A Walk on the Supply Side

What exactly is supply-side economics, anyway?

On July 14, 1977, Rep. Jack Kemp (R-N.Y.) and Sen. William Roth (R-Del.) took the concept of supply-side economics out of the arcane realm of academic theorists and put it into the real world of political policy debate. On that day, with few supporters, Kemp and Roth introduced legislation that would reduce tax rates by 30 percent across the board over three years. Little did the Keynesians realize that that bill, more than any single act, spelled the end of 45 years of dominance by the bankrupt economic principles of Lord Keynes.

Four years later, supply-siders dominate the new national administration. The revolutionaries have come to power. Not surprisingly, the Keynesians deny failure. The social engineers refuse to accept the facts that show their policies inadequate to dealing with the triple horrors of inflation, unemployment, and inexorably rising taxes.

Having gained the position from which to implement their program, the supply-siders now face a different problem. As supply-side theorist Paul Craig Roberts pointed out recently in the Wall Street Journal, "The problem [now] isn't in controlling the policy but in controlling the explanation of it."

ARGUING FOR SUPPLY-SIDE

Until recently, the supply-siders have been on the offensive in a guerrilla war. Now in power, they realize that they must broaden their base of public and political support if administration policy objectives are to be translated into legislative accomplishments and if federal objectives are to filter down to the state and local level. Other than a failure to properly implement supply-side policy in Washington, the greatest threat to proving the viability of this modern economic theory is that states, cities, and counties will fail to throw off the reins of Keynesianism.

If federal tax cuts were simply replaced with increased taxes in the states and localities—whether through inflation-induced "bracket creep" or through legislation—people would not enjoy the renewed economic freedom to save and invest in the ways needed to improve business productivity and increase employment. This could frustrate the federal program.

What do the proponents of supply-side policies have in their favor? Only the facts—the need for such policies and the proven success stories. What they are up against, however, is the danger that opponents of supply-side economics will so distort the facts that political implementation of this important new policy will be impeded.

One of the greatest weapons of the opponents is semantics. Supply-side terms are often cleverly twisted, and negative-sounding generalized clichés are used to define the principles of this economic theory.

A current distortion is the term unearned income, which evokes images of fat capitalists in easy chairs clipping their coupons while looking out the bay windows of their clubs at the peasants below. "Earned income," as the distinction is declared by the IRS, is wages, salary, consulting fees, etc., involving your personal service. "Unearned income" is all other income, whether from a savings bank or dividends. The latter is therefore any income that required the postponement of current consumption for future income (expected to be greater).

It is this postponement of current pleasure that allows for building new competitive plants that create new jobs and increase the long-term demand for labor, thereby raising wages. Ludwig von Mises in the introduction of his book Liberalism called this an example of "reasonable [human] action." "Reasonable action is distinguished from unreasonable action in that it involves provisional sacrifices, since they are outweighed by the favorable consequences that later ensue."

Yet unearned income has joined the ranks of such incriminating phrases as robber baron, bucket shop, and sweat shop as the definition of capitalism. At the same time, anything opposed to capitalism has been blessed with the description progressive, liberal, enlightened, or concerned. This is the power of semantics, which can only be countered with the facts, told again and again.

SAVING VS. SPENDING

Let me begin with some undisputed facts that, collectively, support a conclusive case for sharply reduced taxation and government intrusion in the private sector—the heart of supply-side economics.

Fact 1. The rate of personal saving has dropped steadily throughout the 1970s and now stands at about 60 percent of the rate at the beginning of the decade.

The reason is very simple. Traditional types of saving are, today, money-losing propositions. Inflation and taxes combine to reduce the value of savings and accumulated interest. Rather than saving, therefore, people "invest" by consuming. Let's face it: people are a lot smarter than most policymakers think they are. They see the value of their savings being eroded, and they're doing something about it.

Unfortunately, in doing so traditional savers fuel inflation by bidding up the price of consumer goods and by denying the investment capital needed to create the new plants and tools for modernized basic industries. When it takes more than $30,000 of new capital to buy the machinery needed today to put one worker to work in our major industries, it is no wonder jobs are being lost to foreign competition using more modern technologies.

Fact 2. The total assets of money market funds recently topped $100 billion.

On the surface, this might seem to refute the fact that saving is declining. As in so many cases, the surface impression is an illusion. This huge pool of funds is invested exclusively in debt rather than in equity securities, and many of these instruments are sold by the federal government. Much of the pool comes from individuals who have switched out of equity investments in order to establish a hedge against inflation. Money funds are both riskless and nonproductive. They represent simply an investment shift into high-interest-rate vehicles and not an infusion of new capital. And, of course, money funds owe their very existence to inflation.

Fact 3. The rate of personal indebtedness has recently risen substantially faster than income.

The increase in consumers' use of installment credit parallels the drop in consumer saving. It's the buy-now-pay-later method of fighting inflation. But its impact is substantial. It not only drains credit from more productive uses but places a growing number of consumers into an increasingly precarious financial position.

