Marginal Success

The Growth Experiment, by Lawrence Lindsey, New York: Basic Books, 260 pages, $21.95

First, The Growth Experiment is a great book. It is persuasive about important issues in tax policy. Second, I am biased. I worked with its author, Lawrence Lindsey—now on leave from Harvard for a stint at the White House Office of Policy Development—when he was the tax economist on President Reagan's Council of Economic Advisers and I was senior economist for health and energy.

I found Larry to be a man of great integrity. One piece of evidence: As the CEA person assigned to make sure that Reagan's speeches contained no errors of economic fact, Larry was a tough taskmaster. I remember hearing bits of arguments on the phone between him and Reagan speechwriters who wanted to give Reagan credit for every good development in the U.S. economy after January 20, 1981. Larry also has two traits that are rarely combined in an economist: He weighs evidence carefully, and he doesn't lose the big picture. All these characteristics are on display in his book.

Lindsey begins by detailing what many of us have forgotten or never knew: just how badly the U.S. economy was doing during Carter's administration. He points out that between 1979 and 1981, real wages of American workers had plunged by 9 percent to their 1962 level, wiping out nearly two decades of growth. This reduction in wages, combined with much higher tax burdens, left Americans worse off than their counterparts in 1962. Lindsey reminds us that economists and political leaders were arguing at the time that we were doomed to declining standards of living because we were in an "era of limits."

A major reason for this economic mess, argues Lindsey, was tax-bracket creep. High inflation, combined with a progressive income-tax system that wasn't indexed, threw even middle-income taxpayers into the tax brackets of 40 percent and more that used to be reserved only for the rich. Middle-income taxpayers were responding rationally—by not working as much overtime, by consuming instead of saving, by taking wage increases in untaxed fringe benefits, and by seeking tax shelters. Nor did standard Keynesian policy have an answer. Keynesians saw taxes only as a tool to raise or lower aggregate demand and not as something that affected supply.

Enter the supply-siders, whose numbers did not include Lindsey at the time. By cutting marginal tax rates, the supply-siders argued, the government could increase the incentive to work, to save, and to invest, and could decrease the incentive to avoid taxes with wasteful deductions and tax shelters. The supply-siders started pushing for a tax cut in 1977, and by the time Ronald Reagan won the 1980 presidential nomination, they had recruited him to their cause. Reagan made the tax cut the economic centerpiece of his campaign.

In his book, Lindsey focuses on how much revenue the government actually lost by cutting tax rates. Why such an apparently narrow focus? Because, Lindsey explains, the revenue effects are a good measure of how much high tax rates were hurting the economy. If Reagan's 23-percent cut in tax rates caused a revenue loss of 23 percent, this would mean that cutting tax rates did not expand the tax base at all and therefore that high tax rates were not shrinking the tax base and were not hurting production. But if Reagan's 23-percent tax cut caused a revenue loss substantially less than 23 percent, this would mean that high tax rates were hurting the economy a lot.

Lindsey reports that the government's static loss in revenue—the loss assuming that the tax cuts had no effect on people's behavior—would have been $115 billion in 1985. But Lindsey calculates a demand-side effect of $40 billion in 1985 that even Keynesians would admit. Then, using estimates of the response in labor supply to reductions in tax rates, Lindsey estimates that tax revenue from the added labor supply—the so-called supply-side effect—was $21 billion by 1985. Finally, he estimates that simply reshuffling assets in response to lower tax rates—shifting from tax-exempt to taxable bonds, for example—caused taxpayers to pay more in taxes. He estimates this "pecuniary effect" at $21 billion by 1985.

Thus, the net result of the 1981 tax cut by 1985 was a loss not of $115 billion but of only $33 billion. Whereas $40 billion of the revenue resulting from the cut was due to the standard Keynesian demand-side effect, $42 billion was due to factors the supply-siders had focused on and that Keynesians had assumed to be zero. And in return for that $33-billion loss in federal tax revenue, Lindsey writes, real output of the economy was 2 percent to 3 percent higher. Not a bad deal.

The cut in rates was greatest for the taxpayers in the highest bracket, whose top rate was cut immediately from 70 percent to 50 percent. Lindsey shows convincingly that the tax cut caused taxpayers with annual incomes of more than $200,000 to increase their incomes and to pay more taxes.

