What Is Supply-Side Economics?

“There is nothing difficult, more perilous, or more uncertain of success than to take the lead in introducing a new order of things." -Niccol`o Machiavelli

Reflections - What Is Supply-Side Economics? - Four Decades Later Wikipedia and Academic Economists Still Don’t Know 

By Dr. PAUL CRAIG ROBERTS: It is difficult for truth to emerge anywhere. History, politics, science, medicine,crime and punishment, any academic subject, neighborhood gossip—whereverone looks, falsehood abounds. It is no different for supply-side economics.It has been almost four decades since the Reagan administration gave up on Keynesian demand management, which had resulted in“stagflation”—that is, wors-ening Phillips curve trade-offs between employment and inflation. Now thirty-nineyears later (if the Wikipedia entry on supply-side economics most recently updated on June 28, 2020, can be trusted), journalists, academic economists, and whoever writes Wikipedia entries have no idea what supply-side economics is or what the problem was that it addressed successfully. Indeed, I would be hard pressed to imagine a more incorrect explanation of supply-side economics than the one I just read in Wikipedia, buttressed by uninformed statements by Gregory Mankiw, Paul Krugman, and Alan Blinder. No one has been more intimately involved with supply-side economics than I. I was an expositor and an advocate. In 1975, I penned an article for U.S. repre-sentative Jack Kemp calling for a supply-side policy that was published in the SundayWashington Star. I was involved in the policy process in the House and Senate,where the ground was prepared amongRepublicans and Democrats for theemergence of a supply-side policy. I drafted the Kemp–Roth bill that became whatthe media called“Reaganomics.”I taught the Congress how to use the budgetprocess to enact a supply-side policy. I was appointed the assistant secretary foreconomic policy of the U.S. Treasury and given the task of getting a supply-sidepolicy out of the Reagan administration so that Congress could vote on it. I was theperson who was invited to give the annual state-of-the-economy address to thecombined economic graduate students and faculties of Harvard and MIT, wherePaul Samuelson welcomed me warmly andthe graduate students gave me a standingovation. It was my peer-reviewed bookThe Supply-Side Revolution—published byHarvard University Press in 1984, remaining in print for decades, and appearing in aChinese-language edition—that explained supply-sidetheory and the problems ofgetting it into practice. I was the one who wrote the supply-side entry forThe NewPalgrave Dictionary of Money and Finance(MacMillan 1992 Vol. 3) and forMcGraw-Hill’sEncyclopedia of Economics(1994) in the 1980s, plus a separate entryfor the Laffer curve in the former (Vol. 2). I am the economist who explained thetheory and practice in the leading scholarly economic journals in Germany and Italy.I am the one who explained it to the French government, for which I received theLegion of Honor. I explained it in the journalThePublicInterestin the United Statesand in British bank and policy magazines. I wrote numerousWall Street Journal,Business Week,and other articles about supply-side economics. I made presentationsat economic association meetings. I debated Lawrence Klein and other leadingKeynesian academics before university audiences. Yet I do not appear in theWikipediaentry except in a note at the end containing a list of supply-side articles,which includes only one article written by me published inThe Independent Reviewin the winter of 2003 (“My Time with Supply-Side Economics,”The IndependentReview7, no. 3 [Winter]: 393–97), twenty-two years after I had successfullylaunched a new economic policy.Not only hasWikipediacreated a totally false picture of supply-side economics, butthe entry also shows that the discussion of the policy for the past four decades bears norelationship whatsoever to the actual policy! Academics and journalists have spent fourdecades discussing a nonexistent policy!What is this nonexistent policy? Tax cuts that pay for themselves.The Laffer curve has nothing to do with supply-side economics. It is merely anexpository device that illustrates that high and low tax rates can produce the same tax revenue. Perhaps the Laffer curve should be known as the Ibn Khaldun curve because ithas been traced to this fourteenth-century Arab scholar. There can be little doubt thatIbn Khaldun had much worthwhile to say, but he did not provide the basis for supply-side economics.The origin of the misinformation that“Reaganomics”is based on a claim that taxcuts pay for themselves is mysterious. It cannot be found in official documents. As theofficial and publicly available documents show, the Reagan administration forecast thatevery dollar of tax cut would result in a dollar of lost tax revenue. It was a static-revenueestimate. The Reagan budget submitted to Congress showed large multiyear budgetdeficits. The Office of Tax Analysis in the Treasury had no capability of making revenuefeedback estimates.The Reagan administration predicted a 100 percent revenue loss from the supply-side tax cut. I presided over this forecast myself. We were not interested in revenueeffects. The Treasury was interested to learn if the relative price effects were sufficient toallow the economy to grow without having to pay for it with a rising rate of inflation.Supply-side economics in Congress and in the Reagan administration addressedthe worsening Phillips curve trade-offs. These worsening trade-offs were worrisome toDemocrats and Republicans alike. They meant that the management of economicpolicy