Supply-Side Investing

Get ready for a high-tech future

We are moving into the "Roaring '80s." This is not a period of sluggishness and stagnation like the one that we've just undergone in the '70s. This is a period of major transition and change in our economy and in the world economy, and we are going to look back on this period with wild surprise. We're going to see it as a unique window of opportunity for investment in the new frontiers of the economy, in the new companies that will shape our coming decades. We will look back with amazement that the shares of Intel Corporation, for example, were going for $25 and Amdahl for $19 and Semicon for $4. These are ridiculous underestimates of the value of major companies that are going to shape the future of the world in the coming decades. But to understand the promise of this period we also have to understand better what happened during the 1970s and why the sources of gloom that overcame the world economy during this period are now at last dissipating.

One of the most important sources of the psychological depression we underwent during the last decade was the belief that, in the energy crisis, world capitalism was somehow confronting fundamental limits of growth—that we were exhausting our material resources, that new profits and possibilities would all be captured by OPEC and by foreign countries and masters of physical resources. But today we can clearly see that the energy crisis is essentially over, that for the coming decades energy prices are going to go down, not up, and that the energy problem will be a decreasing force in all our lives. The energy crisis was essentially overcome, not by the big oil companies and by the Department of Energy, as we all know, but by the vitality of capitalism itself—by the development of all sorts of new technologies that pervade the system and increase the energy efficiency of virtually all equipment in the American economy.

On the supply side, the energy crisis was solved to a considerable extent by small companies. Perhaps the most important is one few of you have ever heard of. It was started in Canada in 1974 by two Americans; the leader, named John Masters. Masters had previously been a uranium geologist for Kerr McGee, and in this capacity he found the biggest uranium deposits in America, called Ambrosia Lake, in Utah. He thought that the principles that he had applied to find uranium could also be used to find natural gas. It's a fascinating story. Masters was unable to get any support from the major oil companies or from any major group with expertise in oil and gas. But today his company has probably found some 440 trillion cubic feet of natural gas in western Canada, and the principles he's applied in his geological searches have also opened the way to similar discoveries in the Overthrust Belt of the United States. But this is just one example of the energy developments that have high promise for the future and show that this particular source of gloom—the supposed energy crisis—is coming to an end.

A second source of discouragement was the idea that our economy was becoming fundamentally less productive—that somehow we'd confronted a genuine and profound productivity crisis that could not be overcome for years to come. It was believed that the movement of manpower from manufacturing to service industries would nullify the productivity gains that were earlier achieved by the movement from agriculture to manufacturing. But this is a profound misunderstanding of the process.

I first arrived at this conclusion while I was working at the National Center for Productivity and Quality of Working Life in Washington, D.C.. I discovered that during the 1970s manufacturing productivity rose by a total of 90 percent. Meanwhile, the productivity of offices, which are kind of the factory floor of service companies, rose by a total of only 4 percent in 10 years. And since we're increasingly becoming a service economy, this was a depressing set of statistics. But then I pursued the matter further and found that the very companies that had improved their own manufacturing productivity most during the '70s were largely devoted to producing equipment designed to enhance the productivity of offices—designed, in fact, to improve the productivity of the entire service sector of the American economy.

I think this equipment is now largely in place, and it's moving through the system in ever-greater quantities. All these word processors and distributed-data processors; all the audit equipment of the automated office, the electronic warehouse, and the computer-controlled assembly line—all these new forms of equipment are in place, and people are learning how to gain their real productivity yield. During the next decade we will make major increases in productivity as a result of these important developments.

Probably more important from my point of view—or at least as important, because it permits these favorable trends to come to a favorable fruition—is the triumph of supply-side economics. Many people today laugh when you talk about supply-side economics. It's widely assumed that supply-side economics has already failed. But when you appraise the current economic situation, it's worth understanding that last year we had no tax cuts at all. In 1981 we had a 10-percent tax increase as a result of bracket creep. The problem of the American economy last year is really attributable to the failure to apply that first 10-percent tax cut when it was originally scheduled for application. Instead, taxes were permitted to rise again for another year—10 percent for the average taxpayer—as a result of bracket creep.

