A primary benefit of learning economics is that government policies can be evaluated according to scientific principles. Government policies are often set by political agendas that usually favor the wealthy, because they have the most influence with politicians and most politicians are also wealthy. However, in democracies, politicians must rationalize their self-serving policies, so that voters will, at least, acquiesce. Naturally, many of the wealthy want lower taxes on themselves, so to justify why they should receive most of the tax breaks, they embraced what has become known as supply-side economics.
What exactly constitutes supply-side economics is nebulous; different people have different ideas. The nebulosity of supply-side economics arises from the fact that it is not really an economic theory, but rather a political argument for lowering taxes, particularly for the wealthy, and decreasing regulation. By its name, one would think that supply-side economics means an increase in the supply of something. But what? Goods and services? A market equilibrium exists as an equalization between supply and demand. Increasing supplies reduces prices, which will increase demand, but it can also reduce revenue to the suppliers. Demand increases with lower prices, but whether the increased demand increases revenue for the suppliers depends on the elasticity of both supply and demand. The market equilibrium is the point where suppliers are maximizing their profits. If they could make more money by increasing the supply, then they would do so. So supply-side economics really does not have anything to do with the supply of goods and services.
Supply-side economics is really about increasing the supply of labor, a necessary input for the production of any good or service. Reducing taxes on labor will increase the supply of labor, because the workers will receive a higher disposable income, which is equivalent to a higher supply price, thereby increasing the supply of labor. This will lead to a stronger economy, but only if all of the labor is utilized. So increasing the supply of labor will be of no benefit unless it also leads to increased demand. And as I will argue later, this increased demand will be highly dependent on the tax breaks.
So supply-side economics argues that higher tax rates on labor will reduce disposable income, thereby lowering the incentive to work. People may decide to retire earlier, to stay at home, take more vacation time, forgo overtime opportunities, or even move to another country, or avoid taking excessive risk in business. Inefficiency also result from activity, most of which has no economic value, to avoid or reduce taxes. But this inefficiency can be reduced by eliminating tax loopholes.
Arthur Laffer was a major exponent of supply-side economics, both becoming prominent during the 1970s. Ronald Reagan also became a big fan of supply-side economics, even basing his tax policy implemented in the 1980s on it, which is why supply-side economics was often referred to as Reaganomics.
Laffer argued that increasing taxes can actually reduce tax revenue, because it will disincentivize work. He illustrated this by drawing a curve on the napkin, what later became known as the Laffer curve, showing the relationship between work and the tax rates on work, arguing that tax revenue would, at 1st, increase with increasing tax rates. But when the tax rate got high enough, fewer people would work or they would work less, which would decrease tax revenue. When the tax rate reached 100%, then tax revenue would decline to 0, equivalent to the same situation when the tax rate itself was 0%. Thus, there was some point on the curve that would yield the maximum tax revenue.
Although Laffer’s curve was symmetrical, the real curve is most certainly asymmetrical, because most people must work to earn a living, so the supply of labor is inelastic, especially at lower incomes.
The Republicans, especially, have latched onto supply-side economics to justify lowering taxes on wealthy people. They argued that lower taxes would stimulate the economy, and that increased economic growth would help to pay for the tax cuts, because, although the tax rates are lower, the tax base would increase through economic growth. To increase public support for lowering taxes on the wealthy, supply-side economics is often coupled with trickle-down economics. Giving the tax breaks to the wealthy, it is argued, will stimulate investments, saving, and even incentivize wealthy people to work harder by creating more businesses. Then their wealth will trickle down to lower income people.
The Economics of Supply-Side Economics
Supply-side economics fails as a political argument for reducing taxes on the wealthy because it contradicts a few simple economic principles. The main problem with supply-side economics as a political argument is that it starts with the political goal of reducing taxes on the wealthy, then tries to justify this goal by deriving economic benefits for society as a whole. But by considering a few fundaments of economics, a different conclusion is reached.
One aspect of the economy that seems clear is that consumption drives the economy. While supply is obviously necessary, no good or service will be supplied if it cannot be sold. So if an entrepreneur starts a business, then the business can only thrive if it has customers. If a product or service is demanded by the public, then some entrepreneur will figure out how to produce or provide it. That consumption is the main driver of the economy can also easily be seen by considering the fact that people, as biological beings, have demands that arise from their biology. These demands existed before there was any economy. Civilizations simply provided a better means to satisfy these demands.
