Supply-Side Economics

by James D. Gwartney
About the Author
The term “supply-side economics” is used in two different but related ways. Some use the term to refer to the fact that production (supply) underlies consumption and living standards. In the long run, our income levels reflect our ability to produce goods and services that people value. Higher income levels and living standards cannot be achieved without expansion in output. Virtually all economists accept this proposition and therefore are “supply siders.”

“Supply-side economics” is also used to describe how changes in marginal tax rates influence economic activity. Supply-side economists believe that high marginal tax rates strongly discourage income, output, and the efficiency of resource use. In recent years, this latter use of the term has become the more common of the two and is thus the focus of this article.

The marginal tax rate is crucial because it affects the incentive to earn. The marginal tax rate reveals how much of one’s additional income must be turned over to the tax collector as well as how much is retained by the individual. For example, when the marginal rate is 40 percent, forty of every one hundred dollars of additional earnings must be paid in taxes, and the individual is permitted to keep only sixty dollars of his or her additional income. As marginal tax rates increase, people get to keep less of what they earn.

An increase in marginal tax rates adversely affects the output of an economy in two ways. First, the higher marginal rates reduce the payoff people derive from work and from other taxable productive activities. When people are prohibited from reaping much of what they sow, they will sow more sparingly. Thus, when marginal tax rates rise, some people—those with working spouses, for example—will opt out of the labor force. Others will decide to take more vacation time, retire earlier, or forgo overtime opportunities. Still others will decide to forgo promising but risky business opportunities. In some cases, high tax rates will even drive highly productive citizens to other countries where taxes are lower. These adjustments and others like them will shrink the effective supply of resources, and therefore will shrink output.

Second, high marginal tax rates encourage tax-shelter investments and other forms of tax avoidance. This is inefficient. If, for example, a one-dollar item is tax deductible and the individual has a marginal tax of 40 percent, he will buy the item if it is worth more than sixty cents to him because the true cost to him is only sixty cents. Yet the one-dollar price reflects the value of resources given up to produce the item. High marginal tax rates, therefore, cause an item with a cost of one dollar to be used by someone who values it less than one dollar. Taxpayers facing high marginal tax rates will spend on pleasurable, tax-deductible items such as plush offices, professional conferences held in favorite vacation spots, and various fringe benefits (e.g., a company luxury automobile, business entertainment, and a company retirement plan). Real output is less than its potential because resources are wasted producing goods that are valued less than their cost of production.

Critics of supply-side economics point out that most estimates of the elasticity of labor supply indicate that a 10 percent change in after-tax wages increases the quantity of labor supplied by only 1 or 2 percent. This suggests that changes in tax rates would exert only a small effect on labor inputs. However, these estimates are of short-run adjustments. One way to check the long-run elasticity of labor supply is to compare countries, such as France, that have had high marginal tax rates on even middle-income people for a long time with countries, such as the United States, where the marginal rates have been persistently lower. Recent work by edward prescott, corecipient of the 2004 Nobel Prize in economics, used differences in marginal tax rates between France and the United States to make such a comparison. Prescott found that the elasticity of the long-run labor supply was substantially greater than in the short-run supply and that differences in tax rates between France and the United States explained nearly all of the 30 percent shortfall of labor inputs in France compared with the United States. He concluded:

I find it remarkable that virtually all of the large difference in labor supply between France and the United States is due to differences in tax systems. I expected institutional constraints on the operation of labor markets and the nature of the unemployment benefit system to be more important. I was surprised that the welfare gain from reducing the intratemporal tax wedge is so large. (Prescott 2002, p. 9)

The supply-side economic policy of cutting high marginal tax rates, therefore, should be viewed as a long-run strategy to enhance growth rather than a short-run tool to end recession. Changing market incentives to increase the amount of labor supplied or to move resources out of tax-motivated investments and into higher-yield activities takes time. The full positive effects of lower marginal tax rates are not observed until labor and capital markets have time to adjust fully to the new incentive structure.

Because marginal tax rates affect real output, they also affect government revenue. An increase in marginal tax rates shrinks the tax base, both by discouraging work effort and by encouraging tax avoidance and even tax evasion. This shrinkage necessarily means that an increase in tax rates leads to a less than proportional increase in tax revenues. Indeed, economist Arthur Laffer (of “Laffer curve” fame) popularized the notion that higher tax rates may actually cause the tax base to shrink so much that tax revenues will decline, and that a cut in tax rates may increase the tax base so much that tax revenues increase.