What we really underwent last year was demand-side economics—the assumption that we can ultimately balance the budget by allowing taxes to rise. This fact is generally not understood by the media or, indeed, by many economic experts. They still imagine that somehow tax cuts are a threat to the US economy because huge deficits will result. You can tell when analysts do not understand how these tax cuts will work when you hear them mention the size of the cut as somehow being $552 billion over the next four years, or $760 billion over the next five years. Whenever you hear people say that it's a $552-billion tax cut, the first thing you have to ask is, "Compared to what?" All these estimates of the size of the Reagan-administration tax cut are based on Carter-administration projections, which assume that people continue to produce and work and invest while tax rates rise by 46 percent over four years. This idea is obvious baloney, and all these estimates that the size of the tax cut has been $500 billion or $700 billion are false. The government never would have collected this money. Indeed, I'm assured that the government will get more revenues over the next five years under the Reagan-administration tax structure than it could have acquired by allowing taxes to rise every year.

Incidentally, this last proposition is often believed to have been disproven by the British experience, but in fact has been massively supported by the experience in Britain over the last couple years. What actually happened in Britain? Between 1976 and 1980, social-security tax rates rose by 50 percent. Everybody expected this to greatly increase the revenues available for social security. But, in real terms, revenues declined throughout that period. And, partly due to the fact that social-security taxes are a direct tax on work, unemployment soared. This is precisely what a supply-side economist would have predicted.

Prime Minister Thatcher also virtually doubled the value-added tax (VAT), and it was widely predicted that there would be a huge new influx of revenues from the increased tax. What really happened as a result of this policy? Did the doubled VAT bring in 70 or 80 percent more revenues, as all prevailing economists in England anticipated? No—revenues increased only 45 percent in real terms.

Mrs. Thatcher did, in fact, cut the income tax. Yet the British still have among the highest income taxes in the world. Their 60-percent rate strikes incomes of about $35,000, and their 75-percent rate is one of the highest levels on unearned income. But Thatcher did cut these rates from 98 percent and 83 percent, respectively. She thought, however, that she had to increase the VAT so much, because there would be a big drop in revenues from the income tax. But what happened with income-tax revenues after she cut the rates? At a time of a near-depression in the British economy—largely due to the huge value-added and social-security taxes that had been imposed on the system—revenues from the income tax increased in real terms for the first time in six years.

Ever since the Healy-Callahan government imposed the 98-percent and 83-percent income-tax rates, revenues had gone down every year, year after year. The first year revenues started going up again was 1980, a year of depression in the British economy, but a year when income-tax rates went down. So the British experience, contrary to what many people say, does not disprove supply-side propositions—it fully vindicates them. The results of the increased tax rates were precisely as a supply sider would have anticipated. The result of the tax cuts were precisely what a supply sider would have predicted.

Still, it's regarded as a very grave portent for the US economy that our deficits seem to be going out of control—that deficit spending is somehow going to cause huge increases in interest rates, which in turn will strangle economic expansion. In order to understand why this will not happen, one has to understand the impact of the tax cuts; because in real terms, President Reagan has prevented a catastrophe—the vast expansion of taxes, which would have plunged the country into depression. The real tax cuts don't go into effect until 1983 and 1984. At that juncture, taxes really begin to come down.

We still have to appraise the meaning of the federal deficit. The first principle to understand about deficits is that what matters is not the share of the deficit as a portion of GNP—not the size of the deficit as a portion of total national output—but the size of the deficit in proportion to total national savings. The Carter administration was very effective in reducing the deficit as a portion of GNP. The deficit dropped from about 3.6 percent to about 1 percent of GNP. This was a major success in controlling the size of the deficit by this measure. Because Carter achieved this result by allowing taxes to rise, however, the consequence was that personal savings declined to the lowest level of the last 30 years. As a result of this attempt to lower the deficit through higher taxes, inflation doubled and interest rates doubled. In other words, this policy of allowing taxes to continue to rise year after year, which has been proposed as the answer to our current predicament, will increase interest rates and inflation rather than reduce them.

A lot of people who talk about the rising costs—of oil, of food, of real estate—that we experienced during the '70s often assume that these items, which dominated the consumer price index, were the major factors of that inflationary decade. But the fastest-rising cost in the US economy during the 1970s was not fuel or food or real estate. The fastest-rising cost was government taxes on every level—federal, state, and local.

