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Thursday, July 25, 2013

Supply-Side Economics in One Lesson

What the Critics Don't Tell You

Henry Hazlitt’s Economics in One Lesson shows how powerful, careful thinking can debunk misguided notions about economic interventionism. But its many applications do not include some of the issues that have arisen since the post-World War II era. Supply-side economics—one of the most misrepresented economics topics in memory—is one such issue.

As I explain in my course on macroeconomics, the term “supply-side” was intended to differentiate an economic way of thinking that did not depend on the Keynesian obsession with controlling aggregate demand. Supply-siders insisted that while there may be policy effects on the demand side, one cannot ignore the consequences of the changes such policies make to the incentives of suppliers and entrepreneurs. 

For example, changes in marginal tax rates affect cooperation between suppliers and buyers. So increasing tax rates on “the rich” to transfer the same amount to “the poor” would have no effect in the Keynesian aggregate framework, because it does not change net taxes or disposable income in the household sector as a whole. But supply-siders know such policies change the incentives facing both groups—resulting in negative outcomes. Higher tax rates for “the rich” and unearned income for the poor—both reduce incentives to create additional effort or to be more productive.

In essence, supply-side economists hold that “supply matters, too,” whereas the dominant Keynesian approach ignores this aspect of the economy. 

Supply-side economics also grew out of classical economists’ longer-term view of growth, because altering incentives now changes behavior, which changes economic growth potential. Whatever Keynes thought, in the long run, real economic growth is the prime determinant of well-being. But in the public discussion (or distortion) of supply-side economics, Keynesians largely bypass such issues and violate Hazlitt’s lesson, which he offers in the opening chapter of Economics in One Lesson:

The art of economics consists in looking not merely at the immediate but at the longer effects of any action or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.

Supply-side economics has built on this insight. But many economists today, following Keynes, fail to look carefully at Keynesianism’s long-term effects—not to mention immediate effects—such as the perverse consequences to all affected groups. Supply-side economics adds a corollary to Hazlitt’s definition, tracing not just the impact on all groups, but the impact over the many margins of choice that will be affected.

In Hazlitt’s opening chapter, he also points to an important reason why such basic principles are so often violated in politics:

Bad economists [who ignore his lesson] rationalize this intellectual debility and laziness by assuring the audience that it need not even attempt to follow the reasoning or judge it on its merits, because it is only “classicism” or “laissez-faire” or “capitalist apologetics” or whatever other term of abuse may happen to strike them as effective.

It’s the same story with supply-side economics, because the commonly used pejoratives—“trickle-down economics,” “tax giveaways for the rich,” and “voodoo economics” (and its “deja voodoo economics” variant)—reveal ways in which its opponents failed, often intentionally, to heed Hazlitt’s lesson. 

And yet they have mastered the lesson that bad economics is often good politics. (One need only read The New York Times’s favorite economist to see why.)

Take the term “trickle-down economics,” which no supply-side economist ever used. The false assumption is that taxing high-income earners less only benefits those earners, except of course when the rich spend some of that income to buy goods and services from the rest of us. It also assumes a zero-sum trade-off out of total measured income: more for “the rich” has to be taken from everyone else. That narrative gets support from snapshot income-distribution figures in which a higher share of income to “the rich” is used to suggest they benefitted themselves at others’ expense. 

When people, however rich or poor, get richer through voluntary arrangements, they do not hurt anyone except the envious. Everyone is better off. They benefit each other—as is the nature of market arrangements. And changes in the measured “percentage distribution” of income do not accurately represent the consequences to any given group. 

If I create a massively successful software program, my measured real income will be greater, but all the buyers will also be better off because they face better options than before (using my cool software, which might even make everyone more productive long term). This holds true even if, at any point in time after buying the program, their share of total income is lower. 

So redistribution fans’ campaigns to punish the rich by exploiting envy moves the debate away from the central question—are others helped or hurt? Worsening the productive incentives of high-income people induces them to do less for others, making people worse off than they might otherwise have been. On the other hand, if a rich person gets richer by rigging the political process—say by getting stimulus funds to build a boondoggle—that is certainly objectionable. But it is not a market failure at all. In fact, it’s Keynesian economics par excellence. And the solution is to get the government out of the theft-and-transfer business. (Using perceived unfairness as an excuse to tax high-income earners more heavily just glosses over the bad fiscal policies that make all the cronyism possible.)

