The terms being applied—by the media, by politicians, by economists—to President Reagan’s economic program, and most particularly to the tax-cutting aspect of this program, are “bold,” “revolutionary,” “a risky experiment,” and so on. Clearly, a great many people are nervous about “supply-side” economics, and seem to have difficulty understanding its rationale. This is quite odd. For there is nothing really bold, or revolutionary, or experimental about this program. Nor is it at all difficult to understand.
Indeed, the trouble with the thing we call supply-side economics is that it is just too simple, too easy to understand. Accustomed as we are to the increasing complexity of the natural sciences, and the occult jargon of the social sciences, we are inclined to be suspicious of transparent simplicity, which we are likely to equate with naiveté or wishful thinking. The average person, listening to an exposition of supply-side economics, will nod his head at every point—but, after it is done, will remain incredulous: if it is that obvious, what is the fuss and controversy all about? The average economist, on the other hand, is only too likely to be indignant, outraged, and contemptuously dismissive: what is the point of his hard-won expertise in sophisticated economic theory if economic policy can be reduced to such plain terms?
It must be said that the term itself, “supply-side economics,” may be a source of initial confusion. It originates in deliberate contrast to the prevailing Keynesian approach, which emphasizes the need for government to manage and manipulate-through fiscal and monetary policies—aggregate demand so as to maintain full employment. Supply-side economists say government cannot really do this, no matter how many clever economists it hires, but that if business enterprise is permitted to function with a minimum of interference, it will invest and innovate, so as to create the requisite demand for the goods it produces.
There is certainly a difference in perspective here. Supply-side economists look at the economy from ground level, as it were—i.e., from the point of view of the entrepreneurs and investors who are identified as the prime movers. Keynesian economists look at the economy from above—from the standpoint of a government that is a deus ex machina, and which, in its omniscience, intervenes discreetly to preserve a harmonious economic universe. But it is wrong to infer that we live in a Manichean world in which Supply and Demand are continually at odds, so that we always are having to declare allegiance to one as against the other. They are, rather, opposite sides of the same coin, coexisting of necessity, and there can be no question of choosing between them.
More precisely, it is absurd economically to think in terms of such a choice. Beyond a certain point, a tax on production becomes a tax on consumption—the goods become too expensive and demand falls. Similarly, beyond a certain point a tax on consumption becomes a tax on production—the decrease in demand inhibits supply. Shifting taxes from the one to the other may provide marginal benefits on occasion. But a tax on commercial transactions and economic activity is always a tax on both production and consumption.
When, however, one moves from a purely analytical-economic mode of thought to a political-ideological one—when, in short, one moves from economic analysis to economic policy—then the difference in perspective has significant implications. Supply-side economics naturally gives rise to an emhasis on growth, not redistribution. It aims at improving everyone’s economic circumstances over time, but not necessarily in the same degree or in the same period of time. The aggregate demand created by economic activity, as seen from the supply-side, is indifferent to the issue of equality. Its bias is consequently in favor of a free market for economic activity, because this provides the most powerful economic incentives for investment, innovation, and growth. Those, on the other hand, for whom economic equality is at least as important as economic growth will always want to see government “restructure” this aggregate demand and will be indifferent to the issue of economic incentives.
However, there is another—incidental but important—source of controversy which has already been referred to, and that is the threat that supply-side economics represents to the economics profession as at present constituted. There can be little doubt that the nature of the controversy would be a lot clearer, and we would all be less befuddled, if it were not for the fact that so many distinguished economists are publicly accusing supply-side economics of being inconsistent with the principles of economic science as these are taught in graduate school and incarnated in, say, articles in the American Economic Review. To make matters worse, the accusation has a lot of truth in it, which is why so much of the writing in favor of supply-side economics originates outside the academic universe.
Thus one cannot understand the controversy over supply-side economics without paying some attention to the condition of the economics profession and to its vested interests, both intellectual and material. This condition is, at the moment, painfully ambiguous.
For more than three decades, we have all been looking to our best economists for guidance on economic policy. To that end we even established, after World War II, an extraordinary institution called the Council of Economic Advisers: three economists, with staff, who are supposed to provide the President and Congress with authoritative guidance on our economic problems, prospects, and policies. One must emphasize that word, “authoritative.” Those economists are not brought to Washington to offer their personal opinions, but rather to provide us with expert, scientific advice.
