The term ‘supply-side economics’ dates back to the 1970s, when it was popularized by Jude Wanniski, then an associate editor for the Wall Street Journal, and later an economic advisor to Ronald Reagan. Wanniski, a colorful figure, did not let his lack of academic credentials deter him from taking on big names in the economics profession including not only Keynes and his followers but Milton Friedman. He was later to become one of the first commentators to suggest, correctly, that Saddam Hussein’s ‘weapons of mass destruction’ had been found and destroyed by the UN weapons inspection process.
The central idea of supply-side economics followed directly from the negative conclusions of new classical economics regarding the possibility of successful demand management. If, as the new classical school believed, such demand-side policies were bound to be ineffectual or counterproductive, the only way to improve economic outcomes was to focus on the supply side, that is, to increase the productive capacity of the economy. Although many different policies (improved education, for example) might be advocated as ways to improve productivity, Wanniski focused on the kinds of policies favored by economic liberals, such as reduced regulation and lower income taxes.
Wanniski started the process with his ‘Two Santa Claus’ theory of politics. This was the idea that, in a contest between one political party (the Democrats, in the US) favoring higher public expenditure, and another (the Republicans) favoring lower spending, the high-spending party would always win. Hence, the correct political strategy for conservatives was to campaign for tax cuts, without worrying too much about budget deficits. Any problems with budget deficit would be resolved by the higher growth unleashed by improved incentives and reduced regulation.
This idea was taken much further at a famous lunch meeting between Wanniski, Donald Rumsfeld, Dick Cheney, and University of Southern California economist Arthur Laffer. These four, relatively obscure figures at the time, were to play a central, and disastrous, role in the economic and political events of the next thirty years. Everyone knows the story of how Laffer drew a graph on a napkin, illustrating the point that tax rates of 100 per cent would result in a cessation of economic activity and therefore yield zero revenue. Since a tax rate of zero will also yield zero revenue, there must exist some rate of taxation that yields a maximum level of revenue. Increases in tax beyond that point will harm economic activity so much that they reduce revenue.
Wanniski christened this graph the ‘Laffer curve’, but as Laffer himself was happy to concede, there was nothing original about it. It can be traced back to the 14th century Arabic writer Ibn Khaldun, and Laffer credited his own version to the nemesis of supply-side economics, John Maynard Keynes. And while few economists had made much of the point, that was mainly because it seemed to obvious to bother spelling out.
What was novel in Laffer’s presentation was what might be called the Laffer hypothesis, namely that the US in the early 1980s was on the descending part of the curve, where higher tax rates produced less revenue.
Unfortunately, as the old saying has it, Laffer’s analysis contained a mixture of correctness and originality. The Laffer curve was correct but unoriginal. The Laffer hypothesis was original but incorrect.
More sophisticated economic liberals could also see that the Laffer hypothesis represented something of an ‘own goal’ for their side. If the debate over tax policy turned on whether tax cuts produced higher revenue, and were therefore self-financing, the advocates of lower taxes were bound to lose, at least in policy circles where empirical evidence was taken seriously. Embarrassingly for their more sophisticated allies, supply-siders made, and continue to make, obviously silly arguments.
Fairly typical is the claim that, despite cutting taxes, Ronald Reagan doubled US government revenue, a claim made by commentators like Sean Hannity, and derived from the work of rightwing thinktanks such as the Heritage Foundation. Leaving aside the fact that revenues did not in fact double under Reagan (the Heritage institute figures add in some of the first Bush presidency, such claims ignore the fact that tax revenues, and the cost of providing any given level of government services, rise automatically with inflation, population growth and increases in real wages. Even with cuts in tax rates, revenues are bound to rise over time as the nominal value of national income increases.