BY HOOK OR BY CROOK

Fact 4. During the 1970s the so-called underground economy has tripled as a percentage of GNP as more and more people seek ways to avoid reporting income.

Prof. Peter Gutmann of Baruch College calculates that the underground economy jumped to nearly $265 billion in 1978, or from about 2-4 percent of GNP in the '50s and '60s to 12.6 percent in 1978. Through a host of illegal activities—illegal under the tax laws or in other respects—millions of people are finding ways to avoid reporting income. It must be assumed that the vast majority of these people are not hardened criminals. Given lower tax rates, many of them would not seek to end-run the tax system. Therefore, inflated tax rates not only remove a large source of government income but actively encourage illegal activity.

Fact 5. The use of tax shelters has skyrocketed in recent years.

As tens of millions of people find their inflation-propelled income at or near the highest tax brackets, more and more are seeking legal ways to shelter income. There are no aggregate figures on tax shelters, but one small piece of data illustrates the problem. According to the National Tax Shelter Digest, the total annual investment via limited partnerships has jumped from $1.8 billion in 1974 to a projected $9.6 billion in 1981. And that's just the tip of the iceberg. Only a relatively small number of sophisticated investors use oil and gas or equipment-leasing partnerships as a means of tax postponement. The number of people who have recently bought investment real estate or tax-free bonds would, I suspect, be a real shock.

And remember one thing about tax shelters: they are investments designed solely to reduce taxes. Clearly, the drive to shelter income distorts market signals that direct investment into the most productive enterprises.

Tax shelters are not a new response to excessive taxation, however. In 1920, then-Treasury Secretary David Houston noted that high tax rates left over from World War I were "rapidly driving the wealthier taxpayers to transfer their investments into the thousands of millions of tax-free securities." Houston went on to add that "the effective way to tax the rich is to adopt rates that do not force investment in tax-exempt securities" (in effect, to reduce tax rates and, almost by definition, increase tax revenues).

Fact 6. Unemployment is today stuck at levels that, in the 1950s and '60s, we would have considered disastrous. Reported unemployment among the poor, the young, and minorities is close to being a national scandal. (Many of the underprivileged are being induced into such underground-economy activities as narcotics and street crime.)

Again, the reason is simple. A stagnant economy, starved of productive capital drained off through excessively high tax rates and government deficits, provides business with no ability and no incentive to modernize and expand and thus to hire and train new workers. Simultaneously, a combination of high public benefits and high tax rates gives the unemployed little incentive to look for jobs.

WHAT MAKES PEOPLE WORK?

All of these facts suggest a theme: People, whether potential investors or potential employees, need incentives to participate fully and productively in the economy. Without incentives, they will find ways to drop out. They will borrow and consume rather than save; they will shift capital into nonproductive uses; they will seek illegal or unreported or sheltered income to avoid the big tax bite; they will opt for leisure rather than work.

And what sort of incentives do people need in order to participate productively? The most powerful of all is simply for individuals to be able to enjoy the fruits of their labor, to see a positive improvement in their standards of living, and to have the freedom to spend or invest their incomes without the disincentives inherent in high taxes and high inflation—in other words, to keep their eyes on resource enhancement rather than on tax avoidance.

Past policymakers have assumed that the economic pie is fixed in size, that we can only argue about which groups in society get how large a slice. As a result, today an incentive for one is viewed as a penalty for another. This once-fashionable philosophy has been written about by Prof. Lester B. Thurow of MIT in his book, The Zero-Sum Society, in which he argues for redistribution of wealth by mandatory government programs in a permanently stagnant society. This bankrupt philosophy is also espoused by the Club of Rome, the Brandt Commission report on North-South relations, the United Nations' New International Economic Order, and many environmentalists.

Supply-siders say that is wrong. Rather than fighting over the size of slices, we should be—and can be—enlarging the pie. The result will be larger slices for everyone, including the poor, minorities, the unemployed, the better-off, and even government. That is the essence of supply-side economics.

CLEAR RECORD

And history shows it works. This is not economic snake oil. During the 1920s, under prodding from Treasury Secretary Andrew Mellon, taxes imposed during World War I were drastically reduced. The result was one of the most prosperous decades in American history. Real GNP rose 54 percent; output per man hour rose 66.5 percent.

For those who believe a cut in tax rates would benefit the rich at the expense of the poor, it is instructive to note the actual tax impact of the Mellon cut on those with the highest incomes. In 1920, 3,649 tax returns showed incomes of $100,000 or more and generated $321 million in taxes. By 1928, nearly 16,000 tax returns reported incomes of $100,000 or more, and government revenue from them, at substantially reduced rates, had more than doubled to $714 million. Part of the difference simply reflects increased wealth generated by a growing economy. But another important factor is that at lower tax rates the wealthy simply had no further need to divert income to a host of tax shelters.

The Kennedy tax cut of 1963-64 had similar results. Personal tax rates were cut an average of 20 percent across the board. Far from reducing government income, the tax cut so stimulated economic growth that tax revenue grew substantially. Of particular interest to the social engineers, tax revenue from the wealthy increased steadily throughout the 1960s. Unemployment dropped by nearly half between 1961 and 1969, while unemployment among black males dropped from 11.7 percent to 3.7 percent in the same period.

