The future of supply-side economics

When I was on CNBC’s Kudlow Report last night, the other guests and I talked about the tax plans of Mitt Romney, Newt Gingrich, and Rick Santorum from a supply-side perspective. Now, I sometimes don’t like even using the term “supply-side economics” since so much of it is really a restatement of great economic truths that were abandoned but have been rediscovered over the past few decades. And perhaps none more key than this: Incentives — particularly taxes — greatly affect the supply of labor, savings, and investment. One of my favorite blogs, The Supply Side, has this to say in a new essay about the global acceptance of economist Art Laffer’s insight on marginal tax rates:

Since the 1980s, the top income tax rate has been raised twice and cut once, settling at 35% for the last decade. Income tax rate increases have been offset by cuts in the capital gains tax rate, now at 15%. More than 30 nations have adopted flat tax systems, including, ironically, most of the former Soviet bloc nations, and several other countries are considering them today. Recent discussions of lowering the US corporate tax rate have included bipartisan recognition that lower rates could bring in similar levels of revenue. While in the 1970s many developed nations had top tax rates well above 70%, today, most nations keep tax rates below 50%. In short, Art Laffer is a world historical figure who has helped lead the restoration of classical economics’ focus on production incentives. That his arguments about tax rates’ incentive effects have been accepted in broad terms today among economists of all political stripes is testimony to his tremendous skill as an economist and advocate.

And while I dissected on CNBC the differences between Romney, Gingrich, and Santorum on taxes, all three are proposing cutting tax rates of one kind or another to change incentives and boost growth. Even many liberal economists accept the Laffer Curve’s central economic cosmology and the danger of high-tax rates on worker productivity, except for perhaps the extreme superrich.

But where do we go from here? On taxes, at least, supply-siders should continue to push for lower personal and corporate marginal tax rates, along with the elimination of many market-distorting tax breaks. At the same time, the current code’s bias against savings must be fixed. First, households should not pay tax on interest, dividends, capital gains, or other income from saving. Second, firms immediately should be able to deduct business investments, rather than depreciating them over time. Here’s why:

The income tax’s penalty on saving is an undesirable distortion of consumer choice. It also causes less capital to be accumulated in the United States. The reduction in capital accumulation reduces labor productivity and lowers real wages throughout the economy, depressing the standard of living of future generations. Some studies have found that a switch to consumption taxation would increase the size of the U.S. economy by as much as 9 percent in the long run, although other studies estimate smaller gains.

But taxes and capital are only part of the equation. Certainly just as important in boosting growth is encouraging innovation and technological change. And having the proper reward and incentive system for potential innovators is critical. Taxes matter for this, too.

But two other elements are also necessary. First, America must remain open to the change and Schumpeterian creative destruction that innovation brings and not try to stifle it through regulation, crony capitalism, and anti-competitive trade barriers. Second, America needs to improve its supply of human capital so, as economist Joel Mokyr puts it, there is a “cadre of ingenious and resourceful innovators who are both willing and able to challenge their physical environment for their own improvement.”

This “cadre” can be both imported from overseas (via more high-skilled immigration) and developed at home (through an education system that better cultivates and challenges high-ability individuals). Education reform, in particular, should be the next great battleground for supply-siders. And just as the supply-side tax revolution started at the state level with California’s Proposition 13 in 1978, supply-side education reform is starting local, too, in Wisconsin and New Jersey as Republican governors there battle government teachers unions. This is going to be one my big policy themes for 2012, and hopefully I won’t be alone.

2 thoughts on “The future of supply-side economics

  1. Supply-side economics doesn’t work. It might increase growth but it doesn’t increase tax revenue. Our problem is not one of taxes, it is one of aggregate demand. Either we can offer negative interest rates from banks to get companies to invest or the government can begin investing in infrastructure like power plants, a new space industry, education, and of course roads and bridges. By creating the aggregate demand that the private sector is not creating with their mountains of cash, we can get our economy moving.

    America needs to create 20 million jobs over the next three years, not the next decade. We need to stop housing prices from falling by cutting mortgage balances and getting confidence rebuilt. as for regulations, America is number 10 out 200 countries for least regulated so seriously, it’s not regulation and taxes, it’s concentration of wealth by the 1% and the export of our manufacturing sector to China and India that are our problems.

    If all we do is cut taxes for the rich and raise them for the poor, we will just perpetuate this economic nightmare four more years. Those who forget history (1936) are doomed to repeat it.

  2. @ Mike,

    The whole purpose of supply-side economics (classical economics) is to produce economic growth. The fact that tax revenues are the same or higher is not the focus. Also, the problem right now is not aggregate demand. Consumption has already surpassed pre-recession levels yet we have very little economic growth and massive unemployment. You must remember that the economic cycle begins when we use our labor to produce something of value, it does not begin when we purchase something of value. The mantra is low taxes, low regulation and a stable currency.

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