By Oxford Analytica - 10/24/07 06:53 PM EDT
The leading candidates for the Republican Party’s 2008 presidential nomination have been engaged in heated discussions about the concept of using tax cuts to boost federal revenues (“supply side economics”), sometimes implicitly criticizing the legacy of President George Bush. This could have a major impact on future U.S. fiscal policy.
The central proposition advanced by proponents of supply-side economics in the 1970s and 1980s is the adverse relationship between tax levels and government revenues:
•More from less. Advocates of supply-side economics argued that taxes had reached levels too high to procure sufficient government revenues; therefore, cutting tax rates would actually increase government income. This proposition was advanced by the early-19th century French political economist Jean-Baptiste Say. However, its more recent manifestation dates from the economics profession’s monetarist revolution, led by Milton Friedman, against Keynesian economics in the 1970s.
•‘Laffer curve.’ Publicly, the supply-side economics precept that lower taxes raise revenues was expressed in the ‘Laffer curve’ introduced by economist Arthur Laffer and embraced by Reagan in 1980. This version simplified an economic argument, accepted by many economists, which maintains that in certain circumstances implementing tax cuts may raise government revenues. Examples often cited include cutting Goods and Services Tax (GST, or “sales tax”), or the top level of a high marginal income tax rate.
The “stagflation” of the 1970s inverted the standard assumption of Keynesian policy, the “Phillips curve,” which posited a negative relationship between unemployment and inflation:
•Monetarists, including the group who would support supply-side economics, rejected this relationship, identifying instead a natural rate of unemployment and maintaining that efforts to go below this level simply stored up long-term inflationary pressures.
•Monetarists also rejected deficit spending as a measure to stimulate economic growth.
•However, monetarists and supply-siders united on the importance of controlling the money supply and cutting marginal tax rates to stimulate economic growth.
Those who doubted supply-side economic theory were skeptical about how well government revenues would respond to tax cuts, particularly given the smaller tax base. The theory was never tested in the 1980s — the decision to increase defense spending massively while cutting taxes resulted in a huge deficit, which took more than a decade to erode. (The ratio of public debt to GDP reached 41.2 percent in 1986, compared with 26.1 percent in 1979, and peaked at 50.6 percent in 1992.) Former President Bill Clinton’s reduction of the deficit, which began in 1993, required a tax rise. Yet the principle of using tax cuts to boost revenues did not decline as an article of faith within the Republican Party.
The tax cut principle of supply-side economics was realized in the statutory reductions implemented during the Reagan administration (initially through the Kemp-Roth tax cut). The policy’s advocates recognized that in the short term there would be reductions in revenues in line with reductions in statutory federal income tax. Yet they pinned their hopes on the long term: Government revenues would eventually increase as the individual incentive to work harder became apparent.
The legacy of the monetarist revolution has been profound. Amongst academic economists and practitioners Keynesian policy has lost its dominance. There is much greater attention to creating incentives amongst taxpayers of the sort achieved with modifications to marginal tax rates. The growth of behavioral economics, with researchers employing laboratory experiments to see how changing incentives and opportunities affect behavior, is an extension of this intellectual shift.
Reagan pioneered tax cuts as a core Republican value, coupling them with defense spending increases and reduced domestic discretionary outlays. The former (defense appropriations) were larger than expected, and the latter (domestic fiscal restraint) was much less determined than planned, thus producing a huge deficit. Nonetheless, the principle of tax cuts as a basis for economic policy became a fixture of the Republican platform, and appeared to produce steadily increasing electoral dividends.
‘Fiscal responsibility’ debate.
None of the leading contenders for the 2008 Republican nomination directly challenge the efficacy of the Bush administration’s 2001 and 2003 tax cuts as revenue generators, despite the absence of categorical evidence that they achieved this objective. (Economic growth boosted government revenues after the 2003 tax cut, but the earlier reduction resulted in a drop in receipts.) However, a sotto voce debate about the Reagan legacy and supply-side theory has developed:
•Romney-Giuliani clash. The question of how much to rely upon supply-side theory divides Giuliani and former Massachusetts Gov. Mitt Romney (R). During the Republican candidates’ debate in Michigan on Oct. 9 they clashed sharply over fiscal policy. Employing the language of “fiscal responsibility” and advocating a line-item veto, Romney appeared to be distancing himself from the sort of tax cuts consolidated by the Bush administration. Giuliani argued that during his mayoral tenure New York’s per capita taxes and spending declined. This expressed his support for popular ideas concerning supply-side economics.
•Farewell to ‘the Gipper’? The Giuliani-Romney showdown was the first sign of serious disagreement between the leading candidates on economic issues, in contrast with social issues where there is a considerable diversity of views among the contenders. Tellingly, most polls show a marked grassroots Republican preference for deficit reduction over tax cuts — and high consensus on social issues such as opposition to abortion and gay marriage. Bush’s handling of the federal deficit is roundly excoriated, eliciting an approval rating of only 27 percent, according to an Oct. 4 Gallup poll.
The federal budget deficit fell to $163 billion in the fiscal year that ended in September, on higher government tax receipts, which Bush has touted as proof that supply-side-oriented policies are effective. However, the medium-term fiscal outlook is less rosy:
•Entitlement programs, including the increased Medicare drug benefit enacted under Bush, will balloon the deficit over the next several decades.
•Interest rates must eventually rise to ensure that U.S. government bonds retain their attractiveness to investors.
These strains emanate from the shortage of revenue relative to massively increased spending under Bush. They reprise the difficulties of the Reagan era, when tax cuts did not boost revenues sufficiently to offset surging government outlays. Using supply-side theory as justification for further tax cuts is unlikely to preclude the eventual need for a deficit reduction scheme analogous to the Clinton plan of 2003.
Oxford Analytica is an international consulting firm providing strategic analysis on world events for business and government leaders. See www.oxan.com.