Arnold Kling  

Wesbury on Tax Cuts

Economic Attribution Error... The Poor Get Richer...

Brian Wesbury makes a supply-side case for tax cuts. One point he makes that I agree with is that when we think of the government "crowding out" the private sector, we should focus on spending rather than taxes:

Spending must be financed by either borrowing or taxation.

In other words, we can pay for government programs now, or pay for them later. In fact, if you invoke Ricardian equivalence, as Wesbury does, you are saying that the public believes that taxes will have to go up tomorrow to finance deficits that the government runs today. My instinct is that there would not be much long-term growth impact from a tax cut that you expect to be offset by a future tax increase.

I would argue that the "pay now or pay later" theory implies that the supply-side focus should be on spending cuts, because without spending cuts the government eventually has to raise more revenue. But my point of view tends to differ from typical supply-side analysis.

In fact, the case for tax cuts always seems to me to boil down to saying that with less revenue coming in, the government will spend less. Maybe that is true, but I find myself instead wanting to make the direct argument against government spending.

For Discussion. To me, supply-side economists often appear to make an argument that it is fine to cut taxes without cutting government spending. Is that a fair characterization of supply-side economics? Do you agree with it?

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CATEGORIES: Supply-side Economics

COMMENTS (7 to date)
Eric Krieg writes:

I don't believe the Ricardian analysis is valid, based on personal experience.

I recently refinanced. I went from a 30 year mortgage with a decent rate to a 5 year balloon with a rock bottom rate.

Some would think that I'm crazy, or just shortsighted and greedy. Rates are the lowerst they have ever been, and likely to rise in the future. Why not lock in a low 30 year rate?

I know full well that in 5 years I am going to refinance at a much higher rate. But that's okay. I need the money now. In five years, I will be in a totally different situation. I'll be paid more. I'll be much richer. My home will be worth more. A portion of the money I am saving is going to the stock market, and more than likely my investments will be higher in 5 years.

I don't think the tax cuts are much different. If the bill comes due in the future, we will be that much richer then, and it will be that much easier to pay. We need the money now to grow the economy, grow the stock market, and create jobs.

Keep in mind something else. One thing I noticed from the links on the economic attributin error thread is that the budget defecit fell throughout the '80s. Only the recession of '90 and '91 caused the increases in the defecit. A similar pehenomenon was going on in the '90s, with the defecit dropping in the boom years, growing during the recession, which we are still in.

The economy has more to do with the defecit than tax rates do. But tax rates can be tweaked to grow the economy faster. That is the whole point of supply side economics.

BTW, after refinancing to the 5 year, rates dropped again, and I refinanced again. That was about 3 months ago, and rates have dropped again! Maybe I will refinance once more.

The future is uncertain. Sometimes you just have to improve your life now and not worry about the future.

Tim Swanson writes:

I think James Ostrowski makes some great points regarding this topic:

Additionally, I discuss them here (note, not the most academic, feel free to critique them):

Garry writes:

I have more questions then answers:

Is Say's Law still a valid priniciple...?

Isn't supply side economics bascially a micro version of -Says Law- applied to macro economics.

What role did the monetary reforms of the early 1980's have upon tax cuts-ecnomic and poltical..?

The monetary reforms reduced economic growth and started the economy again in this period. Are we over estimating tax cuts over the impact of monetary polciy.

The did the actual success of monetary policiy begin the process of spending again behind the revenues of tax cuts.

Seems to me that today with more stable monetary policy tax cuts might have a different effect then in the 80's.

The problem is spending how are we ever going to get politicians to slow spending...?

Maybe many are right in that supply side today would force politcians to actual geez-forbid slow spending.

I geuss did the success of monetary polciy in reducing inflation grow the ecnomoy and overshadow tax cuts and concluding spenders started spending again...?

Chris Wilson writes:

Wesbury's article was a blessing. I have been working on persuading a number of friends who have recently taken an interest in politics and economics that they need to be wary of idealogues expressing approval or disapproval for Bush's tax plan. I've been enrouraging them to come to a philosophical position on economics and then analyze Bush's plan from that standpoint. This article is an excellent method for arriving at the only sensible conclusion - supply-side economics is the only way.

I must point out, however, that while the Clinton tax cut in 1997 no doubt played a role in the boom of the late 90's, it cannot be credited with the emergence of the Internet as a mass medium. And it was THAT technological advancement that caused the vast majority of the economic growth. Certainly, the conditions with lower tax rates were right for a boom. But the driver was a technological advancement. It was the promise of the Internet that created the focus on top-line revenues at the expense of sound business models. It was that misguided approach to investing that drove the economy to all-time highs. It is therefore misleading to cite the tax cut of 1997 as an example of a tax cut motivating behavior that resulted in an economic boom. This is misplaced causation. Even if the capital gains taxes had remained at 28%, the "limitless" possibilities associated with the reach of the Internet would have prompted most any entreprenuer to get in the game. The boom would have happened. That capital would have been there. The lower tax rate just means that things would have ended sooner - because the benefits would have had to be higher to justify the business risk.

I suppose it could be argued that no one would have pursued business models that relied upon the Internet if the capital gains taxes had stayed at 28%. But this neglects the fact that, relatively speaking, Internet businesses cost a fraction of what brick and mortar businesses cost. Therefore, the risk associated with implementing them is significantly less. No, the Internet would have happened regardless of Clinton's tax cut. And the boom would certainly have followed.