From what do their authority and expertise derive? They derive from the ambitious reconstruction of economic science after World War II in which the scheme of Keynesian macroeconomics was wedded to new, rigorous, analytical, largely mathematical techniques so as to provide, not a general, abstract model of the economic “system”—the 19th century gave us that—but a specific model of our economy at this particular time. Such a model consists of hundreds of complex correlations, spawned by econometric research, which relate one aspect of our national economic activity to another (or to many others), all fed into a computer which, having been properly programmed, can inform us as to where our economy has been coming from (to adopt a useful term from another part of the culture), where it is now, and whither it is drifting. It is this enterprise, which has come to be called “the neoclassical synthesis,” or “neo-Keynesian” economics, that has defined the nature of economic expertise, the acquisition of which is the dominant goal of graduate studies. And because a mastery of advanced mathematics has been so crucial to the enterprise, economists have secured the mantle of a true scientific elite—often incomprehensible, always indispensable.
It all went reasonably well for a couple of decades, though just what went reasonably well is itself one source of controversy. The neo-Keynesians will say that their sound analysis and good advice were at least partly responsible for our healthy economy from 1945 to 1970. Critics will argue that it was the existence of a healthy economy, created by businessmen and statesmen blissfully ignorant of sophisticated economic theories, that permitted economists to bask in a kind of reflected glory. (These critics point to the remarkable economic recoveries of Germany and Japan in a period when those nations had yet to learn of the neoclassical synthesis.)
But there can be no dispute over the fact that, beginning around 1970, it ceased going well and began to go badly. Not only were those annual forecasts too often very wide of the mark (especially with regard to inflation), but our economics establishment—for that is what it is, by now—could not explain the phenomonon of “stagflation,” a combination of inflation and lagging economic growth that neo-Keynesian theory regards as an impossibility. A note of desperation began to creep into the writings of the economists themselves. Professors of economics who had for years patiently explained to their students the folly (in peacetime) of wage and price and rent controls suddenly began to look upon them with a more sympathetic eye.
But for such a prescription one does not need economists. Ever since the beginnings of time, governments have been quite capable of thinking up such peremptory “solutions” to their economic problems all by themselves. The equivalent in politics is rule under martial law—no doubt necessary in extreme emergencies, but not a subject on which political theory or political philosophy has anything to say.
Simultaneously, and inevitably, a great many people began to take a hard and critical look at the presuppositions of neo-Keynesian economics—and, above all, at the model of the economy upon which it relies. That there are some anomalies in this model had always been conceded. Thus, since the wages of cleaning women are counted in the Gross National Product while the labor of housewives is not, one could easily achieve a huge increase in GNP—and presumably we would all be wealthier—if every housewife were to rent herself out to do her neighbor’s cleaning instead of doing her own cleaning herself. Similarly, there has always been a problem about “investment” by governments: the typical macroeconomics model is incapable of distinguishing among the building of roads, the building of warships, and the building of pyramids, all of which are counted simply as “expenditures,” though their economic status is obviously very disparate. And there are other difficulties with the model that many economists have been aware of, but which they also have thought could be regarded merely as a limitation of models per se, rather than a serious flaw in this particular model.
The new critique of the neo-Keynesian model, however, went far beyond such relatively familiar anomalies. Essentially it asserted that this kind of model, for all its complexity and sophistication—or one can even say because of its complexity and sophistication—reveals profound misconceptions about the nature of economic behavior, and especially about the kind of economic behavior that leads to economic growth.
It is important to realize that the conventional models are utterly blind to entrepreneurship and innovation (technological or otherwise). They can deal with quantifiable aggregates (like “investment”) but what cannot be quantified they ignore. Basically, theirs is a kind of Newtonian model of an economic system, with all the “forces” balancing each other out—except sometimes, when (for reasons still unclear) there is a mismatch between overall supply and overall demand, on which occasions the government, like some benign deity, pumps in the missing quantity of demand and restores the system to equilibrium. All specifically human motivations, intentions, aspirations are ignored. It is the results of past human behavior that the model blandly reflects, and always after the fact. In a sense, the revolt against neo-Keynesian economics is part of a larger revulsion, visible in other social sciences as well, against behaviorism as an adequate guide to human reality.
