My Time with Supply-Side Economics
Published on VDARE.com – January 07,
2003
(Published in The Independent Review, v. VII,
n. 3, Winter 2003, ISSN 1086-1653, Copyright © 2003,
pp. 393– 397.)
Supply-side economics is a major innovation in
economics. It says that fiscal policy works by changing
relative prices and shifting the aggregate supply curve,
not by raising or lowering disposable income and
shifting the aggregate demand curve. Supply-side
economics reconciled micro- and macroeconomics by making
relative-price analysis the basis for macroconclusions.
The argument is straightforward: relative prices govern
people`s decisions about how they allocate their income
between consumption and saving and how they allocate
their time between work and leisure.
The cost to the individual of allocating a dollar of
income to current consumption is the future income
stream given up by not saving and investing that dollar.
The present value of that income stream depends on
marginal tax rates. The higher the marginal tax rate,
the lower is the value of the income stream, and the
cheaper is the price of current consumption. Thus, high
marginal tax rates discourage investment and thereby
lower the rate of economic growth.
The cost to a person of allocating additional time to
leisure is the forgone current or future earnings. The
value of the forgone income depends on the rate at which
additional income is taxed. The higher the marginal tax
rate, the cheaper the price of leisure. Tax rates thus
affect the supplies of labor and entrepreneurship, the
investment rate, the growth rate, and the size of the
tax base.
Supply-side economics presented a fundamental
challenge to Keynesian demand management. Keynesian
multiplier rankings, which showed government spending to
be a more effective stimulus to the economy than
tax-rate reduction, had turned demand management into a
ramp for government spending programs. Powerful vested
interests organized in support of this policy. All
Republicans could do was to bemoan the deficits
necessary to maintain full employment.
Keynesian economists objected to the fiscal emphasis
on relative price effects. They claimed that people have
targeted levels of income and wealth regardless of the
cost of acquiring them. A tax cut would let them reach
their targeted levels of income and wealth sooner,
resulting in a reduction of work effort or labor supply.
Lester Thurow at MIT used this reasoning to argue that a
wealth tax is a costless way to raise revenue because
the income effect runs counter to and dominates the
substitution effect. A wealth tax would cause a rise in
labor supply as people worked harder to maintain their
desired after-tax wealth.
The claim that the elasticities of work and saving to
tax rates were zero or negative possibly could be true
for some individuals but not in the aggregate.
Keynesians did not realize that in making this argument,
they were aggregating a series of partial-equilibrium
analyses while ignoring the general-equilibrium effect.
If the aggregate response to a tax-rate reduction is
less effort, total production would fall, and people
would not be able to maintain their living standards. In
public-debate forums, I explained to Keynesian Nobel
laureates sent to squash the rebellion that their
argument that people would take their tax cut in the
form of increased leisure undercut their own
interpretation of expansionary fiscal policy just as
thoroughly as it undercut the supply-side interpretation
that was their target.
Supply-side economics came out of the policy process.
It was the answer to the “malaise” of the Carter years,
“stagflation,” and the worsening “Phillips curve”
trade-offs between inflation and unemployment.
Supply-side economists convinced policymakers, both
Democrat and Republican, that “stagflation” resulted
from a policy mix that pumped up demand with easy money
while restricting output with high tax rates. This
argument carried the day with policymakers before it did
with academic economists, who resented the diminution of
their policy influence and human capital.
I played a lead role in the economic policy change
(Roberts 1984), but Norman Ture and Robert Mundell were
the first supply-side theorists. Art Laffer recalls that
Mundell discussed the relative-price effects of fiscal
policy at the University of Chicago in the early 1970s,
when Laffer joined the economics faculty. Laffer also
recalls many conversations with Ture in Washington,
D.C., in 1967 and 1968 in which Ture, a Chicago Ph.D.,
described the relative-price effects of fiscal policy.
My conversations with Ture in 1975 solidified my own
thinking.
The interest-rate approach to the cost of capital
predates the income tax. Supply-side economics brought
the insight that marginal tax rates enter directly into
the cost of capital (Robbins, Robbins, and Roberts
1986). A reduction in marginal tax rates makes
profitable investment opportunities that previously
could not return a normal profit after meeting tax and
depreciation charges.
This perspective provided a more promising policy for
stimulating investment than the Keynesian idea of using
monetary policy to drive market interest rates below the
marginal return on plant and equipment. In a world of
global capital markets, central banks cannot alter the
real interest rate in financial markets independently of
the technological, tax, and risk factors that determine
the cost of capital. During the 1970s, such attempts in
the United States resulted in higher nominal interest
rates and a rise in inflation.
The conventional view, which stressed the interest
rate as the important factor in the cost of capital,
suffered from the misconception that higher government
revenues from increased taxation can spur capital
investment by lowering deficits and interest rates or by
creating budget surpluses and retiring debt. Because
taxation reduces investment and economic activity, the
only certain way to reduce “crowding out” is to cut
government expenditure.