associated with the postwar boom was no longer working. The Keynesian so-lution was wage-and-price controls—an incomes policy. Congress had recent experi-ence with trying to control one price—that of oil—and wanted nothing to do with ascheme to control all prices. Leading Democrat committee chairmen in the Senate, suchas Lloyd Bentsen (Joint Economic Committee) and Russell Long (Finance Com-mittee), listened to me more carefully than did Republicans. It was the Joint EconomicCommittee under the chairmanship of Democrat Lloyd Bentsen that published thefirstSenate document calling for a supply-side economic policy. The committee’s staffdirector was James Galbraith, the son of John Kenneth Galbraith.The originality of supply-side economics is its demonstration that some forms offiscal policy—specifically a change in the marginal rate of taxation of income—will shiftthe aggregate supply schedule. Why was this a novel and important breakthrough,indeed a more important one than those for which the Nobel Prize in economics isusually given?The answer is that in Keynesian economics a change in marginal tax rates onlyshifts the aggregate demand schedule. Aggregate demand increases if marginal tax ratesare lowered—a policy used to combat unemployment. Aggregate demand decreases ifmarginal tax rates are raised—a policy used to combat inflation. By neglecting theimpact of tax rates on supply, as inflation was moving people into higher marginal taxbrackets, the increase in consumer demand was encountering diminished incentives toincrease output to meet the demand. Therefore, prices rose along with output and thenmore than output.Why did prices rise as people encountered higher tax brackets? They rose becauseof the behavior of two important relative prices that economists had overlooked. The price of current consumption in terms of forgone future income and the price of leisurein terms of forgone current income. The higher the marginal tax rate, the less the futureincome forgone by consuming income rather than saving and investing it. Thus, thecheaper current consumption is in terms of forgone future income, and the lower savingrates are. For example, the 98 percent tax rate on investment income in the UnitedKingdom meant that the cost of purchasing a Rolls Royce in terms of foregone futureincome was essentially zero.The higher the marginal tax rate, the less current income forgone by enjoyingmore leisure. Thus, the cheaper leisure is in terms of forgone current income. Thus, wewitnessed medical practices that closed at noon on Fridays and high absenteeism in themanufacturing workforce on Mondays.Because marginal tax rates were high when Reagan came to office—70 percent oninvestment income and 50 percent on personal income—supply-side economistsconcluded that the worsening Phillips curve trade-offs between employment and in-flation were due to the neglect of the impact offiscal policy on the supply side of theeconomy.The Reagan administration and Congress reduced the marginal tax rates across theboard for every bracket not in order to trickle down income or to balance the budgetbut to lower the high relative prices that were restraining the response of output toincreased demand. Although economists have failed to notice the obvious, the supply-side policy succeeded in eliminating the worsening Phillips curve trade-offs. The economy again was able to expand without having to pay for the expansion in terms of arising rate of inflation. How is it possible for such a clearly explicated policy in every public and scholarlyforum and the obvious passing away of Phillips curve worries not to be noticed byacademic economists andfinancial journalists? Perhaps the numerically dominant Keynesians were protective of their humancapital. Most economists andfinancial journalists in the 1980s also were liberals moreinterested in taxing the rich than in noninflationary economic growth. Journalists tooktheir cue from the Keynesians, who were traditionally the spokespersons for economics.Many journalists also looked down on a movie actor and his rhetoric.But the primary reason why the clear explication of supply-side economics wasn’t noticed is the authority of existing paradigms. The Keynesians were in authority. Theywere ensconced in the departments of all the leading universities except the Universityof Chicago. They had trained the economic andfinancial journalists. They were theones who testified before Congress and were the consultants to the Federal Reserve andthe corporations. If you were not Keynesian, a career was hard to come by.The problem of changing regimes in science and scholarship is the same as inpolitical and social life. Thomas Kuhn wrote about it inThe Structure of Scientific Revolutions (Chicago: University of Chicago Press, 1962). My Oxford professorMichael Polanyi wrote about it even more successfully. Those responsible for change often pay a price. As Niccol`o Machiavelli said in The Prince,“There is nothing difficult, more perilous, or more uncertain of success than to take the lead in introducing a new order of things. ”About a year ago, I read that an economist had put forward the idea that fiscal policy could shift the aggregate-supply schedule. I meant to save the reference and tocontact him but got busy with other things. More important truths are being buriedevery day.

Paul Craig Robertswas senior research fellow, Hoover Institution, Stanford University; held the William E.Simon Chair in Political Economy in the Center for Strategic and International Studies at GeorgetownUniversity; and was associate editor of theWall Street Journaland assistant secretary of the US Treasury.

Source