Economics: The Supply-Siders Were Right (Partly)

In the late 1970s, Arthur Laffer, Jude Wanniski, and other "supply-siders" claimed that a cut in marginal tax rates could increase tax revenues. At the time, other economists agreed that this is theoretically possible. After all, someone who saw his top marginal tax rate fall from 60 or 70 percent to, say, 50 percent, would have a greater incentive to earn income and realize capital gains and less incentive to take deductions, shelter income, and evade taxes. Each of these factors would expand the tax base. But few economists other than the supply-siders believed that the tax base would expand enough to offset the decline in rates. I was one of the skeptics. We were (partly) wrong.

Surprisingly, evidence supporting this view comes from that Ivy League bastion of mainstream economics, Harvard University. In a recent article in the Journal of Public Economics, Harvard's Lawrence B. Lindsey shows that cutting the top rate from 70 percent in 1980 to 50 percent in 1982 actually increased tax revenues from high-income taxpayers.

In 1984, for example, the latest year for which Lindsey had data, taxpayers with incomes of $200,000 a year or more paid $42.1 billion in taxes. This was $8 billion more than they would have paid under the old tax law. In 1985, according to some unpublished data provided to me by Lindsey, they paid $49.5 billion—$9.6 billion more than they would have paid. Bottom line: to soak the rich, cut their tax rates!

How could Lindsey tell what tax revenues would have been? Using detailed data on 25,000 taxpayers in 1979, he developed a model to do just that. He adjusted for the recession of 1981–82 and the recovery and expansion of 1983–85. He tested his model by seeing how well it predicted revenues for 1980, the year before the first installment of the tax cut. The fit was very close.

Why were the supply-siders only partly right? Because the more extreme of them spoke as if total revenues, not just revenues from the rich, would increase (although I confess that I have not been able to find this claim in anything written by Laffer or Wanniski). As Lindsey shows, that did not happen. Not even close. Had there been no tax cut, revenues for 1984 would have been $385.6 billion. Their actual level: $304.0 billion.

This failure of the most extreme supply-side prediction is not surprising. First, cuts in the marginal tax rates of lower and middle-income taxpayers were small—for a median-income family the marginal rate dropped from 32 percent to 25 percent. Which means the after-tax reward for earning income rose from 68 cents on the dollar to 75 cents, an increase of only 10 percent. Compare that to a high income taxpayer whose after-tax return goes from 30 cents on the dollar to 50 cents, a whopping 67 percent!

Second, the non-rich have less room to maneuver than the rich. As Lindsey points out, when rich taxpayers' rates drop, they can realize more capital gains. Also, the self-employed rich and even high-income employees can typically alter their compensation packages away from perks and toward money.

Based on his data, Lindsey estimates that a top tax rate of about 35 percent would maximize federal tax revenues. Since the period of time he studied, President Reagan and Congress cut the top rate further, from 50 percent down to 28 percent (or 33 for a few taxpayers with the alternative minimum tax). So the top rate is now close to the revenue-maximizing rate.

The implication of this finding for future tax and budget policy is enormous and crucial. Even if we wanted to increase taxes on the rich (I don't want to, and not just because I plan to be one of them some day), we can't. Raising the top tax rate further would yield at most a few billion dollars and could even cause revenues to fall.

What about raising tax rates on capital gains? As Lindsey shows in a recent paper, the revenue maximizing rate on capital gains is 15–20 percent. Since the top rate on capital gains is now 28 percent, the only way to raise more revenues here is to cut this rate.

Follow the logic further. Because the non-rich don't have much room to maneuver when tax rates change, the only surefire way to raise more revenues from income taxes is to increase taxes on the non-rich. And that would be wrong, as someone in the White House once said. It would also be political suicide, as Mr. Mondale learned. The last year during peacetime that tax rates were raised explicitly (rather than through bracket creep caused by inflation) was 1940!

We could raise corporate taxes, but Stanford tax economist John Shoven argues that the poor (as well as the rich) bear a disproportionate burden of that tax: many of the poor are old people who depend on income from their investments.

A consumption tax? To be a sure money-raiser, it would have to hit the non-rich, or it would cause some of the same disincentive effects as the income tax.

Bottom line: we're stuck.

"What you mean, we, kemo sabe?"

"You're right, Tonto." They—the ones who want to tax us more—are stuck. They can't raise taxes without hurting poor and middle-income taxpayers. Period. They'd better figure out how to cut spending.

David R. Henderson writes frequently for Fortune.