How likely is this inverse relationship between tax rates and tax revenues? It is more likely in the long run when people have had a long time to adjust. It is also more likely when marginal tax rates are high, but less likely when rates are low. Imagine a taxpayer in a 75 percent tax bracket who earns $300,000 a year. Assume for simplicity that the 75 percent tax rate applies to all his income. Then the government collects $225,000 in tax revenue from this person. Now the government cuts tax rates by one-third, from 75 percent to 50 percent. After the tax cut, this taxpayer gets to keep $50, rather than $25, of every $100, a 100 percent increase in the incentive to earn. If this doubling of the incentive to earn causes him to earn 50 percent more, or $450,000, then the government will get the same revenue as before. If it causes him to earn more than $450,000, the government gets more revenue.

Now consider a taxpayer paying a tax rate of 15 percent on all his income. The same 33 percent rate reduction cuts his rate from 15 percent to 10 percent. Here, take-home pay per $100 of additional earnings will rise from $85 to $90, only a 5.9 percent increase in the incentive to earn. Because cutting the 15 percent rate to 10 percent exerts only a small effect on the incentive to earn, the rate reduction has little impact on the amount earned. Therefore, in contrast with the revenue effects in high tax brackets, tax revenue will decline by almost the same percentage as tax rates in the lowest tax brackets. The bottom line is that cutting all rates by a third will lead to small revenue losses (or even revenue gains) in high tax brackets and large revenue losses in the lowest brackets. As a result, the share of the income tax paid by high-income taxpayers will rise.

As the Keynesian perspective triumphed following World War II, most economists believed tax reductions affect output through their impact on total demand. The potential supply-side effects of taxes were ignored. However, in the 1970s, as inflation pushed more and more Americans into high tax brackets, a handful of economists challenged the dominant Keynesian view. Led by Paul Craig Roberts, Norman Ture, and Arthur Laffer, they argued that high taxes were a major drag on the economy and that the top rates could be reduced without a significant loss in revenue. They became known as supply-side economists. During the presidential campaign of 1980, Ronald Reagan argued that high marginal tax rates were hurting economic output, but contrary to what many people think, neither Reagan nor his economic advisers believed that cuts in marginal tax rates would increase tax revenue.

The 1975–1985 period was an era of great debate about the impact of supply-side policies. The supply siders highlighted the positive evidence from two earlier major tax cuts—the Coolidge-Mellon cuts of the 1920s and the Kennedy tax cut of the 1960s. Between 1921 and 1926, three major tax cuts reduced the top marginal rate from 73 percent to 25 percent. The Kennedy tax cut reduced rates across the board, and the top marginal rate was sliced from 91 percent to 70 percent. Both of these tax cuts were followed by strong growth and increasing prosperity. In contrast, the huge Hoover tax increase of 1932—the top rate was increased from 25 percent to 63 percent in one year—helped keep the economy depressed. As the economy grew slowly in the 1970s and the unemployment rate rose, supply-side economists argued that these conditions were the result of high tax rates due to high inflation.

Keynesian economists were not impressed with the supply-side argument. They continued to focus on the demand-side effects, charging that it was irresponsible to cut taxes at a time when inflation was already high. They expected the rate cuts to lead to larger budget deficits, which they did, but also that these deficits would increase demand and push the inflation rate to still higher levels. As Walter Heller, chairman of the Council of Economic Advisers under President John F. Kennedy put it, “The [Reagan] tax cut would simply overwhelm our existing productive capacity with a tidal wave of demand.” But this did not happen. Contrary to the Keynesian view, the inflation rate declined substantially from 9 percent during the five years prior to the tax cut to 3.3 percent during the five years after the cut.

Economists continue to debate the precise effects of the 1980s tax cuts. After extensive analysis of the 1986 rate reductions, both Lawrence Lindsey and Martin Feldstein concluded that for taxpayers previously facing marginal tax rates of 40 percent or more, the drop in tax rates caused such a large increase in taxable income that the government was collecting even more revenue from taxpayers in these top brackets. This would mean that tax rates of 40 percent had had a highly destructive impact on economic activity. Joel Slemrod argued that Lindsey’s and Feldstein’s estimates of the extra income due to tax rate cuts are too high because they inadequately reflect people’s shifting of personal income from high-tax-rate years to low-tax-rate years and of business income from regular corporations to partnerships and Sub-S corporations in response to the lower personal tax rates. According to Slemrod, only a small portion of the increase in the tax base resulted from improvements in efficiency and expansion in the supply of labor and other resources.