“Tax giveaways to the rich” was another denigrating description of supply-side economics. That term emphasizes looking only at the short run, which is of course where politicians’ incentives all lie. Economic growth, however, is the most important variable in long-run determinants of well-being. To get robust economic growth, you need to improve productivity. To do that, you need to establish good incentives for rich and poor alike—and to improve incentives wherever possible.

Supply-siders focus on making productive incentives permanently better for everyone, and reducing tax rates and regulatory burdens does the most good for incentives. The immediate benefits will, it’s true, go to the people who own the assets affected by those changes. Present and anticipated gains will be capitalized into those assets’ prices. Those owners are mostly going to be wealthy people. But treating that fact as solely a “tax giveaway to the rich” ignores that what is primarily rewarded is doing more that others value, making those others better off. The greater economic output that results will benefit everyone. But the effects often take some time to come to fruition. That should be fine: Sound economics is always about wisely and productively creating the future. Living for the now is like thinking your credit card has no limit and you’re going to die tomorrow. Unfortunately, legislating for now, despite adverse consequences for the future, is often a good way to get votes.

Then there’s another term that suggests supply-siders don’t live in the real world. “Voodoo economics” implies that the analysis involves some bogus “magical” assumptions that could not possibly be true. This term was used to imply that lowering tax rates on those who are heavily taxed cannot possibly increase the tax revenue from them. 

In particular, critics emphasize that estimates of labor supply elasticities (how much more people work in response to changes in take-home wages) are far too low to support large supply-side effects. But those estimates look only at the short run and do not incorporate the longer-term effects of permanently improved incentives on upward mobility, investment, formal and informal education, tax evasion and cheating, and other choices that will change.

Looking at long-term labor supply responses to incentives generates a very different picture than that for a smaller time slice. Nobel Prize-winning economist Edward Prescott found that long-term labor responses are far greater. With regard to supply-side incentives, he says: “I find it remarkable that virtually all of the large [nearly 30%] difference in labor supply between France and the United States is due to differences in tax systems.”

Further, supply-side opponents dramatically misrepresent the effects of reducing tax rates by focusing on near-term labor supply as if it is the only relevant variable. Behavior will change at other margins. Permanently lower tax rates might not produce great changes in the current year. But the lower rates mean workers who acquire higher-margin returns keep more of those gains than before. So they have a stronger incentive to invest and acquire those skills (through education, on-the-job training, etc.), increasing overall human capital. In parallel, employers can make capital investments to increase worker productivity. Better incentives will increase how many secondary workers there will be in households and how much they will work. And workers may have incentives to delay retirement, expanding the lifetime labor supply.

The lower rates, in short, reduce disincentives to engage in productive risk-taking by shrinking the tax penalty on those risks that pay off. They reduce the incentive for people to choose things they might desire less, simply because of tax deductibility—distortions which are greater the higher the tax rate. Lower tax rates also reduce tax evasion and tax cheating. They can even cause the in-migration of productive people from less-friendly tax and regulatory climates. 

Recognizing all the dimensions at which people’s actions will be affected paints a very different picture than the far more blinkered view supply-side opponents take. In addition to underestimating the effects of supply-side policies, this narrow view understates the costs of interventionist policies. When government policy distorts people’s choices, it causes a welfare cost to society—the difference between what people really want and what the distorted incentives created by government intervention led them to choose instead.

One cannot honestly prove that improvements in incentives do not expand productive behavior, benefitting others, because that contradicts one of the most basic economic realities. The embellished version of Hazlitt’s lesson (examine the effects of a policy on all groups… over all margins of choice that will be affected) suggests a basic test that should be applied to every political proposal, not just those related to supply-side economics. 

In other words, whenever you see the truth being distorted or effects being ignored to “sell” you some political proposal, its backers either don’t know enough to competently evaluate their own positions or they are lying to you. And since the best way to demonstrate that a truly good idea advances the “general welfare” is to accurately present the whole truth, both possibilities tell you not to “buy” the political line that is being sold.

  • Gary M. Galles is a Professor of Economics at Pepperdine University and a member of the Foundation for Economic Education faculty network.

    In addition to his new book, Pathways to Policy Failures (2020), his books include Lines of Liberty (2016), Faulty Premises, Faulty Policies (2014), and Apostle of Peace (2013).