David R. Henderson  

Mike Lee's Anti-Supply-Side Tax Cut

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Arguably, one of the biggest accomplishments of supply-side economist Art Laffer in the late 1970s and early 1980s was to get mainstream economists to take marginal tax rates seriously. We all knew that the deadweight loss from a tax is proportional to the square of the tax rate so that, say, doubling the tax rate quadruples the deadweight loss. But, for some reason, economists talked very little about this. And this was during an era when the top federal marginal tax rate on income in the United States was a whopping 70 percent and the top federal marginal tax rate on "earned" income was 50 percent.

But, in part due to Laffer, mainstream economists like Jerry Hausman of MIT started looking at the potentially large negative effects of high marginal tax rates on labor supply, especially the labor supply of married women.

Laffer's other big accomplishment was to get politicians, especially Republican politicians, to recognize the damage to incentives and, therefore, to real output, done by high marginal tax rates.

Many Republicans got sloppy though, advocating almost any kind of tax cut and often using supply-side rhetoric to justify such cuts.

Unfortunately, U.S. Senator Mike Lee from Utah now advocates a tax cut with a strong "anti-supply-side" component. According to Matthew Continetti of the Weekly Standard, Lee's "tax plan would simplify and reduce rates and offer a $2,500 per-child credit (up from $1,000 today) that would offset both income and payroll taxes." The "simplify and reduce rates" part, assuming I understand it correctly, is great. The problem is the $2,500 per child tax credit.

Why? This gets us to one of the points Laffer emphasized. Any cut in tax rates has two effects that offset: an income effect and a substitution effect. When tax rates are cut, people's real incomes net of tax are higher and they use some of that higher real income to "purchase" leisure. That is, they work less. That's the income effect.

But the cut in marginal tax rates also increases the "price" of leisure. Every hour you don't work, you're giving up more real income because your net-of-tax income per hour has increased. So you're inclined to work more. This effect is called the substitution effect.

Laffer argued that the substitution effect, especially for higher-income workers in high tax brackets, outweighed the income effect and so the net effect of a cut in marginal tax rates at the high end would be more work and more output.

But what happens if the government doesn't cut marginal tax rates and, instead, simply increases tax credits? Then there's no substitution effect towards more work and more output. People's net-of-tax real income increases and, therefore, they "buy" more leisure. That is, they work less and the economy's real output is less. All the distortions from those high marginal tax rates remain.

According to Continetti, Lee proposes lowering tax rates also. But for a given loss in revenue to the federal government or for a revenue-neutral tax cut, rates could be cut even more without that increase in tax credits. So, relative to a straight cut in marginal tax rates that yield the same revenue as Lee proposes, his tax cut would make the economy smaller.

Art Laffer, call your office.


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CATEGORIES: Taxation



COMMENTS (13 to date)
Evan writes:
But what happens if the government doesn't cut marginal tax rates and, instead, simply increases tax credits? Then there's no substitution effect towards more work and more output. People's net-of-tax real income increases and, therefore, they "buy" more leisure. That is, they work less and the economy's real output is less. All the distortions from those high marginal tax rates remain.

All those people who think we're spending too much money on stupid stuff could have a field day with this. They could advocate more tax credits to get people to quit working to make money and buy stuff and take time off instead. From their paternalistic point of view there'd be no downside, since the portions of the economy that would shrink would be making stuff we "don't really need" anyway.

Of course, I don't know how realistic the above scenario is, since most of those people are on the left, and supply-side economics are generally regarded as being "right wing."

Andrew_FL writes:

Excellent points. But I wonder if the problem here is less a lack of understanding and more politics. Republicans are very weary of being accused of only doing anything for "the rich." Which unfortunately means they are very prone to flailing around looking for something they can offer voters that sounds like a conservative idea.

There has also been a great deal of rhetorical success in equating any cut in tax rates as being exactly the same as an increase in spending in terms of the deficit issue.

All in all I fear sensible policy has suffer a generational setback, at least.

8 writes:

This is a supply-side tax cut. It is designed to increase the supply of babies.

BCar writes:

Why would the substitution effect outweigh the income effect for high income earners in high tax brackets?

Chris writes:
We all knew that the deadweight loss from a tax is proportional to the square of the tax rate

This assumes the relevant supply and demand curves are linear in the region of interest. High tax rates will see third order, fourth order effects etc. Doubling the marginal tax rate from 50% to 100% would cause much more than 4x the deadweight loss.

Do you know of any empirical research on these higher order deadweight loss effects?

ThomasH writes:

To offset the payroll and income tax why not a higher EITC?

OTOH, I did not know that we were worried about the deadweight loss from payroll and income taxes on low income workers. I'm pretty skeptical that low income workers want to buy a lot more leisure and would do so if their incomes increased a bit.