Does this increase in taxable income mean that the rich got a lot richer? Not necessarily. Rather, Lindsey writes, the lower marginal rates simply caused them to change their behavior so as to expose more of their income to taxation. Lindsey makes a persuasive case that the revenue-maximizing tax rate is probably below 40 percent and that the optimal tax rate is well below 40 percent. Indeed, Lindsey goes further, arguing for a flat tax rate of 19 percent combined with a large standard deduction to shield lower-income people.

Lindsey buttresses his case that high marginal tax rates distort the economy by tracking the effects of the income tax since it began in 1913. He shows that whenever tax rates on high-income people rose, their taxable income fell and so did the share of tax revenue they paid. Conversely, after tax rates on high-income people fell—with the cuts instigated by Coolidge's treasury secretary, Andrew Mellon, for example—their taxable income and their share of tax revenue rose. Though these facts have been known at least since supply-sider Jude Wanniski reported them in his path-breaking 1978 book, The Way the World Works, Lindsey reports and interprets them more carefully.

While Exhibit A for Lindsey's supply-side case is the Reagan tax cuts, Exhibit B is President Kennedy's similar cuts. Lindsey shows that demand-side factors account for only one-quarter of the added growth caused by Kennedy's tax cut. As evidence that the other three-quarters was due to the tax-rate cuts, Lindsey notes that most of the growth in the tax base occurred among high-income taxpayers who had previously faced marginal tax rates as high as 91 percent and who now faced a top rate of 70 percent.

Each chapter is filled with nuggets of economic wisdom. Lindsey shows that the federal deficit is due almost entirely to increases in spending rather than to tax cuts, that simply keeping inflation-adjusted government spending constant would eliminate the deficit by 1994, and that the standard measure of American savings drastically understates true savings. Lindsey also documents our current tax code's strong bias against saving and proposes a plan for removing this tax bias.

One of the best chapters is the one titled "Helping Hands," in which Lindsey argues that private charities are much more effective than government subsidies: They target those who need help most, they must be successful to keep donors and volunteers, and they avoid huge bureaucracies. He describes the experience of the Brookings Institution's John Chubb, an education researcher who called the New York City Board of Education to find out how many bureaucrats worked in its central offices. Chubb made about six calls before finding someone who knew. But this person was not allowed to tell him. After at least six more calls, he found someone who could tell him. The answer: 6,000. Chubb then called the Archdiocese of New York to find out how many people worked in the central office of their school system, which serves about one-fifth as many pupils as the New York public schools. The first person he reached said she didn't know. Chubb expected the same runaround. Then she said, "Wait a minute. Let me count." The answer: 26.

Lindsey advocates expanding the charitable deduction in the personal income-tax system to give people a greater incentive to contribute to charities. Lindsey's own story of his meetings with congressional aides to discuss his proposal is very revealing. These aides, he reports, do not dispute economists' findings that a 1-percent reduction in the after-tax cost of charitable giving yields an additional 1.2 percent to 1.3 percent in donations. Instead they object to letting individuals decide which charities should receive the money! This, to them, is "undemocratic." Lindsey's understated commentary: "Their faith in the omniscience of the state inflicts a high price on the country's needy."

My generally strong enthusiasm for The Growth Experiment is tempered by one main criticism. When he uses ideas or evidence from articles by Harvard colleagues or by fellow researchers associated with the National Bureau of Economic Research in Cambridge, Lindsey refers to them by name and gives the articles' titles, publication dates, etc. But when he talks about the supply-siders, he rarely refers to a person, let alone an article, by name, except to criticize. Lindsey cites Wanniski's book, for example, only to criticize (correctly) Wanniski's equation of the revenue-maximizing tax rate with the optimal tax rate.

In discussing the revenue effect of the Kennedy tax cut, Lindsey never refers to some similar work done on the subject by James Gwartney of Florida State University and Richard Stroup of Montana State. And nowhere does Lindsey even mention Paul Craig Roberts. Without Roberts's work as a congressional aide in the late 1970s on the Kemp-Roth tax cut and as a point man in Reagan's Treasury Department in 1981, the 1981 tax cut might never have happened.

But this asymmetry in the credit that Lindsey gives to others is a relatively small negative in a sea of positives. If you buy one book this year about the effects of taxation, The Growth Experiment is the one to buy.

Contributing Editor David R. Henderson is an associate professor of economics at the Naval Postgraduate School in Monterey, California, and a senior fellow with the National Center for Policy Analysis.