All in all, however, this article goes into my "must-have" file. Great work.

Brian Wesbury writes:

Let me address the above comments one at a time.

First - the idea of Ricardian Equivalence is only applicable in the case of rebates. Rebates generate no new supply-side economic activity and therefore are looked at as a one-time transfer that must be paid for at some point, unless they are offset with spending cuts.

Supply-side tax cuts, however, generate an increase in real economic activity. As a result, they are not viewed as zero-sum. I am not suggesting that all supply-side tax cuts will pay for themselves, just that the economy will operate more efficiently at lower tax rates than at higher tax rates.

Art Laffer made the point that there were always two tax rates associated with any given level of government revenue. For example, 70% marginal tax rates would discourage so much economic activity that 30% tax rates could actually result in the same tax revenue. At some points on the Laffer Curve, lower tax rates will increase revenue, but not at all points. Since we do not know where we are on the curve, no one should ever make the claim that tax cuts will pay for themselves.

Freidman says that cutting taxes is always good and that deficits are the only way to keep spending under control. I find myself in agreement.

Second – Eric has it right. Tax cuts will make the future better. Incomes will be higher and the economy will create more wealth. The only question is whether or not government keeps a lid on spending.

Third – Garry addresses monetary policy. My view is that monetary policy can always do harm, but never any good. In other words, when monetary policy is functioning correctly, the value of money is stable and the economy will grow at whatever rate technology, population, tax rates, and regulation allow it to grow.

When monetary policy is bad – either deflation or inflation – the economy suffers. In the 1970s, the Fed made a mess of monetary policy and created double digit inflation. Yes, the Fed fixed that problem, but, without the tax cuts, the economy would still be in the doldrums. Remember Stagflation? The Fed controls the “flation” part, while fiscal policy controls the “stag” part. The Reagan tax cuts cured the “stag” and Volcker cured the “flation.” In this case it took two to Tango.

Fourth – I want to thank Chris for his kind words. This is the way I see it Chris. The Reagan tax cuts were the real stimulus behind the boom in U.S. technology investment. Between 1980 and 1986, the top marginal tax rate was cut from 70% to 28% and the capital gains tax rate was reduced from almost 50% to 28%. This encouraged a huge increase in investment.

And while the economy would have experienced good growth in the late 1990s without it, the Republican-Congress-passed, Clinton-signed, capital gains tax cut (from 28% to 20%) added fuel to the fire.

Imagine what would have happened if Europe had pushed tax rates down to 28%, while the U.S. left them at the 1970s levels. The tech boom would have happened on the other side of the Atlantic.

Matt Young writes:

The only honest rule for taxes is that folks should pay only for the government services they receive. This rule ensures that government is no different than any other semi-monopoly provider in the economy, and the debate goes away.

With that model in mind, then the discussion becomes when should government deviate from the model. One trivial answer is when tax efficiency overides, like the Russian flat income tax, blurring slightly the distinction between government services individually received and payments rendered.

Supply side economics start with the assumption that this honest rule is greatly ignored, and the supply siders simply move toward the honest rule. In other words, they take a greatly broken system and fix it.

The other deviation is that government renders services not paid for. For example, consider two competing enterprises, SUN Micro systems and the Linux group. The former relies on extensive government services for domestic/international trademark and intellectual property protection, the later forgoes this protection; yet they pay the same taxes on income. Government provides many services to the rich, protection of trade routes, negotiation of free trade, (but not free labor rights}, much of the high level law enforcement, free contract settlements in courts, export sudsidies, as well as hundreds of billions in direct and indirect subsidies yearly.

The broad sword says that a higher tax on the filthy rich will cure them very quickly of their demand for these subsidies. In other words, if the supply siders make the rich pay for all their subsidies, then the rich will demand less government support, and less taxes result.

Mark Anderson writes:

Wesbury's latest demonstrates just how candid the supply-siders are about their indifference - make that tutelage - of government deficits.

Mr. Wesbury makes a number of errors.

"Myth #1—Deficits Drive Up Interest Rates"

I just love these carefully crafted statements, which have germs of truth. Depending on how deficits are financed, he is correct. If the government finances the deficit by selling bonds which end up in the hands of the FOMC, then deficits artificially suppress interest rates.

This happens for two reasons: 1)the government, in concert with the FOMC, is injecting more funds into the loan market. Naturally, the nominal rate of interest, i.e., price of loanable funds, will tend to drop. 2)The real rate of interest for current debtors drops, since they are able to extinguish their liabilities with a depreciated dollar.

However, many creditors - especially those granting long term credit - will account for a depreciating dollar. Consequently, interest rates will go up. Interest rates must inevitably go up, actually - lest we linger in economic calamity forever, by having circulating credit outstrip saving in perpetuity. In fact, I would suggest that the high interest rates in the 70s fueled the quasi economic growth during the 80s.

If the government finances the deficit through regular bank borrowing, that will cause interest rates to go up, since the government is actually tapping into bank reserves. However, I don't believe the government is likely to tap into bank reserves, since that would defeat their Keynesian/Monetarist/Supply-side (

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