We've had endless experience with the impact of higher taxes on inflation, federal deficits, and interest rates. The results are entirely negative, and that's why we have to move in the other direction—cutting tax rates in order to expand savings, which ultimately fund the deficit. If, while the deficit drops, savings drop more rapidly—as happened during the Carter administration—there is more inflationary pressure, that is, more pressure on the Fed to print money. The Reagan administration program is based on the proposition that when you reduce tax rates, savings increase; thus, the pressure on the Fed to print money declines, and the deficit, as a proportion of national savings—which is the crucial measure—steadily decreases.

The reason this proposition is true is that each marginal tax rate inhibits savings three ways. First, it taxes the very funds—marginal earnings—that an individual has the highest propensity to save. Each new dollar that you earn you are more likely to save than the previous dollar. Progressive taxes take away from the very dollars that you have the highest propensity to save. Second, high marginal tax rates deter people from earning the additional dollars they're most likely to save. And third, high marginal tax rates also tax the returns from savings at the highest possible levels. So, cutting marginal tax rates imparts a triple stimulus to savings but only a single stimulus to consumption.

After every major tax cut, whether in Japan, the United States, Germany, or Britain, savings always increase faster than the deficit. And, as a result of the cut in marginal tax rates, inflationary pressures that derive from the deficit steadily decline. This, of course, has been most striking in Japan, where they've cut taxes 18 out of the last 20 years, and every year savings increased. Every year, incidentally, tax revenues increased as well, and the savings rate rose from 17 to 24 percent during that period.

Perhaps the worst misconception of supply-side economics that I've recently encountered is the idea that it somehow widens the gap between the rich and the poor. There are endless examples of the utter fatuity of that claim, but perhaps the best example comes from the 1920s, when the top income-tax rate was reduced from 73 to 25 percent in four years. All established economists during that period—or a great many of the liberal economists who even then dominated our economic discourse—predicted that these tax rates would radically reduce the taxes of the rich and increase the burdens on the poor. On the contrary, the tax payments in the top bracket increased by nearly 200 percent. The share of total taxes paid by the rich rose from 27 to 63 percent, and the share of taxes paid by the poor plummeted.

How can this be the case? If you consider it closely, you'll understand. The poor and middle class usually pay their taxes at source—that is, their taxes are withheld from their paychecks—so with across-the-board tax cuts, the poor and middle class actually pay less. The rich, however, have mobile money, and nothing can mobilize it faster than contemplating a 70-percent tax rate. People don't rise to the 70-percent tax bracket by being dumb, and when they face this kind of confiscatory rate it greatly concentrates the mind. They have an incentive to devote about 70 percent of their time to figuring out how to avoid these punishing rates of taxation, and they succeed.

So, contrary to what nearly everybody imagines, high progressive tax rates do not redistribute income. What progressive tax rates do is redistribute taxpayers. They redistribute money out of productive, dynamic investments in the industries of the economy and into off-shore tax havens and tax shelters of every description, into the underground economy, into leisure activities, into the purchase of Rolls Royces and collectibles—they redistribute wealth from productive activity into relatively unproductive activity.

I myself got a further understanding of this process during the course of writing Wealth and Poverty, when I interviewed businessmen. I didn't interview economists, because I thought that they had done enough damage already. So, just as when I wrote a book on poverty I interviewed hundreds of poor people, when I wrote a book on wealth I interviewed rich people or people in business who had made major contributions to the economy.

I learned a lot about the future possibilities of the American economy. It was exciting, because I discovered that beyond the gloom of the 1970s was an exciting new economy emerging on our horizons. I was frustrated, however, because I wanted to invest in it, but I didn't have any money.

Wealth and Poverty surprised me beyond all expectations, however, and began earning me lots of money. I then wanted to invest in the future of the American system, but what did I discover? No sooner did I acquire some money than I was beset on every side by people urging me to eschew this productive knowledge I had acquired during the course of writing the book. Instead, they told me all about the Cayman Islands, 1031 real-estate swaps, triple net real-estate leases, butterfly straddles, and every kind of intricate mode of avoidance of the productive domains of the US economy. They told me to invest in porno films, race horses, and cattle. I actually did invest in cattle, and I sit in my house eating breakfast, watching my tax shelters bound around in the field across the way depreciating like mad. The crucial thing I learned is that this happens to everybody who earns money in the US economy. And this strikes at the very dynamic crux of capitalism.

