# A Walk on the Supply Side **URL:** **By** Tyler Cowen **Published:** August 1, 1981 --- “Both the theory and the practice of supply-side economics are seriously flawed.” _Reaganomics: Supply-Side Economics in Action_, by Bruce Bartlett. Arlington House, Westport, Conn., 207 pp., $14.95. Bruce Bartlett’s _Reaganomics: Supply-Side Economics in Action_ attempts to provide the most thorough, carefully reasoned, and well-documented case for supply-side economics to date. When viewed in these terms the book must be considered a success, for Bartlett expresses his ideas clearly and supports them with some fairly convincing evidence. This book will probably stand for quite some time as the standard reference on supply-side economics. When viewed in terms of a guide to economic theory and policy, however, _Reaganomics_ is lacking in both substance and depth. Only a reader’s natural sympathy for tax cuts prevents much of this book from appearing to be an extended series of apologetics for the Republican Party. Nonetheless, Bartlett has performed a valuable service for both the advocates and the critics of supply-side theory and policy. By making the strongest case possible for supply-side economics, he has laid out its strengths and weaknesses for all to see. Bartlett clearly deserves to be classified as one of the “rational” supply-siders — à la Paul Craig Roberts — and not as one of the “mystical” supply-siders—George Gilder and Jude Wanniski. Say’s Law and the Laffer Curve are not presented as the keys to unlocking the secrets of the universe, but rather as just some of the good, old-fashioned tools of economic theory. Absent are the wild discussions about sexuality, “potlatching,” and the cosmos that characterize _Wealth and Poverty_; as well as the Wanniskiesque implication that the Laffer Curve is both a category of human action and the primary ruling force in human history. To Bartlett, Say’s Law and the Laffer Curve are perhaps the two most important ideas in economics. In his initial description of supply-side economics, Bartlett says: “In many respects, supply-side economics is nothing more than classical economics rediscovered. More particularly, it is Say’s Law of Markets rediscovered. The essence of Say’s Law, named for the great French economist Jean-Baptiste Say, is that goods are ultimately paid for with other goods. Thus it is production which limits the satisfaction of human wants, not the ability to consume.” The Laffer Curve, the second tool in the supply-side bag of tricks, implies that there are always two tax rates which will bring in the same amount of revenue. Either a high tax rate on a low tax base or a low tax rate on a high base yields the same amount of tax money. Hence—on the right-hand side of the curve—a cut in tax rates will increase tax revenue by creating incentives and broadening the tax base. Most of the supply-side criticism of modern Keynesian economic theory is based upon these two principles. Keynesians treat “effective demand” — consumption + investment + government spending — as the chief determinant of macroeconomic activity, and government manipulation of these variables through monetary and fiscal policies is supposed to bring the economy to a state of full employment and to boost economic growth. The supply-siders object to this model because it does not focus enough attention on the economy’s ability to produce an adequate _supply of goods_ and services (hence the name _supply-side economics_). Say’s Law implies that without a corresponding increase in production, any increase in demand can only result from an artificial stimulation of certain economic variables, such as the money supply. Tampering with the market process cannot increase productivity but will only create inflation. The supply-side treatment of the issues of incentives and the Laffer Curve is also an important departure from the neoclassical-Keynesian orthodoxy. Neoclassical economists are unable to predict whether an increase in personal income tax rates will diminish an individual’s work effort (the “substitution effect”) because it is equally likely that his desire for a given income level will drive him to work even more (the “income effect”). Bartlett and other supply-siders argue that an increase in taxes definitely will decrease an individual’s supply of labor. While the supply-siders have never been fully successful at refuting the neoclassical argument on theoretical grounds — Bartlett’s attempt can be found on page 10—the performance of the welfare state in the twentieth century would seem to indicate on empirical grounds that the supply-siders are right. These criticisms of standard economic theory are basically well-taken and Bartlett also avoids many of the theoretical errors that other supply-siders have made. The most important of these is the now-common confusion between the in-effectiveness of government management of demand in promoting prosperity and the effectiveness of _market_ demand in directing economic activity. The failure of the former does not imply the impotence of the latter. Unfortunately, after reading Bartlett’s summary of supply-side economics, one gets the peculiar feeling that there is precious little there besides Say’s Law and the Laffer Curve. If supply-side economics ever wishes to succeed beyond the level of a few short-run policy victories, it needs to develop a fairly sophisticated body of economic theory. Its current failure to do so is one reason why it commands little respect in the academic community. If all supply-side economics consists of is cutting taxes and increasing productivity — as _Reaganomics_ would seem to indicate—then it should stop parading as an independent school of economic thought and content itself with merely being an addendum or an improvement to be fitted into some other body of economic theory. The different visions of supply-side economics range from the more metaphysical (Gilder) to the more empirical (Bartlett). At Bartlett’s end of