What is Supply-side Economics?

What is Supply-side Economics?

Four decades after the event Wikipedia and academic economists still don’t know

Paul Craig Roberts

As my many readers are aware, one of my hallmarks is my emphasis on how difficult it is for truth to emerge anywhere. History, politics, science, medicine, crime and punishment, any academic subject, neighborhood gossip, wherever one looks falsehood abounds. It is no different for supply-side economics.

It has been almost four decades since the Reagan administration gave up on Keynesian demand management, which had resulted in “stagflation,” that is, worsening Phillips Curve tradeoffs between employment and inflation.  Now 39 years later (if the Wikipedia entry as of 12:43 pm US Central time on April 11, 2020, can be trusted) journalists, academic economists, and whoever writes Wikipedia entries have no idea whatsoever what supply-side economics is or what the problem was that it addressed successfully.  Indeed, I would be hard pressed to imagine a more incorrect explanation of supply-side economics than the one I just read in Wikipedia buttressed by uninformed statements by Gregory Mankiw, Paul Krugman, and Alan Blinder.

No one has been more intimately involved with supply-side economics than I.  I was an expositor and an advocate. In 1975 I penned an article for US Representative Jack Kemp  calling for a supply-side policy that was published in the Sunday Washington Star. I was involved in the policy process in the House and Senate where the ground was prepared with Republicans and Democrats for the emergence of a supply-side policy. I drafted the Kemp-Roth Bill that became what the media called “Reaganomics.” I taught the Congress how to use the the budget process to enact a supply-side policy. I was appointed the Assistant Secretary of the US Treasury for Economic Policy and given the task of getting a supply-side policy out of the Reagan Administration.  I was the person who was invited to give the annual state of the economy address to the combined economic graduate students and faculties of Harvard and MIT, where Paul Samuelson welcomed me warmly and the graduate students gave me a standing ovation.  It was my peer-reviewed book, The Supply-Side Revolution, published by Harvard University Press which HUP keep in print for decades and which had a Chinese language edition, that explained supply-side theory and the problems of getting it into practice.  I was the one who wrote the supply-side entry for the The New Palgrave Dictionary of Money & Finance, and for McGraw Hill’s Dictionary of Economics in the 1980s.  I am the economist who explained the theory and practice in the leading scholarly economic journals in Germany and Italy.  I am the one who explained it to the French government for which I received the Legion of Honor.  I explained it in The Public Interest in the US and in British bank and policy magzines.  I wrote numerous Wall Street Journal, Business Week, and Scripps Howard News Service articles about supply-side economics.  I made presentations at economic association meetings.  I debated Lawrence Klein and other leading Keynesian academics before university audiences.  Yet I do not appear in the Wikipedia entry except in a note at the end containing a list of supply-side articles that lists one article written by me published in The Independent Review in the winter of 2003, 22 years after I successfully launched a new economic policy.

Not only has Wikipedia created a totally false picture of supply-side economics, but the entry also shows that the discussion of the policy for the last four decades bears no relationship whatsoever to the actual policy!  Academics and journalists have spent four decades discussing a non-existent policy!

What is this non-existent policy?  Tax cuts that pay for themselves.  

The Laffer Curve has nothing to do with supply-side economics.  It is merely an expository device that illustrates that high and low tax rates can produce the same tax revenue.  Perhaps the Laffer Curve should be known as the Ibn Khaldun Curve as it has been traced to this 14th century Arab. There can be little doubt that Ibn Khaldun had much worthwhile to say, but he did not provide the basis for supply-side economics. 

The origin of the misinformation that “Reaganomics” is based on a claim that tax cuts pay for themselves is mysterious.  In cannot be found in official documents. As the official and publicly available documents show, the Reagan administration forecast that every dollar of tax cut would result in a dollar of lost tax revenue.  It was a static revenue estimate.  The Reagan budget submitted to Congress showed large multi-year budget deficits.  The office of tax analysis in the Treasury had no capability of making revenue feedback estimates.  Norman Ture, Steven Entin, and I could have produced a ballpark figure, but we knew better than to try.  Traditionally, this was the responsibility of the office of tax analysis.  If we encroached on their territory, a stink of supply-siders putting in a fix would have been raised.

To repeat, the Reagan Administration predicted a 100% revenue loss from the supply-side tax cut.  I presided over this forecast myself.  

