The Return of the Naïve Supply-Sider

By Kevin D. Williamson

Wednesday, May 24, 2017

President Donald J. Trump has produced a very silly budget proposal. Thankfully, presidential budget proposals have all the effect of a mouse passing gas in a hurricane — Congress, not the president, actually appropriates funds and writes the tax code.

Presidential budget proposals are not received as actual fiscal blueprints but as statements of priorities, and so we must conclude that President Trump’s top priority is refusing to deal with reality.

Here’s the situation: About 80 percent of federal spending is consumed by five things: 1. National defense; 2. Social Security; 3. Medicare; 4. Medicaid and other related health-care benefits; 5. Interest on the debt. President Trump wants to increase spending on defense by about 10 percent while shielding Social Security and Medicare from cuts. Short of a default, he doesn’t have any choice but to pay the interest on the debt. So that leaves things pretty tight.

On top of that, he wants to pass what he boasts is one of the largest tax cuts in history . . . and balance the budget.

Naturally, the White House budget monkeys are messing with the numbers a little bit.

It’s the return of the Naïve Supply-Sider.

Conservatives of a Reaganite orientation will be familiar with the basic thinking behind the pro-growth tax cut: If you cut a business’s taxes by $1,000, you do not necessarily lose $1,000 in revenue, because that business might take the $1,000 it would have paid in taxes and reinvest it — by buying equipment, paying for more labor, expanding lines of production, etc. — to produce new economic activity that generates additional taxable income either for the business, its employees, or its suppliers. Additionally, if tax rates are very high, businesses and individuals simply might forgo certain kinds of taxable economic activity in favor of tax-advantaged alternatives or simple consumption, and lower rates could reverse that behavior. Theoretically, you could get the same tax revenue, or even higher tax revenue, with lower tax rates. Or, short of that, you might find that a tax cut that costs $1,000 on paper actually ends up costing only $500 or $800 in lost revenue as businesses or individuals generate new taxable economic activity with the money they save from the tax cut. This is the effect described by the Laffer curve, and it is true, as far as it goes.

But it does not go as far as Republicans typically claim it does, and it certainly does not go as far as the Trump budget seems to think.

There isn’t a straightforward mathematical formula to work out how large a growth effect can be expected from any given tax cut. That’s because it matters a great deal where you’re starting from and where you end up. Cutting the top rate in half from 90 percent to 45 percent will have a different effect than halving it from 20 percent to 10 percent, and a ten-point reduction in a 60 percent top rate will have different effects from a ten-point reduction in a 15 percent top rate. It matters a great deal which taxes you are cutting (personal income vs. corporate income or capital gains) and what is going on in the broader economy when those cuts are made. And rates are not the only factor in what businesses and institutions actually pay in taxes: Our progressive friends like to point to the sky-high statutory tax rates of the Eisenhower years as evidence that confiscatory tax rates are compatible with broad prosperity, but in spite of higher rates, taxes actually paid (taxes as a share of GDP) were slightly lower in those years than they are today.

Republicans here have fallen into the trap of taking their own campaign rhetoric too seriously. The example you will hear about constantly is the Reagan-era tax cuts: Tax rates went down and, overall, federal revenue went up. (But it did not go up nearly as much as spending, hence the large deficits of that era.) The problem with this simplistic analysis is that it credits 100 percent of economic growth to tax cuts, when in fact economic growth is the result of many factors — the U.S. economy has experienced periods of strong growth with much higher tax rates, as it did in the 1950s and 1960s. The meaningful comparison is not between what tax revenue was before the tax cuts and what it was after the tax cuts but between what it was after the tax cuts and what it would have been without them — which, unfortunately, is a counterfactual.

Economists who have looked at the issue have found evidence of growth effects and sometimes evidence of very strong growth effects. What they have not found is evidence of growth effects amounting to 100 percent of forgone revenue, i.e. the holy grail of “self-financing tax cuts.” The Trump budget proposal includes tax cuts that not only are self-financing but doubly self-financing, tax cuts that would, if we are to take him at his word — and that is impossible to do — not only pay for themselves but generate enough new revenue to balance the budget ten years down the road.

You can bet that free lunch will turn out to be expensive.

In the real world, we need genuine tax reform that is something close to revenue-neutral, significant entitlement reforms that will be politically unpopular, and defense spending that is flat or slightly lower. Nobody wants that eat-your-spinach budget, but the sooner we get serious about fiscal responsibility, the less painful reform will be.