the spectrum, there is much less to criticize but there is also much more being said. After Bartlett’s first chapter tells us what supply-side economics is, he spends several chapters showing us exactly how high marginal tax rates are and what their effect has been on production. Bartlett correctly treats welfare payments as the economic equivalent of a high marginal tax rate in kind, for any effort the welfare recipient makes to earn income will deprive him of welfare benefits. For instance, a worker capable of either earning $10,000 in the labor market or receiving $8,000 in welfare is facing an effective marginal tax rate of 80 percent since his $10,000 job will only yield a real increase of $2,000 in income. These chapters are filled with charts and diagrams giving information about our current tax system—perhaps the book’s most useful feature. There are different sections on the progressivity of tax rates, the inflationary phenomenon of “bracket creep,” the underground economy, and regional growth and decline. In several instances, Bartlett’s analysis goes far beyond what one would expect from a current book on economic policy bearing Ronald Reagan’s name. There is an entire chapter attacking econometrics from a somewhat “Austrian” point of view. In several other places, Bartlett makes some excellent points about war and militarism — “Historically, tax systems come into being during wartime. The enormous war-spawned revenue demands of government can only be met by unprecedented tax rates on all citizens;” and: “\[World War I\] not only led to a vast increase in tax rates but made the income tax an institution. As Gerald Carson put it: ‘World War I built an acceptance for the income tax that would probably never have occurred otherwise, since paying soon became an act of patriotism.’” In spite of the book’s good points, there are strong middle-of-the-road and sometimes statist tendencies within _Reaganomics_. Bartlett criticizes all those who “... argue against tax cuts because they are inflationary or who demand matching spending cuts. ...” Now, while it is true that a tax cut with no corresponding cut in spending may be better than no tax cut at all, one should not go as far as Bartlett, who argues that “deficits _per se_ are not harmful to the economy.” This is true only in a narrow, almost absurd sense, and is equivalent to arguing, “Printing paper money, _per se_, isn’t harmful. It’s only harmful when the government puts it into circulation.” In his section on work and welfare, Bartlett proclaims his desire to develop “... a social welfare system which aids the truly needy while providing the maximum incentive to work. ...” Later on in the chapter he endorses David Stockman’s guaranteed-annual-income-for-children plan as a means for achieving this end. No matter how anti-interventionist Bartlett may try to be, like most other supply-siders he can scarcely resist sounding gleeful about the realization that a tax cut may result in increased government revenue. At first, Bartlett is rather subdued about this particular point, only noting that a cut in marginal tax rates would bring the underground economy into the taxable sector, but later on he is proudly parading the fact that the tax cuts of the 1920s actually increased the government’s in-take of cash, and he says elsewhere that “... Hong Kong is an almost perfect example of the Laffer Curve in action — low tax rates generate high rates of real economic growth, leading to increased revenues which can be used for social welfare....” (emphasis added) The second half of _Reaganomics_ is devoted to an economic history of supply-side economics, both in America and abroad. Bartlett starts with the Harding-Mellon tax cuts of the 1920s, takes us through to the Carter administration, and then looks at the experience of such foreign countries as Great Britain, Hong Kong, and Puerto Rico. Like many historical analysts, Bartlett sees the twentieth century as a struggle between two opposing “forces” or principles. However, rather than viewing the conflict as “liberty vs. power” as a libertarian would, Bartlett sees the titanic issue of modern American history as being the Republican party vs. the Democratic party! This belief is described in detail in Chapter 14, where Bartlett says: “The thesis and antithesis of our political system are embodied in the philosophies of the two major political parties. For most of this century the Democrats won their elections and established the dominant thesis of our political system with ever-increasing government spending.” The Republican party, on the other hand, has “...clearly reestablished \[itself\] as the party of tax reduction...” and thus claimed its rightful place in history. Reaganomics does contain chapters on Harding and Coolidge (both Republicans) but, strangely enough, there is no real discussion of Nixon and Ford, our two most recent previous Republican Presidents, each of whom incurred record deficits and increased government spending at a breakneck pace. Bartlett’s book does contain historical fallacies. For instance, he proclaims, “Until the Depression, the dominant thesis in the American political system was one of laissez-faire. This did not mean that the government stayed entirely out of the economy, merely that when there was doubt about what the government should do, it tended to do nothing. Therefore, when the Depression hit and there was no clear-cut way to respond to it, the government did nothing. (or at least gave the appearance of doing nothing).” For a refutation of the myth of pre-Depression laissez-faire, see Jonathan Hughes’s _The Governmental Habit_, and for an outline of Hoover’s interventionist reaction to the Depression see Murray Rothbard’s _America’s Great Depression_. Bartlett also claims that the boom of the 1920s was caused by Andrew Mellon’s tax cuts rather than by the continual supply of artificially-created credit which the Federal Reserve pumped into the loan market during those years. For