Economists attuned to the theories incarnated in such models cannot explain the “whys” of economic phenomena. They cannot, for instance, explain why economies grow, and why some economies grow faster than others. They try to come up with such an explanation, of course. By now the literature on “growth theory”—much of it mathematical and arcane—fills a good-sized library. But as our current textbooks on economic growth will admit, after hundreds of pages in which the various theories of diverse economists are adumbrated, there is nothing near a consensus about this issue.
Is that surprising? Only if we forget that economics is still a “social” science—the most methodologically rigorous of them all, to be sure, but still a social science—and not a “natural” science like physics or chemistry. We are hardly astonished, after all, if our political scientists fail to come up with a rigorous theory of political change, or if our sociologists fail to come up with a rigorous theory of social change, one which informs us precisely and authoritatively as to where our polity and society have been, where they are, where they are going. That is because we understand intuitively that any such theory, dealing with human beings, would require a degree of self-knowledge—of our present characters and personalities, from which we could make strong inferences as to our future motivations and actions—which is, by the nature of things, unavailable. (If we had any such complete self-knowledge we would be God—the Being in Whom thought and existence are one.) But economics, in striving to become an objective and positive science like physics, has promised us exactly this kind of self-knowledge, at least insofar as we are economic men and women. It has not been able to deliver on such a grandiose promise—has, in truth, reached a dead end in its efforts to do so.
In all fairness, one must say that not all economists have been coopted into this ambitious intellectual enterprise. The “neo-Austrians,” headed by Friedrich Hayek, have always been very skeptical of the utility of such mathematical models, and of the ability of economic analysis to provide the kind of exact, quantitative answers—how much? how long? when?—that politicians naturally yearn for (and the media always assume to be available). The neo-Marxists, too, more interested in the dynamics of economic change than in the static calibrations of economic phenomena at any one point in time, have made trenchant criticisms of the prevailing mode of economic theorizing. But the economics profession as a whole remains committed to the neoclassical or neo-Keynesian synthesis, and practically every course in macroeconomics introduces the student to it.
Supply-Side Economics may be viewed as a kind of “humanistic” rebellion against the mathematical-mechanical type of economic analysis in which economic aggregates, themselves dubious in nature, are related to one another so as to achieve a supposedly accurate series of snapshots of the economic universe we inhabit—something comparable to the universe we perceive when we go to a planetarium. Supply-side economics is uninterested in such a beautifully architected equilibrium because it believes this is the wrong paradigm for understanding an economy that consists of the purposive yet inconstant behavior of millions of individuals. Purposive, because economic behavior generally has as its goal the improvement of one’s economic conditions. Inconstant, because only the individual himself can define “improvement” for us, and his behavior will be profoundly influenced by all sorts of contingent factors—religious heritage, family relations, and, not least, the actions of government.
So far from being new or revolutionary, supply-side economics is frankly reactionary. “Back to Adam Smith” can be fairly designated as its motto. Not, however, in the sense of returning to some purist version of laisser-faire—all supply-siders agree (as would have Adam Smith, author of The Theory of Moral Sentiments) that, when a society is sufficiently affluent to provide a safety net for those unable to participate fully in the economy, we all have a moral obligation to see that such provision is made. “Back to Adam Smith” has to be understood, rather, as “Back to The Wealth of Nations” as the paradigm for economic reasoning—a book that makes sense to any literate person with some worldly experience (as distinct from book-learning which often inclines the reader toward otherworldliness). It may sound incredible, but supply-side economics really does believe that, if you want an economic education, The Wealth of Nations is still the best book to read. Indeed, the publicists of supply-side economics—Jude Wanniski in The Way the World Works and George Gilder in Wealth and Poverty—will readily allow that their books are but elaborations on themes by Adam Smith.
Nothing conveys more clearly the radically different perspectives on economic activity of supply-side and neo-Keynesian theory than the issue of incentives. It is an issue about which much confusion exists, and the confusion arises because contemporary economists are uneducated in the world of business, i.e., in the world of real economic activity. They are trained instead in the world of economic analysis, which stands in relation to business as academic political science stands in relation to politics. It is a distant relation, which easily warps one’s perspective.