Another fundament of the economy is that marginal utility declines with increasing consumption of any particular good or service. When you are hungry, you eat. As you eat more, you become less hungry, until you are no longer hungry. If you continue to eat, then you will get sick. What is true of eating, is true of all consumption of goods and services. Since money is used to purchase goods or services, money itself also has a declining marginal utility. In other words, the marginal utility of money is inversely proportional to the wealth of the individual. Why is that? Poor people must spend all of their money for the goods and services that are needed to survive. On the other hand, the wealthy have far more money than what is required even for a splendid living, so having more money does not increase their standard of living by much. This would suggest that tax breaks to the poor would be far more effective in stimulating consumption, and therefore, stimulate the economy more than giving tax breaks to the wealthy. And if the tax breaks to the wealthy are paid for by reducing social welfare programs, then the negative impact of reducing the income for the poor on the economy will exceed any stimulatory effect of giving tax breaks to the wealthy, because overall consumption will be reduced.
Another fundament of the economy is that the marginal propensity to consume is inversely proportional to wealth. This is related to the declining marginal utility of money. Because the wealthy already have everything they need or want, they do not spend additional income. Instead, they invest it, mostly in secondary financial markets, such as the stock market, or they buy collectibles, like art.
Short History of the Federal Debt and Tax Cuts
History shows that cutting taxes on the wealthy increases both the annual deficit and the total debt. We can see this clearly just from looking at recent history, beginning with Ronald Reagan.
Ronald Reagan used supply-side arguments to rationalize his tax cuts in the 1980s, during his presidency, instituting a 30% reduction in both individual and corporate income taxes over a 3-year period, while increasing funding for the military and cutting discretionary spending significantly, including social welfare programs, such as education, food stamps, low-income housing, school lunches for poor children, Medicaid, and Aid To Families With Dependent Children.
The 1st tax cuts from the Reagan Administration was the Economic Recovery Tax Act of 1981. However, even after these tax cuts, in 1982, there was a severe recession, bankruptcies and farm foreclosures reached record levels, the federal deficit went from $25 billion in 1980 to $111 billion in 1984. Most of these problems were the result of stagflation that existed at that time, with extremely high inflation, but the economy did not improve with the tax cuts.
Massive budget deficits resulted, so Reagan backed a $98.3 billion tax increase in 1982. The following year, the economy started to recover, with unemployment and inflation significantly reduced. Economic growth continued with Reagan’s presidency, even though he increased taxes by that point. Eventually, he would pass more tax cuts as the Tax Reform Act of 1986. These tax cuts were followed by Black Monday in 1987, by the S&L Crisis in 1989, and by recession in 1990 and 1991.
When George HW Bush was elected president in 1988, he promised: “Read my lips, no new taxes!” But then Bush discovered the same thing, that cutting taxes, especially on the wealthy, increases deficits. So, to the consternation of his conservative allies, Bush did raise taxes in 1990, to deflate the soaring budget deficit.
During his presidency, Bill Clinton increased taxes on the wealthy, which increased tax revenue. During the last 3 years of his presidency, the federal government actually had a budget surplus, which helped to reduce the debt. And even though he raised taxes, the economy boomed, which belies the argument that raising taxes on the wealthy hurts the economy.
Then, as befitting a Republican president, George W. Bush passed tax cuts benefiting mostly the wealthy in both 2001 and in 2003, again increasing the deficit. But those big tax breaks did not prevent the Great Recession, which arrived in 2007, with the government being more indebted than ever. Nonetheless, when Barack Obama became president, he had to increase the deficit even more to stimulate the economy out of the Great Recession. Even though the economy grew significantly under President Obama, the Republicans continually complained about the increasing deficit and federal debt.
Obama successfully stimulated the economy during his 2 terms as president, but then Donald Trump became president and with a Republican Congress, they passed the Tax Cuts and Jobs Act of 2017, giving significant tax breaks to the wealthy.
Donald Trump and his Republican Congress argued that the tax cuts would pay for themselves. As of January 2020, the federal debt is now increasing by more than 6% compounded annually. (Naturally, the Republicans have stopped complaining about the increasing federal debt!)
Ironically, Donald Trump promised, during his 2016 presidential campaign, to eliminate the federal debt, but now, after 3 years in office, the federal debt is bigger than ever and growing faster than ever!
Sam Brownback: Kansas Tax Reforms
Tax cuts on the wealthy do not stimulate economic growth, but they do lead to a decline in tax revenue, with a subsequent requirement to cut expenses, usually by cutting social programs. There is no better illustration of this than the state of Kansas in 2012.
Sam Brownback, the governor of Kansas then, sought to boost the Kansas economy, by giving major tax breaks to the wealthy. The government reduced the tax rate on pass-through business income, such as income earned from partnerships or S corporations, to 0%, and reduced the top income tax rate from 6.45% to 4.9%. So naturally, many taxpayers converted their business income into pass-through entity income, thus avoiding paying the income tax, thus reducing tax revenue even more.