Capitalism is not simply a matter of physical capital formation. The reason capitalism succeeds is that it joins knowledge with power. Every business is in essence an experiment—virtually a laboratory test of an entrepreneurial idea—and the outcome is not predetermined. It's an experiment the outcome of which will shape future investment, for each business experiment has a double yield. It has a financial profit, on which everybody focuses in considering the economy; but it also has an invisible profit of knowledge. Along with the accumulation of physical capital, there is an expansion of metaphysical capital, and it's the fusion of these two forms of capital that is the dynamic synthesis of economic growth.

High tax rates stultify wealth, because their effect is to divorce knowledge from power, to divert physical capital in unproductive directions, and thus to bring to a halt the dynamic processes on which capitalism subsists. From this point of view, I think we can learn a lot from the experience of Japan, because the most important event since World War II is the triumph of capitalism in Asia.

When I was at Harvard, everybody told me that the future of Asia lay in Maoism. As a matter of fact, they said, the great experiment in Communist China would exert this magnetism on all countries on the periphery of the Mainland. The overseas Chinese in Hong Kong, Taiwan, and Singapore would look to Maoist China for inspiration for the future of their economies. Even Japan, they declared, would increasingly succumb to the allure of communist ideas.

The most important phenomenon of the recent era is that all the magnetism comes from the other direction. Rather than the massive land mass of China exerting magnetism on the little barren regions of Hong Kong, Taiwan, and Singapore, the metaphysical capital accumulated through capitalism in these areas is exerting a magnetism on Communist China. The Communist leaders now confess the failure of their system and are consulting with the overseas Chinese and the Japanese to learn how to import capitalist techniques onto the Mainland. This is a crucial fact to understand: capitalism triumphed in those very countries that had the least natural resources, the least promise on the surface for dynamic growth.

Reading the media these days, however, you might suppose that Japan is some sort of socialist country. This is one of the most absurd ideas that I've encountered anywhere. Japan's success is largely attributable to having twice as many small businesses per capita as the United States and much more dynamic competition than the United States. In turn, these developments are largely attributable to Japan's having the lowest marginal tax rates on personal income of any country in the industrialized world. The Japanese have a very high top tax rate of 70 percent, which was imposed by General MacArthur and the American advisors after World War II. But that rate only applies to incomes over $396,000. Essentially, the Japanese have the lowest tax rates of any major industrial country.

It's often said that MITI—the Ministry of Trade and Industry in Japan—which is supposedly a great force of government planning, is the key to the Japanese economy. To get an idea of the role of MITI, it's worth understanding that during the 1960s the main recommendation of Japan's planners was that the Japanese get out of the auto industry. They proposed that Nissan Motors and Toyota combine into one company and that capital slowly be diverted from automobiles into other parts of the economy. Above all, they said that companies in other industries—motorcycle companies like Honda and Suzuki, and machine tool companies like Toyo Kogo, which made the Mazda—had no role in the Japanese auto industry and should not be permitted to enter it.

The Japanese economy, however, was an open capitalist system, and as a result the Japanese auto companies told MITI to jump in the Asian Ocean, and they proceeded to create such a dynamic auto industry so intensely competitive in Japan's domestic market that it has overflowed to conquer the world. This is a triumph of capitalism and entrepreneurship—the triumph of the spirit of enterprise over the limits of physical capital—and it is on this type of success that the future of the American economy most depends.

During this period the Japanese invested less in real estate, less in energy, less in physical commodities, than virtually any other major country. What they essentially invested in was new ideas. In the United States, as entrepreneurs are unleashed, we can expect that the highest possibilities will derive from the emancipation of metaphysical capital, the capital of ideas rather than the capital of physical resources.

This is an age when the sand from which the silicon chip is manufactured will be a more important natural resource than iron or gold. This is an age when mind will triumph over matter, and the place to go with your investments is to the frontiers of American technology, the frontiers of mind and spirit, rather than the commodities and condominia and collectibles, which have dominated our horizons in the last decade.

George Gilder, author of Wealth and Poverty, is program director of the Manhattan Institute and chairman of the Economic Round Table at the Lehrman Institute. This article is adapted from a speech presented at the 1981 conference of the National Committee for Monetary Reform in New Orleans.