite decrease in corporate income. At other times, increases in personal income turned out to be a result of corporate executives shifting the timing of their year-end compensation from a high-tax year to a low-tax year.

Shifts like these have nothing to do with supply-side economics. The academic debate continues, but thus far, the new Laffer curve has looked more like a fleeting figment of economic imagination.

That is sad, because it would be great if we could cut taxes and raise revenue at one stroke. Alas, the research suggests that we will have to pay for high-income tax cuts the old-fashioned way — by actually cutting spending or just busting the budget.

One argument I've never liked is that we can't raise taxes on high income people because they will just find a way to slither out of paying them, even if it means hiring legions of people to figure out how to do it, or even if it means taking their ball and going home and refusing to play the game at all.

So do we just give up? Or do we close the loopholes? To the extent it is true that the rich avoid taxes when they are raised - see here for an argument that raising taxes on the richest 1% raises tax revenue, i.e. that the new taxes aren't entirely avoided - but to the extent that taxes are avoided I say close the loopholes - we can do it if we put our minds to it. And, though I doubt that many of them would be able to suppress their competitive instincts enough to quit playing the game, if they want to go sit on the couch (or maybe their golf cart) and pout because taxes are higher, that's their problem and their choice - it will enhance upward mobility as people with lower tax rates takes up the opportunities they are letting go. [And in many cases, aging sports stars and over-the-hill rock stars come to mind, superstars could do us all a big favor by retiring sooner, but I doubt a change in taxes would overcome the large ego that seems to come with the territory, be it in sports, music, or the corporate world where similar hangers-on fill the upper echelons of management and boardrooms while perfectly capable underlings wait in the wings. Let them take their ball and go home if they want - nobody's that important and we can get along just fine without them.]