A literalist approach to “supply-side” economic policy

The “supply-side” revolution of the early 1980s was based on the logical combination of two seemingly uncontroversial premises:

  1. In a free market economy, people are basically paid according to the economic value they produce, which means that people who want to make more money will work harder (or smarter) to get it
  2. After-tax income is what matters to people, so tax policy can encourage or discourage people from working harder

If you put these pieces together, you come to the conclusion that lower marginal income tax rates create a richer economy for everyone. That was the conclusion of policymakers in the 1980s, and, to a lesser extent, in the 2000s.

But why stop with lowering marginal rates? The “supply-siders” ought to admit that the ultimate conclusion of their theories is a regressive tax regime.

Right now, taxes are collected on a progressive schedule; people who earn more pay a higher share of their income than those who earn less, but only up to a certain point. In practice, the average effective tax rate in the U.S. looks something like this:

The rationale is that a single dollar is relatively less important to someone who is able to comfortably satisfy his basic needs, including retirement saving. If you took this logic too seriously you would end up with a marginal tax rate of 100% on all income above “comfortable.” This would not be a good idea. After all, no one would bother working past the bare minimum to reach the salary of “comfortable.” This is the kernel of truth embedded in the “supply-side” logic—the economy will not produce at its full potential if people cannot keep enough of what they earn to feel rewarded for their efforts.

So why should “supply-siders” favor regressive taxation? They want to maximize the output that every individual produces. Their stated belief is that the best way to do this is by increasing the benefits to having a huge salary by lowering the tax burden on the rich. Logically, they should also want to impose high tax rates on the poor because this would, according to “supply-side” theory, make them work harder until they reach the higher income brackets.

In practice, the two groups of extremists want income tax schedules that look something like this:

This is what net incomes would look like under the two extremist tax regimes:

The extremist progressive plan is punitive and removes most of the incentives for creating value. On the other hand, the idealized “supply-side” plan grotestquely redistributes wealth from the poor to the rich.

At this point you might ask why no nation has adopted a regressive tax structure where the upper brackets pay negative rates and the poor pay the vast majority of their income in taxes. It is not because ideologically-motivated class warriors have prevented the creation of a capitalist paradise on Earth. It is because the premises of “supply-side” economics need a few significant caveats.

Over time, a free market generally pays the biggest rewards to those who produce the most stuff that people want. This does not mean, however, that the tax code can force individuals to produce more. Some, perhaps many, simply do not have the innate abilities required to create signficant economic value. Should the government single them out for punishment with confiscatory tax rates? The market already does that by paying them so little. And why should the resources of the state be deployed to subsidize those who already earn vast sums?

Another caveat: tastes and needs often change faster than skills. Someone who had been able to produce a lot of value may suddenly find himself unable to do so. A pill that cured cancer would put every oncologist out of work. Similarly, it is possible for those previously believed to be talentless and lazy to earn fortunes if the public acquires a taste for their antics. The cast of “Jersey Shore” comes to mind. As creative destruction reallocates people from obsolete occupations into those that the people demand, some are forced to suffer while others reap great rewards—all for essentially random reasons. Why should government policy exacerbate these outcomes?

The final point is that we do not live in a free market. The reality is that the government—taxpayers—heavily subsidizes certain industries and certain professions. Occupational licenses and immigration rules restrict the supply of all sorts of niche workers from hair stylists to lawyers. Many financial firms have explicit and implicit government guarantees that allow them to gamble with house money. Government contractors are more or less unaccountable and are notorious for over-charging taxpayers. Pharmaceutical, biotech, and energy companies pay almost no taxes and take advantage of government-subsidized research. How can one know, under these circumstances, whether a high income was earned or stolen?

This is not to say that it would be a good idea to suddenly raise marginal income tax rates to, say, 80%—at the time their ideas first became popular, the “supply-siders” were on to something, just like those who invented progressive taxation. But you should bear all this mind next time someone talks about the impact of lowering the marginal income tax rate by a few percentage points.

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About Matthew C. Klein
I write about the economy and financial markets for Bloomberg View. Before that I wrote for The Economist on a fellowship provided by the Marjorie Deane Financial Journalism Foundation. I have worked at the world's largest hedge fund and read every FOMC transcript since May, 1987.

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