For the Laffer hypothesis to be supported, tax cuts would have to increase revenue more rapidly than would be expected as a result of normal income growth. In fact, as the US Office of Management and Budget reported , "Income tax receipts grew noticeably more slowly than usual in the 1980s, after the large cuts in individual and corporate income tax rates in 1981." (Quoted by CBPP http://www.cbpp.org/cms/?fa=view&id=119)
The dynamic trickle down hypothesis
Mainstream economic liberals were generally disdainful of the ‘voodoo economics’ of the Laffer hypothesis. But that didn’t shake their commitment to the central postulate of trickle-down economics, namely, that policies favorable to the wealthy will, in the long run, produce benefits for everyone, compared to the alternative of progressive taxes and redistributive social welfare policies. Rather than rely on the simplistic, and easily refuted, Laffer hypothesis, they claimed that the trickle-down effect would work through so-called ‘dynamic’ effects of free-market reforms, and particularly tax reforms.
As with other economic terms, such as ‘efficiency’, the appeal of this argument depended, in large measure on conflating the ordinary language meaning and connotations of ‘dynamic’ with the technical economic meaning. In technical terms, ‘dynamic’ effects are those realised over time, as the capital stock in an economy varies. But in political discussion, it is easy to slide from this use into rhetoric about dynamism, sclerosis and so forth.
The crucial distinction between the two is that while dynamic effects, in the technical sense, can raise or lower the level of national income in the long run, they do not, in standard economic models, affect the long-term rate of economic growth, which depends ultimately on productivity. Standard economic analysis suggests that the adoption of tax policies more favorable to owners of capital will, not surprisingly, increase savings and investment, and therefore raise the level of national income in the long run. This idea formed the basis of a number of ‘dynamic scoring’ exercises aimed at estimating the effects of the Bush tax cuts of 2001. Supporters of the Laffer hypothesis hoped that these exercises would show tax cuts paying for themselves in the long run.
Dynamic scoring analyses typically found some positive effects on capital accumulation, but they were too small, in terms of their effect on incomes and tax revenues to offset the cost of the initial costs. The most optimistic study, undertaken by Greg Mankiw, former chairman of President Bush's Council of Economic Advisors and Matthew Weinzierl found that, assuming that the conditions of the standard neoclassical model were satisfied, dynamic effects would offset about 17 per cent of the initial cost of a cut in taxes on labor income and about 50 per cent of the cost of a cut in taxes on capital income.
However, as subsequent analysis showed, these results depended critically on technical assumptions about how the tax cut was initially financed. Mankiw and Weinzierl assumed that tax cuts are associated with expenditure cuts sufficient to maintain budget balance, and that these expenditure cuts do not create any additional market failures (that is, that the expenditure in question was a pure transfer). Eric Leeper and Shu-Chun Susan Yang examined the case when, as actually happened with the Bush tax cuts, the cuts were initially financed by higher debt. In this case, it turns out that dynamic effects can actually increase the initial cost of a tax cut.
A further difficulty was that, since the increased income was the result of additional savings, it could not, in economic terms, be regarded as a pure economic benefit. The relevant measure of economic benefit, netting out costs from benefits, is the change in the present value of consumption, which is typically much smaller than the final change in income - even for large tax cuts, the net dynamic benefit is rarely more than one per cent of national income. The same point may be made in terms of the effects on the government budget. Even if tax cuts eventually generated enough extra revenue to match the annual cost of the cuts (and of course they never do!) the budget would still be in long-term deficit because of the need to service the debt built up in the transitional period.
The implications for the trickle-down hypothesis are even worse. Under standard assumptions about the way the economy works, all the benefits of additional investment go to investors (or those whose savings finance the investment). That is, cutting taxes for the rich may lead them to save and invest more, thereby making themselves still richer, but there is no reason to expect any benefit for the rest of the community, except to the extent that the cost of the original tax cut is partially defrayed.
Finally, and most importantly of all, the neoclassical model used to derive estimates of dynamic benefits implicitly incorporates the efficient markets hypothesis. The extra investment generated by more favorable tax treatment is supposed to be allocated efficiently so as to produce sustainable long-term economic growth. Until the financial crisis the experience of countries that followed this logic and cut taxes on capital income appeared to bear out this view. Iceland, Ireland and the Baltic States among others, experienced rapid economic growth as a result of high domestic investment and strong capital inflows.
But the economic crisis proved that this apparent success was built on sand. Much of the extra investment went into real estate, or into speculative ventures that collapsed when the bubble burst. Having cut taxes drastically, governments were left with inadequate financial resources to convince (now-cautious) investors that their bonds were a safe investment.