Why 'trickle down' economics don't work

Just had a rousing debate at the Texas Public Policy Foundation with economist Arthur Laffer on supply-side economics.  It was his crowd, to be sure, but we actually found some common ground and I thought I saw a few heads nod (and more heads shake) on some of my key points.

But since I spent a few moments organizing my thinking on this, let me elaborate why I think supply-side, trickle down doesn’t work.  (Hat tip to my CBPP colleague Chye-Ching Huang who’s been doing important, forthcoming work on this topic).

–Supply-siders vastly overstate the behavioral reactions to tax changes.  Labor supply, investment, business activity, just isn’t nearly as responsive to tax changes as they would have you believe, particularly among the wealthy.   That’s not to say there’s no response, but they’re much more likely to re-structure income—define earnings as capital gains, for example, or passing through business income to the personal side–and timing of things like capital gains realizations.  That’s not at all what the supply-siders envision, unless the trickle down refers to tax lawyers.

–Supply-siders don’t care nearly enough about budget deficits. As OTE’ers know, I’m no deficit hawk.  But over the long term, we must pay for what we spend, and any long-term budget projection will show you that we won’t be able to that on the current trajectory.  History also clearly shows that supply-side tax cuts, since they don’t have the growth effects that their adherents tout, are causally linked to structural budget deficits (meaning deficits that persist even at full economic capacity).  As long as policy makers believe this stuff, it will be near impossible to get on a sustainable fiscal path.

–Supply-side economics is one factor behind rising inequality. I’ve often remarked that when you cut taxes on the wealthy, pretty much all you do is raise the after-tax income of the wealthy (and lose federal revenues).  In this simple sense, supply-side tax policies exacerbate market-driven increases in income inequality.  More recent, interesting scholarly analysis by economist Emmanuel Saez et al, discussed here, shows that by over time and across advanced economies, lower marginal tax rates are associated with greater income inequality but not with faster growth.  These researchers argue that “lower top tax rates induce top earners to bargain more aggressively for higher pay” and since they’re not adding more value—they’re just flexing their K-Street induced bargaining clout—it’s a zero sum proposition.   Their gain is somebody else’s loss.

–Supply-side is not demand side. Supply siders can’t understand why you’d need stimulus spending to offset a demand contraction because demand doesn’t contract in their model.  Against my arguments that we needed and still need more stimulus, Art kept stressing that in a world where farmer A gives money to farmer B, there’s no more money/demand in the system.  Others in this benighted camp argue similarly that stimulus just takes water from one end of the swimming pool and puts it in the other end.

That’s clearly a world where demand doesn’t fluctuate, where there’s always enough jobs for all comers (unemployment is voluntary!…or induced by nasty ideas like unemployment benefits), where farmer A never sits on excess savings that could actually generate more aggregate output if she lent it to under-employed farmer B (i.e, the gov’t borrowed it from her and provided it to B—or better yet, ordered crops from B).

How you can miss these relationships in an economy that’s clearly been so demand constrained is beyond me, but in fact, Art’s way of viewing the problem is probably the dominant one right now.  Just listen to Republican rhetoric around the need to extend UI benefits.

So what did we agree on?

Actually, a critical point: we need more revenue!  And while we differed on how you get it—remember, these supply-siders believe growth and revenue are always a tax cut away—the theory is always structured around marginal rate cuts.  So true supply-siders are quite comfortable with ideas that broaden the tax base, say by ending the privileged  status of non-labor income, like cap gains and dividends, something I’ve advocating for big-time around these parts.

I should also add that Art is a great, personable guy and a highly influential economist who makes his case with humor and requisite humility.  To say we don’t agree is a vast understatement but we listened carefully to each other and I’m quite certain that respectful debates like this in front of audiences that are also willing to listen, to bring some facts to the table, and to challenge their priors are an important part of the way forward.  We also agreed on that.