Trevor H writes:

Though I realize the point of the article was to discuss the tax proposal from an economics perspective, the political side is where all the action is.

Mike Lee, senator from UTAH, the Utah with the biggest average family size in the country? The purpose of this tax proposal is for Lee to reduce the proportion of the overall US tax burden that his constituents face. Any effects on deadweight loss and overall economic output are purely incidental.

Marla Hughes writes:
I'm pretty skeptical that low income workers want to buy a lot more leisure and would do so if their incomes increased a bit.

As a former recipient of EOIC and knowing family members/friends who still receive it, I have to strongly disagree. The majority of EOIC payments that I'm familiar with are spent on larger/more technologically advanced televisions, game consoles, smart phones, and other items not normally associated with lower incomes and not necessary to the survival of their recipients.
When we received EOIC, we did try to make sure it was 'invested' in a newer car each year, however on the years where the car was running fine and satisfactory, that EOIC windfall was gone in a few months while we enjoyed our new toys.

Daniel Marsh writes:

Let me understand this: the way to achieve economic liberty is to make sure that the married-with-children working classes are so perpetually near abject poverty that they'll scrounge for any extra hours of work they can pick up... because parents raising kids will just "waste" their "leisure" hours? Meanwhile, tax cuts should only go to the wealthy because inflated prices on luxury brands, and an endless series of economy-destroying bubbles are good for the economy. After all, don't we all realize that actually having the time to parent your kid benefits absolutely no-one economically?

As a lifelong Republican who is infuriated by the constant sell-out of our leaders in Washington, let me just say that I am absolutely positive that it is hate-filled nonsense like this which explains why voters are just out for the rich: because GOP-e types fail to repudiate it in the strongest terms. And yes, to say that the working class will waste extra money, but that the rich class will not is the most outrageous, hate-filled propaganda I have ever read published in a heretofore "respectable" American publication.

David R. Henderson writes:

@Daniel Marsh,

I don't think you do understand. Also, I don't think you have much sense of what abject poverty is. Also, in no place did I say that when people take more leisure, they are wasting it. I have no idea how you got that idea from my post.

Moreover, I did not say that tax cuts should go just to the wealthy. I said that cuts in the highest brackets cause the greatest supply-side effects. I actually advocate cutting all marginal tax rates. That means that everyone who pays social security, Medicare, and federal income taxes would get a tax cut.

Finally, in calling the standard economic analysis of the effects of tax cuts "hate-filled," you're claiming that virtually every economist who has ever studied the economics of taxation is a hater. Maybe that doesn't bother you; maybe you believe that. But you should be aware of what you're saying.

Joe writes:

One piece that's not considered at all in the impact-to-the-economy question is where the next generation of productive workers will come from.

As a former at-home dad and economics minor whose wife is now homeschooling, I would argue that considering these activities as "leisure" in the face of "productivity" is false. Economically, parenting is a lasting private capital investment whose future returns are largely socialized. Our choice to invest tremendously from our private resources into our four children yields incredible future economic returns for the American economy and for the culture and values that it requires to flourish, just as a plant needs soil. They are becoming much more capable of selflessly investing in others than if my wife and I cranked up our economic productivity and largely delegated the emotional, moral, and rational parts of their raising to a crass, self-centered peer culture shaped by Miley Cyrus.

The problem with Mr. Henderson's article is that his scope of analysis is far too time-limited. New workers of the future, educated well, securely attached, and socialized to serve others, must somehow materialize out of thin air to make it work.

Alas, they do not. They are produced through sacrificial investments made by moms and dads which will tremendously benefit the future of America and its economy. Any fair free-market economic analysis of Senator Lee's proposal needs to at least come to grips with the core fact that investments in parenting are not a private consumption of leisure, but a private investment with a public return.

LD Bottorff writes:

Prof. Henderson, you are the economist with access to the research, so I guess I should take your word for it. But, I am skeptical. Most employed people have little control over how much they work. So, if they have a pay raise from a tax break, they either spend it, reduce their debt, or invest it. On the other hand, the wealthy frequently do have options regarding what to do with their wealth. They can invest their wealth in safer investments that do not pay much return or they can invest in more risky businesses that may not pay off, but also may generate a lot of return and economic growth. If marginal tax rates are higher, they have more incentive to invest in safer investments. When marginal tax rates were 70 percent, tax-free municipal bonds looked really good. I don't think those bonds generated much economic growth.

Pithlord writes:

Professor Henderson,

There is a tacit assumption in your post that government policy should maximize money income. That doesn't even seem like neoclassical welfare economics to me. But it isn't what Mike Lee wants to do. He wants to find a way to redistribute wealth to working people with kids while broadening the base of support for reducing the revenue take of the federal government.

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