Supply-side economics in Congress and in the Reagan administration addressed the worsening Phillip curve trade-offs.  These worsening trade-offs were worrisome to Democrats and Republicans alike.  They meant that the management of economic policy associated with the post-war boom was no longer working. The Keynesian solution was wage and price control—an incomes policy.  Congress had recent experience with trying to control one price—oil—and wanted nothing to do with a scheme to control all prices.  Leading Democrat committee chairmen in the Senate, such as Lloyd Bentsen (Joint Economic Committee) and Russell Long (Senate Finance Committee), listened to me more carefully than did Republicans.  It was the Joint Economic Committee under the chairmanship of Democrat Lloyd Bentsen that published the First Senate document calling for a supply-side economic policy. The committee’s staff director was James Galbraith, the son of John Kenneth Galbraith.

The originality of supply-side economics is its demonstration that some forms of fiscal policy—specifically a change in the marginal rate of taxation of income—will shift the aggregate supply schedule.  Why was this a novel and an important breakthrough, indeed a more important one than those for which the Nobel prize in economics is usually given?  

The answer is that in Keynesian economics, a change in marginal tax rates only shifts the aggregate demand schedule.  Aggregate demand increases if marginal tax rates are lowered—a policy used to combat unemployment.  Aggregate demand decreases if marginal tax rates are raised—a policy used to combat inflation.  By neglecting the impact of tax rates on supply as postwar inflation was moving people into higher marginal tax brackets, the increase in consumer demand was encourtering diminished incentives to increase output to meet the demand.  Therefore, prices rose along with output and then more than output.  

Why did prices rise as people encountered higher tax brackets?  They rose because of the behavior of two important relative prices that economists had overlooked.  The price of current consumption in terms of forgone future income and the price of leisure in terms of forgone current income.  The higher the marginal tax rate, the less the future income forgone by consuming income rather than saving and investing it. Thus, the cheaper is current consumption in terms of forgone future income and the lower are saving rates.  For example, the 98% tax rate on investment income in the UK meant that the cost of purchasing a Rolls Royce in terms of foregone future income was essentially zero. 

The higher the marginal tax rate, the less current income forgone by enjoying more leisure.  Thus, the cheaper is leisure in terms of forgome current income. Thus medical practices that closed at noon on Fridays and high absenteeism in the manufacturing workforce on Mondays.

As marginal tax rates were high when Reagan came to office—70% on investment income and 50% on personal income, supply-side economists concluded that the worsening Phillips curve tradeoffs between employment and inflation were due to the neglect of the impact of fiscal policy on the supply-side of the economy. (I did not support the George W. Bush and Trump tax cuts. I doubt there was a supply-side case for them.)

The Reagan administration and Congress reduced the marginal tax rates across the board for every bracket not in order to trickle-down income or to balance the budget, but to lower the high relative prices that were restraining the response of output to increased demand.  Although economists have failed to notice the obvious, the supply-side policy succeeded in eliminating the worsening Phillips curve trade-offs. The economy again was able to expand without having to pay for the expansion in terms of a rising rate of inflation.

How is it possible for such a clearly explicated policy in every public and scholarly forum and the obvious passing away of Phillips curve worries not to be noticed by academic economists and financial journalists?  

For the Keynesians who were clearly numerically dominant, perhaps it was jealousy and protection of human capital.  Most also were liberals more interested in taxing the rich than in noninflationary economic growth.  Journalists took their cue from the Keynesians who were traditionally the spokespersons for economics.  Many journalists also looked down on a movie actor and his rhetoric.  

But the primary reason is the authority of existing paradigms.  The Keynesians were in authority. They were ensconced in the departments of all the leading universities except the University of Chicago.  They had trained the economic and financial journalists. They were the ones who testified before Congress and were the consultants to the Federal Reserve and the corporations.  If you were not Keynesian, a career was hard to come by.  

The problem of changing regimes in science and scholarship is the same as in political and social life.  Thomas Kuhn wrote about the Structure of Scientific Revolutions.  My Oxford professor Michael Polanyi wrote about it even more successfully.  Those responsible for change often pay a price.  As Niccolo Machiavelli said: “There is nothing more difficult, more perilous or more uncertain of success than to take the lead in introducng a new order of things.”

About a year ago, I think it was, I read that an economist had put forward the idea that fiscal policy could shift the aggregate supply schedule.  I meant to save the reference and to contact him, but got busy with other things.  More important truths are being buried every day.

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