Supply-Side Economics: Myths and Realities

by Jack Chambless

In 1962 the federal budget deficit stood at $7.1 billion – the third largest shortfall since World War II. The U.S. was on the precipice of even greater funding shortfalls as the combined effects of the space race, Cold War outlays and the Vietnam conflict loomed.

Faced with the reality that the economy would not be able to sustain the tax revenues necessary to fund these endeavors, John F. Kennedy stood before the Economic Club in New York in December of 1962 and said, “It is increasingly clear that…an economy hampered by restrictive tax rates will never produce enough revenues to balance our budget just as it will never produce enough jobs or enough profits. In short, it is a paradoxical truth that tax rates are too high and tax revenues are too low and the soundest way to raise the revenues in the long run is to cut the rates now.”

The following year, President Kennedy was successful in producing legislation that would lower the top income tax rate from a staggering 91% to 70%.

From 1963 to 1966 total federal tax revenues increased by 16%. Tax collections from those individuals earning more than $50,000 per year shot up by 57%, while revenue from people who made less than $50,000 increased by 11%. During that same time period, the U.S. unemployment rate fell from 5.5% to 3.6%.

It is somewhat ironic today that policymakers continue to debate the effects of changes in marginal tax rates on the deficit and overall level of economic activity. Any serious economic analysis of the history of tax cuts would make the job of legislators much more manageable. Beginning in the 1920s, economists have observed an immutable fact concerning taxes and tax revenues. Mr. Kennedy was right. Soaking the rich as an instrument for lowering the deficit or creating new revenues simply does not work.

The Mellon Tax Cuts

When the 16th amendment was ratified in 1913, creating the first federal income tax, Congress established a progressive income tax system that ranged from 1% on incomes between $20,000 and $50,000 to 7% on incomes over $500,000. In effect, only the richest Americans were exposed to income taxation. With the top marginal tax rate set at a level that did not distort incentives to create new jobs, the nation’s wealthiest individuals did not engage in wholesale income tax avoidance. That came later.

During World War I the Wilson administration increased the top tax rate on the wealthy to 77%. Subsequently, the number of people with incomes over $300,000 dropped from 1,296 in 1916 to only 246 by 1921 and the demand for tax-exempt municipal bonds increased by threefold, costing the federal government millions of dollars in lost tax revenue.

With capital investment being withdrawn from the economy at an alarming rate, treasury secretary Andrew Mellon remarked, “It seems difficult for some to understand that high rates of taxation do not necessarily mean large revenue to the Government, and that more revenue may often be obtained by lower rates.”

What followed were The Revenue Acts of 1921, 1924 and 1926 that slashed tax rates from 77% to 25%. Tax rates on those earning under $4,000 were reduced from 4% to ½ percent and those in the $4,000 – $8,000 bracket saw their tax burden fall from 8% to 2%.

From 1921 to 1929 total federal income tax receipts surged from $719 million to $1.16 billion – an increase of more than 61% in a period that saw record economic growth with virtually nonexistent inflation. Moreover, the Progressives who argued that higher rates would lead to lower tax burdens on the wealthy were proven incorrect as the share of the tax burden paid by the rich climbed to 78% (from 44% in 1921).

Hoover, FDR and Tax Evasion

While it is popular in some circles to pin the Great Depression on excessive wealth accumulation, irrational exuberance in the stock and real estate markets and corporate greed, the reality is that the downturn in the 1930s stemmed in large part from ignoring the causes of the prosperous 1920s.

When the stock market collapsed and the economy began to lose steam, the Hoover administration responded with a bewildering decision to increase the top marginal tax rate from 25% to 63%. Combined with the disastrous effects of the Smoot-Hawley Tariff Act – which raised tariffs dramatically and helped plunge the world into a global downturn – and Federal Reserve policies that actually tightened the money supply and increased interest rates, the Depression was more government-created than a result of excessive capitalism.

During World War II, Franklin Roosevelt discovered first hand how tax rates impact incentives and economy activity. With the top tax rate already at 88.9%, FDR argued that all “excess income” should be allocated to the war effort. He called upon Congress to impose a top income tax rate of 100% on incomes over $25,000 per year. When Congress balked, FDR signed an executive order that created the 100% rate. Late in 1943, Internal Revenue Service officials notified Roosevelt that zero Americans had reported incomes of more than $25,000.

Reaganomics

The 1980s saw the emergence of what became known as “Reaganomics”, even though the ideas of the Reagan administration were almost two hundred years old. In 1803 the French economist, Jean Baptiste Say theorized that “supply creates demand.” Simply put, in any economic system, the only way long run economic growth can be sustained is by encouraging suppliers (i.e. entrepreneurs) to take the necessary risks associated with providing new products and services. If those incentives are present, more suppliers will appear and with them the jobs, income and tax revenue that is necessary for the system to survive.

However, the U.S. government adopted a “demand-side” approach to economics from the Great Depression through the 1970s. Any disruption in economic activity was seen as evidence that there was not enough demand and thus, operating under the guidance of Keynesian economics, government simply increased spending in order to stimulate consumption. The results proved to be counterproductive by the 1970s as increased government expenditures ultimately proved to be inflationary. With inflation and unemployment increasing simultaneously for the first time in American history, economists, led by Arthur Laffer, began arguing for a return to the idea that new suppliers are more important than more demanders.

