The Way the World Works, by Jude Wanniski, New York: Basic Books. 1978. 319 pp. $12.95.
Economists are still full of ideas about how to stimulate production and employment, despite a decade of uniquely dismal economic performance under their expert guidance. One group promises miraculous results from merely adjusting the federal budget by a few billion one way or the other. Another watches the monthly gyrations in various measures of money and suggests printing the stuff at a slightly faster or slower rate. And then there are those who blame the whole mess on something called "capitalism"—the definition of which changes to fit the latest complaint.
A couple of generations have been taught that when the government spends more than it collects in tax revenues, the resulting deficit stimulates production. But a long string of huge deficits has obviously produced nothing but trouble, so Keynesian economists feel compelled to explain that the theory is right but the world has gone wrong. Wanniski has a more convincing explanation.
To spend more money than it has, the government has to borrow the difference by peddling some IOUs ("bonds"). But if the government borrows a dollar from Smith and uses it to cut Jones's taxes by a dollar, nothing much has changed. Jones is supposed to feel a dollar richer, but he is going to have to pay more taxes in the future in order to pay interest on Smith's bond. An increase in public debt could therefore inspire more production only if people failed to realize that it simply substitutes future taxes for present taxes—that is, if they suffered from "bond illusion." People are not that gullible, in Wanniski's view, and Keynesian ideas just provide politicians with an excuse to redistribute the misery in a stagnant economy.
Instead of borrowing the money to cover its deficits, however, the government might just pay its bills with new money. In this case, the Federal Reserve buys the new government securities and pays for them by writing a check that ends up increasing bank reserves. With more reserves, the banks can make more loans, creating new checking accounts in the process.
Like Wanniski, monetarist economists argue that this game ends with more inflation. Unlike Wanniski, most monetarists think a shot of new money will first stimulate production for a while, by lowering the real cost of labor and credit, until people notice the higher inflation and raise wages and interest rates to compensate for it. This is "money illusion," and Wanniski finds it no more palatable than Keynesian "bond illusion."
People don't work, invest, and exchange goods and services simply because the government prints more money. They understand that the trouble with money is that when you print more it ends up being worth less.
People won't work harder because the government sells more securities to cover its deficits. They could hardly fail to realize that those public assets imply a matching public tax liability, since almost 10 percent of the federal budget now goes to pay interest on past deficits.
The real source of sustained economic expansion is not such tricks and illusions, says Wanniski, but the real after-tax rewards for productive effort and investment. He also revives Adam Smith's emphasis on the importance of specialization, both within and between countries, and gives it a startling new relevance to tax policy. In place of the postwar fetish with short-term manipulation of demand, Wanniski brings back the classical concern with the fundamental motives behind the growth of supply.
Lord Keynes described the appropriate use of classical economics as "a condition where a reduction in the real rewards of the factors of production will lead to a curtailment in their supply." Both Keynes and the monetarists would agree that "in the long run," Wanniski's classical explanation of economic growth is essentially correct. In practice, however, the long run is always pushed into the future, and attention is instead focused on fiscal and monetary nostrums to fix immediate problems.
Keynes was sure that inflation would make labor cheaper, thus increasing employment, because prices would outrun wages. "No trade union," wrote Keynes, "would dream of striking on every occasion of a rise in the cost of living." Moreover, he suggested that "rising prices may delude entrepreneurs into increasing employment." Keynesian policy is based on the unlovely art of deceiving people, and because people are not so easily fooled, it doesn't work.
When the Keynesian prescription takes the form of tax cuts, however, it may have the right effect for the wrong reason. The purpose of reducing tax rates is not to stimulate spending (something more easily accomplished by dropping money from helicopters) but to increase the incentive for workers to work, employers to employ, and investors to invest. For that purpose, not just any tax cut will do. Two tax cuts that would supposedly generate the same loss of revenues, if nothing else was changed, might well have radically different effects on incentives, production, and therefore on tax revenues.
