On The Supply-Side

Another loyal reader emails in response to Saturday's post on Obamonics and tax credits:

Tell me you aren't a supply sider! Usually I welcome your economic posts, but if you buy into the "tax cuts raise revenue" mantra, you're putting politics over economics just as you cut into Hillary for the same.

She is referring to this paragraph, specifically where I have added emphasis:

The fourth and final problem with tax credits is also the most important: Unlike tax reduction through cutting of marginal tax rates, tax credits yield no incentive to increase work—in fact, they act as a disincentive. A decrease in your marginal tax rate is like an increase in your wage: Your income goes up and thus your consumption rises. A tax credit's effects are similar, but the credit differs vis-á-vis the marginal cut in one important way: A credit does not increase the marginal utility of work but the marginal rate cut does, thus the rate cut encourages work and makes leisure more expensive. A tax credit does not make leisure more expensive with-respect-to work, but it does increase its recipient's income. Some people, happy with their old consumption level but unhappy with their labor-leisure balance, might respond to the tax credit by working less. Certainly, unlike with a marginal rate cut, folks won't work more.

Ah, but I never said that tax cuts raise revenue, and I am no supply-sider. The backlash, particularly in the press, to the "tax cuts raise revenue" argument has taken us so far in the other direction that we forget that tax cuts do increase productivity. If you cut taxes by ten percent, tax revenue will decrease by less than ten percent.

The supply-side argument goes further: It contends that the productivity gains are so large they will pay for the cut. That is a bold (and often ridiculous) claim. Let me be clear: The "tax cuts raise revenue" thesis is not true hic et ubique, it won't be true tomorrow, and it was almost certainly not true in 2001. That said, the argument can be true—logic suggests that, in some form, the Laffer curve exists. Even John Keynes, the demand-sider to Laffer and Mundell's supply, wrote:

Nor should the argument seem strange that taxation may be so high as to defeat its object, and that, given sufficient time to gather the fruits, a reduction of taxation will run a better chance than an increase of balancing the budget. For to take the opposite view today is to resemble a manufacturer who, running at a loss, decides to raise his price, and when his declining sales increase the loss, wrapping himself in the rectitude of plain arithmetic, decides that prudence requires him to raise the price still more—and who, when at last his account is balanced with nought on both sides, is still found righteously declaring that it would have been the act of a gambler to reduce the price when you were already making a loss.

Indeed, for at least the top brackets, the Kennedy and the Reagan tax cuts likely moved the marginal rate from the right-side to the left-side of the curve. But once or twice does not prove universality. The dishonesty is the insistence that marginal rates are always on the right-side of the curve and thus taxes should always be lowered and that said reduction will always increase revenue. Wrong and wrong, Mr Bueller.

Martin Gardner's Rendition of the Laffer Curve, licensed cc-by

There are, however, benefits to lowering marginal tax rates that do not rely on supply-side arguments. The productivity gains from marginal rate cuts are welcome in and of themselves. Lower effective rates lower the incentive to evade taxes. On the short-run and if enacted quickly, marginal rate cuts funded by debt are an effective form of fiscal stimulus. And there is the Nozickian take: The government should transfer to itself as little of your income as possible.

That said, cutting taxes to the point of incurring a long-run structural deficit is a rape of my generation by my parents'. As Chairman Bernanke recently put it:

So as I've said on a number of occasions, the law I'm most in favor of is the law of arithmetic—you know, what comes in at least has to equal what goes out at some point. And if you think about the various alternatives that the Congress has over the longer period, I hope the law of arithmetic will be part of your consideration.