Supply-side economics also added the insight that the
total resources claimed by government (tax revenues plus
borrowing) is an inadequate measure of the tax burden
because it ignores the production that is lost owing to
disincentives. In this perspective, a tax cut can be
real even if it is not matched dollar for dollar with a
spending cut. The relative-price effects will expand
economic activity, thus making the tax cut partially
self-financing even if people expect that taxes will be
raised in the future to pay off government debt incurred
by cutting tax rates.
As a policy, supply-side economics first won over
Republicans in the House. Jack Kemp was the leader.
Next, it won over important Democratic committee
chairmen in the Senate, such as Joint Economic Committee
chairman Lloyd Bentsen and Finance Committee chairman
Russell Long. For example, in 1979 and 1980 the annual
report of the Joint Economic Committee abandoned demand
management and called for the implementation of a
supply-side policy. By the time of Ronald Reagan`s
election as president, there was bipartisan support in
Congress for a supply-side change in the policy mix.
Inflation would be restrained with monetary policy, and
output would be expanded by lowering the after-tax cost
of labor and capital.
President Reagan`s
economic program was contained in a document called
A Program for Economic Recovery, published on
February 18, 1981. Contrary to many uninformed academic
economists` assertions, the administration did not base
its program on a “Laffer curve” forecast that the tax
cut would pay for itself. The administration decided not
to fight the battle for a dynamic revenue forecast and
used the standard static revenue forecasting still in
use today. Tables in the document show that the
administration assumed that every dollar of tax cut
would result in a dollar of lost revenue.
The tax cut was expected to slow the growth of
revenues. Receipts as a percentage of gross national
product (GNP) were expected to fall from 21.1 percent in
1981 to 19.6 percent in 1986. To avoid rising deficits,
the budget plan showed the necessity of slowing the
growth of spending below the contemporary policy
projections.
The “Reagan deficits” occurred because inflation fell
substantially below the budget assumptions, and
therefore real spending rose above projections (Roberts
1992, 2000). As the budget deficits resulted from the
unexpected rate at which inflation declined, the
deficits themselves could not be a source of inflation
and high interest rates. The economic establishment and
Wall Street mistook a result of unanticipated
disinflation as a potential cause of inflation.
Consequently, the inflation and high interest rates
predicted by many economists never materialized.
Reagan`s economic policy caused an increase in the
willingness to hold dollars. The decline in velocity,
together with tight monetary policy and a smaller tax
component in the cost of labor and capital, broke the
back of inflation more rapidly than forecasts,
constrained by concepts such as “core inflation,” had
predicted. The decline in the income velocity of money
during the 1980s is proof that the long recovery was not
a Keynesian demand phenomenon. A demand-led recovery
would have increased the income velocity of money.
Supply-side economics provides a different
explanation of the U.S. current and capital accounts
during the 1980s than the critique that blames the “twin
deficits” on an excessive Keynesian expansion. The 1981
business tax cut and the reductions in personal income
tax rates in mid-1982 and mid-1983 raised the after-tax
rate of return on real investment in the United States
relative to that in the rest of the world. Consequently,
instead of exporting capital, the United States retained
it. U.S. balance of payments statistics show that a
collapse in U.S. capital outflows accounts for the shift
of the net capital inflow from negative to positive
between 1982 and 1983. U.S. capital outflows declined
$71 billion. Foreign capital inflow fell by $9 billion.
During the 1982–84 period, when the story of foreign
money pouring into the United States to finance
overconsumption was fixed firmly in the world`s
conscious-ness, there was no significant change in the
inflow of foreign capital into the United States. U.S.
capital outflow, however, collapsed from $121 billion to
$24 billion, a decline of 80 percent. The money stayed
at home, and we financed our own deficit.
The collapse in U.S. capital outflow is clearly the
origin of the large trade deficit, which by definition
is a mirror image of the capital surplus. Not until
1986, with the dollar falling and U.S. interest rates
low, did the foreign capital inflow increase
significantly. The “twin deficits” theory was just
another Keynesian hoax.
Among politicians, Democrats moved early to identify
with supply-side economics. Republicans, however, were
divided. The Republican establishment had no stake in a
policy identified with outsiders such as Jack Kemp and
Ronald Reagan. With a view to the succession,
establishment Republicans portrayed Reagan`s policy as
extreme and in need of their moderate hand. Political
self-serving by the Republican establishment aided and
abetted the Keynesian misinterpretation of Reagan`s
supply-side policy.
References Robbins, A. E., G. A. Robbins, and
Paul Craig Roberts. 1986. The Relative Impact of
Taxation and Interest Rates on the Cost of Capital. In
Technology and Economic Policy, edited by Ralph
Landau and Dale Jorgenson, 281–316. Cambridge, Mass.
Harper and Row/Ballinger.
Roberts, Paul Craig. 1984.
The Supply-Side Revolution. Cambridge, Mass.:
Harvard University Press.
———. 1992. Supply-Side Economics. In
The New Palgrave Dictionary of Money and Finance,
615–18. London: MacMillan.
———. and Alan Reynolds 2000.
What Really Happened in 1981. The Independent
Review 5 (fall): 279–81.