The result of these cuts was that economic growth lagged neighboring states and of the country overall. Kansas bond ratings were downgraded twice, and government programs were severely cut, including education, infrastructure, Medicaid, court funding, and the Temporary Assistance for Needy Families.
When Kansas lowered taxes for the wealthy and cut government programs, especially those that benefited the poor, Kansas, in effect, gave more money to people with a lower propensity to consume and paid for it by taking money away from those with a higher propensity to consume. This led to sluggish growth and lower revenues, the exact opposite of what was argued.
Kansas even passed another tax rate cut, lowering the top rate by an additional percentage point in 2018, but lower revenues caused the Republican-controlled legislature to not only vote to raise taxes, but did so over the governor's veto.
In spite of this well-known Kansas experiment, Donald Trump and the Republicans implemented many of the same ideas, including the reduction in taxes on pass-through entities and sole proprietorships, in their tax reduction package. And in spite of the fact that the Kansas tax reforms increased deficits, amply demonstrating that tax cuts to the wealthy do not pay for themselves, and in spite of the fact that the history of federal tax cuts for the wealthy in the past have also increased the federal deficit, the Republicans continued to use the same rebutted argument that tax cuts for the wealthy would pay for themselves. Although the economy continued to grow, as it tends to do as it moves through its cycles, the federal debt has grown much faster and will continue to do so as long as these tax cuts remain in effect.
As stated earlier, supply-side economics is a political argument, not an economic theory. The proponents of supply-side economics want to reduce taxes for the wealthy. To rationalize this to people who are not wealthy, they came up with trickle-down economics. But how much is a trickle? How long will it take to trickle down? Don’t the poor need the money sooner rather than later? Don’t they need more than a trickle? But more importantly, does trickle-down economics work?
The inverse relationship between wealth and the marginal propensity to consume shows that giving tax breaks to the poor and the middle class is a much more effective way of stimulating the economy. This increases the supply of labor, because the workers are receiving a higher disposable income, so, they are, in effect, receiving a higher price for their supply, and higher supply prices increases supplies. Higher incomes also increase aggregate demand, which is necessary to support an increased supply of labor. And because wealthier people own businesses, they will sell more goods and services, thus earning more money. So we can call this form of supply-side economics trickle-up economics. By giving more money to lower income people, they will use more of that money to buy goods and services, because their marginal propensity to consume is higher than it is for wealthy people.
This inverse relationship also shows that if tax breaks to the wealthy are paid for by cutting social welfare programs, then the net economic effect will be a decline, because money is being transferred from those with a greater marginal propensity to consume to those who have a much less marginal propensity to consume.
The inverse relationship between wealth and the marginal utility of money shows that taxes are less burdensome to the wealthy than for others. Even if the wealthy pay a higher tax rate, that money has a lower marginal utility to the wealthy than it does for the poor or the middle class, because lower income people need more to pay for necessary expenses. Thus, taxing someone who earns $1 million at a 90% rate still leaves them with $100,000, enough to live a pretty decent life. On the other hand, taxing someone who earns $20,000 at 20% is much more of a tax burden, since they would need every penny just to live.
Another problem with the supply-side economics argument is that many of the tax breaks apply to investments and gratuitous transfers, because they benefit mostly the wealthy, but they do not affect the supply of labor. Indeed, they may even reduce the supply of labor by allowing people to live off of their investment income or their inheritance. Since labor is a necessary input for the creation of economic wealth, a lower labor supply lowers the maximum wealth that could be created by an economy. Thus, to increase the supply of labor, taxes should be increased on investments and especially on gratuitous transfers, so that more people are forced to work. And consider the Laffer curve for gratuitous transfers. Tax revenue is maximized when the tax rate is 100%. Why is that? Because people will continue to die at the same rate regardless of the tax rate. So if politicians want to justify tax breaks to the wealthy using supply-side economics, then it stands to reason that work should be the least taxed form of income, compared to income from investments or gratuitous transfers. Instead, work is the most highly taxed form of income!
The traditional argument of supply-side economics also adds that the wealthy would invest more, and investments stimulate the economy. But investments only stimulate the economy if people buy the products or the services provided by the investments. Investments cannot earn a return unless there is consumption of the products of the investments. A higher consumption is supported by higher incomes for those who have the higher marginal propensity to consume. And if lower income people did have more money, they, too, would save and invest more. While lower income people are not as rich as wealthy people, they are far more numerous, so their total investments and savings could easily exceed that of the wealthy.
Hence, the upshot is that trickle-up economics would maximize economic growth, reduce inequality, and maximize government revenue, while allowing lower income people to live better and to depend less on government handouts.