Political scientists know that it is ambition which energizes the political system, but in their models—and yes, they have them—ambition is simply taken for granted, as a constant in magnitude and quality. Similarly, all economists know that incentives energize the economic system, but in their models they take incentives for granted, as a constant in magnitude and quality. In both cases, the reason is the same: since political ambition and economic incentives are essentially subjective and non-measurable essences, there is no place for them in an objective, quantified model.
Supply-side economics takes incentives—the innate human impulse to better one’s condition, as Adam Smith would put it—as the fons et origo of economic activity and, most important, of economic growth. We do indeed know of primitive cultures where that impulse is either weak or missing—and where economic growth is, as a consequence, also weak or missing. We know, too, of historical societies where the impulse has been frustrated by religious or political authorities—and where economic growth has been sporadic and cyclical. It is only with the emergence of a modern, commercial civilization, in which self-interested transactions in the marketplace are morally vindicated and politically tolerated, that the impulse to better one’s condition becomes translated into steady, progressive economic growth over decades and centuries.
Now, one way of frustrating that impulse, and economic growth as well, is to tax it. This accords with both common sense and common observation. As a matter of fact, it is a proposition that any economist, even the most devoted neo-Keynesian, will casually agree to. But when you suggest that one way of encouraging economic growth is to decrease the taxes on economic activity, many of these same economists will suddenly and inexplicably balk.
This balkiness is unquestionably ideological. These are people who are persuaded that the “collective goods” our taxes pay for—not only public works but also a more equal distribution of income—give us fair value, if not in purely economic terms. This is a perfectly sensible argument in defense of a tax system, but it is rarely made in the United States in 1981, presumably because it is not so evident that our taxes are actually getting us our “money’s worth” in those collective goods. Instead, these economists engage in the most curious kind of research to refute the notion that anyone’s incentive will be affected by a cut in taxes.
This research involves polling people, asking them whether they will work harder if their taxes are cut by 10 percent or 20 percent—or will they, perhaps, just consume more, by way of goods or leisure? Such studies often find that it makes little or no difference. And such studies are not worth the paper they are printed on—they are parodies of what economic analysis should be.
Who on earth ever said that, in a commercial society such as ours, we achieve economic growth by having to work harder? On the contrary the whole point of economic growth is that people should work less hard— but more productively. The human impulse to work less hard is just as strong as the human impulse to better one’s condition—always has been, one suspects always will be. It is the genius of market capitalism to satisfy both of these impulses at once by encouraging entrepreneurship, the incentive to innovate, among that minority of human beings who are, unlike most of us, peculiarly “economic activists.” The existence of such human beings—of entrepreneurs who, by innovating, make us all more productive without necessarily being less lazy1—is simply ignored in the atomistic poll data or the aggregate statistics that economists so solemnly analyze.
It does not matter in the least whether you or I will respond to a tax cut by sharpening our economic incentives. Some of us will, some of us will not. What does matter is that there is, out there, in the real business world as distinct from the academic world of the economists, a minority who will respond in this way—not necessarily the nicest people, not necessarily the smartest people, but the ones who, for whatever reason, relish economic success. For such people, the incentives to save and invest (and invest again) are extraordinarily powerful, and it is the incentives of these “economic activists” that are blunted and thwarted by a heavy tax burden. True, if we knew who they were in advance, we could cut only their taxes. But we only know who they are after the fact.
Still, taxes do have to be paid to acquire the necessary and desirable level of public services, and the question is immediately posed: how do we know, in fact, that taxes are too high? To put it another way: how do we know, since people do value many of those public services (if in varying measure), that our tax level is so high as to have a deleterious effect on economic incentives? This brings us to the so-called “Laffer curve,” a simple but powerful concept that is not in the least new—one can find an excellent summary of it by Ibn Khaldun in the 14th century.
All that the Laffer curve says is that, after a certain point, a tax—or the tax level as a whole—can become counterproductive. It is the point at which people experience taxes as an excessive and unfair burden—they are not getting their “money’s worth” for the tax they pay—with the result that their incentives to economic activity are adversely affected. The tax, in effect, represses economic activity to such an extent that, if it were substantially reduced, the government would end up collecting more in tax revenues, since there would be a lot more economic activity contributing to these tax revenues.
