What Supply-Side Economics Means

By Alan Reynolds
Thursday, April 26, 2007

In "The Seven Fat Years," Robert Bartley, the legendary former editor of The Wall Street Journal, wrote: "On March 26, 1976 Herb Stein coined a label, the 'supply-side fiscalists,' telling a conference at the Homestead Resort in Virginia that it consisted of 'maybe two' economists. Alan Reynolds passed this along to Jude (Wanniski), who promptly appropriated the label, though dropping 'fiscalists' as awkward and misleading." The label was new, but the basic concepts had been explained in Wanniski's Journal article of Dec. 11, 1974, "It's Time to Cut Taxes."

In 1977, Bruce Bartlett went to work for Jack Kemp, the congressional quarterback for what eventually became President Reagan's first round of tax rate reductions.

In a recent New York Times article, Bruce wrote: "I think it is long past time that the phrase (supply-side economics) be put to rest. ... It has become a frequently misleading and meaningless buzzword that gets in the way of good economic policy. Today, supply-side economics has become associated with an obsession for cutting taxes under any and all circumstances. No longer do its advocates in Congress and elsewhere confine themselves to cutting marginal tax rates -- the tax on each additional dollar earned -- as the original supply-siders did. Rather, they support even the most gimmicky, economically dubious tax cuts with the same intensity. ... Today, it is common to hear tax cutters claim, implausibly, that all tax cuts raise revenue."

Labels aside, those remarks are nothing new. In a July 2004 column, Bartlett correctly remarked that, "The vast bulk of tax cuts since 2001, in revenue terms, have gone for tax rebates, kiddy credits and other measures having no impact on marginal incentives."

Of course such "gimmicky tax cuts" lose tax revenue. But Wall Street Journal columnist Robert Frank, writing on economist Greg Mankiw's blog, recently imagined he had witnessed "the supply-sider Bruce Bartlett now conceding that tax cuts for top earners don't boost total tax revenues." Bartlett conceded no such thing. Revenues have risen impressively since the 2003 reduction of tax rates, and nearly all of the gains are from top earners, including profits, capital gains and dividends.

In 2004, Bartlett wrote that "with federal revenues at just 15.8 percent of gross domestic product (GDP) -- well below their historical level of 18 percent -- I don't think our economy is overtaxed." The Congressional Budget Office now estimates federal revenues of 18.6 percent of GDP this year and 19 percent next year.

Phrases intended to describe complex ideas in a word or two, such as Keynesian or monetarist, invariably become misused or hijacked after three decades. But such semantic abuses can't be halted by Bartlett's white flag. Like it or not, the phrase "supply-side economics" will doubtless continue to be used and abused.

Bartlett says, "The context in which the term had meaning no longer exists, and therefore it has become a barrier to communication." That context refers to a debate about the appropriate "policy mix" in a situation of double-digit inflation combined with severe recession, as in 1974-75 or 1980-82. The supply-side innovation, from Nobel Laureate Bob Mundell, was to suggest that (1) monetary policy is the right tool to keep inflation in check, and that (2) the focus of tax policy should be shifted from short-term accounting results (deficits) toward improving longer-term incentives for productive work and investment. The first part of that package is actually monetarist, and neither part ever ceases to be relevant to inflation and economic growth, respectively.

I wrote a paper on "The Fiscal-Monetary Policy Mix" for the Fall 2001 Cato Journal. It began by saying: "In the early postwar years, during the heyday of fiscal fine-tuning ... the predominant view was that the main function of monetary policy was to 'stimulate' debt-financed purchases by keeping interest rates low. Inflation was first considered a useful lubricant to be traded for lower unemployment, and inflation could be reduced only by tolerating high unemployment. In the late '60s and early '70s, when the shrinking dollar proved less popular than expected, inflation was routinely described by a thermal metaphor ('overheating') and regarded as an endemic problem to be endlessly 'fought' by using fiscal policy (a surtax) and incomes policy (wage-price controls), but never monetary policy."

The context of my remarks was the conventional unwisdom that gave us LBJ's surtax in 1968 and Nixon's price controls in 1971. In a blog commenting on Bartlett's piece, New York Times columnist Paul Krugman was irritated by Bartlett's comment that "Keynesians of that era" thought "monetary policy is impotent and inflation is caused by low unemployment." Krugman replied: "I was a grad student at MIT -- the great Keynesian stronghold -- in the 1970s, and this bears no resemblance to what was being taught. In fact, I still have my copy of Dornbusch-Fischer, 'Macroeconomics,' the 1978 edition -- and it doesn't make any of those assertions."

By 1978, however, supply-side ideas were even getting attention in textbooks. In the 1978 edition of Campbell McConnell's best-selling "Economics" text, the "Last Word" on fiscal policy was a paper of mine that is still online at taxfoundation.org. The 1978 Dornbusch-Fischer text found supply-side tax policy "intriguing" and thought we may well need "fiscal policies that operate on aggregate supply."

Bartlett says: "I still think (supply-side economics) was the right cure for the economic problems we were facing in the late 1970s. I also think it embodies some fundamental truths that are applicable at all times. But these fundamental truths, such as the idea that high marginal tax rates are bad for the economy, are now almost universally accepted." That is almost true. Mainstream economics almost universally accepts "optimal tax theory" and the "elasticity of taxable income" -- elegant elaborations of original supply-side themes. If incentives didn't matter, then we might as well discard the word "economics," not just supply-side (incentive-based) microeconomics.

Greg Mankiw is a "new Keynesian" scholar who thinks tax incentives matter a lot. Ed Prescott is a "real business cycle" scholar who thinks tax incentives matter even more. But Mankiw, Prescott, Martin Feldstein and others still quarrel with their retrograde peers. Being "almost universally accepted" is almost good enough, but not quite. When tax policy in most countries is as close to optimal as Hong Kong's, I will gladly stop mentioning supply-side economics.