With the election of Ronald Reagan – who was in the 94% tax bracket in the 1950s - came a sharp turn towards supply-side fiscal policies. In 1981 and again in 1986 Reagan signed legislation that eventually lowered the total number of tax brackets from fourteen to two and the top income tax rate from the Kennedy-era 70% to 28%. Reagan repeatedly claimed that by lowering rates across the board, the incentives to save, invest and spend would increase.

With the exception of the Federal Reserve Bank induced recession of 1982, the U.S. economy expanded for the longest period of time in peacetime history. Total federal tax receipts increased from $599 billion in 1981 to $991 billion in 1989. The nation’s unemployment rate fell from 10.8% in 1982 to 5.0% in 1989.

Keynesian economists argued that Reagan’s tax cuts would stimulate demand more than supply and thus trigger inflationary pressure. The opposite occurred. Inflation was running at 10.3 % in 1981. With massive gains in productivity, labor force participation rates and new technological investments, the nation’s aggregate supply increased at a rate that brought inflation down to 1.9% by 1986 – the year Reagan’s last tax cut was passed.

While the Reagan tax cuts represented smaller cuts as a percentage of the economy than Kennedy’s rate cuts, Democrats during and after the 1980s argued that rich people gained at the expense of the poor. Here again, the data does not line up with the conventional wisdom.

According to the IRS, The share of income taxes paid by the top 10% of tax earners climbed to 57% in 1988 from 48% in 1981. The top 1% saw their share of the tax bill rise to 28% in 1988 from 18% in 1981.

As it turns out, supply-side economics also helped the middle class and the poor. According to the Federal Reserve Bank, while people earning more than $50,000 saw a gain in net wealth of 6.6%, people earning $30,000-$50,000 realized an increase in net wealth of 27.7%. Families with incomes in the $20,000 range gained 28.9% and those earning $19,999 and under had a gain in net wealth of 21.1%.

Meanwhile, the ‘Decade of Greed’ gave us a transfer of wealth, in the form of charity, of 5.1% a year, compared with a rate of 3.5% over the previous 25 years. Charitable giving increased faster than jewelry purchases, beauty parlor and health club spending and consumer debt.

The Bush/Clinton Tax Hikes

In 1980 candidate George H.W. Bush called Reagan’s supply-side proposals, “Voo-Doo” economics. In 1990, President Bush proved that he was not convinced of the merits of supply-side economics when he increased income taxes during the outset of the 1990-91 recession.

His tax increase was designed to bring down the bloated federal budget deficit, the results did not work out as he and Congress intended. While the deficit increased from $221 billion in 1990 to $269 billion in 1991 and a record $290 billion in 1992, Mr. Bush did not even get to claim that the rich paid for his tax hike.

The top income tax rate increased from 28% to 31% in 1990. On July 7, 1993 The Wall Street Journal published the data on what the rich did with the tax hike. Of course, they called their accountants and instructed them to look for ways to lighten their tax load. In 1990 wealthy Americans paid $106.1 billion in taxes. In 1991 they paid $99.6 billion.

Opponents of supply-side tax policy point out – and accurately so – that the 1990s broke the record set in the 1980s for economic growth and that tax revenues increased every year until surpluses were once again being accumulated. Of course all of this happened during a time when Bill Clinton increased the top marginal tax rate from 31% to 39.6% in 1993. Why did the Clinton tax hike seemingly create more revenue? It is very simple.

In 1986 Congress passed, and Reagan signed, legislation that increased the capital gains tax to 28%. Immediately, a drag on capital formation threatened to slow the progress the Reagan administration had made in boosting aggregate supply.

In 1997 President Clinton signed legislation that cut the capital gains tax rates to 20%. In addition, Mr. Clinton helped eliminate the capital gains tax on many home purchases, launched the widely successful Roth IRA and managed to oversee a level of budgetary discipline that kept federal spending from rising at a rate that would damage private sector incentives.

While many economists predicted that the capital gains tax reductions would lead to a loss of $50 billion in revenue over five years, the reality was an increase in capital gains tax revenue of over $100 billion. By contrast, the Clinton personal income tax increase was expected to raise $241 billion but raised only a third of that figure.

Clinton benefited from the ongoing economic boom launched during the 1980s, as well as reductions in the federal funds rate from 9% to 3% and post-Cold War cuts in military spending, but he also helped prolong the boom by adopting enough of the supply-side mantle to help offset the deleterious effects of his less effective income tax policies.

Where We Stand Now

During his first term in office, George W. Bush stunned traditional supply-siders by saying, “I am a Keynesian and a Supply-Sider.” While it would seem to be a totally inconsistent stance his policies have certainly lined up on the side of demand and supply-side expansionism.

The top marginal income tax rate has fallen from the 39.6% rate to 35%. In addition, IRS data now shows that the bottom 50% of income earners – thanks to expanded tax credits and lower rates – now pay only 4% of the nation’s total tax bill, while the top 5% of taxpayers pay over 54% of all the revenue used by the federal government.

While federal spending, adjusted for inflation, actually fell by .7 percent during Clinton’s first term, the Keynesian side of Bush managed to usher in a 21 percent increase in spending, even when factoring out the war in Iraq and the creation of the Department of Homeland Security. Therein lies the problem.

Economic history shows that sustained deficits are not only inflationary but also tend to drive up interest rates and damage the economy. If spending does not get under control during the next three years the next administration might opt to undo the Bush tax cuts altogether.

The record from last century clearly shows what a mistake that would be.

Contact Jack Chambless, Professor of Economics.

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