Also take capital gains rates, for example. At 100 percent the tax revenues to the government would necessarily approach zero, of course. In 1969 capital gains rates were nearly doubled from a 25 percent tax rate. Revenues plummeted from this source, and of course the venture capital that finances new industries substantially dried up. In 1978 the Steiger Amendment reduced the maximum capital gains rate to 28 percent, and tax revenues increased rapidly while venture capital formation revived. Where venture capital exists, new technology and new plants follow.

Other examples abound. In Puerto Rico a series of tax cuts totalling 15 percent between 1977 and 1980 has resulted in one of the greatest periods of growth in the island's history. Proposition 13 in California, passed in 1978, has helped push the state's growth well beyond the national average. The phenomenal growth of the Japanese economy since World War II was fueled in part by a steady stream of 11 cuts in overall tax rates between 1954 and 1974.

The point is proved also in the reverse. As Jude Wanniski points out in his epic work, The Way the World Works, a good laboratory case of supply-side theory is found in the neighboring countries Ghana and the Ivory Coast since 1960. Ghana imposed heavy taxes (especially at the margin, with progressive disincentives at the higher brackets), while the Ivory Coast did not. Although both started with similar natural resources, ethnic structures, and per capita incomes, today the Ivory Coast has many times the per capita income of Ghana.

Sweden, often seen by social engineers as the model economic structure, has some of the highest personal tax rates in the world. As a result, the Swedish economy is in total stagnation. No less an expert than Gunnar Myrdal, a major architect of the Swedish social economy, has stated that the Swedish income tax system must bear much of the blame.

In Italy, another country that leads the pack in personal income tax rates, it is estimated that as much as 50 percent of all income comes from the underground economy. High taxes have made tax avoidance a major Italian challenge and virtually guarantee that investment is channeled into unproductive uses.

The point of these examples is clear. Supply-side policy works. To state it even more strongly: no other economic strategy can create a growing, innovative, and increasingly productive economy that will spur investment, increase jobs, and cut inflation.

Supply-side pioneer Arthur Laffer has explained the fundamental principle of taxation that lies behind supply-side economics in a remarkably simple and graphic manner. His "Laffer curve" is not only an economic truism but also a very basic statement of behavior.

What Professor Laffer shows is that people respond to incentives. Up to a certain point marginal tax rates—the rate paid on the next dollar earned—will not keep people from earning and investing savings to increase earnings even more. Beyond that point, when taxes are pushed up by inflation or by law, more and more people will seek ways to hide income or will simply decide that working is not worth the effort, since the rewards are not great enough.

WHAT KIND OF CUT?

Of course, it is argued by the Keynesians and the social redistributors—the so-called Robin Hood groups—that a tax cut is fine, but only if the benefits go to those in the lowest income brackets. In fact, such a tax cut would virtually guarantee increased inflation by encouraging consumption while doing little to promote production, or the supply of goods and services to be consumed.

An even-handed reduction in tax rates would have quite a different impact. At lower income levels, there clearly would be some additional consumption. In addition, however, part of that excessively high level of installment debt would be paid off, which in itself is a form of saving. At higher income levels, saving and investment would be powerfully stimulated, since a larger proportion of the income from investment would be tax-free. In addition, the incentive to hide or shelter income would disappear, and, in becoming more lucrative, investment would become more productive. More important, those at lower income levels would be given a real incentive to increase earnings by working harder and working more productively.

Finally, there are those who would cut business taxes while leaving personal taxes high. This, too, would be counterproductive. True, it would give existing industries and existing firms more money to plow back into existing businesses. But it would do nothing to encourage entrepreneurs to invest in wholly new ventures. It would provide no incentive for new companies to enter existing industries, thus stimulating competition and innovation. Business tax cuts are needed, but only in conjunction with personal rate reductions. The combination will maximize incentives to earn more across the board.

FREEDOM FRAMEWORK

This is the supply-side economic story. It needs telling. The point, simply put, is that government, at all levels, must avoid erecting barriers that destroy incentives to innovate, to improve productivity and encourage the retooling of American industry. Further, government must remove ill-conceived economic regulations so that enhanced competition will achieve the desired results. And government must be made predictable so that businesses and individuals will be able to make plans for the future.

None of this implies that government does not have a role to play in protecting the rights of consumers, workers, and investors. It means simply that government policies must permit innovation and should not be so inflexible, capital-consuming, and diverting that business simply throws up its hands and ceases to innovate.

Overall, supply-side policy is a declaration of economic independence, of personal freedom. As such, it provides the framework in which the economic pie can grow, benefiting every person in our still-free nation.

J. William Middendorf, II, is the president of a financial firm and of the Committee for Monetary Research and Education. He was formerly the US ambassador to the Netherlands and was recently appointed American States. This article is adapted from his presentation at the Ninth Annual CMRE Conference, "Money, Budgets, and Taxes."