None of this is controversial; every economist would concede the general validity of the point; every citizen, from his own experience, can provide anecdotal confirmation. (Under Prohibition, when the tax on liquor was 100 percent, the government’s tax revenues were zero; when the tax was lowered, revenues sharply increased.) The question that academic critics of the Laffer curve raise is whether the American tax system has gone beyond the point of diminishing returns. “How do we know this?” they ask querulously. “Prove it,” they demand. To judge by last November’s election results, a clear majority of Americans are already convinced. But academic economists want academic proof—not, one suspects, because of their devotion to pure science, but because they would really prefer that government collect money and redistribute it more equally than see everyone improve his condition unequally through untrammeled economic growth.
The academic question as to whether we are beyond the point of diminishing returns in our tax system is unanswerable in strictly academic terms. It is a matter for political judgment, since it all depends on how people feel about the level of taxation. In wartime they feel one way; in peacetime, another. Yes, people always do grumble about taxes, at just about any level, but they don’t always do something about it. They don’t always make strenuous efforts to avoid or evade; they don’t always regard overtime (at time-and-a-half pay) with indifference or hostility. On the other hand, a housewife thinking of entering the job market will certainly think twice if her take-home pay barely covers the cost of the babysitter.
Though one cannot provide the kind of elegant, mathematical proof economists wish, there are in fact some persuasive signs that the American economy has gone too far up on the Laffer curve. One is our flourishing (because untaxed) underground economy—just how large it is, no one knows; but that it is very much larger today than yesterday, no one can deny. This underground economy is a new phenomenon in American society, and a most unhealthy one.
Another such sign is the tens of billions of dollars that seek and find legal tax shelters, investments that would not exist except for their relative tax advantage and which are therefore, by definition as it were, uneconomic. The volume of such commercial transactions, based on tax evasion and tax avoidance, is so enormous that even a slight shift, resulting from a lowering of tax rates, would bring substantial tax revenues to the Treasury. More precise than this, one cannot be; but in any case the demand for precise estimates of revenues gained and lost as a result of a decrease in tax rates is largely a smokescreen. The real opposition to the Laffer curve has less to do with economics than with liberal egalitarianism.
If the Laffer curve indicated that a cut only in tax rates for those in the lower-income bracket would pay for itself in recouped tax revenues, the demand for precision would vanish overnight. It cannot, however, show any such thing, since the major portion of our income tax is paid by people in upper-income brackets. (That is where the income is.) Does anyone really think that, even if we could prove beyond the shadow of a doubt that reducing the tax rates on more affluent Americans would result in their actually paying more in taxes than they now do, the reductions would become less controversial? There are many people, including quite a few economists, for whom it is more important to have a symbolic tax rate of 70 percent on very high incomes even if very few of the rich actually pay it, than to have an effective tax rate of, say, 40 percent which many of the rich would pay instead of fooling around with (often problematic) tax shelters.
But there are some thoughtful people who, having little quarrel with the general tenor of supply-side economics, nevertheless wonder whether it is appropriate in today’s inflationary economy. It is these people, genuinely concerned about inflation as our overriding problem, who feel that cuts in tax rates, for rich and poor alike, should wait upon our prior success in bringing down the rate of inflation. Since many of these critics of Kemp-Roth are themselves conservatives who supported Ronald Reagan—one thinks of Arthur Burns, Herbert Stein, and presumably Paul Volcker—and since their criticism is clearly not ideological, they are all the more influential, especially within the financial and business communities.
For such as these, it is not the tax cuts themselves that are “bold” and “radical” but the fact that they are being contemplated in a particular economic environment, i.e., one of an unprecedentedly high and sustained peacetime rate of inflation. And it is their disinterested concern over this issue which has served to fuel the criticisms of others who, while warning solemnly against “radical experimentation” in economic policy, have a different species of fish to fry.
The conservative case against reliance on supply-side economics in present circumstances cannot be lightly dismissed. It has a long and solid tradition of classical economic thought behind it. The only question is whether it is relevant to today’s environment, both economic and political.
