January 20, 2008

Economic View

Is the New Supply Side Better Than the Old?

By AUSTAN GOOLSBEE

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 — those earning more than, say, a quarter-million dollars a year — on the grounds of restoring balance and raising money.

All the major Republican candidates have called for extending the Bush tax cuts indefinitely, and several advocate several hundred billion dollars in additional high-income cuts — 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. After all, the budget deficit exploded when the government cut taxes in the 1980s and again in the 2000s, and it disappeared when the government raised taxes in the 1990s.

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 leading Republican candidates do not advertise their academic influences, but they appear to have adopted these ideas.

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 the Republican presidential contender Fred D. Thompson. But the origins of the current debate, and the seriousness with which it is taken in academic circles, largely center on the work of the Harvard economist Martin Feldstein.

Professor Feldstein, head of the National Bureau of Economic Research, is perhaps the godfather of modern public-sector economics and is often cited as a potential Nobel laureate. The former chairman of President Reagan’s Council of Economic Advisers, he 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 published in a magazine of the Federal Reserve Bank of Minneapolis, 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.

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.

An example illustrates the point: Emmanuel Saez, a professor of economics at the University of California, Berkeley, has compiled data on the incomes of the very rich from 1913 to 2006. Using his data, my 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.

Austan Goolsbee is a professor of economics at the University of Chicago Graduate School of Business and a research fellow at the American Bar Foundation. He is advising the campaign of Senator Barack Obama of Illinois for the Democratic presidential nomination. E-mail: [email-masked].

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