a correct analysis of the inflation of the ’20s, see Lionel Robbins’s _The Great Depression and Banking and the Business Cycle_ by Phillips, McManus, and Nelson, as well as the aforementioned Rothbard book. Almost all of Bartlett’s analysis suffers from the general flaw of almost completely disregarding monetary policy. Not only do supply-siders have many of the strengths of the classical economists, but they also have many of their weaknesses—including an inadequate appreciation for the importance of monetary policy and theory. The supply-side explanation of America’s declining productivity gives too small a role to inflation. In the last chapter of _Reaganomics_, Bartlett outlines his plan for reform of the American economy. He calls for a > “radical reduction in the overall burden of government,” but this reduction seems more gradualist than radical as it includes only an indexation of the tax code, an across-the-board cut in tax rates, a cap on government spending, and a reduction of government regulations. Bartlett shows considerable insight, however, when he warns us, “The greatest challenge of the 1980s will be to prevent supply-side economics from being perverted into an industrial policy, which would substitute government subsidies and tariffs for tax reduction or regulatory reform and put the United States on the road to centralized economic planning.” Unfortunately, this may be exactly where we are headed under the Reagan administration, despite the title of Bartlett’s book, a title which is particularly curious because he makes little attempt to tie Reagan in with supply-side economics. In fact, the manuscript was written before Reagan was elected and had previously gone through at least two titles — _Supply-Side Economics_ and the clever _Take a Walk on the Supply Side_. Although many of the people employed in the Reagan administration, or Congress (Bartlett is deputy director of the Joint Economic Committee), may be consistent supply-siders, it is clear that Reagan is not. One chink in Reagan’s supply-side armor is his fervent commitment to a sizable increase in the defense establishment, an area which diverts more capital, more research and development money, and more scientists from the private sector than any other government intervention. In 1974, for instance, the total value of all military materiel and installations was $214 billion, 38 percent of the total assets of all American manufacturing corporations. Since World War II, the American economy has spent over $200 billion on research and development, 80 percent of which has gone into either defense, space, or the Atomic Energy Commission! Is it any mystery that we are experiencing a productivity slowdown? In spite of these facts, the Reagan administration proposes to increase defense spending over the next three years by an amount greater than the entire defense budget of 1978. This year the Pentagon will spend $163 billion—by 1984 they will be spending $267 billion. It is interesting to note that Reagan’s entire proposed domestic budget cut could be swallowed up and regurgitated whole by one quarter’s unexpected price escalation for the Pentagon’s weapons systems ($47.6 billion in the last quarter of 1980). In fact, the prices for military goods are rising 50 percent faster than the underlying rate of inflation. There is absolutely no protest over the “military-industrial complex” in _Reaganomics_. Bartlett’s only mention of the topic comes when he says, “... it is (not) clear that an increase in already unprecedented tax levels will leave us with an economy strong enough to fend off the Soviets ... a strong economy is critical to a strong defense. Fortunately for the Republican Party, its nominee for President of the United States in 1980, Ronald Reagan, understands the need for tax cuts and a strong defense.” Another of Reagan’s retreats from supply-side economics came when he reneged on his campaign promise that tax reduction would begin on January 1, 1981 and pushed the date back to July 1, 1981, over concern for “revenue loss.” Reagan also overruled a Treasury-OMB proposal to immediately drop the 70 percent top tax rate on dividends and interest to 50 percent. The Kemp-Roth plan endorsed by Reagan would accomplish this goal only after three years. Even if President Reagan’s currently proposed tax plan escapes Congress unscathed, the mild change in marginal tax rates it would bring is unlikely to mean any significant tax relief at all. After accounting for inflation, the marginal tax rate for a median-income family of four will fall by only one percentage point (to 23 percent) between 1980 and 1984. For a family of four earning half the median income, the marginal rate would drop to 15 percent, only one point lower than the 1979 rate. And a family of four receiving two incomes of $22,500 and $40,000 would experience no drop in marginal rates at all! Neither the $1,000 personal exemption nor the zero bracket amount— the equivalent of the former standard deduction — will be increased, while their value will be eroded by at least 35 percent in four years due to inflation. Low-income families on a $7,500 income will actually see their marginal tax rates go up 15 percentage points because their earned income credit will decline as their income rises. Both the theory and the practice of supply-side economics are seriously flawed. They are, however, a major improvement over the Keynesian paradigm which has dominated economic theory and policy since the 1930s, and Bartlett is to be commended for writing a guide to the recent “supply-side mania.” Nonetheless, Reaganomics suffers both from a shallowness of historical insight and from an excessively cautious stance — or even silence—on many important issues, issues which contradict and are likely to torpedo the confident predictions and projections of the supply-siders. Tyler Cowen is the managing editor of _The Austrian Economics Newsletter_, published by the Center for Libertarian Studies.