Supply-Side Economics in Fact and Fancy

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Supply-Side Economics in Fact and Fancy

Supply-side economics is a hearty perennial, one that closely follows the election cycle. Every four years ambitious Republican politicians (and not a few ‘centrist’ Democrats) rediscover that the wealthy would like to pay less in taxes. But the rhetoric of politics does inhibit the wealthy, their kept intellectuals, and paid spokesmen from arguing their case directly. In democracies, even those resembling plutocracies, the rich must present their own interests as coinciding with the general good.

With this in mind, and yet still aspiring to a tax cut, the wealthy have lavishly supported ‘astroturf’ political organizations and ‘think tanks’ which, in turn, hire photogenic and eloquent spokespersons to present their case to the public. In its best form, the argument is that tax cuts for the rich will: (1) increase the national savings rate because the wealthy save a larger percentage of their incomes than others. This increased quantity of savings will (2) provide the funds required to spur business investment in plant and equipment. From this it follows that (3) supply-side tax cuts will have the effect of providing strong economic growth, which will “trickle down” to the “regular guy.” We are assured that not only are these propositions true, but that they were proven decisively during the Reagan Administration.

Let’s look up the figures. The key to this theory is in steps 1 & 2, describing a causal relationship between lower tax rates and increased private investment. Our starting point, or baseline, will be the average of what is called "net private domestic investment" over President Jimmy Carter's four years (1977-1980), which we will compare to the average across the four years of President Ronald Reagan’s second term (1985-1988). The reason to select the former years is that they are widely recalled as having been dismal. Indeed, we have been repeatedly told that they were so bad that voters granted Reagan a mandate to pursue supply-side economic policies. Likewise, the latter years are selected as the effects of the enormous tax cuts enacted during Reagan’s first term should have had their strongest effect during his second term. Selecting data from Reagan’s second term allows us to set aside the economy’s abysmal performance during his first term with its devastating recession -- the worst that occurred between the Great Depression and the Crash of 2008. In addition, by Reagan’s second term the wealthy should have had ample opportunity to adjust to their lower tax rates.

When we look up the figures on the official National Income and Product Accounts, we find that “net private domestic investment” did not increase. On the contrary, it declined from an average of 7.0% of total Gross Domestic Product during Carter’s four years to an average of 5.7% during Reagan’s second term. More shockingly, if we factor out inflation, we find that the real dollar amount of investment fell slightly despite the fact that the American economy of the late 1980s was over 17% larger than the late 1970s. To put it mildly, this is a powerful refutation of the supply-side story.

But, proponents might respond, surely overall savings rose as a consequence of the lower tax rates? Let us check. Comparing the averages over these same two four-year periods, consumption as a share of total National Income increased from 64.8% to 67.2%. Because the median American income for a full time year-round employee declined between 1980 and 1988 (from $34,483 to $34,253 in constant 1994 dollars according to the Bureau of the Census), this increase in the nation’s consumption was most likely undertaken by persons in the upper echelons of the income distribution.

In light of facts presented in the previous two paragraphs, we are ready to sum up. President Ronald Reagan's supply-side economic policies left us with more consumption on the part of the wealthy, a lower savings rate, less net private sector investment, and a lower median income for a full-time year-round worker. These who lived through those years will not be surprised by these numbers, as conspicuous consumption on the part of the wealthy was a dominant and widely-noted theme of that era.

The ‘moral of the story’ is that proponents of more tax cuts for the rich will have to argue that its beneficial effects are very gradual, occurring only after an orgy of increased expenditure on the part of the policy’s immediate beneficiaries. Alternatively, they could argue that the National Income and Product Accounts put together by the Bureau of Economic Analysis at the Department of Commerce are profoundly flawed. Finally, they could drop the pretense that the Reagan years are an affirmation of their favored theory. The numbers presented above and the conclusions they point to simply cannot be sidestepped. If tax cuts for the wealthy are good for savings, investment, and the incomes of “regular guys” (that is to say the median earner), then some precedent other than the Reagan years will have to be invoked.

Robert E. Prasch

Robert E. Prasch is Professor of Economics at Middlebury College where he teaches courses on Monetary Theory and Policy, Macroeconomics, American Economic History, and the History of Economic Thought. His latest book is How Markets Work: Supply, Demand and the ‘Real World’ (Edward Elgar, 2008).

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