The GOP and Snake-oil Tax Cuts

On many occasions, PP has discussed the economic fallacy, long touted by Republicans, of Supply Side Economics. We have argued that this is a myth believed only by the GOP partisans and their supporters, while the consensus among economists is that the idea is false (in fact, those who have been readers of Greg Mankiw long enough will remember a textbook he wrote which labeled supply siders as Charlatans!).

This is very relevant, since John McCain has recently embraced these ideas and his economic adviser, Phil Gramm, is one of the few people possessing economic PhDs that believes this stuff.

Last week, Harvard economist Jeff Frankel (famous for work about the possibility of the euro replacing the dollar, among other things) wrote a post and a paper to debunk the myth once and for all. The post is essential reading for wonks of all persuasions, and the paper is not for journals so it's much more accessible than your average econ lit. The paper is especially valuable as a survey of relevant literature.

The Myths:

What are the charlatans' basic arguments here? Essentially, the arguments from the Right come in a contradictory pair. (1) Supply side economics typically refers to the Laffer Curve. This is the graph shown in the image above. The idea is that higher tax rates remove incentives for production, thus decreasing government tax revenue. Thus, the argument put forward by people like Buckley, Reagan, Hannity, Bush, and the rest, is that tax cuts will increase government revenue due to increased production and incentives for work. Even the dubious Laffer Curve shows that this depends on the current rate of taxation; but the supply siders aren't deterred by facts. Many will argue that any and all tax cuts will increase government revenues.

(2) The second argument is known as the Starve the beast hypothesis. This is the idea that if we cut taxes substantially, future governments will be automatically constrained in their spending habits, thus decreasing the size of government. Arguments (1) and (2) are made by the same people, despite the obvious contradiction: argument (1) says that tax cuts increase government revenue, while argument (2) says that tax cuts decrease government revenue! In addition to the obvious contradiction here, both theory and evidence indicate that both arguments are inaccurate in most cases (argument #1 may apply to some Scandinavian countries with astronomical tax rates).

The Evidence:

Supply Siders Debunked: Several empirical and theoretical studies by the nonpartisan Congressional Budget Office, Greg Mankiw, and others, have indicated that the supply side effect of tax cuts on tax receipts is far less than the claims of the supply siders. It turns out that these results match "the view of almost all professional economists, including the illustrious economic advisors to Presidents Reagan and Bush." (Those interested in reading some of these academic documents can find them on Google Scholar or email me). Those who would cite the Bush tax cuts and subsequent increases in tax revenue as evidence of supply side claims confuse correlation with causality, and they obviously lack an understanding of basic econometrics (I'm thinking Bill O'Reilly here, who made this claim during his interview with Obama).

Starve the Beast Debunked: It turns out that deficits don't have a significant effect on future government spending. Says Frankel, "The theory fails on both conceptual grounds and empirical grounds." At least for now, lawmakers show little restraint on spending regardless of the state of the debt. A note should be added here, however: as global demand for the dollar declines (both for commerce and reserves), our ability to run massive deficits will decline, eliminating both the ability to spend beyond our means and the ability to cut taxes irresponsibly!

Obviously, this is just a quick summary of the evidence. A reading of the Frankel paper will be more informative and persuasive to curious/disbelieving readers.

As usual, political dialog tends to polarize the debate. The GOP says we need more tax cuts, and anybody who disagrees doesn't understand incentives or is anti-growth. The Dems say we need higher taxes on the rich, and anyone who disagrees fails to understand the problems posed by inequality. Somewhere, there is a middle ground which recognizes the importance of incentives, freedom, responsibility, and growth, while also recognizing the importance of equality and poverty alleviation. This middle ground would recognize the negative impact of deficits on growth and the need to spend less than revenues so that our children don't pay for our foolishness. In other words, there is a middle ground which actually believes in genuine fiscal responsibility, instead of just giving lip service to it as Republicans have for decades.

We need to redefine fiscal responsibility to include solvent budgeting, incentives for growth, and humane concerns. But in the midst of loud, partisan voices, the best solution is drowned out. Voters and media should demand that John McCain and the GOP explain their addiction to snake-oil economics.