Tax cut is a big test for economic theories

Bruce Bartlett
Posted: Feb 26, 2001 12:00 AM
Many commentators, both for and against George W. Bush's proposed tax cut, have compared his plan to Ronald Reagan's in 1981. While there is a similarity, in that both plans cut marginal income-tax rates across the board, the underlying philosophy is different. Whereas the Reagan plan was based on supply-side economics, the Bush plan owes much more to Keynesian economics. There is danger in this that Bush and his advisers so far appear to be unaware of. In the Keynesian model, based on the work of British economist John Maynard Keynes (1883-1946), consumption spending by individuals and investment spending by businesses drive the economy. Saving, therefore, is a drag on the economy because it reduces spending. The government can add to total spending by running a budget deficit, either through purchases of goods and services or by reducing taxes. Thus, budget surpluses are like saving and subtract from spending, causing growth to slow. This Keynesian view of the economy was very dominant among policymakers throughout most of the postwar era. Whenever the economy entered a slowdown, Congress was usually quick to enact some sort of countercyclical fiscal policy. Usually this took the form of increased public works outlays, but occasionally involved a cut in taxes. The former was preferred because it added dollar-for-dollar to total spending, whereas some of a tax cut would be saved, thus reducing its "bang for the buck." In order to limit saving from a tax cut, Keynesians favored tax cuts aimed at those with lower incomes, who were more likely to spend all of their tax cut. The supply-side view, which arose in the 1970s, found deep fault with the Keynesian approach to economic policy. Supply-siders observed a steady deterioration in growth and productivity over the postwar era, the failure of Keynesian measures to prevent or even moderate business cycles, rising inflation and a bias toward the public sector at the expense of the private sector. The supply-siders, basing their analysis on pre-Keynesian neoclassical economics, argued that the Keynesian focus on spending was misplaced because it ignored the role of incentives and production in the economy. The Keynesians, in effect, argued that producers produced and workers worked simply because there was demand for their products and labor. Supply-siders said it was for profit. If a worker cannot buy goods and services with his labor that are worth more to him than the cost of that labor, he just won't work. And a critical component of the rate of return is the marginal tax rate -- the tax on each additional hour worked or dollar earned. With inflation raising nominal incomes, workers were being steadily pushed up into higher and higher tax brackets. By the late 1970s, workers increasingly found that even though their incomes rose, what they could actually consume out of each additional dollar earned was going down. It became common to hear about workers rejecting overtime because they believed they would actually lose money on the deal. That may not have been literally true, but the perception was widespread and there was no question that taxes were rising faster than incomes. Supply-siders said that the excessive focus on demand in the Keynesian model was largely responsible for double-digit inflation. It was essential, they said, to restore incentives to work, produce and invest. Instead of being discouraged, saving should be promoted -- because that provides the resources needed for investment. Investment, in turn, creates jobs and raises real incomes by raising productivity. Ronald Reagan embraced the supply-side view of the economy. That is why he strongly defended tax-rate cuts for the so-called rich. It was not so much that he saw the rich as being particularly productive, but because he saw the urge to become wealthy as the driving force in the economy. If people couldn't become rich or at least have the hope, then the economy's entrepreneurial dynamism would wither. Bush says he shares Reagan's vision, which is why he is pressing hard to lower the top income tax rate from 39.6 percent to 33 percent. However, he seldom uses Reagan's arguments. One almost never hears from Bush any talk about entrepreneurship, risk-taking, investment or innovation in his speeches supporting tax reduction. Rather, one hears primarily about putting dollars into people's pockets, increasing disposable income and the need to counter an economic slowdown. These arguments have far more in common with the old-fashioned Keynesian model than supply-side economics. Critics of supply-side economics and the few remaining devotees of Keynesian economics have noticed. Sebastian Mallaby of The Washington Post, one of the former, took note of Bush's apparent apostasy in a Feb. 19 article. "Mr. Bush is in some respects the anti-Reagan," said Mallaby. "Instead of pushing Reaganite supply-side arguments, the Bush team is stressing the demand side." Mallaby correctly notes that this sort of Keynesianism is "goofy." Yet this has not discouraged some of the few remaining hard-core Keynesians from one-upping Bush. For example, the Jerome Levy Institute in New York, a redoubt of Keynesian purists, believes Bush should triple the size of his tax cut. It is too small to pump up demand enough to offset a looming economic collapse, it believes. This collapse is due largely to the budget surplus, which is depressing spending. Thus the Levy economists favor abolition of surpluses and a return to large budget deficits. Bush would help himself by downplaying the Keynesian countercyclical case for his tax cut, if only because the current slowdown is likely to be over by the time a tax cut is signed into law. And by stressing the supply-side argument about the long-term benefits of lower marginal tax rates, Bush can help defuse the concern that his plan will extinguish the surplus. He should point out that faster growth will lower the budgetary cost of his tax cut. Harvard economist Martin Feldstein estimates that faster growth will reduce the actual revenue loss from Bush's tax plan from $1.6 trillion to $1.2 trillion over 10 years. A new
Heritage Foundation study finds even stronger feedback effects, with faster growth recouping almost half the static revenue loss. Bush does not need to stop talking about how his tax plan will help average people and perhaps counter a recession. But he should not neglect the supply-side argument as well.