That classical tradition has its own policy for coping with inflation. And, in truth, it is a policy that has always worked. It involves slowing down the rate of growth of the money supply to bring it in line with the growth in productivity. It also involves reducing governmental expenditures and bringing the budget into balance—this, to preclude the necessity of the Federal Reserve Board “monetizing” a deficit. Both of these measures, taken jointly, induce a recession, during which all of the distortions caused by inflation are “purged” from (or “wrung out of”) the economic system. After the recession has achieved this effect, a normal economic recovery may be expected to set in, and non-inflationary growth is once again possible.
That is the prescription, and it is a prescription for recession as a cure for inflation. This must be emphasized because, understandably enough, its advocates tend not to stress it. Only Hayek has been candid enough to say openly that we need a recession. Unfortunately, many of the politicians and businessmen who are swayed by these arguments do not, on their own, fully comprehend the implications of those arguments.
I have noted that these policies have in fact worked in the past. But would they work under the present, truly novel, circumstances? Can they even be tried under these circumstances? The answer to the first question is: probably not. The answer to the second is: certainly not.
One of the novel things about our present economic condition is not merely the endemic high inflation but the existence of a welfare state. This means that as the economy slows down, government expenditures actually increase, as the number of people who are now “in need” increases, and all sorts of welfare programs are triggered. The deficit, instead of going down, tends to go up—especially since tax revenues are also decreasing. As a result, whereas a relatively shallow and short-lived recession could do the trick in a pre-welfare state economy, what is now required is a deep and prolonged recession. (This is what Margaret Thatcher has discovered, to her dismay.) The economic costs of such a recession are so enormous as to make it a most questionable instrument of policy.
And the political costs are, to put it bluntly, intolerable. In this decade of the 1980’s, no administration, no political party—certainly not this Republican administration or the Republican party—can survive association with policies that bring on a long and severe recession. Once upon a time, in a different world, it was possible; it no longer is. All those politicians who are now, in innocence and good faith, advocating such policies would be the first to panic when the recession arrived, and would predictably opt for any scheme at hand, to deal with it.
That is why the Reagan administration has added a cut in tax rates, for business firms and individuals, to the traditional dual strategy of fighting inflation by slowing down the growth of the money supply and of government spending. It is the only possible answer to our predicament—encouraging economic growth so as to annul or at least ameliorate the recessionary effects of other anti-inflationary policies.
Some hostile economists have triumphantly pointed out that what we have here is a case of policies moving in opposite directions. Yes—and so does the policy of providing poor people with both welfare and job opportunities at the same time. Mixed solutions of this kind are as appropriate to economic policy as to social policy, and for the same reason: they are the only solutions that, under the circumstances, make practical sense.
Will it work? There are plenty of good reasons for thinking it will. True, it might temporarily increase the deficit and the national debt—but if the predicted growth eventually occurs, both deficit and debt will be imposed on a larger and stronger economy which can easily support them.
Moreover, we do have some solid historical evidence that the “feedback” effects of cuts in tax rates, in terms of increased tax revenues, are always larger than our economists and Treasury officials—whose econometric models cannot cope with such “feedback” effects—expect to be the case. This is what happened with the Kennedy-Johnson tax cuts which were as large, in terms of the 1964 economy, as the Reagan tax cuts are in the 1981 economy. There is no reason why it should not happen again.
One final point, often overlooked. Because of the increase in social-security taxes that has taken effect this year, and because of automatic “bracket creep” in the income tax resulting from inflation, we shall in effect be experiencing something like a $40-billion tax increase in 1981. No economist of any persuasion, no politician of any persuasion, no commentator (liberal or conservative) has been heard to say that such a tax increase would be good for the economy in its present condition. Yet many of these same people are volubly disturbed by a tax cut that will, in 1981, at best keep our tax burden in a steady state, and in 1982 only alleviate it modestly.
Somehow, the current condition of economic theory, combined with existing ideological trends, has given us a level of public discourse on economic policy that is disgracefully inadequate to our economic and political realities. No one, critical though he may be, seems even to feel the need to offer a practicable alternative to Reagan’s economic policy. One even suspects that many critics of supply-side economics want above all to see it fail, since its success would threaten their ideological investments.
1 We are, incidentally, too easily inclined to think of such innovation as being primarily technological. But Henry Ford did not invent the automobile, only the assembly line, on which auto workers worked less hard, over shorter hours, but more productively than had previously been the case.