Even though economists still disagree about the size and nature of taxpayer response to rate changes, most economists now believe that changes in marginal tax rates exert supply-side effects on the economy. It is also widely believed that high marginal tax rates—say, rates of 40 percent or more—are a drag on an economy. The heated debates are now primarily about the distributional effects. Supply-side critics argue that the tax policy of the 1980s was a bonanza for the rich. It is certainly true that taxable income in the upper tax brackets increased sharply during the 1980s. But the taxes collected in these brackets also rose sharply. Measured in 1982–1984 dollars, the income tax revenue collected from the top 10 percent of earners rose from $150.6 billion in 1981 to $199.8 billion in 1988, an increase of 32.7 percent. The percentage increases in the real tax revenue collected from the top 1 and top 5 percent of taxpayers were even larger. In contrast, the real tax liability of other taxpayers (the bottom 90 percent) declined from $161.8 billion to $149.1 billion, a reduction of 7.8 percent.

Since 1986, the top marginal personal income tax rate has been less than 40 percent, compared with 70 percent prior to 1981. Nonetheless, those with high incomes are now paying more. For example, more than 25 percent of the personal income tax has been collected from the top 0.5 percent of earners in recent years, up from less than 15 percent in the late 1970s. These findings confirm what the supply siders predicted: the lower rates, by increasing the tax base substantially in the upper tax brackets, would increase the share of taxes collected from these taxpayers.

Supply-side economics has exerted a major impact on tax policy throughout the world. During the last two decades of the twentieth century, there was a dramatic move away from high marginal tax rates. In 1980, the top marginal rate on personal income was 60 percent or more in forty-nine countries. By 1990, only twenty countries had such a high top tax rate, and by 2000, only three countries—Cameroon, Belgium, and the Democratic Republic of Congo—had a top rate of 60 percent or more. In 1980, only six countries levied a personal income tax with a top marginal rate of less than 40 percent. By 2000, fifty-six countries had a top marginal income tax rate of less than 40 percent.1

The former socialist economies have been at the forefront of those moving toward supply-side tax policies. Following the collapse of communism, most of these countries had a combination of personal income and payroll taxes that generated high marginal tax rates. As a result, the incentive to work was weak and tax evasion was massive. Russia was a typical case. In 2000, Russia’s top personal income tax rate was 30 percent and a 40.5 percent payroll tax was applied at all earnings levels. If Russians with even modest earnings complied with the law, the tax collector took well over half of their incremental income. Beginning in January 2001, the newly elected Putin administration shifted to a 13 percent flat-rate income tax and also sharply reduced the payroll tax rate. The results were striking. Tax compliance increased and the inflation-adjusted revenues from the personal income tax rose more than 20 percent annually during the three years following the adoption of the flat-rate tax. Further, the real growth rate of the Russian economy averaged 7 percent during 2001–2003, up from less than 2 percent during the three years prior to the tax cut.

Ukraine soon followed Russia’s lead and capped its top personal income tax rate at 13 percent. Beginning in 2004, the Slovak Republic imposed a flat-rate personal income tax of 19 percent. Latvia and Estonia also have flat-rate personal income taxes.

Supply-side economics provided the political and theoretical foundations for what became a remarkable change in the tax structure of the United States and other countries throughout the world. The view that changes in tax rates exert an impact on total output and that marginal rates in excess of 40 percent exert a destructive influence on the incentive of people to work and use resources wisely is now widely accepted by both economists and policymakers. This change in thinking is the major legacy of supply-side economics.


About the Author

James D. Gwartney is a professor of economics and director of the Gus A. Stavros Center for the Advancement of Free Enterprise and Economic Education at Florida State University. He was previously chief economist of the Joint Economic Committee of the U.S. Congress.


Further Reading

Canto, Victor A., Douglas H. Joines, and Arthur B. Laffer. Foundations of Supply-Side Economics. New York: Academic Press, 1983.
Federal Reserve Bank of Atlanta. Supply-Side Economics in the 1980s. Westport, Conn.: Quorum Books, 1982.
Gruber, Jonathan, and Emmanuel Saez. “The Elasticity of Taxable Income Evidence and Implications.” NBER Working Paper no. 7512. National Bureau of Economic Research, Cambridge, Mass. 2000.
Lindsey, Lawrence. The Growth Experiment: How the New Tax Policy Is Transforming the U.S. Economy. New York: Basic Books, 1990.
Prescott, Edward C. “Richard T. Ely Lecture: Prosperity and Depression.” American Economic Review, Papers and Proceedings, 92, no. 2 (2002): 1–15.
Slemrod, Joel, ed. Does Atlas Shrug: The Economic Consequences of Taxing the Rich. New York: Russell Sage Foundation, 2000.
U.S. Congress. Joint Economic Committee. The Mellon and Kennedy Tax Cuts: A Review and Analysis. Washington, D.C.: Government Printing Office, 1982.

Footnotes

These figures are from James Gwartney and Robert Lawson, Economic Freedom of the World, 2003 Annual Report.


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