The key question is whether additional effort to supply what others are anxious to buy will yield enough reward, relative to the alternatives, to justify the effort. Among the alternatives to taxable income are numerous sources of income that are effectively invisible and therefore exempt from taxation—mowing lawns, prostitution, casual labor, selling marijuana, gambling, and so on. Then there are the broader aspects of what Wanniski calls "the barter economy"—housework, do-it-yourself projects, trading babysitting and other tasks with relatives and neighbors. In all of these cases, there is little or no efficient organization and specialization of work. Finally, there are many taxpayer-financed benefits that are given only on condition that recipients work less or not at all—welfare, unemployment, disability and retirement benefits; payments to farmers for not farming.
We commonly think of the economy as consisting entirely of the sort of activity that can be easily measured on a W-2 tax form, where labor is efficiently organized and specialized in large enterprises. When taxes on such conspicuous activities are sufficiently demoralizing, however, many people drop back into the inefficient barter economy or drop out of work altogether. Even those who remain in the conventional economy will make little effort to produce and earn more if, with each upward step, they get to keep smaller proportions of their income. It follows that inflation, by pushing more and more people into higher and higher tax brackets, has had a depressing impact on real production. This is Wanniski's sensible explanation of the supposed paradox of simultaneous inflation and recession.
WEDGES AND CURVES
Wanniski puts together a model with two tools borrowed from Arthur Laffer of the University of Southern California—the "wedge model" and the "Laffer Curve." Taxes and regulations create a "wedge" between what business pays for labor and capital and what workers and investors ultimately receive. An employer might have to pay $10 an hour, including payroll taxes and the cost of various regulatory requirements, in order to offer $8 to a worker, which will actually leave him with only $6 in after-tax income. The gap between the $10 and $6 is one sort of wedge, and it reduces both the employer's demand for labor and the worker's willingness to leave the barter economy or the dole.
The Laffer Curve neatly illustrates a situation in which tax rates become so high that they are counterproductive—discouraging the taxed activity so effectively that tax revenues actually fall. It offers politicians the alluring possibility of offering to cut both taxes and the budget deficit at the same time. Again, not just any tax cut will do. The Carter administration proposes to increase the progressivity of the tax system at a time when inflation is already pushing nearly everyone who works into the brackets once reserved for economic royalty. That is not the sort of tax cut that keeps people from retiring a little earlier each year, including some who retire on the job.
A major appeal of Wanniski's book is the way in which political history is reinterpreted in terms of his economic model. History is seen as a process of struggling toward systems capable of producing politicians who can effectively resolve the inherent tension between creating and redistributing real income. Excessive taxes or tariffs are seen as the cause of overpopulation in India, pollution and prostitution in the United States, World War II, illegal immigration from Mexico, underdevelopment in many countries, and Quebec separatism. The French Revolution wasn't an attempt to achieve equality through stiff taxation, but to stop taxing the peasants at an 82 percent rate to help the idle rich.
Among the political heroes are such diverse characters as Alexander the Great, Napoleon, Coolidge, Robert Taft, Harry Dexter White, and John Kennedy. It would all be simply outrageous if it weren't so rigorously documented. The Crash of '29, for example, is examined in minute detail by linking the ups and downs of the stock market to the changing congressional fate of the Smoot-Hawley tariff (a tax or "wedge" on international specialization).
For years, the Republican response to Democratic spending initiatives has been to do the "fiscally responsible" thing and vote tax increases to pay the bills. Democrats spend, Republicans tax, and those who are not too impressed with either the spending or the taxes have left both parties in droves. It wasn't always so, and the greatest political and economic successes of each party have been the periods when the pattern was broken. The Coolidge prosperity combined drastic tax cuts with a freeze on federal spending; John Kennedy did the same in fiscal 1965. Recent events suggest that we are once again entering an era in which good economics will also be good politics.
Those who doubt the relevance of economics may be surprised to see the clear imprint of Wanniski's ideas on politics from coast to coast—from California's Proposition 13 to Jeffrey Bell's primary upset in New Jersey. At the federal level, Wanniski's efforts are directly tied to the snowballing support behind Rep. Jack Kemp's bill to slash income tax rates and to Rep. William Steiger's amendment to roll back the post-1969 increases in the capital-gains tax rate. It will be difficult to understand what is going on in this country, and possibly others, without a careful reading of this boldly innovative book.
Alan Reynolds is a REASON contributing editor and columnist and vice-president of research at a major US bank.
This article originally appeared in print under the headline "Tax-Revolt Bible".